Finance 325 - Final - Whidbee

opportunity cost

the most valuable alternative that is given up if a particular investment is undertaken.

What is a portfolio weight?

the percentage of a portfolio's total value that is invested in a particular asset

accounting break-even

the sales level that results in zero project net income

What 3 components does cash flow from assets include?

operating cash flow, capital spending, changes in net working capital.

What does a beta coefficient measure?

the amount of systematic risk present in a particular risky asset relative to that in an average risky asset.

project evaluation

the application of one or more capital budgeting decision rules to estimated relevant project cash flows in order to make the investment decision.

variance

the average squared difference between the actual return and the average return

marginal, or incremental, cost

the change in revenue that occurs when there is a small change in output.

operating leverage

the degree to which a firm or project relies on fixed costs.

What is the systematic risk principle?

the expected return on a risky asset depends only on that asset's systematic risk

efficient markets hypothesis (EMH)

the hypothesis that actual capital markets, such as the NYSE, are efficient.

relevant cash flows

the incremental cash flows associated with the decision to invest in a project.

standard deviation

the positive square root of the variance

cost of equity

the return that equity investors require on their investment in the firm.

cost of debt

the return that lenders require on the firm's debt. Interest rate the firm must pay on new borrowing.

What is capital rationing? What types are there?

the situation that exists if a firm has positive NPV projects but can't find necessary financing. Soft rationing: the situation that occurs when units in a business are allocated a certain amount of financing for capital budgeting. Hard rationing: the situation that occurs when a business cannot raise financing for a project under any circumstances.

How do you calculate a portfolio beta?

Multiply weight of return times beta, add all together.

erosion

the cash flows of a new project that come at the expense of a firm's existing projects. Relevant only when sales wouldn't otherwise be lost.

What are the implications of operating leverage for the financial manager?

One way of coping with highly uncertain projects is to keep the degree of operating leverage as low as possible. This will generally keep degree of operating leverage as low as possible.

What are the relevant incremental cash flows for project evaluation?

A relevant cash flow for a project is a change in the firm's overall future cash flow that comes about as a direct consequence of the decision to take that project.

Why is it important to consider changes in net working capital in developing cash flows? What is the effect of doing so?

Because net working capital is based off of sales, which by nature fluctuate. Calculating for changes in sales helps lead to a more accurate development of cash flows.

Why might a financial manager be interested in the accounting break-even point?

Because revenues are equal to costs. It is relatively easy to calculate and explain. A project that doesn't break even in an accounting sense actually reduces total earnings. A project that just breaks even on an accounting basis loses money in a financial or opportunity cost sense.

What are the top-down and bottom-up definitions of operating cash flow?

Bottom-up: Start w/ accountant's bottom line (net income) and add back any noncash deductions (like depreciation). Top-down: Start at top of income statement w/ sales and work way down to net cash flow by subtracting costs, taxes, and other expenses. Leave out strictly noncash items like depreciation.

How is depreciation calculated for fixed assets under current tax law? What effects do expected salvage value and estimated economic life have on the calculated depreciation deduction?

Depreciation for each year is computed my multiplying the cost of the asset by a fixed percentage. Expected salvage value and expected economic life aren't explicitly considered in calculation of depreciation.

What happens to the standard deviation of return for a portfolio if we increase the number of securities in the portfolio?

The standard deviation declines as the number of securities increases.

What is the primary determinant of the cost of capital for an investment?

The use of funds (NOT THE SOURCE)

How is the WACC calculated?

WACC = (E/V) × RE + (D/V) × RD × (1 − TC)

What is net income at the accounting break-even point? What about taxes?

Net income and taxes are 0.

What are the two basic parts of a return?

Normal or expected return from the stock and the uncertain or risky part.

What is the capital asset pricing model (CAPM)? What does it tell us about the required return on a risky investment?

CAPM: the equation of the SML showing the relationship between expected return and beta. It tells us the pure time value of money, the reward for bearing systematic risk, and the amount of systematic risk.

What is an increase in NWC - a cash outflow or inflow?

Cash outflow; additional investment firm makes.

What are two approaches to estimating the cost of equity capital?

Dividend growth and SML approach

Under what circumstances do we have to worry about unequal economic lives? How do you interpret the EAC?

Equivalent annual cost: the PV of a project's costs calculated on an annual basis. Annuity factor = (1-1/(1+discount rate)^yr PV of costs = EAC * annuity factor

What do we mean by excess return and risk premium?

Excess return: investment returns from a security or portfolio that exceed a benchmark or index with a similar level of risk. Risk premium: the excess return required from an investment in a risky asset over that required from a risk-free investment.

How do we calculate the expected return on a security?

Expected return: the return on a risky asset expected in the future. Multiply possibilities by probabilities and add results.

True or false: The expected return on a risky asset depends on that asset's total risk. Explain.

False, it only depends on its systematic risk. Unsystematic risk can be eliminated at virtually no cost (by diversifying), so there is no reward for bearing it.

What is forecasting risk? Why is it a concern for the financial manager?

Forecasting risk: the possibility that errors in projected cash flows will lead to incorrect decisions. Also known as estimation risk. We can calculate that a project has a positive NPV when it really doesn't.

