Corporate Finance Test 2
present value of growth opportunities (PVGO)
- net present value of a firm's future investments - price difference of a company's growth and non-growth values ( ex from above: 100 - 55.53 = 44.4 )
primary market
market for the sale of new shares by corporations (ex: IPO)
secondary market
market in which previously issued shares are traded among investors
forecasted cash flows
net present value depends solely on the ______ ______ ______ from the project and the opportunity cost of capital
book value
net worth of the firm according to the balance sheet
common stock
ownership shares in a publicly held corporation
dividend
periodic cash distribution from the firm to the shareholders
P/E ratio
price per share dividend by earnings per share
U.S. Tax Cuts and Jobs Act
what act dropped the corporate tax rate from 35% to 21% in 2018?
1. easy to understand 2. adjusts for uncertainty of later cash flows 3. biased toward liquidity
what are 3 advantages of payback?
Internal rate of return rule
invest in any project offering a rate of return that is higher than the opportunity cost of capital
true
(T/F): a dollar today is worth more than a dollar tomorrow
True - profitability index
(T/F): a set of limited resources and projects can yield various combinations
True (depreciation)
(T/F): new law allows companies to take bonus depreciation to write off 100% of investment immediately - it is a temporary provision and will soon start to phase out
Project E (look at NPV over IRR, Project E has a much higher NPV)
if Project D has an IRR of 100% and NPV of +8,182, and Project E has an IRR of 75% and NPV of +11,818, which project is the better choice?
117.36 0 1 2 I--------I--------I 0 6.00 6.50 + 134 140.5 CF0 = 0 CF1 = 6.00 CF2 = 140.5 NPV, i=12, Compute = 117.36
Company A is forecasted to pay a $6.00 dividend at the end of year 1 and a $6.50 dividend at the end of year 2. At the end of the 2nd year the stock will be sold for $134. If the discount rate is 12%, what is the price of the stock?
a) 3.5% b) 9.8% a) r = (Div1 / P0) + g = (3.00 / 85.7) + 0 = 0.035 = 3.5% b) r = (Div1 / P0) + g = (3.00 / 85.7) + 0.063 = 0.098 = 9.8%
Company B stock was selling for $85.7 per share at the start of 2015. Dividend payments for the next year were expected to be $3.00 a share. a) what is the expected return (r), assuming no growth? b) what is the expected return (r), assuming 6.3% growth?
7.91 0 1 2 3 4 5 I-----I-----I-------I-------I------I 0 0 0.24 0.48 0.68 0.84 0.84 / (0.11 - 0.03) = 10.5 CF0 = 0 CF1 = 0 CF2 = 0.24 CF3 = 0.48 CF4 = 0.68 + 10.5 = 11.18 NPV, i=11, Compute = 7.91
Company C produces dividends in 4 consecutive years of 0, 0.24, 0.48, and 0.68, respectively. The dividend in year 5 is estimated to be 0.84 and should grow in perpetuity at 3%. Given a discount rate of 11%, what is the price of the stock?
$75 CF0 = 0 CF1 = 3 CF2 = 3.24 CF3 = 3.50 + 94.48 = 97.98 NPV, i=12, Compute = 75
Current forecasts are for XYZ Company to pay dividends of $3, $3.24, and $3.50 over the next three years, respectively. At the end of three years you anticipate selling your stock at a market price of $94.48. What is the price of the stock given a 12% expected return?
$100 0 1 2 I--------I--------I 0 5 5.50 + 121 126.50 CF0 = 0 CF1 = 5.00 CF2 = 126.50 NPV, i=15, Compute = 100
Fledgling Electronics is forecasted to pay a $5.00 dividend at the end of year one and a $5.50 dividend at the end of year two. At the end of the second year the stock will be sold for $121. If the discount rate is 15%, what is the price of the stock?
