FIN 630 Final
Clean-up Clause
All loans must be repaid in a given period after which no further loans will be issued to the debtor
What is the benefit of using MIRR over IRR?
Avoids issue of multiple IRR's; measures the expected return of the project and its cash flows reinvested at the WACC
Incremental Cash Flow=
CF with project- CF without
Bait and Switch
Investing borrowed funds in riskier assets than anticipated by lenders; Management increases firm's risk in order to increase equity value at the expense of debt value;
What will be returned by the end of project's life?
Investment in NOWC
What factors are considered when deciding on projects?
NPV, IRR, MIRR, PI, Regular and Discounted Payback
The IRR is the rate at which ___.
NPV=0
Profitability Index=
PV of future CF/initial cost
Marginal cost of Capital
The cost of the last unit of capital raised
The higher the proportion of fixed costs relative to variable costs:
The greater the operating leverage
Nonnormal Cash Flow
There are multiple changes between cash inflow and outflow
Risk Adjusted Cost of Capital
WACC of debt, stock, equity adjusted for project risk and capacity
When is a project acceptable?
When PI>1
The purchased of fixed assets is not accounted as a deduction of from accounting income, but instead ___.
a depreciation expense is deducted each year through an assets life
Corporate Governance boils down to:
financial and operational decisions
What do IRR/MIRR measure?
profitability as percentage of Rate of Return
How can lenders address the potential of asset switching/increased leverage?
1) Charging higher rates 2) Detailing debt covenants that specify the actions a borrower can take
What must be accounted for after NOPAT to determine actual cash flow?
1) Depreciation 2) Asset purchases 3) changes in working capital 4) Opportunity Costs 5) Externalities 6) Sunk Costs (Think SWAEDO)
Basic three theories of payout:
1) Dividends irrelevant to investors (irrelevance theory) 2) Investors prefer a high payout (bird in the hand theory) 3) Investors prefer a low payout (tax effect theory)
Additional Funds Needed Method identifies the financing surplus/deficit by:
1) Finding the amount of additional funding required by additional assets due to growth in sales 2)Identify the amount of spontaneous liabilities 3) Identify the amount of funding generating internally available for reinvestment 4) Assume no new external financing Identifies costs of assets and liabilities, and the amount of internal funding available, assuming no external
What do debt covenants prevent a borrower from?
1) Increasing debt ratio 2) Repurchasing stock/paying dividends unless earnings reach a certain amount 3) Reducing liquidity ratios
Explain the 7 steps of the Financing Feedback Loop
1) LOC required to balance added to balance sheet 2) Interest Expense increases 3) Net income decreases 4) Internally generated financing decreases 5) Financing Deficit increases 6) an additional amount of the LOC is added to balance sheet to balance 7) Rinse, Repeat
How does increased threat of bankruptcy influence managerial behavior?
1) Less likely to waste on unneccessary expenditures 2) Decrease willingness to take on projects with higher risk and high NPV
What factors affect perceived risk?
1) Risk of existing assets 2) Expectations of risk of asset additions 3) Existing capital structure 4) Expectations of capital structure changes
What Five key factors influence the additional funds needed?
1) Sales Growth Rate 2) Capital Intensity Ratio 3) Spontaneous Liabilities to Sales Ratio 4) Profit Margin 5) Payout Ratio
Why might a company establish an ESOP?
1) employees with stock work better/smarter/harder 2) Without, other compensation required but doesn't benefit the employer 3) Increases retention 4) Tax incentive 5) Defense against takeovers
Describe risk analysis process in capital budgeting
1) preliminary risk-adjust cost of capital based on past projects 2) quantitative analysis using stand-alone 3) qualitative analysis of market risk and corporate risk 4) determine new RACoC--if different than preliminary re-estimate value with new one
What factors determine free cash flow using forecasting operating assumptions and policy assumptions?
1) projected income statements 2) projected financing surplus/deficit 3) projected balance sheets
Three sources of preliminary additional financing:
1) spontaneous liabilities 2) external financing (i.e. bonds or equity) 3) internal financing (reinvested earnings not retained as dividends)
What are major internal provision areas for corporate governance?
1)Monitoring and discipline by the BoD 2) Hostile takeover prevention 3) Compensation Plans 4) Capital structure choices 5) Accounting control systems
Agency Relationship
A principal hires an agent to perform a service then delegates decision making to that agent
Project Cash Flows
A project's incremental cash flow; differences between cash flow if a project is implemented vs rejected
Cannibalization
A project's negative effects on the existing business
Operating Leverage
Change in EBIT, NOPAT, ROIC, ROA, ROE caused by a change in quantity of sold product
What is the main "carrot" in corporate governance?
Compensation-- Managers have greater incentive to maximize value if they are well compensated
What is the most common noncash charge?
Depreciation
What is the advantage of using accelerated depreciation vs straight-line?
Despite having equal total cash flow and taxation, receiving cash earlier under accelerated means higher NPV, IRR, and MIRR
Two general types of projects:
Expansion and Replacement
Total net cash flow from all projects is equal to the
FCF of a firm
True or False: Interest charges are included in project cash flows
False
Financing Feedback
Financing feeds back and causes need for more financing
Excess Capacity
Firm's productivity is suboptimal due to "lumpy assets," fixed discrete units that dictate production that can become worn down/outdated
What is important about the Dividend Irrelevance Theory
Investors are indifferent between dividends and capital gains
Sunk costs are NOT incremental costs, and therefore ___.
