Finance - Core

Question 1

Capital Budgeting Buy vs. Lease Finance Core – Level B

Answer 1

•Calculate NPV of each option and compare to determine which option is cheapest
•NPV of buy option – consider:
-Cost of asset
-PV of tax shield
-Maintenance costs

•NPV of lease option – consider:
-PV of after tax lease payments

•Qualitative factors to consider:

• Impact on covenants
• Cash flows (leasing lessens the current cash burden)
• Leasing may be easier to come by if company has trouble obtaining financing
• Purchasing the asset might provide more flexibility (ownership of asset)
• Leasing might insulate company from severe declines in asset value
• Possible tax advantages (no capital leases for tax purposes – CRA sees all leases the same so cash payments would be deductible, however no CCA)

Question 2

Financing Options – Debt vs. Equity Finance Core – Level B

Answer 2

• Debt financing options:

• Loan- consider loan term, and security/collateral required
• Lease
• Government assistance

• Equity financing options:

• Angel investors- can be friends or family looking for a return on investment; generally passive investors
• Venture capitalists- professional investment funds, looking for superior returns (>30%); active participants in management, with a clear exit strategy
• Private equity- tends to participate later in business lifecycle, hence lower risk
• Public markets

Question 3

Incremental Cash Flows Finance Core – Level B

Answer 3

• Incremental cash flows comprise the additional cash flows from taking on a new project, incorporating the tax-affected initial outlay, annual revenues & expenses and terminal value (or cost) associated with the project, in accordance with the scale and timing of the project
• When determining incremental cash flows from a new project, consider:
• Sunk Costs – These are the initial outlays that cannot be recovered even if a project is accepted. As such, these costs will not affect the future cash flows of the project and are not considered incremental
• Opportunity Costs – These represent any potential loss of current cash flows due to accepting a new project and are considered incremental
• Cannibalization – This is the opportunity cost where a new project takes sales away from an existing product
• Working Capital Changes – These represent changes in receivables, payables and inventory due to accepting a new project and are therefore considered incremental

Question 4

Net Present Value (NPV) vs. Internal Rate of Return (IRR) Finance Core – Level B

Answer 4

• The NPV rule states that you invest in any project which has a positive NPV when its cash flows are discounted at the opportunity cost of capital, also known as the discount rate (usually the cost of raising the capital to fund the project)
• The IRR rule states that you invest in any project offering a rate of return which exceeds the opportunity cost of capital
• A project’s rate of return is calculated as the discount rate at which the NPV of the project would be zero
• Therefore, the NPV and IRR rules should give the same accept/reject answer about a project, in most circumstances
• A project’s cash flows should include incremental elements only (i.e. additional sales, associated expenses, lost margin on cannibalization, investment & associated tax-shield, etc., but no financing elements, as discounting of the cash flows already addresses financing)

Question 5

Discounted vs. Undiscounted Cash Flows Finance Core – Level B

Answer 5

• Incremental cash flows (excluding financing elements) should be discounted to recognize the time value of money for the purposes of making a decision regarding accepting or rejecting a project
• Incremental cash flows (including financing elements) should be analyzed year over year, without discounting, to determine if a certain cash position would be met by a certain time

Question 6

Payback Period Finance Core – Level A

Answer 6

• Payback period is the time in which the initial cash outflow of an investment is expected to be recovered from the cash inflows generated by the investment
• In general, investments with lower payback period are preferred
• To determine, calculate the cumulative net cash flow for each period and then use the following formula for payback period:
Payback Period = A + B / C, where:
- A is the last period with a negative cumulative cash flow;
- B is the absolute value of cumulative cash flow at the end of the period A; and
- C is the total cash flow during the period after A.

Question 7

Financial Ratio Analysis Finance Core – Level A

Answer 7

Financial ratios are categorized according to the financial aspect that the ratio measures:
• Liquidity ratios measure the availability of cash to pay short-term debts.
E.g., Current ratio, Quick ratio, Working capital ratio
• Asset turnover ratios measure efficiency in utilizing assets. E.g., accounts receivable turnover, inventory turnover
• Profitability ratios measure how well assets are used and expenses are controlled to generate a return. E.g., gross profit margin, net profit
• Debt service ratios measure the ability to repay long-term debt. E.g., debt to equity, times interest earned, debt to assets

Ratios generally are not useful unless they are benchmarked against something else such as past performance or another organization. Therefore, the ratios of organizations in different industries, which face different risks, capital requirements, and competition, are usually hard to compare.