Finance Exam Four
real options
"real" to distinguish them from financial options like an option to purchase shares of Boeing stock, and "options" because they offer the right but not the obligation to take the future action to increase cash flows. Real options are valuable, but this value is not captured by conventional NPV analysis. Therefore, a project's real options must be considered separately.
The payback has three flaws:
(1) All dollars received in different years are given the same weight (i.e., the time value of money is ignored); (2) cash flows beyond the payback year are given no consideration regardless of how large they might be; (3) unlike the NPV, which tells us how much wealth a project adds, and the IRR, which tells us how much a project yields over the cost of capital, the payback merely tells us when we will recover our investment.
types of real options
(1) abandonment, where the project can be shut down if its cash flows are low; (2) timing, where a project can be delayed until more information about demand and/or costs can be obtained; (3)expansion, where the project can be expanded if demand turns out to be stronger than expected; (4)output flexibility, where the output can be changed if market conditions change; and (5)input flexibility, where the inputs used in the production process (say, coal versus natural gas for generating electricity) can be changed if input prices and/or availability change.
bankruptcy-related costs have two components
(1) the probability of their occurrence and (2)the costs that will be incurred if financial distress arises.
Business risk depends on a number of factors
1. Competition 2. demand variability 3. sales price variability 4. input cost variability 5. product obsolescence 6. foreign risk exposure 7. regulatory risk and legal exposure Each of these factors is determined partly by industry characteristics and partly by managerial decisions
Two types of projects can be distinguished
1. expansion projects: where the firm makes an investment, 2. replacement projects: where the firm replaces existing assets, generally to reduce costs. -Replacement analysis is complicated by the fact that almost all of the cash flows are incremental, found by subtracting the new cost numbers from the old numbers.
Firms can reduce excess cash flow in a variety of ways.
1. funnel some of it back to shareholders through higher dividends or stock repurchases. 2. tilt the target capital structure toward more debt in the hope that higher debt service requirements will force managers to become more disciplined. -If debt is not serviced as required, the firm will be forced into bankruptcy, in which case its managers would lose their jobs. -Therefore, a manager is less likely to buy an expensive corporate jet if the firm has large debt service requirements.
Conceptual Issues in Cash flow Estimations
1. FCF vs Accounting Income 2. Timing of cash flows 3. incremental cash flows 4. replacement projects 5. sunk costs 6. opportunity costs associated with assets 7. externalities
Is MIRR as good as the NPV?
1. For independent projects with normal cash flows, the NPV, IRR, and MIRR always reach the same accept/reject conclusion, so in these circumstances the three criteria are equally good. 2. However, if projects are mutually exclusive and they differ in size, conflicts can arise. In such cases, the NPV is best because it selects the project that maximizes value.* 3. Our overall conclusions are: (1) The MIRR is superior to the regular IRR as an indicator of a project's "true" rate of return. (2) NPV is better than IRR and MIRR when choosing among competing projects.
For most firms, assuming reinvestment at the WACC is more reasonable for the following reasons:
1. If a firm has reasonably good access to the capital markets, it can raise all the capital it needs at the going rate 2. Because the firm can obtain capital at r%, if it has investment opportunities with positive NPVs, it should take them on, and it can finance them at a r% cost. 3. If the firm uses internally generated cash flows from past projects rather than external capital, this will save it the r% cost of capital. Thus, r% is the opportunity cost of the cash flows, and that is the effective return on reinvested funds.
increasing debt and reducing free cash flow has its downside:
1. It increases the risk of bankruptcy
conclusions regarding risk analysis are as follows:
1. It is very difficult, if not impossible, to quantitatively measure projects' within-firm and beta risks. 2. Most projects' returns are positively correlated with returns on the firm's other assets and with returns on the stock market. This being the case, because stand-alone risk is correlated with within-firm and market risk, not much is lost by focusing just on stand-alone risk. 3. Experienced managers make many judgmental assessments, including those related to risk, and they work them into the capital budgeting process. Introductory students like neat, precise answers, and they want to make decisions on the basis of calculated NPVs. Experienced managers consider quantitative NPVs, but they also bring subjective judgment into the decision process. 4. If a firm does not use the types of analyses covered in this book, it will have trouble. On the other hand, if a firm tries to quantify everything and let a computer make its decisions, it too will have trouble. Good managers understand and use the theory of finance, but they apply it with judgment.
Conclusions of capital budgeting methods
1. NPV: single best criterion because it provides a direct measure of value the project adds to shareholder wealth. 2. IRR and MIRR: measure profitability expressed as a percentage rate of return, which is useful to decision makers. Further, IRR and MIRR contain information concerning a project's "safety margin." 3. MIRR: has all the virtues of the IRR, but it incorporates a better reinvestment rate assumption and avoids the multiple rate of return problem. So if decision makers want to know projects' rates of return, the MIRR is a better indicator than the regular IRR. 4. Payback and discounted payback: provide indications of a project's liquidity and risk. A long payback means that investment dollars will be locked up for a long time; hence, the project is relatively illiquid. In addition, a long payback means that cash flows must be forecasted far out into the future, and that probably makes the project riskier than one with a shorter payback Because it is easy to calculate all of them, all should be considered when capital budgeting decisions are being made. For most decisions, the greatest weight should be given to the NPV, but it would be foolish to ignore the information provided by the other criteria.
