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