FINC12-200 Final Exam
How is the opportunity cost concept used in the capital budgeting process?
The opportunity cost concept is considered in the capital budgeting process primarily through the use of the appropriate required return used to evaluate a project. This required return (the risk‐adjusted discount rate) considers the returns (opportunities) that are available on other projects of equivalent risk.
Why might an investor be willing to pay more than the $1000 face value for a bond?
If the current yield exceeds the required return, then the investor may be willing to pay more than face value for a bond and incur a capital loss which will be offset by the the high current yield.
Explain what is meant by interest rate risk.
Interest rate risk represents the variation in the market price of a bond and hence its realised rate of return (if sold prior to maturity) due to changes in prevailing interest rates (i.e. required rates of return).
What are net cash flows?
Net cash flows, also net operating cash flows, are the incremental changes in a firm's operating cash flows that result from investing in the project. These flows include the changes in the firm's revenue, operating expenses, depreciation, tax, and net working capital with and without the project.
What is the coupon rate?
The annual interest rate of interest paid to bondholders expressed as a percentage of par value.
What factors make valuation of common stock more complex than the valuation of preferred stock and bonds?
- Common stock returns can take two different forms: cash dividend payments and/or increases in the share price over time - There is no contractual obligation for the firm to pay dividends (in contrast to interest paid on debt), and the dividends to common stockholders are expected to grow over time to compensate investors for the risks attaching to residual ownership (in contrast to dividends paid on preferred stock); hence the simple annuity and perpetuity formulas are not applicable -The future returns from common stocks (i.e. cash dividends and/or price appreciation) are more uncertain than the returns from bonds and preferred stock.
What effect does capital rationing have on a firm's ability to maximise shareholder wealth?
Capital rationing (being a constraint placed upon the amount of investable funds) is normally not consistent with shareholder wealth maximisation. This type of constraint forces the rejection of otherwise acceptable projects, thereby removing the opportunity to increase shareholder wealth, and forcing independent projects to act as mutually exclusive when competing for the scarce capital resource.
What are common stock classes?
Common stock classes occur when firms choose to issue two or more classes of common stock with unequal voting rights (not applicable to dividend rights). In these cases, firms issue the class with the most significant voting rights to directors and officers of the company to ensure that they maintain control of the firm whilst raising additional equity capital.
What are the advantages and disadvantages of preferred stock financing?
Advantages: - Gives firms flexibility associated with declaring dividends compared to long term debt financing in which firms have a contractual obligation to pay interest on the debt. Disadvantages: -
Do voting rights exist in preferred stock?
Generally, preferred stockholders are not entitled to vote for the company's board of directors. However, special voting procedures can take place if the company omits its preferred dividends or incurs losses for a period of time. In this case, preferred stockholders vote as a separate group to elect one or more members of the board of directors. This ensures they will have direct representation on the board.
In the context of the constant growth dividend valuation model, explain what is meant by a. Dividend yield b. Price appreciation yield
The dividend yield is the next period dividend expressed as a percentage of the current price, i.e. D1/P0. It is the current income, i.e. cash dividends received during the holding period. Price appreciation yield is the reinvestment of earnings into the firm which leads to growth in the earnings, dividends and therefore share price over the coming period. It is equivalent to capital gain = (P1-P0)/P0.
How does the yield-to-maturity on a bond differ from the coupon yield or current yield?
The yield to maturity is the annual rate of return expected to be earned if a bond is purchased at a given price and held until maturity. The coupon or current yield is the annual interest payment divided by the current price - it is the return from interest alone. Yield to maturity takes into account interest returns as well as any capital gains or losses over the remaining life of the bond. The coupon or current yield considers only the interest returns and ignores any capital gains or losses.
Describe the relationship between the coupon rate and the required rate of return that will result in a bond selling at: a. A discount b. Par value c. A premium
a. A bond will sell at a discount if the required rate of return is greater than the coupon rate. b. A bond will sell at par value if the required rate of return is equal to the coupon rate. c. A bond will sell at a premium if the required rate of return is less than the coupon rate.
When are multiple rates of return likely to occur in an internal rate of return computation? What should be done when a multiple rate of return problem arises?
