Term
| Why must potential projects be ranked? |
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Definition
| Because investment capital is a scarce resource. |
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Term
| corporate performance measure (main one) |
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Definition
| The success or failure of an entity in achieving the desired return for its stakeholders. |
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Term
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Definition
| firm's ability to pay its noncurrent obligations as they come due and thus remain in business over the long-run |
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Term
| When sufficient resources are available... |
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Definition
| every project with a positive NPV should be undertaken. |
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Term
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Definition
| management needs a tool to determine which investments provide not necessarily the highest total return, but the highest per dollar invested |
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Term
| profitability index (PI) (or excess present value index) |
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Definition
| method for ranking projects to ensure that limited resources are places with the investments that will generate the higher return per dollar invested |
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Term
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Definition
| NPV of project / initial investment |
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Term
| When the initial investment is the same, which independent project is accepted? |
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Definition
The independent project with the higher NPV is the project with the higher profitability index.
Therefore, PI always yields the same accept/reject decisions for independent projects as the NPV method (and IRR method). |
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Term
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Definition
| a firm's ability to remain in business in the long-run |
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Term
| When sufficient resources are available... |
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Definition
| every project with a positive NPV should be undertaken. |
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Term
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Definition
| management needs a tool to determine which investments provide not necessarily the highest total return, but the highest per dollar invested |
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Term
| profitability index (PI) (or excess present value index) |
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Definition
| method for ranking projects to ensure that limited resources are places with the investments that will generate the higher return per dollar invested |
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Term
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Definition
| NPV of project / initial investment |
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Term
| When the initial investment is the same, which independent project is accepted? |
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Definition
The independent project with the higher NPV is the project with the higher profitability index.
Therefore, PI always yields the same accept/reject decisions for independent projects as the NPV method (and IRR method). |
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Term
| What ratios measure the return generated for a corporation's owners? |
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Definition
| ROI, in % or residual income, in $. |
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Term
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Definition
| operating income / avg. invested capital |
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Term
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Definition
| (operating income / sales) * (sales / avg. invested capital) |
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Term
| If ROI > cost of capital... |
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Definition
| firm is adding to shareholder wealth. |
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Term
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Definition
| operating income – target return on invested capital |
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Term
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Definition
| asset (investment) turnover * return on sales (or profit margin) |
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Term
| If ROI = cost of capital... |
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Definition
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Term
| ROI vs. Residual Income (card 1) |
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Definition
| IRR is similar to ROI and NPV is similar to residual income. |
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Term
| ROI vs. Residual Income (card 2)- advantages of ROI |
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Definition
Like IRR, ROI is a % measure and, like NPV, residual income is a monetary measure.
Like IRR, ROI is a very popular tool b/c it allows quick and easy comparisons with other %-based measures such as the firm's cost of capital and the ROIs of other competitors. |
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Term
| ROI vs. Residual Income (card 2)- disadvantages of ROI |
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Definition
However, also like IRR, ROI leads to the temptation to reject capital projects that would decrease the ROI in spite of the fact that they would increase shareholder wealth.
Dealing in absolute dollars rather than %s forces management to consider all decisions in the light of increasing shareholder wealth, not just historical % returns. |
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Term
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Definition
NI / average total assets
NI = net income |
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Term
| earnings per share (EPS) & formula |
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Definition
measures the amount of current-period earnings that can be associated with a single share of a corporation's common stock
EPS = (NI – preferred dividends) / common shares outstanding |
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Term
| income available to common shareholders |
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Definition
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Term
| return on common equity (ROCE) & formula |
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Definition
measures income earned per dollar invested by common shareholders.
ROCE = (NI – preferred dividends) / avg. common equity |
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Term
| price-earnings (PE) ratio & formula |
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Definition
amount that investors are willing to pay for $1 of the company's earnings
P/E = PPS / EPS
PPS = market price per share |
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Term
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Definition
| higher confidence of the market in the company's ability to grow and produce higher returns for the investors |
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Term
| economic rate of return on common stock (ERORCS) & formula |
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Definition
amount of shareholder wealth generated during a period of time relative to the amount invested
ERORCS = (dividends paid + change in stock price) / beginning stock price |
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Term
| economic value added (EVA) & formula |
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Definition
EVA represents a business unit's true economic profit b/c a charge for the cost of equity capital is implicit in the WACC.
after-tax operating income + (investment * WACC).
investment = debt + equity |
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Term
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Definition
| opportunity cost; the return that could have been obtained on the best alternative investment of similar risk |
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Term
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Definition
| EVA measures the marginal benefit obtained by using resources in a particular way; it is useful for determining whether a business segment is increasing shareholder value. |
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Term
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Definition
| EVA also allows for R&D costs to be capitalized and amortized for its purposes, and true economic depreciation rather than the amount used for accounting or tax purposes may be recognized. Adjustments will vary from firm to firm. |
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Term
| key ingredients of solvency |
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Definition
| firm's capital structure and degree of leverage (DOL) |
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Term
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Definition
| external sources; creditor interest in the firm and a contractual obligation to repay |
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Term
| When is debt financing advantageous? |
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Definition
| If return on debt > interest paid, debt financing is advantageous. Interest payments on debt are tax-deductible. |
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Term
| Is debt financing or equity financing riskier for the issuer? |
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Definition
| While debt is less risky for a creditor than equity is for the shareholder, debt is riskier than equity for the issuer b/c interest rate will either eventually be higher or creditors will refuse to loan more money. |
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Term
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Definition
| internal sources; ownership interest in the firm. It is permanent capital of an entity. |
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Term
| Debt payments (return on debt) are guaranteed to creditors through a contractual obligation to repay. Do shareholders have any of the same guarantees? |
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Definition
| No. ROE is uncertain b/c it embodies only a residual interest in the firm (after all debt has been satisfied). |
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Term
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Definition
| periodic returns to owners of excess earnings. Contractually obligated to pay preferred dividends (par value * preferred rate) but not common dividends. |
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Term
| How does the capital structure (mix of debt and equity) affect the firm's risk? |
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Definition
| higher debt % = higher risk |
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Term
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Definition
| When relative amount of debt is high, equity investors demand a higher rate of return; when relative amount of equity is high, creditors will accept lower interest in exchange for the equity cushion. |
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Term
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Definition
Unless specified otherwise, total is implied.
debt/assets
debt/capital
debt/equity
LTD/equity
LTD = long-term debt
debt/assets = debt/capital |
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Term
| Should capital structure ratios be higher or lower? |
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Definition
Credtors prefer low debt/capital and debt/equity ratios because that suggests a higher equity cushion and thus better chances of repayment.
A low LTD/equity ratio means that a firm will have an easier time raising new capital b/c of a lower debt load.
debt/assets = debt/capital |
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