FI 410 Exam 2
There is an ________ associated with using retained earnings, hence they are not "free"
"Opportunity cost"
Rationale for the NPV method
-NPV = PV inflows - cost -This is net gain in wealth, so accept project if NPV > 0 -Choose between mutually exclusive projects on basis of higher positive NPV. Adds most value
The three approaches to estimate the component cost of retained earnings
1. CAPM 2. Discounted cash flow(DCF) or dividend-yield-plus-growth rate approach 3. Bond-yield-plus-risk-premium approach
Opportunity cost
A cash flow that a firm must forgo in order to accept a project. For example, if the project requires the use of a building that could otherwise be sold, then the market value of the building is an opportunity cost of the project
Assume a project has normal cash flows. All else equal, which of the following statements is correct?
A project's NPV increases as the WACC declines
Jefferson City Computers has developed a forecasting model to estimate its AFN for the upcoming year. All else being equal, which of the following factors is most likely to lead to an INCREASE of the additional funds needed (AFN)?
A sharp increase in its forecasted sales
Which of the following assumptions is embodied in the AFN equation?
Accounts payable and accruals are tied directly to sales
If a typical U.S. Company correctly estimates its WACC at a given point in time and then uses that same cost of capital to evaluate all projects for the next 10 years, then the firm will most likely
Become more risky and also have an increasing WACC. Its intrinsic value will not be maximized
Define AFN
Forecasts the additional financing needed by the operating plan · Basic idea: o Estimate new assets required o Subtract new spontaneous liabilities (i.e. accounts payable and accruals) o Subtract reinvested profit (net income minus dividends)
The term "additional funds needed (AFN)" is generally defined as:
Funds that a firm must raise externally from non-spontaneous sources, i.e., by borrowing or by selling new stock, to support operations
Spontaneously generated funds are generally defined as:
Funds that arise out of normal business operations from its suppliers, employees, and the government, and they include spontaneous increases in accounts payable and accruals
The IRR method assumes that cash flows will be reinvested at the _______
IRR
Which of the following statements is correct? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows
If a project's NPV is less than zero, then its IRR must be less than the WACC
Westchester Corp. is considering two equally risky, mutually exclusive projects, both of which have normal cash flows. Project A has an IRR of 11%, while Project B's IRR is 14%. When the WACC is 8%, the projects have the same NPV. Given this information, which of the following statements is CORRECT? a. If the WACC is 13%, Project A's NPV will be higher than Project B's. b. If the WACC is 9%, Project A's NPV will be higher than Project B's. c. If the WACC is 6%, Project B's NPV will be higher than Project A's. d. If the WACC is greater than 14%, Project A's IRR will exceed Project B's. e. If the WACC is 9%, Project B's NPV will be higher than Project A's.
If the WACC is 9%, Project B's NPV will be higher than Project A's
One defect of the IRR method:
It assumes that the cash flows to be received from a project can be reinvested at the IRR itself, and that assumption is not often valid
Preffered stock is ________ risky to investors than debt
MORE
Suppose Tapley Inc. uses a WACC of 8% for below-average risk projects, 10% for average-risk projects, and 12% for above-average risk projects. Which of the following independent projects should Tapley accept, assuming that the company uses the NPV method when choosing projects? a. Project A, which has average risk and an IRR = 9%. b. Project B, which has below-average risk and an IRR = 8.5%. c. Project C, which has above-average risk and an IRR = 11%. d. Without information about the projects' NPVs we cannot determine which one or ones should be accepted. e. All of these projects should be accepted.
Project B, which has below-average risk and an IRR = 8.5%
What are the three types of risk?
Stand-alone risk Corporate risk Market risk
Which of the following is NOT a relevant cash flow and thus should NOT be reflected in the analysis of a capital budgeting project?
Sunk costs that have been expensed for tax purposes
One defect of the IRR method VS the NPV method is:
The IRR does not take proper account of differences in the sizes of projects
A company expects sales to increase during the coming year, and it is using the AFN equation to forecast the additional capital that it must raise. Which of the following conditions would cause the AFN to INCREASE?
The company increases its dividend payout ratio
The WACC that should be used in capital budgeting:
The firm's marginal, after-tax cost of capital
Sales growth (g)
The higher g is, the larger AFN will be—other things held constant.
Capital intensity ratio (A0*/S0)
The higher the capital intensity ratio, the larger AFN will be—other things held constant.
Spontaneous-liabilities-to-sales ratio (L0*/S0)
The higher the firm's spontaneous liabilities, the smaller AFN will be—other things held constant
Profit margin (Net income/Sales)
The higher the profit margin, the smaller AFN will be—other things held constant.
Payout ratio (DPS/EPS)
The lower the payout ratio, the smaller AFN will be if other things held constant.
The NPV method assumes that cash flows will be reinvested at the _______
WACC
When calculating the cost of debt...
a company needs to adjust for taxes, because interest payments are deductible by the paying corporation
What is a sunk cost?
a cost that was incurred and expensed in the past and cannot be recovered if the firm decides not to go forward with the project
Example of externality:
a situation where a bank opens a new office, and that new office causes deposits in the bank's other offices to DECLINE
Sunk Costs
an outlay related to the project that was incurred in the past and that cannot be recovered in the future regardless of whether or not the project is accepted. Therefore, sunk costs are not incremental costs and thus are not relevant in a capital budgeting analysis
If a company's tax rate INCREASES, then, all else equal, its weighted average cost of capital will _______
decline
Controllable factors that affect WACC
o Capital structure policy. o Dividend policy. o Investment policy. Firms with riskier projects generally have a higher cost of equity
Normal cash flow project
o Cost (negative CF) followed by a series of positive cash inflows. o One change of signs.