Multiple rates of return are likely to occur when a project's cash flow stream contains more than one sign change (from positive to negative or negative to positive). Under these circumstances, it is best to use the net present value approach. For any given discount rate applied, a project only ever has one net present value. This calculation of net present value represents the change in shareholder wealth today as a result of accepting the project, thereby providing a basis for accepting or rejecting projects that is consistent with management's overriding objective.
What is net investment? What is its formula? (you need to memorise).
Net investment is the initial cash outlay required to place a project in service. It is equal to the initial project cost (C+I+S+M+T) plus the change in net working capital minus after tax net sale proceeds.
Under what conditions will a bond's current yield be equal to its yield-to-maturity?
The current yield will be equal to the yield to maturity when the current price of the bond is equal to its par (face) value. In this case, there will be no capital gain (or loss) when the bond matures.
Which do you think is more risky for a firm trying to raise capital-an underwritten offering or a best-efforts offering?
A best-efforts offering is more risky than an underwritten offering for a firm trying to raise capital. With an underwritten offer, the firm has a known floor in the amount of capital to be raised (pre-fees); being the number of shares issued multiplied by the underwriter's purchase price. When an investment bank operates on a best efforts basis, they perform a marketing function only, for which they earn a fee, with no obligation on the bank to purchase unsubscribed shares of common stock.
According to the general dividend valuation model, a firm that reinvests all its earnings and pays no cash dividends can still have a common stock value greater than zero. How is this possible?
A firm that reinvests all its earnings and pays no cash dividends can still have a share price greater than zero when evaluated using the general dividend valuation model because, at some future point in time, it is reasonable to expect that the firm will begin to pay cash dividends to its shareholders. In addition to ordinary cash dividends, shareholders may receive liquidating dividends if the firm sells its assets and ceases to operate as a going concern. Alternatively, the returns may consist of the proceeds from the sale of the firm's outstanding common stock if the business is acquired by another company.
What is a bond?
A long-term debt instrument sold on an exchange that is governed by a legal contract, in which a borrower agrees to make repayments of principal and interest, on specific dates, to the holders of the bond. The series of periodic interest payments are called coupons, and the principal borrowed (face value) is paid back at maturity. They are standardised to have a par value of $1000 and are mainly sold by the government as they require a constant funding source
What is meant by a normal/non-normal cash flow pattern?
A normal cash flow pattern has an initial cash outlay or outlays followed by a stream of positive net cash flows. I.e. normal cash flow occurs when there is only 1 change in sign of cash flows over a period of time. A non-normal cash flow pattern occurs when there is either more than 1 change in sign or no changes in sign of cash flows over a period.
What is participation?
A preferred stock issue in which the holders share in any increased earnings of the company. Virtually all preferred stock is non-participating.
What is a trustee?
A trustee is a representative, usually from a commercial bank or trust company, who acts on behalf of the debt holder to ensure that the borrowing company adheres to all of the terms and covenants set out in the indenture. The expense is paid for by the issuing firm.
Depreciation is a noncash expense; why is it considered when estimating a project's net cash flows?
Although depreciation itself is a non-cash charge against the profits of the firm, it has the effect of reducing taxable net income and, hence, reduces income tax payable, which is a real cash outflow for the firm. The effect of depreciation on cash flow is equal to the amount of depreciation multiplied by the firm's marginal tax rate.
What is the formula for a perpetual bond?
P0= I/kd
Explain the concept of capital budgeting and why it is important.
Capital budgeting involves the planning for the purchase of an asset (estimation of net cash flows and net investments) whose returns are expected to generate returns for over (an arbitrary period of) 1 year. Such investments are important to firms because they require significant cash outlay and have a long-range impact on performance. It is also important because it determines which products will be produced, where production facilities will be located, and the type of technology used. Also, it is important because it is extremely difficult to reverse capital expenditure without incurring considerable additional expense.
What is the cost of capital?
Cost of capital is the cost of external funds (i.e. debt, preferred stock, and common equity) used to finance investments made by a company. Importantly, it is also the minimum required return of investors on a new investment. If returns > cost of capital, shareholder wealth will increase.
What are stock dividends?
Dividends paid out in new shares of common stock rather than cash. Commonly expressed as a percentage, with stock dividends normally in the 2-10% range - i.e. number of shares outstanding is increased by 2 to 10%.