Companies use, the following criteria for deciding to accept or reject projects:
1. Net present value (NPV) -best method, primarily because it addresses directly the central goal of financial management, maximizing shareholder wealth. 2. Internal rate of return (IRR) 3. Modified internal rate of return (MIRR) 4. Regular payback 5. Discounted payback
Checklist for Capital Structure Decisions
1. Sales stability 2. Asset Structure 3. Operating Leverage 4. Growth rate 5. Profitability 6. Taxes 7. Control 8. Management attitudes 9. Leader and rating agencies attitudes 10. market conditions 11. the firms internal conditions 12. Financial flexibility
Two basic conditions cause NPV profiles to cross and thus lead to conflicts
1. Timing differences: If most of the cash flows from one project come in early while most of those from the other project come in later, the NPV profiles may cross and result in a conflict. 2. Project size (or scale) differences: If the amount invested in one project is larger than the other, this too can lead to profiles crossing and a resulting conflict.
Three procedures can be used for finding IRR:
1. Trial and error 2. Calculator solution 3. Excel
Firms' actual capital structures change over time, and for two quite different reasons:
1. deliberate actions 2. market actions
firms generally categorize projects and then analyze them in each category somewhat differently:
1. replacement: needed to continue current operations. 2. Replacement: cost reduction. 3. Expansion of existing products or markets. 4. Expansion into new products or markets. 5. Safety and/or environmental projects 6. Other projects. 7. Mergers.
differences between security valuation and capital budgeting
1. stocks and bonds exist in the security markets, and investors select from the available set; firms, however, create capital budgeting projects. 2. for most securities, investors have no influence on the cash flows produced by their investments, whereas corporations have a major influence on projects' results
Payback flaws
1. the regular payback doesn't consider the cost of capital, it doesn't specify the true break-even year. The discounted payback does consider capital costs, but it still disregards cash flows beyond the payback year, which is a serious flaw. 2. if mutually exclusive projects vary in size, both payback methods can conflict with the NPV, which might lead to a poor choice. 3. there is no way of telling how low the paybacks must be to justify project acceptance.
MIRR has two significant advantages over the regular IRR
1. whereas the regular IRR assumes that the cash flows from each project are reinvested at the IRR, the MIRR assumes that cash flows are reinvested at the cost of capital (or some other explicit rate). Because reinvestment at the IRR is generally not correct, the MIRR is generally a better indicator of a project's true profitability. 2. the MIRR eliminates the multiple IRR problem—there can never be more than one MIRR, and it can be compared with the cost of capital when deciding to accept or reject projects.
Sales stability
A firm whose sales are relatively stable can safely take on more debt and incur higher fixed charges than a company with unstable sales.
strategic business plan
A long-run plan that outlines in broad terms the firm's basic strategy for the next 5 to 10 years. provide a general guide to the operating executives who must meet them.
replacement chain (common life) approach
A method of comparing projects with unequal lives that assumes that each project can be repeated as many times as necessary to reach a common life. The NPVs over this life are then compared, and the project with the higher common-life NPV is chosen. the replacement chain method is easier to explain to decision makers
equivalent annual annuity (EAA) method
A method that calculates the annual payments that a project will provide if it is an annuity. When comparing projects with unequal lives, the one with the higher equivalent annual annuity (EAA) should be chosen. involves three steps: 1. Find each project's NPV over its initial life. 2. There is some constant annuity cash flow [the equivalent annual annuity (EAA)] that has the same present value as a project's calculated NPV. For Project F, here is the time line The EAA method is often easier to apply than the replacement chain method
Financial leverage
The extent to which fixed-income securities (debt and preferred stock) are used in a firm's capital structure.
Scenario Analysis
A risk analysis technique in which "bad" and "good" sets of financial circumstances are compared with a most likely, or base-case, situation. allows us to change more than one variable at a time, and it incorporates the probabilities of changes in the key variables. we begin with the base-case scenario, which uses the most likely set of input values. We then ask marketing, engineering, and other operating managers to specify a worst-case scenario (low unit sales, low sales price, high variable costs, and so forth) and a best-case scenario.
Mutually exclusive projects
Accept the project with the highest positive NPV. If no project has a positive NPV, reject them all.
Replacement Analysis
An analysis involving the decision as to whether to replace an existing asset with a new asset. The key here is to find the incremental cash flows.
Financial risk
An increase in stockholders' risk, over and above the firm's basic business risk, resulting from the use of financial leverage. the additional risk placed on the common stockholders as a result of using debt.
When should we worry about unequal life analysis?
As a general rule, the unequal life issue (1) does not arise for independent projects but (2) can arise if mutually exclusive projects with significantly different lives are being compared. -This should be done only when there is a high probability that the projects will be repeated at the end of their initial lives
Unlevered Beta, bu
The firm's beta coefficient if it has no debt
Negative Within-Firm Externalities
Cannibalization: the situation when a new project reduces cash flows that the firm would have otherwise had
Chapter 11
Capital Budgeting
Market, or beta, risk
Considers both firm and stockholder diversification. It is measured by the project's beta coefficient. the riskiness of the project as seen by a well-diversified stockholder who recognizes (a)that the project is only one of the firm's assets and (b)that the firm's stock is but one part of his or her stock portfolio. theoretically the most relevant of the three because it is the one reflected in stock prices. Unfortunately, market risk is also the most difficult to estimate, primarily because new projects don't have "market prices" that can be related to stock market returns.
Chapter 13
Capital Structure and Leverage
Chapter 12
Cash Flow Estimation and Risk Analysis
Web Appendix 12E
Comparing Mutually Exclusive Projects with Unequal Lives
market actions
Competitive responses to forces in markets The firm could incur high profits or losses that lead to significant changes in book value equity as shown on its balance sheet and to a decline in its stock price. Similarly, although the book value of its debt would probably not change, interest rate changes due to changes in the general level of rates and/or changes in the firm's default risk could cause significant changes in its debt's market value. Such changes in the market value of the debt and/or equity could result in large changes in its measured capital structure.
market conditions
Conditions in the stock and bond markets undergo long-and short-run changes that can have an important bearing on a firm's optimal capital structure.
product obsolescence
Firms in high-tech industries like pharmaceuticals and computers depend on a constant stream of new products. The faster its products become obsolete, the greater a firm's business risk.