Preferred Stock
o Flotation costs for preferred are significant, so are reflected. Use net price o Preferred dividends are not deductible, so no tax adjustment. Just rps o Nominal rps is used
Rationale for the IRR method
o If IRR > r, then the project's rate of return is greater than its cost-- some return is left over to boost stockholders' returns o Example: r = 10%, IRR = 15% --- So this project adds extra return to shareholders
Debt
o Interest is tax deductible, so calculate after tax cost of debt o Use the nominal rate o Flotation costs are small, so ignore
Uncontrollable factors that affect WACC
o Market conditions, especially interest rates. o The market risk premium. o Tax rates.
The reinvestment rate assumptions for NPV and IRR
o NPV does not have a reinvestment rate assumption, so reinvestment will not change the final outcome of NPV of a project. IRR does consider reinvestment rate assumption. The IRR assumes that the company will reinvest cash inflows at the rate of return for the entire lifetime of the project
Nonnormal cash flow project
o Two or more changes of signs. o Most common: Cost (negative CF), then string of positive CFs, then cost to close project. o For example, nuclear power plant or strip mine
EAA (Equivalent Annual Annuity)
o Use to compare mutually exclusive projects with different lifespans. Convert the unequal annual cash flows of a project into a constant cash flow stream (i.e., an annuity) whose NPV is equal to the NPV of the initial stream. Do for both projects and compare the annuities o Converting the PV into a stream of annuity payments with the same PV o Higher EAA = better project
replacement chain (common life) approach
o a capital budgeting decision model that compares two or more mutually exclusive capital proposals with unequal lives. The replacement chain method involves repeating shorter projects multiple times until they reach the lifetime of the longest project o A method of comparing mutually exclusive projects that have unequal lives. Each project is replicated so that they will both terminate in a common year. If projects with lives of 3 years and 5 years are being evaluated, then the 3-year project would be replicated 5 times and the 5-year project replicated 3 times; thus, both projects would terminate in 15 years
If a project has "normal" cash flows, then it can have only ______
one real IRR
One drawback of the payback criterion is that this method does not____________
take account of cash flows beyond the payback period
Corporate risk (within-firm risk)
the variability the project contributes to the corporation's returns, considering the fact that the project represents only one asset of the firm's portfolio of assets and so some of its risk will be diversified away by other projects within the firm
What are the capital components?
· Capital components are sources of funding that come from investors · Debt, preferred stock, and common equity o Most firms use long term debt · Accounts payable, accruals, and deferred taxes are NOT sources of funding that come from investors, so they are not included in the calculation of the cost of capital o We do adjust for these items when calculating the cash flows of a project, but not when calculating the cost of capital
When do multiple IRRs occur?
· If a project's cashflow have a nonnormal (i.e., the cash flows have more than one sign change), it is possible for the project to have more than one positive IRR · If the sign changes more than once, don't even calculate the IRR because it is at best useless and at worst misleading
What are flotation costs?
· The commissions, legal expenses, fees, and any other direct costs that a company incurs when it issues new securities
What is the self-supporting growth rate?
· The maximum growth rate the firm could achieve if it had no access to external capital · Self-supporting growth rate is influenced by the firm's capital intensity ratio. The more assets the firm requires to achieve a certain sales level, the lower its sustainable growth rate will be
Capital Budgeting
· The whole process of analyzing projects and deciding whether they should be included in the planned expenditures on fixed assets · A firm's ability to remain competitive and to survive depends on a constant flow of ideas for new products, improvements in existing products, and ways to operate more efficiently. Therefore, it is vital for a company to evaluate proposed projects accurately
Why is the cost of new common equity higher than the cost of retained earnings?
· When a company issues new common stock, they also have to pay floatation costs to the underwriter · Issuing new common stock may send a negative signal to the capital markets, which may depress stock price
Stand-alone risk
· due to the variability of its cash flows. It is the risk that a company would have if the company had only this one project o Assumes that project is isolated; does not take diversification into effect
Options to eliminate a financing SURPLUS
· occurs when additional financing is greater than additional assets · If surplus, eliminate it by paying a special dividend
Options to eliminate a financing DEFICIT
· occurs when additional financing is less than additional assets · If deficit, draw on a line of credit. The line of credit would be tapped on the last day of the year, so it would create no additional interest expenses for that year
NPV profile
· shows the sensitivity of a project's NPV (net present value) for different discount rates
Crossover rate
· the discount rate at which the NPVs of both the projects are equal
Externalities
· the effects of a project on other parts of the firm or on the environment. As explained in what follows, there are three types of externalities: negative within-firm externalities, positive within-firm externalities, and environmental externalities o Positive externalities increase your cash flows o Negative externalities decrease your cash flows
Market risk (beta risk)
· the risk of the project as seen by a well-diversified stockholder who owns many different stocks o Best but more difficult to estimate
Cannibalization
· type of negative within-firm externalities; A type of externality in capital budgeting in which introduction of a new product causes the sales of existing products in the firm to decrease
When should a firm accept a project?
· when estimated (expected) return exceeds the cost of capital