What is meant by the 'par value' of stock?
Par value refers to the value assigned to stock by the issuing company and is frequently the same as the initial selling price, although it isn't always. No relationship necessarily exists between par value and initial selling price of stock.
Explain what is meant by reinvestment rate risk.
Reinvestment rate risk is the potential decrease in interest income that results when a bond issue matures (or is called) and, because of a possible decline in interest rates, the investor has to reinvest the principal at a lower coupon rate.
Explain the concepts of stock splits and reverse stock splits.
Stock splits occur when a firm increases the number of issued shares, leading to a reduction in share price. Firms may execute stock splits when they feel that the share price is too high and wish to attract more purchasers. Reverse stock splits occur when a firm reduces the number of shares outstanding and consequently cause an increase in share price. They may execute reverse stock splits when they feel as though the share price is too low and wish to bring it up to a more desirable trading level. In a perfect capital market, a stock split should not change the total market value of a firm.
What are termination cash flows?
Termination cash flows (TCF) are unique cash flows that occur at the time of a project's termination when a firm liquidates its investment. They include the recovery of net working capital and the recovery of the after-tax salvage value of fixed assets. Land is the only asset that does not depreciate. It can be assumed that all other assets depreciate on a straight-line basis to a salvage value of $0, unless stated otherwise.
What variables must be known (or estimated) in applying the capitalisation of cash flow method of valuation to a physical or financial asset? In other words, what factors are important when valuing assets?
The variables which must be known (or estimated) are: - The expected cash returns during each period; - The required rate of return (discount rate); and - The holding period of the asset. The above is a fancy way of saying timing, amount, and risk are key factors when valuing assets.
What is adjustable rate preferred stock?
With adjustable-rate preferred stock, dividends are reset periodically and offer returns that vary with interest rates. Most preferred stock does not have this feature.
What is preferred stock?
- Preferred stock is another form of fixed-income security. This is because dividends paid to preferred stockholders are fixed (do not fluctuate with earnings of a firm) and in the event the company is liquidated, stockholders will be paid a fixed amount. - They have a priority claim on assets compared to common stock in bankruptcy, although the claims are subordinated to all forms of debt instruments. usually paid at regular intervals. - They typically have no maturity date, although some can be callable. - Dividends are not tax-deductible, hence preferred stock has a higher after-tax cost than debt. - Preferred stockholders exposed to more risk than a bond holder, so they demand a greater required return.
What is common stock? How does it differ from bonds and preferred stock?
- Variable income security: market price tends to fluctuate more than the market price of bonds and preferred stock, hence the returns vary more over time than those of bonds and preferred stock. Also, dividend payments fluctuate with the company's earnings. - Residual form of ownership: common stockholders have the least senior claim on a firm's earnings and assets after debt holders and preferred stockholders respectively in the case of bankruptcy or liquidity, hence they have the highest seniority risk of the three. - A permanent form of long-term financing: unlike debt and some preferred stock, common stock has no maturity date. It is a non-callable perpetuity.
Explain the 6 principles of cash flow estimation.
1. Cash flows should be measured on an incremental basis. That is, the cash flow stream for a project should be estimated from the perspective of how the entire cash flow stream of the firm will be affected if the project is adopted compared with how the stream will be affected if the project is not adopted. 2. Cash flows should be measured on an after-tax basis, as the initial investment made on a project requires the outlay of after-tax cash dollars. 3. Sunk costs should not be considered when evaluating a project, as they have already been incurred in the past and cannot be recovered. 4. Indirect effects of accepting a project must be included in cash flow calculations. An example of an indirect cost is product cannibalisation, i.e. when a new product directly competes with another of the firm's products and reduces sales. 5. The value of resources used in a project should be measured in terms of their opportunity cost. The opportunity costs of resources (assets) are the cash flows those resources could generate if they are not used in the project under consideration. 6. Investment decisions (all cash returns to investors such as interest on debt and dividends on equity) should not be included in the evaluation of cash flows, as they have already been accounted for in the cost of capital.
Explain why a firm might repurchase its own common stock.