Lender and rating agency attitudes
Corporations often discuss their capital structures with lenders and rating agencies and give much weight to their advice
threshold level of debt
D1 : which the probability of bankruptcy is so low as to be immaterial. -Beyond D1, however, bankruptcy-related costs become increasingly important, and they begin to offset the tax benefits of debt. In the range from D1 to D2: bankruptcy-related costs reduce but do not completely offset the tax benefits of debt, so the firm's stock price continues to rise (but at a decreasing rate) as its debt ratio increases. beyond D2: bankruptcy-related costs exceed the tax benefits, so from this point on, increasing the debt ratio lowers the stock price. D2 = is the optimal capital structure, the one where the stock price is maximized.
Web Appendix 13A
Degree of Leverage
foreign risk exposure
Firms that generate a high percentage of their earnings overseas are subject to earnings declines due to exchange rate fluctuations. They are also exposed to political risk.
TIE ratio
EBIT/ interest expense gives an indication of how vulnerable the company is to financial distress. This ratio depends on three factors: (1)the percentage of debt, (2)the interest rate on the debt, and (3)the company's profitability.
Calculator solution
Enter the cash flows in the calculator's cash flow register just as we did to find the NPV; then press the calculator key labeled "IRR." Instantly, you get the IRR
Net debt
Equal to short-term debt plus long-term debt less cash and equivalents. Companies often look at this measure when setting their target capital structure. Holding other factors constant, firms that have more cash or other assets that are suitable as security for loans tend to use debt relatively heavily. General-purpose assets that can be used by many businesses make good collateral, whereas special-purpose assets do not. Thus, real estate companies are usually highly leveraged, whereas companies involved in technological research are not
Safety and/or environmental projects
Expenditures necessary to comply with government orders, labor agreements, or insurance policy terms fall into this category. How these projects are handled depends on their size, with small ones being treated much like the Category 1 projects.
regulatory risk and legal exposure
Firms that operate in highly regulated industries such as financial services and utilities are subject to changes in the regulatory environment that may have a profound effect on the company's current and future profitability. Other companies face significant legal exposure that could damage the company if they are forced to pay large settlements.
input cost variability
Firms whose input costs are uncertain have higher business risk.
sales price variability
Firms whose products are sold in volatile markets are exposed to more business risk than firms whose output prices are stable, other things held constant.
Environmental Externalities
Government rules and regulations constrain. Always want to be environmentally friendly. Ex= ill feelings from fumes
Independent projects
If NPV exceeds zero, accept the project.
If an independent project with normal cash flows is being evaluated, the NPV and IRR criteria always lead to the same accept/reject decision:
If NPV says accept, IRR also says accept, and vice versa. (1) the IRR says accept if the project's cost of capital is less than (or to the left of) the IRR and (2) if the cost of capital is less than the IRR, the NPV will be positive. For normal, independent projects, if the IRR says accept, so will the NPV.
Competition
If a firm has a monopoly on a necessary product, it will have little risk from competition and thus have stable sales and sales prices. However, monopolistic firms' prices are often regulated, and they may not be able to raise prices enough to cover rising costs. Still, other things held constant, less competition lowers business risk.
deliberate actions
If a firm is not currently at its target, it may deliberately raise new money in a manner that moves the actual structure toward the target.
The extent to which costs are fixed: operating leverage.
If a high percentage of its costs are fixed and thus do not decline when demand falls, this increases the firm's business risk. This factor is called operating leverage
several potentially serious weaknesses inherent in this type of analysis:
If inflation is expected, replacement equipment will have a higher price. Moreover, both sales prices and operating costs will probably change. Thus, the static conditions built into the analysis would be invalid. (2)Replacements that occur later will probably employ new technology, which in turn might change the cash flows. This factor can be built into the replacement chain analysis but not into the EAA approach. (3)It is difficult enough to estimate the lives of most projects, so estimating the lives of a series of projects is often just speculation.
Mergers.
In a merger, one firm buys another one. Buying a whole firm is different from buying an asset such as a machine or investing in a new airplane, but the same principles are involved. The concepts of capital budgeting underlie merger analysis.
IRR decision rules:
Independent projects. If IRR exceeds the project's WACC, accept the project. If IRR is less than the project's WACC, reject it. Mutually exclusive projects. Accept the project with the highest IRR, provided that IRR is greater than WACC. Reject all projects if the best IRR does not exceed WACC.
taxes
Interest is a deductible expense, and deductions are most valuable to firms with high tax rates. Therefore, the higher a firm's tax rate, the greater the advantage of debt. However, with the passage of new tax legislation, the corporate tax rate is a flat 21%. The lower tax rate reduces the value of the tax deduction associated with debt financing.
profitability
It is often observed that firms with very high rates of return on investment use relatively little debt. Although there is no theoretical justification for this fact, one practical explanation is that very profitable firms such as Intel, Microsoft, and Google do not need to do much debt financing. Their high rates of return enable them to do most of their financing with internally generated funds.
within each category, projects are grouped by their dollar costs:
Larger investments require increasingly detailed analysis and approval at higher levels.
capital rationing
Limit set on the amount of funds available for investment
Positive Within-Firm Externalities
New project is complementary to old one and the cash flows increase
Management attitudes
Management, then, can exercise its own judgment about the proper capital structure. Some managers tend to be relatively conservative and thus use less debt than an average firm in the industry, whereas aggressive managers use a relatively high percentage of debt in their quest for higher profits.