Under what conditions will a company's announcement have no effect on common stock prices?

If it is the same as the forecast.

What problems does capital rationing create for discounted cash flow analysis?

If we face hard rationing, then we are not going to take a new project no matter what the return on that project is.

In setting a bid price, we used a zero NPV as our benchmark. Explain why this is appropriate.

It is the lowest possible price we can profitably charge.

Why is the coupon rate a bad estimate of a firm's cost of debt?

It tells us what the firm's cost of debt was when the bonds were issued, not what the cost of debt is today.

What is meant by the term depreciation tax shield?

OCF = (Sales-costs) * (1-T) + Depreciation * T The tax saving that results from the depreciation deduction, calculated as depreciation multiplied by the corporate tax rate.

How is operating leverage measured?

OCF = DOL * % change in Q Q = current output level DOL = 1+FC/OCF 0 fixed costs would result in DOL of 1, meaning % changes in quantity sold would show up 1 for 1 in operating cash flow.

What is the definition of project operating cash flow? How does this differ from net income?

Project operating cash flow = earnings before interest and taxes + depreciation - taxes. Net income is (sales - variable costs - fixed costs - depreciation) = [EBIT - taxes (%)] = NI.

What is the security market line? Why must all assets plot directly on it in a well-functioning market?

SML: a positively sloped straight line displaying the relationship between expected return and beta. All assets plot directly on it because it has an average systematic risk, or beta of 1.

What are scenario, sensitivity, and simulation analysis?

Scenario: the determination of what happens to NPV estimates when we ask what-if questions. Positive best and worst case scenarios and calculate NPVs. Sensitivity: investigation of what happens to NPV when only one variable is changed. Useful in pinpointing the areas where forecating risk is especially severe. Simulation: a combination of scenario and sensitivity analysis. Vary several input variable simultaneously, then construct a distribution of possible NPV estimates.

With 20/20 hindsight, what do you say was the best investment for the period from 1926 through 1935?

Small-cap stocks

What is the principle of diversification?

Spreading an investment across a number of assets will eliminate some, but not all, of the risk.

What are the two basic types of risk?

Systematic risk: a risk that influences a large number of assets. Also, market risk. Unsystematic risk: a risk that affects at most a small number of assets. Also, unique or asset-specific risk.

What are some potential sources of value in a new project?

Technological edge, economies of scale, product differentiation, cost advantages, access to distribution channels, favorable gvt. policy

Why do we multiply the cost of debt by (1 − TC) when we compute the WACC?

The aftertax interest rate is equal to the pretax rate multiplied by (1-tax rate).

What is the relationship between the required return on an investment and the cost of capital associated with that investment?

The cost of capital will reflect the required return on the firm's asset as a whole. Required return, appropriate discount rate, and cost of capital essentially mean the same thing.

What is the fundamental relationship between risk and return in well-functioning markets?

The reward-to-risk ratio must be the same for all the assets in the market.

What is the distinction between the two types of risk?

Total return = Expected return + systematic part of surprise + unsystematic portion

Explain why interest paid is not a relevant cash flow for project evaluation.

We are interested in the cash flow generated by the assets of the project. Interest paid is a component of cash flow to creditors, not cash flow from assets. It is a financing expense, not a component of operating cash flow.

How do we calculate the expected return on a portfolio?

Weighted average of likely profits of assets in portfolio, weighted by likely profits of each asset class.

For the shark attractant project, why did we add back the firm's net working capital investment in the final year?

Whenever we have an investment in net working capital, that same investment has to be recovered; in other words, the same number needs to appear at some time in the future with the opposite sign.

What are the two parts of total return?

You may receive some cash directly while you own the investment (called income component). Value of the asset you purchase will often change (capital gain or loss).

sunk cost

a cost we have already paid or have already incurred the liability to pay. Not relevant and not an incremental cash flow.

accelerated cost recovery system (ACRS)

a depreciation method under US tax law allowing for accelerated write-off of property under various classifications.

portfolio

a group of assets such as stocks and bonds held by an investor

What is an efficient market?

a market in which security prices reflect available information. All investments in that market are 0 NPV investments.

normal distribution

a symmetric, bell-shaped frequency distribution that is completely defined by its mean and standard deviation

What do the incremental cash flows for project evaluation consist of?

any and all changes in the firm's future cash flows that are a direct consequence of taking the project.

What are the likely consequences if a firm uses its WACC to evaluate all proposed investments?

can result in the firm's incorrectly accepting relatively risky projects and incorrectly rejecting relatively safe ones. A firm that uses its WACC as a cutoff will tend to reject profitable projects with risks less than those of the overall firm.

variable costs

costs that change when the quantity of output changes. 0 when production is 0. Direct labor costs and raw materials costs are usually considered variable.

fixed costs

costs that do not change when the quantity of output changes during a particular time period. Sunk cost.

stand-alone principle

evaluation of a project based on the project's incremental cash flows.

pro forma financial statements

financial statements projecting future years' operations

Under what conditions is it correct to use the WACC to determine NPV?

we use WACC to determine NPV when an investment isn't as typically risky as other investments by the company