1. Financial restructuring - the firm can gain the benefits of increased financial leverage through the issuance of debt and using the proceeds to repurchase its common stock; the ability to issue debt increases with the maturity of the issuing firm where earnings and assets become known with greater certainty 2. Future corporate needs - repurchased stock can be used within future corporate objectives such as the acquisition of other companies via a stock offering and to satisfy obligations arising from the exercise of executive stock options, warrants and convertible securities 3. Disposition of excess cash - the company may want to dispose of excess cash obtained from operations or sale of assets. In the absence of positive NPV projects, the funds are expendable because management may not feel they can be invested profitably within the company in the foreseeable future 4. Reduction of takeover risk - reducing the number of shares in circulation increases the price per share and concentrates ownership in the hands of a smaller number of investors, thereby reducing returns to investors who may be considering acquisition of the firm
Describe the capital budgeting process. (4 step circle diagram).
1. Generate project proposals - brainstorming stage 2. Estimate cash flows - cost of capital/sales projections 3. Evaluate project - accept or reject and look at alternatives 4. Post-audit/Review - Reflect on the project after its execution - e.g why did actual cash flows differ from expected cash flows; should the project be terminated?
Explain the 3 different ways that securities are sold.
1. Public cash offerings: occurs when common equity is sold to the public. It is relatively expensive to issue due to marketing expenses and gives rise to the possibility that control of the company may be diluted, due to the large pool of potential investors. This method of selling securities can be done in one of two ways: underwritten (dealer) approach versus best-efforts (broker) approach. In the underwritten approach, investment bankers make an agreement with the issuing firm to value and market the company, facilitate the transaction, as well as purchase the shares at a set price (discount), whether it be the entire issue or a proportion. The investment banker then resells the issues to the public at a higher price. In the best-efforts approach, brokers will only value the company and market the issue to the public but have no obligation to purchase the company's shares if some cannot be sold. From a firm's perspective, the underwritten approach is preferable. 2. Private (direct) placement: a behind-closed-doors contract between two parties in which a company chooses to directly place debt or preferred stock issues with one or more institutional investors instead of having them underwritten and sold to the public. It will possibly increase the concentration of control in the company. The private market is an important source of long-term debt capital, especially for smaller companies. Private security placements have several advantages: 1. They reduce issuance costs by eliminating the underwriting costs 2. They can avoid time delays associated with the preparation of registration statements and with the waiting period 3. They can offer greater flexibility in the covenants outlined in the indenture between the borrower and lender. 3. Rights offering: when shares are sold to an established pool of existing investors (shareholders); this is especially linked with pre-emptive rights of common stockholders. Each stockholder receives one 'right' for each shared owned. Firms usually enlist the services of investment bankers, who urge rights holders to purchase the stock.
What are bond ratings?
A bond rating is a grade given to a bond based on its risk of default. This rating is issued by an independent firm and updated over the life of the bond. The most trusted rating agencies are S&P and Moody's. They consider a variety of factors such as earnings stability, coverage ratios, the relative amount of debt in the firm's capital structure, and the degree of subordination, as well as past experience. According to Moody's, the highest quality, lowest-risk issues are Aaa, and the scale continues down through Aa, A, Baa, Ba, B, Caa, Ca, and C. On the Standard & Poor's ratings scale, the top rating of AAA goes to highest-quality bonds, followed by AA, A, BBB, BB, B, etc. Most debt issues fall into one of the A or B categories. Bonds rated Baa/BBB or higher are classified as 'investment-grade debt', while those Ba/BB or lower are known as 'junk bonds' or 'speculative-grade debt'. The latter typically yield 2-3 percentage points or more over the highest-quality corporate debt and constitute an important segment of all corporate debt outstanding. They are issued by companies with weak financial positions (e.g. highly leveraged balance sheets or low earnings) to obtain the capital needed for internal expansion or for corporate acquisitions and buyouts.
Explain the Net Present Value decision model as well as its advantages and disadvantages.
Absolute measure of project performance. Decision rule: Accept projects with either a 0 or positive net present value, as this is either directly maintaining or increasing the value of a firm and consequently shareholder wealth, as well as the firm's share price. Reject projects with a negative net present value, as this is directly decreasing a firm's value, shareholder wealth, and its share price.
What is a call feature on a bond?