0.9 0 1 2 3 4 5 6 7 I-----I-----I-----I-----I------I-------I-------I 0 0 0 0 0.42 0.46 0.50 [1.09...........] PV of near term cash flows: 0 + 0 + 0 + (0.42/(1.10)^4) + (0.46/(1.10)^5) + (0.50/(1.10)^6) = 0.9
Given the cash flows for Concatenator Manufacturing Division, calculate the PV of near term cash flows, PV (horizon value), and the total value of the firm when r=10% and g=6%. Assume horizon value is at year 7. CF0 = 0 CF1 = 0 CF2 = 0 CF3 = 0 CF4 = 0.42 CF5= 0.46 CF6 = 0.50 CF7 = 1.09
15.4 0 1 2 3 4 5 6 7 I-----I-----I-----I-----I------I-------I-------I 0 0 0 0 0.42 0.46 0.50 [1.09...........] horizon value = FCF = 1.09 (r-g) (0.10-0.06) = 27.3 PV of horizon value = 27.3 / (1.10)^6 = 15.4
Given the cash flows for Concatenator Manufacturing Division, calculate the PV of near term cash flows, PV (horizon value), and the total value of the firm when r=10% and g=6%. Assume horizon value is at year 7. CF0 = 0 CF1 = 0 CF2 = 0 CF3 = 0 CF4 = 0.42 CF5= 0.46 CF6 = 0.50 CF7 = 1.09
16.3 CF0 = 0 CF1 = 0 CF2 = 0 CF3 = 0 CF4 = 0.42 CF5 = 0.46 CF6 = 0.50 + 27.3 = 27.8 ( + horizon value ) NPV, i=10, Compute = 16.3 or: PV of horizon value + PV of near term cash flows 15.4 + 0.9 = 16.3
Given the cash flows for Concatenator Manufacturing Division, calculate the PV of near term cash flows, PV (horizon value), and the total value of the firm when r=10% and g=6%. Assume horizon value is at year 7. CF0 = 0 CF1 = 0 CF2 = 0 CF3 = 0 CF4 = 0.42 CF5= 0.46 CF6 = 0.50 CF7 = 1.09
$100 P0 = (DIV1 + P1) / (1 + r) P0 = (5.00 + 110) / (1.15)^1 P0 = 100
If Fledgling Electronics is expected to sell for $110 one year from now, what is the price of this stock today if the dividend one year from now is forecasted to be $5.00 and expected return equals 15%?
15% r = (DIV1 + P1 - P0) / P0 r = (5.00 + 110 - 100) / 100 r = 0.15 r = 15%
If Fledgling Electronics is selling for $100 per share today and is expected to sell for $110 one year from now, what is the expected return if the dividend one year from now is forecasted to be $5.00?
increase
If a firm elects to pay a lower dividend and reinvest the funds, the stock price may ________ because future dividends may be higher
11.8% r = (Div1 / P0) + g = (2 / 49.43) + 0.077 = 0.118
Northwest Natural Gas stock was selling for $49.43 per share at the start of 2015. Dividend payments for the next year were expected to be $2.00 a share. What is the expected return (r), assuming a growth rate of 7.7%?
4.1% r = (Div1 / P0) + g = (2 / 49.43) + 0 = 0.041
Northwest Natural Gas stock was selling for $49.43 per share at the start of 2015. Dividend payments for the next year were expected to be $2.00 a share. What is the expected return (r), assuming no growth?
before: 55.53 after: 100 before (no growth): 8.33 / 0.15 = 55.53 after (with growth): g = plowback x ROE = 0.40 x 0.25 = 0.10 = 10% growth 60% x 8.33 = 5.00 = new dividend P0 = Div1 / (r-g) = 5.00 / (0.15 - 0.10) = 5.00 / 0.05 = 100
Our company forecasts to pay a $8.33 dividend next year, which represents 100% of its earnings. This will provide investors with a 15% expected return. Instead, we decide to plowback 40% of the earnings at the firm's current return on equity of 25%. What is the value of the stock before and after the plowback decision?
9.13 1 2 3 4 I--------I---------I----------I 0 0.31 0.65 0.67 PH = DivH / (r-g) = 0.67 / (0.10-0.04) = 11.17 CF0 = 0 CF1 = 0 CF2 = 0.31 CF3 = 0.65 + 11.17 = 11.82 NPV, i=10, Compute = 9.13
Phoenix produces dividends in three consecutive years of 0, 0.31, and 0.65, respectively. The dividend in year four is estimated to be 0.67 and should grow in perpetuity at 4%. Given a discount rate of 10%, what is the price of the stock?