Asset Structure
Many companies also take their desired cash holdings into account when setting their target capital structure. Holding other factors constant, a company is able to take on more debt if it has more cash on the balance sheet. For this reason, some analysts also evaluate an alternative measure, net debt
Difference between NPV and IRR
NPV method the discount rate is given, and we find the NPV; with the IRR method the NPV is set equal to zero, and we find the interest rate that produces this equality.
Operating leverage
Other things the same, a firm with less operating leverage is better able to employ financial leverage because it will have less business risk.
Growth rate
Other things the same, faster-growing firms must rely more heavily on external capital. Further, the flotation cost involved in selling common stock exceeds that incurred when selling debt, which encourages rapidly growing firms to rely more heavily on debt. At the same time, however, those firms often face higher uncertainty, which tends to reduce their willingness to use debt.
sensitivity analysis
Percentage change in NPV resulting from a given percentage change in an input variable, other things held constant. -most commonly used type of risk analysis It begins with a base-case situation, where the project's NPV is found using the base-case (most likely) value for each input variable we change one variable at a time
option value
The difference between the expected NPVs with and without the relevant option. It is the value that is not accounted for in a traditional NPV analysis. A positive option value expands the firm's opportunities.
Cannibalization
Project x would reduce the after-tax cash flows of another division by $x per year. Project S would now have a negative NPV; hence, it would be rejected.
Corporate, or within-firm, risk
Risk considering the firm's diversification but not stockholder diversification. It is measured by a project's effect on uncertainty about the firm's expected future returns. a project's risk to the corporation as opposed to its investors. Within-firm risk takes account of the fact that the project is only one asset in the firm's portfolio of assets; hence, some of its risk will be eliminated by diversification within the firm.
Stand-alone risk
Sensitivity analysis, scenario analysis, and Monte Carlo simulation we should be more concerned with within-firm and beta risk than with stand-alone risk.
modified IRR (MIRR)
The discount rate at which the present value of a project's cost is equal to the present value of its terminal value, where the terminal value is found as the sum of the future values of the cash inflows, compounded at the firm's cost of capital. similar to the regular IRR except that it is based on the assumption that cash flows are reinvested at the WACC (or some other explicit rate if that is a more reasonable assumption). We compound each cash inflow, sum them to determine the TV, and then find the rate that causes the PV of the TV to equal the cost.
control
The effect of debt versus stock on a management's control position can influence capital structure
Chapter 11
The Basics of Capital Budgeting
base-case NPV.
The NPV when sales and other input variables are set equal to their most likely (or base-case) values.
reserve borrowing capacity
The ability to borrow money at a reasonable cost when good investment opportunities arise. Firms often use less debt than specified by the MM optimal capital structure in "normal" times to ensure that they can obtain debt capital later if necessary.
optimal capital structure
The capital structure that maximizes a stock's intrinsic value.
trade-off theory
The capital structure theory that states that firms trade off the tax benefits of debt financing against problems caused by potential bankruptcy
risk-adjusted cost of capital
The cost of capital appropriate for a given project, given the riskiness of that project. The greater the risk, the higher the cost of capital.
crossover rate
The cost of capital at which the NPV profiles of two projects cross and, thus, at which the projects' NPV can be found by calculating the IRR of the differences in the projects' cash flowss are equal.
discounted payback
The length of time required for an investment's cash flows, discounted at the investment's cost of capital, to cover its cost. cash flows are discounted at the WACC; then those discounted cash flows are used to find the payback Each inflow is divided by (1+r)t, where t is the year in which the cash flow occurs and r is the project's cost of capital, and those PVs are used to find the payback
demand variability
The more stable the demand for a firm's products, other things held constant, the lower its business risk.
abandonment option
The option to shut down a project if operating cash flows turn out to be lower than expected. This option can lower its risk, increase its expected profitability, and raise its calculated NPV.
operating breakeven
The output quantity at which EBIT = 0
salvage value
The price that the company receives for a fixed asset at the end of the project The company will also have to pay taxes if the asset's salvage value exceeds its book value.
Stand-alone risk
The risk an asset would have if it were a firm's only asset and if investors owned only one stock. It is measured by the variability of the asset's expected returns. a project's risk assuming: (a)that it is the only asset the firm has and (b)that the firm is the only stock in each investor's portfolio. Stand-alone risk is measured by the variability of the project's expected returns. -Diversification is totally ignored. -reflects uncertainty about its cash flows. EX) required investment, unit sales, sales prices, and operating costs
Business risk
The riskiness inherent in the firm's operations if it uses no debt. -single most important determinant of capital structure riskiness of the firm's assets if no debt is used. -can change over time -varies from industry to industry and also among firms in a given industry commonly used measure of business risk is the standard deviation of the firm's return on invested capital, or ROIC
pecking order
The sequence in which firms prefer to raise capital: first spontaneous credit, then retained earnings, then other debt, and finally new common stock. Their first source of funds is accounts payable and accruals. Retained earnings generated during the current year would be the next source. Then, if the amount of retained earnings is not sufficient to cover capital requirements, firms issue debt. Finally, and only as a last resort, they issue new common stock.
asymmetric information
The situation where managers have different (better) information about firms' prospects than do investors -has an important effect on the optimal capital structure.
the IRR is based on the assumption that projects' cash flows can be reinvested at the IRR.
This assumption is generally incorrect, and this causes the IRR to overstate the project's true return we can modify the IRR to make it a better measure of profitability
Other projects.
This catch-all includes items such as office buildings, parking lots, and executive aircraft. How they are handled varies among companies.
Risk Analysis
Three separate and distinct types of risk are involved: 1. Stand-alone risk 2. Corporate, or within-firm, risk 3. Market, or beta, risk
To what extent can firms control their operating leverage?