A call feature, once again outlined in the indenture of a bond, is a feature that allows borrowing companies to retire the debt issue prior to maturity. Firms will usually use the call feature when market interest rates decline, as they can then replace the old debt issues with new debt issues of lower coupon rates - this is bond refunding. It gives them significant flexibility in debt financing, but may deprive lenders of the advantage they would gain from holding the debt until maturity. Therefore, compensation is provided in the form of a call premium, the difference between the bond's call price and par value (where the call price is higher). Call premiums can be fixed, declining over the years. A deferred call occurs when a bond is not callable for the first few years of its life. Interest rates are higher on callable bonds.
What is a mutually exclusive investment project? An independent project? A contingent project? Give an example of each.
A mutually exclusive investment project is one whose acceptance precludes the acceptance of one or more alternative proposals, because the projects have the capacity to perform the same function for a firm. E.g. a firm deciding which city to build their headquarters in. An independent project is one whose acceptance or rejection does not directly eliminate other projects from consideration. Many independent projects are made mutually exclusive when there are restraints on capital funds. E.g. a firm's desired project of installing a new telecommunications system in it headquarters does not hinder them from simultaneously installing a new drill press, as long as there are no fund constraints and both projects meet the investment criteria. A contingent project is one whose acceptance is dependent on the adoption of one or more other projects. E.g. A firm's project of building a steel plant is dependent on their project of investing in suitable air and water pollution control equipment.
What is a conversion feature?
A provision that allows the holder to exchange the bond for shares of the company's common stock at the option of the holder.
What is a call feature on preferred stock?
A provision that gives the company the option to redeem (i.e. retire) its preferred stock issues at some pre-specified price. Similar to a call feature in bonds, a firm usually must provide investors with a call premium if ti attaches a call feature to its preferred stock. The probability that a firm will exercise the call privilege increases when market interest rates decrease.
What is a cumulative feature?
A provision which provides that if a firm fails to pay its preferred dividend, it cannot pay dividends on its common stock until it has satisfied all (or a pre-specified portion of) past-due preferred dividends.
What is a sinking fund provision?
A sinking fund provision is a feature of bonds outline in the indenture that allows a borrowing firm to make gradual deposits in an interest earning account so that there is just enough funds in the account upon maturity to repay lenders the principal. Lenders often require borrowing companies to gradually reduce outstanding balance of debt issue over its life instead of all at once on the maturity date. There are two ways for firms to do so: 1. Buy a portion of its own bonds back from open market - firms should do this if the price of a bond <$1000, i.e. when market interest rates are higher than the coupon rate. 2. Call a random number of bonds each year by a fraction using a lottery technique - firms should do this if the price of a bond >$1000, i.e. when market interest rates are lower than the coupon rate.
Explain why bondholders prefer a sinking fund provision in a bond issue.
A sinking fund provision is used to reduce the amount owed on the maturity date and hence reduce the risk that the borrower will default on the bond issue. Also, a sinking fund provision may add liquidity to a bond issue if the company satisfies its sinking fund obligation by buying bonds in the open market.
What are the advantages and disadvantages of common stock financing?
Advantages: - No fixed-dividend obligation exists (an advantage for the firm; in principle as dividend cuts are relatively uncommon for companies paying a 'regular' dividend) - Allows firms greater flexibility in financing plans than fixed-income securities, meaning common stock is less risky for firms as a source of financing than fixed-income securities. - Common stock can be advantageous to firms whose capital structure contains more than an optimal amount of debt. Under these circumstances, common stock financing can lower the firm's weighted cost of capital. Disadvantages: - Highest seniority risk compared to debt holders and preferred stockholders. Common stockholders only have a residual claim on a firm's assets/earnings in the event of liquidation/bankruptcy. - Firm's cost for common stock financing is high compared with fixed-income securities because investors in common stock have a higher required return due to the heightened riskiness of investing in variable-income security. - Expensive for the firm to issue due to high issuance costs associated with common stock sold to the public - Initially dilutes earnings per share for the company (although this should have no adverse effect on a well-informed market and should only be temporary if the firm is investing wisely)
What are the advantages and disadvantages of long-term debt financing.