NPV
What decision rule should be the primary decision method?
28.0776 rate of return = payoff / investment -1 CF0 = -4,000 CF1 = 2,000 CF2 = 4,000 IRR, Compute = 28.0776
You can purchase a turbo-powered machine tool gadget for $4,000. The investment will generate $2,000 and $4,000 in cash flows for two years, respectively. What is the IRR on this investment?
dividend growth rate
___________ can also be derived from applying the return on equity to the percentage of earnings plowed back into operations
reject
accept/reject: IRR < discount rate
accept
accept/reject: IRR > discount rate
-2,758.72 CF0 = -100,000 CF1 = 25,000 Frequency = 5 NPV, i=9, Compute = -2,758.72
an investment costs $100,000 and has a cash inflow of $25,000 every year for 5 years. the required return is 9%, and required payback is 4 years. a) what is the payback period? b) what is the NPV? c) What is the IRR? d) should we accept the project?
4
an investment costs $100,000 and has a cash inflow of $25,000 every year for 5 years. the required return is 9%, and required payback is 4 years. a) what is the payback period? b) what is the NPV? c) What is the IRR? d) should we accept the project?
7.93 CF0 = -100,000 CF1 = 25,000 Frequency = 5 IRR, Compute = 7.93
an investment costs $100,000 and has a cash inflow of $25,000 every year for 5 years. the required return is 9%, and required payback is 4 years. a) what is the payback period? b) what is the NPV? c) What is the IRR? d) should we accept the project?
no NPV = negative = reject IRR = less than discount rate = reject
an investment costs $100,000 and has a cash inflow of $25,000 every year for 5 years. the required return is 9%, and required payback is 4 years. a) what is the payback period? b) what is the NPV? c) What is the IRR? d) should we accept the project?
limit order
an order to buy or sell shares at a predetermined price, to be executed when the market price reaches the requested price
market order
an order to buy or sell shares at the best currently available market price
dividend discount model
computation of today's stock, price which states that share value equals the present value of all expected future dividends
future cash flows
dividends represent the ____ _____ ______ of the firm
market value balance sheet
financial statement that uses market value of assets and liabilities
dividends; sales price
for a stock, the future cash flows are _________ and the ultimate ______ _______ of the stock
plowback ratio
fraction of earnings retained by the firm
2 possible IRRs
how many IRRs are possible for the following set of cash flows? CF0 = -$1,000, C1 = $500, C2 = -$300, C3 = $1,000, C4 = $200
you ignore it first and calculate NPV. afterwards, you can see which financing method (all equity or using debt) gives you a better alternative
how should you treat the proceeds from the debt issue and the interest and principal payments on the debt?
payout ratio
ratio of dividends to earnings per share
sustainable growth rate
steady rate at which a firm can grow: plowback ratio x return on equity
highest
the (lowest/highest) weighted average PI (profitability index) can indicate which projects to select?
payback period
the _______ _______ of a project is the number of years it takes before the cumulative forecasted cash flow equals the initial outlay (number of years to recover your original investment)
payback rule
the _______ ________ says only accept projects that "payback" in the desired time frame
bid-ask price
the difference between the bid price and the ask price
Internal Rate of Return (IRR)
the discount rate at which NPV = 0
operating cash flow (OCF)
the net increase in sales revenue from the new project less outlays
how many IRRs
the number of (-) cash flows indicates what?
expected return
the percentage yield that an investor forecasts from a specific investment over a set period of time
present value
the price of any share of stock can be thought of as the ______ _______ of the future cash flows
ask price
the prices at which current shareholders are willing to sell their shares
bid price
the prices at which investors are willing to buy shares
capital investment
the up-front investment in plant, equipment, research, start-up costs, and diverse other outlays
terminal value
the valuation horizon is sometimes called the _____ ______ and is calculated like PVGO
valuation horizon (H)
the value of a business or project is usually computed at the discounted value of free cash flows out to a _______ _______
investment in working capital
this represents a negative cash flow
depreciation, capital expenditure
to determine cash flow from income, add back ___________ and subtract _________________
TTM
trailing twelve months
1. Ignores the time value of money 2. Requires an arbitrary cutoff point 3. Ignores cash flows beyond the cutoff date 4. Biased against long-term projects, such as research and development, and new projects
what are 4 disadvantages of payback?