To a large extent, operating leverage is determined by technology. although industry factors do exert a major influence, all firms have some control over their operating leverage.
improve forecasts
When decision makers are forced to compare their projections with actual outcomes, there is a tendency for estimates to improve. Conscious or unconscious biases are observed and eliminated; new forecasting methods are sought as the need for them becomes apparent; and people simply tend to do everything better, including forecasting, if they know that their actions are being monitored.
non-normal cash flows
a cash outflow occurs sometime after the inflows have commenced, meaning that the signs of the cash flows change more than once -++-++- EX) strip coal mine where the company spends money to purchase the property and prepare the site for mining, has positive inflows for several years, and then the company spends more money to return the land to its original condition
Sunk Costs
a cash outlay that has already been incurred and that cannot be recovered regardless of whether the project is accepted or rejected Because sunk costs were incurred in the past and cannot be recovered regardless of whether the project is accepted or rejected, they are not relevant in the capital budgeting analysis. Not handling sunk costs properly can lead to incorrect decisions.
capital structure decisions must be made using
a combination of judgment and numerical analysis
If the actual debt ratio has surpassed the target
a firm can sell a large stock issue and use the proceeds to retire debt. Or, if the stock price has increased and pushed the debt ratio below the target, it can issue bonds and use the proceeds to repurchase stock. And, of course, a firm can gradually move toward its target through its annual financings to support its capital budget
decision tree
a graph of decisions and their possible consequences; it is used to create a plan to reach a goal
net present value profile
a graph showing the relationship between a project's NPV and the firm's cost of capital Verticle axis: To make the profile, we find the project's NPV at a number of different discount rates and then plot those values to create a graph. Note that at a zero cost of capital, the NPV is simply the net total of the undiscounted cash flows the IRR is the discount rate that causes the NPV to equal zero, so the discount rate at which the profile line crosses the horizontal axis is the project's IRR
If the firm were debt-free, its beta would depend entirely on
its business risk and thus would be a measure of the firm's "basic business risk."
Monte Carlo Simulation
a risk analysis technique in which probable future events are simulated on a computer, generating estimated rates of return and risk indexes technically more complex than scenario analysis, but simulation software makes the process manageable.
the announcement of a stock offering is generally taken as
a signal that the firm's prospects as seen by its management are not bright. This, in turn, suggests that when a firm announces a new stock offering, more often than not, the price of its stock will decline Empirical studies have shown that this situation does exist.
ROIC measures the
after-tax return that the company provides for all of its investors. Because ROIC does not vary with changes in capital structure, the standard deviation of ROIC σ (σROIC) measures the underlying risk of the firm before considering the effects of debt financing, thereby providing a good measure of business risk
A firm whose earnings are relatively volatile
all else equal, faces a greater chance of bankruptcy and thus should use less debt than a more stable firm.
expansion projects
all of its cash flows were incremental—they occurred only if the firm accepted the project.
Measuring Stand-Alone Risk
all the inputs are expected values, and actual values can vary from expected values. Three techniques are used to assess stand-alone risk: (1)sensitivity analysis, (2)scenario analysis, and (3)Monte Carlo simulation.
signal
an action taken by a firm's management that provides clues to investors about how management views the firm's prospects
best-case scenario.
an analysis in which all of the input variables are set at their best reasonably forecasted values
base-case scenario
an analysis in which all of the input variables are set at their most likely values
worst-case scenario
an analysis in which all of the input variables are set at their worst reasonably forecasted values
leveraged buyout (LBO)
an attempt by employees, management, or a group of investors to purchase an organization primarily through borrowing -good way to reduce excess cash flow debt is used to finance the purchase of a high percentage of the company's shares. -high debt payments after the LBO force managers to conserve cash by eliminating unnecessary expenditure
Opportunity Costs
an opportunity cost, and it should be reflected in our calculations. We would add $100 to the project's cost. The result would be an NPV of $78.82-$100=-$21.18, so the project would now be rejected.
managers with more limited free cash flow
are less able to make wasteful expenditures.
The Hamada Equation
attempts to quantify the increased cost of equity due to financial leverage
Modern capital structure theory
began in 1958 when Professors Franco Modigliani and Merton Miller (hereafter, MM) published what has been called the most influential finance article ever written.* MM proved, under a restrictive set of assumptions, that a firm's value should be unaffected by its capital structure. suggest that it does not matter how a firm finances its operations—hence, that capital structure is irrelevant
Analyzing capital expenditure proposals is not costless
benefits can be gained, but analysis does have a cost
the threat of bankruptcy, not just bankruptcy per se
brings about these problems. If they become concerned about the firm's future, key employees start "jumping ship," suppliers start refusing to grant credit, customers begin seeking more stable suppliers, and lenders start demanding higher interest rates and imposing stricter loan covenants.
Traditional discounted cash flow (DCF) analysis
cash flows are estimated and then discounted to obtain the expected NPV—has been the cornerstone of capital budgeting since the 1950s. However, in recent years it has been shown that DCF techniques do not always lead to proper capital budgeting decisions. originally developed to value securities such as stocks and bonds (passive investments)
IRR calculation is based on the assumption that
cash flows can be reinvested at the IRR
Incremental Cash Flows
cash flows that will occur if and only if the firm takes on a project Cash flows such as investments in buildings, equipment, and working capital needed for the project are obviously incremental, as are sales revenues and operating costs associated with the project.