Advantages: - Reduces taxable income for a company, as interest paid on bonds is tax-deductible (really good point) - Financial leverage (how much debt you have in a corporation) can increase earnings per share possible - Ownership is not diluted. A person who buys a bond is a creditor, and a creditor only. They have no say in decisions made about the company. Disadvantages: - Increased financial risk - more debt, more likeliness to default - Indenture covenants will significantly restrict a firm's operating flexibility. Covenants restrict what a firm can do throughout the life of a bond (e.g. cannot sell more bonds, buy out a company, etc.)
Distinguish between asset expansion and asset replacement projects. How does this distinction affect the capital expenditure analysis process?
Asset expansion projects require a firm to invest funds in additional assets in order to increase sales and/or reduce costs. They frequently require a significant incremental investment in net working capital. Expansion projects possess a greater amount of risk than asset replacement projects, as by accepting them, a firm will reach a greater capacity than they have ever reached before, thus the revenues generated by such projects are more uncertain. Asset replacement projects involve the retirement of one asset and the replacement of the old asset with a newer and more efficient one. Replacement investments usually do not require significant, incremental net working capital investments, and there is typically greater certainty regarding the nature, amount and timing of project benefits.
What are assumptions/limitations of the common stock valuation (constant growth) model/dividend discount model?
Assumptions: - The growth rate has to be constant. It cannot be used if the growth rate changes over time. - Firm pays dividends Limitations: - (May occur in the exam) Cannot be used when the required return (ke) is less than or equal to the growth rate.
How are bonds classified?
Bonds are classified as secured (mortgage) or unsecured (debentures) bonds. Mortgage bonds are bonds that are secured by some form of collateral asset which is pledged by sellers/borrowers and can be sold in the event of default. Lower Debentures are not secured by any physical asset, and thus possess a greater amount of risk. Debentures can be further classified into unsubordinated and subordinated debentures. Unsubordinated debentures are ranked above other loans/securities with regards to claims on assets or earnings and are second-in-line after mortgage bondholders. Subordinated debentures are ranked after other debts in terms of their bondholders' claim on assets/earnings if a company falls into liquidation or bankruptcy. They are ranked third-in-line after mortgage bondholders and unsubordinated bondholders. Debentures can also be classified as senior or junior debt. Senior debt has a higher priority claim to a firm's earnings and/or assets than junior debt. Junior debt has a lower priority. claim to a firm's earnings and/or assets than senior debt.
What is the primary difference between the book value and the market value of an asset?
Book value is a function of the historical acquisition cost of the asset, whereas market value is a function of the expected future returns of the asset. Market value may be greater than or less than book value depending on the changes that occur over time in the market capitalisation rate and the asset's expected future returns.
What are break points? Describe how to derive them in the marginal cost of capital schedule.
Breakpoints are the vertical lines in the MCC. They indicate the points where funds for a particular type of financing are exhausted. The breakpoints in the marginal cost of capital schedule are determined by dividing the maximum amount raised from a source of financing by the weight of that financing source in their capital structure. The first breakpoint will be the smallest number obtained from these calculations. This process is repeated until all funds that can be included in the optimal capital structure are used.
List some typical covenants outlined in the indenture of a bond.
In an indenture, restrictions are placed on the firm by lenders, typically: 1. Minimum coverage, or times interest earned, ratio the firm must maintain 2. The maximum amount of dividends a firm can pay on common and preferred stock (this affects bondholders as although their payments are fixed, the variable nature of common stock means there is technically no limit on the dividend amount a firm pays common stockholders) 3. The minimum level of working capital (i.e. firm's investment in current assets less its current liabilities) the firm must maintain
When is it possible for the net present value and the internal rate of return approaches to give conflicting rankings of mutually exclusive investment projects?
In the case of mutually exclusive investments, it is possible for the net present value and internal rate of return approaches to give conflicting rankings. This is most likely to occur when the projects under consideration are significantly different in terms of size or pattern of cash flows.
What is an indenture?
Indenture - a contract between a firm and its creditors that specifies the nature of a debt issue, the manner in which the principal must be paid, and restrictions (covenants) placed on the firm by lenders.
Why is it generally incorrect to consider interest charges when computing a project's net cash flows?