1. change in CF sign -- multiple IRRs 2. mutually exclusive projects 3. there is more than one opportunity cost of capital
what are the 3 pitfalls of internal rate of return?
NPV and IRR
what are the most commonly used primary investment criteria?
1. capital investment 2. operating cash flow 3. investment in working capital
what are the three elements of project cash flows?
capital expenses and working capital
what are the two aspects of applying the net present value rule, rule 1: discount cash flows, not profits?
1. calculate NPV for each project 2. calculate PI = NPV / investment
what are the two steps to calculate profitability index?
1. knowing a return is intuitively appealing 2. it is a simple way to communicate the value of a project to someone who doesn't know all the estimate details 3. if the IRR is high enough, you may not need to estimate a required return, which is often difficult
what are three advantages of IRR?
1. easy to understand and communicate 2. useful when available investment funds are limited
what are two advantages of profitability index?
IRR (because there is more than one IRR when there are more than one negative cash flows)
what can you not use if there are more than one negative cash flows?
time horizon for your investment
what does the "H" in some formulas stand for?
payback
what is a commonly used secondary investment criteria?
market capitalization rate
what is expected return also called?
it may lead to incorrect decisions in comparisons of mutually exclusive investments
what is one disadvantage of profitability index?
working capital
what is the difference between company's short-term assets and liabilities (CA-CL)
real value x (1+inflation)^t
what is the formula for finding nominal value?
[(1 + nominal) / (1 + inflation)] - 1
what is the formula for finding real rate?
what happens when there is more than one opportunity cost of capital
what is the third pitfall of internal rate of return?
CF from capital investment and disposal + OCF + CF from working capital
what is the total/net cash flow formula?
rule 3: treat inflation consistently
what rule does all of the following: - be consistent in how you handle inflation - use nominal interest rates to discount nominal cash flows - use real interest rates to discount real cash flows - you will get the same results, whether you use nominal or real figures
rule 5: remember to deduct taxes
what rule does all of the following: - cash flows should be estimated on after-tax basis - subtract cash outflows for taxes from pretax cash flows and discount net amount - be careful to subtract cash taxes - cash taxes paid are usually different from taxes reported on the income statement
rule 2: discount incremental cash flows
what rule does all of the following: - include all incidental effects - do not confuse average with incremental payoffs - forecast product sales today but also recognize after-sales cash flows - include opportunity costs - forget sunk costs - beware of allocated overhead costs - remember salvage value
remember to deduct taxes
when applying the net present value rule, what is the fifth rule?
discount cash flows, not profits
when applying the net present value rule, what is the first rule?
separate investment and financing decision
when applying the net present value rule, what is the fourth rule?
discount incremental cash flows
when applying the net present value rule, what is the second rule?
treat inflation consistently
when applying the net present value rule, what is the third rule?
when they occur
when do you record capital expenditures?
expected return
when estimating the cost of equity capital, the expected return on a stock investment plus the expected growth in the dividends.
profitability index
when resources are limited, what provides a tool for selecting among various project combinations and alternatives?
payback method
which method uses an arbitrary value?
IRR sometimes ignores the magnitude of the project
why are mutually exclusive projects a pitfall?
because it ignores later year cash flows and the present value of future cash flows
why is the payback method flawed?
$5.5 year: CF(real): nominal: NPV@15%: 0 -100 = -100 -100 1 35 = 35x(1.10)^1= 38.5= 38.5/1.15 = 33.48 2 50 = 50x(1.10)^2= 60.5= 60.5/1.15^2 = 45.75 3 30 = 30x(1.10)^3= 39.9= 39.9/1.15^3 = 26.23 nominal rate = 15% add up NPV values: -100 + 33.48 + 45.75 + 26.23 = 5.5
you invest in a project that will produce real cash flows of -$100 in year zero and then $35, $50, and $30 in the three respective years. If the nominal discount rate is 15% and the inflation rate is 10%, what is the NPV of the project?