NPV calculation is based on the assumption that
cash inflows can be reinvested at the project's risk-adjusted WAC
We can use NPV profiles to see when
conflicts can and cannot arise
The firm's internal condition
connection with asymmetric information and signaling.
replacement: needed to continue current operations.
consists of expenditures to replace worn-out or damaged equipment required in the production of profitable products. The only questions here are should the operation be continued and if so, should the firm continue to use the same production processes? If the answers are yes, the project will be approved without going through an elaborate decision process.
A firm's growth, and even its ability to remain competitive and to survive, depends on
constant flow of ideas relating to new products, to improvements in existing products, and to ways of operating more efficiently. Accordingly, well-managed firms go to great lengths to develop good capital budgeting proposals.
More detailed analyses are required for
cost-reduction projects, for expansion of existing product lines, and especially for investments in new products or areas.
if a project has most of its cash flows coming in the later years
its NPV will decline sharply if the cost of capital increases, but a project whose cash flows come earlier will not be severely penalized by high capital costs.
Bankruptcy-related problems are likely to increase the more
debt a firm has in its capital structure. bankruptcy costs discourage firms from pushing their use of debt to excessive levels
the impact of an increase in the cost of capital is much greater on
distant than near-term cash flows
externalities
effects on the firm or the environment that are not reflected in the project's cash flows 1. negative within-firm externalities, 2. positive within-firm externalities, and 3. environmental externalities
if a firm uses a considerable amount of both operating and financial leverage
even small changes in sales will lead to wide fluctuations in EPS
Higher debt forces managers to be more careful with shareholders' money
even well-run firms can face bankruptcy (get stabbed) if some event beyond their control, such as a war, an earthquake, a strike, or a recession, occurs. To complete the analogy, the capital structure decision comes down to deciding how big a dagger stockholders should use to keep managers in line.
Higher leverage increases
expected EPS , but it also increases risk.
Typically, using debt increases the
expected rate of return for an investment. However, debt also increases risk to the common stockholders.
Expansion of existing products or markets.
expenditures to increase output of existing products or to expand retail outlets or distribution facilities in markets now being served. Expansion decisions are more complex because they require an explicit forecast of growth in demand, so a more detailed analysis is required. The go/no-go decision is generally made at a higher level within the firm.
a firm with unfavorable prospects would want to
finance with stock, which would mean bringing in new investors to share the losses like to finance with outside equity
high-leveraged companies
financed heavily with debt, have lower coverage ratios.
Investors are particularly concerned with
free cash flow
Financial leverage takes over where operating leverage leaves off
further magnifying the effects on earnings per share of changes in the level of sales For this reason, operating leverage is sometimes referred to as first-stage leverage and financial leverage as second-stage leverage.
Firms with good investment opportunities generally do
have good access to debt and equity markets.
low-leveraged companies
have high coverage ratios
Firms in bankruptcy
have high legal and accounting expenses, and they have a hard time retaining customers, suppliers, and employees. Moreover, bankruptcy often forces a firm to liquidate assets for less than they would be worth if the firm continued to operate. Assets such as plant and equipment are often illiquid because they are configured to a company's individual needs and because they are difficult to disassemble and move.
sophisticated financial managers use their forecasted ratios to predict
how bankers and other lenders will judge their firms' risks and thus their costs of debt.
financial managers use financial statement forecasting models to determine
how changes in the debt-to-capital ratio will affect the current ratio, times-interest-earned (TIE) ratio, and EBITDA coverage ratio.* They then discuss their projected ratios with bankers and bond rating agencies, which ask probing questions and may make their own adjustments to the firm's forecasts. The bankers and rating agencies compare the firm's ratios with those of other firms in its industry and arrive at a "what if" rating and corresponding interest rate. Moreover, if the company plans to issue bonds to the public, the SEC requires that it inform investors what the coverages will be after the new bonds have been sold.
Improve operations
if costs are above and sales below predicted levels, then executives in production, marketing, and other areas will strive to improve operations and to bring results into line with forecasts
business risk depends in part on the extent to which a firm builds fixed costs into its operations
if fixed costs are high, even a small decline in sales can lead to a large decline in ROIC. So other things held constant, the higher a firm's fixed costs, the greater its business risk. Higher fixed costs are generally associated with more highly automated, capital-intensive firms and industries. However, businesses that employ highly skilled workers who must be retained and paid even during recessions also have relatively high fixed costs, as do firms with high product development costs, because the amortization of development costs is a fixed cost.
The post-audit has two main purposes:
improve forecasts and improve operations not a simple process 1. recognize that each element of the cash flow forecast is subject to uncertainty, so a percentage of all projects undertaken by any reasonably aggressive firm will necessarily go awry. 2. projects sometimes fail to meet expectations for reasons beyond the control of their sponsors and for reasons that no one could be expected to anticipate. 3. it is often difficult to separate the operating results of one investment from those of a larger system. 4. it is often hard to hand out blame or praise because the executives who were responsible for launching a given investment have moved on by the time the results are known.
Replacement: cost reduction
includes expenditures to replace serviceable but obsolete equipment and thereby to lower costs. These decisions are discretionary, and a fairly detailed analysis is generally required.
Steeper slope
indicating that a given increase in the cost of capital causes a larger decline in the project than the other
tax-shelter benifits
interest paid is a deductible expense makes debt less expensive than common or preferred stock. In effect, the government pays part of the cost of debt—or to put it another way, debt provides tax shelter benefits. As a result, using more debt reduces taxes and thus allows more of the firm's operating income (EBIT) to flow through to investors. This factor, on which MM focused, tends to raise the stock's price.
Expansion into new products or markets
investments relate to new products or geographic areas, and they involve strategic decisions that could change the fundamental nature of the business. Invariably, a detailed analysis is required, and the final decision is generally made at the top level of management.
capital
investor-supplied funds—debt(L&ST Loans), preferred stock, common stock, and retained earnings.* Accounts payable and (accruals are not included in our definition of capital because they are not provided by investors—they come from suppliers, workers, and taxing authorities as a result of normal operations, not as investments by investors.)