Irrelevant in capital budget analysis
What is the danger of a debt covenant?
It may prevent value-add activities
Opportunity Cost
Loss of potential gain from alternatives when one action is chosen
What is the consequence of forgetting to include inflation in budget analysis?
Lowers NPV; causes company to reject a project that should have been accepted
Underinvestment Problem
Managers forgo risky but valuable projects due to fear of bankruptcy, in turn reducing the firm's value
Sensitivity Analysis
Measures change in NPV from given percentage change in one variable with others constant
Agency Cost
Minority shareholders will pay less for shares of stock; reduction of value due to agency conflicts
Free Cash Flow
Money available for distribution to investors after expenses, taxes and investments in operating capital
If a project's cash flow has a nonnormal pattern, it may have ___.
Multiple IRR's
If conflicts exist between NPV, IRR, MIRR, and PI, what should be used?
NPV
What is considered the best criterion for evaluating projects?
NPV
Is it better to use daily cash flows in analysis than monthly or annual?
No, it would be laborious, and could not make accurate forecasts more than a couple of months out
Agency Conflict
Occurs when an owner authorizes another agent to act on their behalf
Net Present Value
Present value of a project's expected cash flow discounted at the risk-adjusted rate
Capital Budgeting
Process of analyzing projects and choosing which to accept
Externalities
Project's effects on other parts of the firm or environment
Profitability Index
Ratio of payoff to investment of a project
Additional Funds Needed=
Required Increase in Assets-Increase in Spontaneous Liabilities- Increase in retained earning
IRR, MIRR, and PI all concern a project's ____.
Safety margin
Corporate Governance
Set of bylaws and procedures that influence company operations and managerial decision
Explain the relationship between NPV and IRR in evaluating mutually exclusive projects
Since you cannot accept both projects: -If the IRR is higher for project X than Y, and Cost of Capital is higher than the crossover rate, both methods agree to accept X -If the crossover rate is higher than the Cost of Capital for project X, there is a conflict between NPV and IRR. In this case pick highest NPV
What two "forms" do corporate governance provisions come in?
Sticks and Carrots
Explain the relationship between NPV and IRR in evaluating independent projects with normal CF's
The NPV and IRR criteria will always lead to the same accept/reject decision
Distribution Policy
The level, form, and stability of cash distributions to stockholders
Are ESOP's good for shareholders?
Yes and No; it serves as motivation for employees and cost is mitigated by tax incentives, however it can entrench management
Employee Stock Ownership Plans
a qualified defined-contribution employee benefit plan designed to invest primarily in stock of the sponsoring employer
Financing Surplus
additional financing is greater than additional assets
Financing Deficit
additional financing is less than additional assets
If there is a positive change in NOWC for a project beyond the cost of fixed assets, what does this mean?
additional financing is needed
Replacement Chain approach (common life)
analyzes both projects over an equal life.
Equivalent Annual Annuities method
calculates constant annual cash flow of a project over its lifespan if it were an annuity
The difference between the required increase in operating current assets and increase in operating current liabilities is ____.
change in NOWC
Internal Rate of Return
discount rate that forces the PV of the expected future CF's to equal the initial CF; "uses the initial cost of the project and estimates of the future cash flows to figure out the interest rate"; accept projects whose IRR exceeds CoC
Financial Plan
forecasting additional sources of financing needed to fund the operating plan; MUST include the dividend policy and capital structure
What does NPV measure?
how much wealth the project contributes to shareholders
Sources of FCF depend on:
investment opportunities and effectiveness of investments
Economic Life
life that maximizes NPV, thus shareholder wealth
Payback and discounted payback indicate a project's ____.
liquidity and risk
A long payback period implies ___.
low liquidity; higher risk (as greater reliance on forecasting)
Marginal Cost of Capital is raised as
more capital is raised
Which is more important in capital budgeting: net cash flow or accounting income?
net cash flow
Normal Cash Flow
one or more cash outflow is followed only by inflows (or vice versa)
Sunk Cost
outlay related to the project incurred in the past and cannot be recovered in the future regardless of whether a project is accepted; i.e. the cost of researching a project whether or not its actually taken on
Physical Life
potential functional service life of an asset
As debt level increases:
probability of bankruptcy increases
Operating Plan
provides detailed implementation guidance for operations, including choice of marketing segments, product lines, sales, marketing, and logistics; EXPLAINS WHO IS RESPONSIBLE FOR EACH PARTICULAR FUNCTION usually on a 5-year horizon; PARTIALLY A FORECAST OF FCF
Market risk
risk due to a project's effect on the firm's beta
Break Even Analysis
sensitivity analysis that calculates the coefficient of an input that produces an NPV of zero
Optimal Capital Budget
set of projects that maximize firm value
What does the coefficient of variation measure?
stand-alone risk per dollar of NPV
Three ways to view project risk:
stand-alone, corporate risk, market risk
If a highly risky project is successful, who benefits more: stockholders or creditors?
stockholders, creditors returns are fixed at the low-risk rate
How do ESOP's prevent takeovers?
the CEO serves as trustee for the ESOP and votes their shares according to their will. ESOP participants (employees) oppose takeovers because of labor cutbacks
Distribution Policy:
the level, form, and stability of distributions to shareholders
What is the major "stick" in corporate governance?
threat of removal (by board members or hostile takeover)
Value-Based Management
uses the FCF valuation model to identify value drivers and guide strategy
Corporate risk
variability a project contributes to stock returns, as one of many. Diversifiable