When a company's stock is overvalued (trading for more than its intrinsic value)
its managers can take the opportunity to issue new equity at a time when its market value is relatively high. Likewise, managers may choose to repurchase stock when the firm's stock is undervalued.
firms have target debt ratios that call for
less than 100% debt to limit the adverse effects of potential bankruptcy.
payback methods provide information about
liquidity and risk The shorter the payback, other things held constant, the greater the project's liquidity. This factor is often important for smaller firms that don't have ready access to the capital markets. Also, cash flows expected in the distant future are generally riskier than near-term cash flows, so the payback is used as one risk indicator.
The optimal capital structure is the one that
maximizes the price of the firm's stock, and this generally calls for a Debt/Capital ratio that is lower than the one that maximizes expected EPS.
the capital structure that maximizes the stock price also
minimizes the WACC, and at times, it is easier to predict how a capital structure change will affect the WACC than the stock price.
firms should, in normal times, use
more equity and less debt than is suggested by the tax benefit/bankruptcy cost trade-off model
long-term project
more total cash inflows but they come in later in its life
NPV and IRR can produce conflicting conclusions when a choice is being made between
mutually exclusive projects, and when conflicts occur, the NPV is generally better.
In some respects, we can think of the sale of fixed assets at the end of the project as a
negative capital expenditure—instead of using cash to purchase fixed assets, the company is selling the assets to generate cash.
Why might it be logical for a firm to follow this pecking order?
no flotation costs are incurred to raise capital as spontaneous credit or retained earnings, and costs are relatively low when issuing new debt. However, flotation costs for new stock issues are quite high, and the existence of asymmetric information/signaling effects makes it even more undesirable to finance with new common stock.
Taking on a project with a great deal of stand-alone or corporate risk will
not necessarily affect the firm's beta
payback period
number of years required to recover the funds invested in a project from its cash flows. the shorter the payback, the better the project
passive investments
once the investment has been made, most investors can take no actions that influence the cash flows they produce
normal cash flows
one or more cash outflows (costs) followed by a series of cash inflows. ---+++++
Business risk is an important determinant of the
optimal capital structure.
capital budgeting projects are not
passive investments—managers can often take positive actions after the investment has been made that alter the cash flow stream. Opportunities for such actions are called real options
stock prices are
positively related to expected earnings but negatively related to higher risk. Therefore, to the extent that higher debt levels raise expected EPS, financial leverage works to increase the stock price. However, higher debt levels also increase the firm's risk, which raises the cost of equity and works to reduce the stock price.
most decision makers do a
quantitative analysis of stand-alone risk and then consider the other two risk measures in a qualitative manner.
free cash flow
represents the net amount of cash that is available for all investors after taking into account the necessary investments in fixed assets (capital expenditures) and net operating working capital
Increasing the debt ratio increases the
risk that bondholders face and thus the cost of debt. More debt also raises the risk borne by stockholders, which raises the cost of equity, rs.
firms whose assets are illiquid and would have to be sold at "fire sale" prices
should limit their use of debt financing.
firms with high operating leverage (and thus greater business risk)
should limit their use of financial leverage.
Although managers recognize the importance of within-firm and beta risk, they generally end up dealing with these risks
subjectively, or judgmentally, rather than quantitatively. The problem is that to measure diversification's effects on risk, we need the correlation coefficient between a project's returns and returns on the firm's other assets, which requires historical data that obviously do not exist for new projects.
beta is the only variable in the equity cost equation
that is under management's control. The other two variables, rRF and RPM, are determined by market forces that are beyond the firm's control, but bL is determined by the firm's operating decisions, which as we saw earlier affect its basic business risk, and by its capital structure decisions as reflected in its debt (or D/E) ratio.
Because discounting at a given rate assumes that cash flows can be reinvested at that same rate,
the IRR assumes that cash flows are reinvested at the IRR.
optimal capital budget
the annual investment in long-term assets that maximizes the firm's value
opportunity costs
the best return that could be earned on assets the firm already owns if those assets are not used for the new project
The Post-Audit
the comparison of the actual results of capital investments to the projected results which involves: (1)comparing actual results with those predicted by the project's sponsors and (2)explaining why any differences occurred.
Managers should set as the target capital structure
the debt-equity mix that maximizes the firm's stock price. However, it is difficult to estimate how a given change in the capital structure will affect the stock price.
incremental cash flows
the difference between a firm's future cash flows with a project and those without the project
internal rate of return (IRR)
the discount rate that forces the PV of its inflows to equal its cost. This is equivalent to forcing the NPV to equal zero. The IRR is an estimate of the project's rate of return, and it is comparable to the YTM on a bond. The rate that forces NPV to equal zero is the IRR If both projects were independent, both projects would be accepted because both IRRs are greater than the firm's WACC. If both projects were mutually exclusive, using the IRR method Project X would be chosen because its IRR is greater than the IRR of Project Y, and it is greater than the firm's WACC.
Operating leverage
the extent to which fixed costs are used in a firm's operation High: When a high percentage of total costs are fixed; implies that a relatively small change in sales results in a large change in ROIC.
If the actual debt ratio were significantly below the target range
the firm would probably raise capital by issuing debt, whereas if the debt ratio were above the target range, equity would probably be used.
The more uncertainty there is about future EBIT and thus ROIC
the greater the company's business risk
The greater the difference between the stock's book value and market value
the greater the difference between the alternative WACCs.
the higher a firm's operating leverage
the higher its business risk.
Capital structure
the mix of debt, preferred stock, and common equity that is used to finance the firm's assets typically defined as the percentage of each type of investor-supplied capital, with the total being 100%.
The greater the use of fixed operating costs as measured by the degree of operating leverage
the more sensitive EBIT will be to changes in sales.
The greater the use of debt as measured by the degree of financial leverage
the more sensitive EPS will be to changes in EBIT.
degree of total leverage (DTL)
the numerical measure of the firm's total leverage shows how a given change in sales will affect earnings per share useful primarily for the insights it provides regarding the joint effects of operating and financial leverage on earnings per share
windows of opportunity
the occasion where a company's managers adjust its firm's capital structure to take advantage of certain market situations -these attempts to time the market have had a profound effect on these companies' capital structures
if we were comparing two projects
the one with the steeper sensitivity lines would be riskier, other things held constant, because relatively small changes in the input variables would produce large changes in the NPV
degree of operating leverage (DOL)
the percentage change in operating income (or EBIT) that results from a given percentage change in sales percentage change in earnings per share that results from a given percentage change in EBIT
Net present value (NPV)
the present value of the project's free cash flows discounted at the cost of capital. -The NPV tells us how much a project contributes to shareholder wealth; the larger the NPV, the more value the project adds—and added value means a higher stock price. Thus, NPV is the best selection criterion.
Capital Budgeting
the process a firm uses to evaluate long-term investment proposals
if the project has high stand-alone risk and if its returns are highly correlated with returns on the firm's other assets and with returns on most other stocks in the economy
the project will have a high degree of all three types of risk.
The first bracketed term in the free cash flow equation [EBIT(1 − T) + Depreciation and amortization] represents
the project's operating cash flows. In most cases, these cash flows will vary over the life of the project.
Why is the discount rate that causes a project's NPV to equal zero so special?
the reason is that the IRR is an estimate of the project's rate of return. If this return exceeds the cost of the funds used to finance the project, the difference will be an additional return (in a sense a "bonus") that goes to the firm's stockholders and causes the stock price to rise.
stock's beta
the relevant measure of risk for a diversified investor. Moreover, beta increases with financial leverage. -Robert Hamada formulated the following equation to quantify this effec
The higher the percentage of debt in the capital structure
the riskier the debt and, for that reason, the higher the interest rate lenders would charge.
short-term project
the sense that more of its cash inflows come early
multiple IRRs
the situation where a project has two or more IRRs
symmetric information
the situation where investors and managers have identical information about firms' prospects -MM assumed this
The larger the range
the steeper the variable's slope and the more sensitive the NPV is to changes in this variable.
the use of debt, or financial leverage, concentrates the firm's business risk on
the stockholders changes in the use of debt would cause changes in earnings per share (EPS) as well as changes in risk—both would affect the stock price.
once a corporation's operating leverage has been established
this factor exerts a major influence on its capital structure decision
Bondholders recognize that if a firm has a higher Debt/Capital ratio,
this increases the risk of financial distress, which leads to higher interest rates.
In the real world, a project's cash flows are rarely just given to you; instead, the finance staff will need to assemble the relevant information
this information comes from a variety of sources within the company. For example, the marketing department may provide sales projections, the company's engineers may estimate costs, and the accounting staff may provide information about taxes and depreciation.
if a firm reduced its operating leverage
this would probably lead to an increase in its optimal use of financial leverage On the other hand, if it decided to increase its operating leverage, its optimal capital structure would probably call for less debt.
Issuing stock emits a negative signal
thus tends to depress the stock price; even if the company's prospects are bright, a firm should, in normal times, maintain a reserve borrowing capacity that can be used in the event that some especially good investment opportunity comes along.
we would expect a firm with very favorable prospects
to avoid selling stock and instead raise any required new capital by using new debt, even if this moved its debt ratio beyond the target level. prefer not to finance through new stock offerings
Trial and error
try a discount rate, see if the equation solves to zero, and if it doesn't, try a different rate. We could then continue until we found the rate that forces the NPV to zero; that rate would be the IRR.
problem with the IRR
under certain conditions a project may have more than one IRR
Effect of Different Depreciation Rates
under the straight-line method, the depreciation cash flows are spread out over n years, while under immediate expensing, the depreciation cash flows are received immediately. Because of the time value of money, dollars received earlier have a higher present value than dollars received later.
grocery stores, utility companies, and airlines
use debt relatively heavily because their fixed assets make good security for mortgage bonds and their relatively stable sales make it safe to carry more than average debt.
Petroleum, biotechnology, and steel companies
use relatively little debt because their industries tend to be cyclical, oriented toward research, or subject to huge product liability suits
when conflicts exist between mutually exclusive projects
use the NPV method.
even though the component cost of equity is higher than that of debt
using only lower-cost debt would not maximize value because of the feedback effects of debt on the costs of debt and equity.
When we calculate a present value
we are implicitly assuming that cash flows can be reinvested at a specified interest rate
similarities between security valuation and capital budgeting
we forecast a set of cash flows, find the present value of those flows, and make the investment only if the PV of the inflows exceeds the investment's cost.
Timing of Cash Flows
we generally assume that all cash flows occur at the end of the year. Note, however, for projects with highly predictable cash flows, it might be useful to assume that cash flows occur at midyear (or even quarterly or monthly). But for most purposes, we assume end-of-year flows.
Financial flexibility
we know for sure that having to turn down promising ventures because funds are not available will reduce our long-run profitability
replacement projects
we must find cash flow differentials between the new and old projects, and these differentials are the incremental cash flows that we analyze.
when choosing between mutually exclusive projects
we must first determine whether they can be repeated. If the projects can be repeated, we must consider this fact when we estimate their profitability.