Interest expense is considered in the discounting process of capital budgeting analysis, rather than estimated within the incremental cash flows of the project. If interest expense was to be included within incremental cash flow estimates AND the discount rate included the cost of debt, the analyst would effectively be double-counting the impact of debt financing. It is generally incorrect to associate a particular method of financing with the investment decision for a project, hence the cost of debt is included in the cost of capital (discount rate) rather than deducted from project cash flows.
Explain the Internal Rate of Return decision model as well as its advantages and disadvantages. When will it generate conflicting conclusions to the NPV model?
Internal Rate of Return (IRR) model is a relative measure of project performance that uses the discount rate needed to achieve an NPV of 0 to determine if a project should be accepted. The internal rate of return is the discount rate that equates the present value of future cash flows to the present value of the net investment. The decision rule is to accept projects with IRR greater than or equal to ka (cost of capital), and to reject projects with IRR less than ka. Advantages: - Expresses returns in percentage form rather than as a dollar value, which many people prefer as it is easier to compare with other rates of return. - Takes timing and magnitude of cash flows into account (like NPV model). Disadvantages: - No IRR (Error 7 in financial calculator. If this happens, state that no IRR could be found and the NPV approach should be used instead, then use NPV method) - Multiple IRRs: multiple IRRs are possible when cash flows are non-normal - Reinvestment rate assumption. It is assumed that cash flows are reinvested at the IRR for the entire life of the project. This is different to the NPV model, where it is assumed that cash flows are reinvested at cost of capital for the entire project life. This can be problematic when cost of capital is significantly different to IRR. The higher the IRR, the more unrealistic it is that a firm can reinvest at that rate. IRR and NPV will reach the same accept/reject conclusion when there are two or more independent projects with normal cash flows and no capital rationing. Conflict may arise when deciding between mutually exclusive projects. If so, choose NPV always. IRR is biased towards projects with larger initial cash flows.
How do we classify investment projects in terms of their driving forces (not mutually exclusive, etc.)
Investment projects can be classified into 3 groups: 1. Projects generated by growth opportunities - firms take on such projects to expand into new lines of business/products, and to increase capacity. This is riskier than other project types. 2. Projects generated by cost reduction opportunities - firms adopt such projects to replace existing operating processes with new and more efficient ones. Promoted by technological development. 3. Projects generated by mandated obligations -firms take on such projects as a result of mandatory legal obligations such as environmental or workplace health and safety standards. If the cost of such a project is too high (e.g. mines), the firm may shut down. These projects are often contingent upon other projects.
Do investors require a higher return on debentures or mortgage bonds? Why?
Investors usually require a higher return on debentures because they are secured only by a company's earning power and unmortgaged assets, whereas mortgage bonds are secured by specific physical assets as well as the company's earning power. Since debentures are unsecured, their credibility depends on the earning power of the issuing company. As a result, debentures are issued by large, financially strong firms.
What are issuance costs (direct and indirect)?
Issuance costs are costs incurred by a firm when issuing securities. A major direct issuance cost is the underwriting spread - a set amount of money which investment bankers demand as compensation for assuming a certain amount of risk when underwriting a security issue. It is equal to the selling price to the public - proceeds to company. Another direct issuance cost is advisors' fees (lawyers, accountants), taxes, Securities and Exchange Commission registration/listing fees, and printing costs. Other (indirect) issuance costs include: - Cost of management time in preparing the security offering - Opportunity costs arising from underpricing an initial equity offer (relative to the correct market value) due to the uncertainty associated with the value of initial public offerings and the desire to ensure it is a success - Disclosing price-sensitive commercial information on an ongoing basis - Ongoing compliance costs
Explain the Payback Period decision model as well as its advantages and disadvantages.
Payback period decision model is a relative measure of project performance. It calculates the number of years taken to recover the initial investment using present value of net cash flows. PB = NINV/PVNCF. It can only be used when cash flows are the same every year. Decision rule: Accept project is PB is less than or equal to an arbitrary maximum period of time. The strengths of the payback approach are that it is easy to use and communicate, and it may be used as a crude measure of a project's risk and its liquidity. The weaknesses associated with this decision criteria are that it ignores cash flows that occur after the payback period has been achieved, it fails to consider time value of money, and there is no objective criterion for decision making.
In what ways is preferred stock similar to long-term debt? In what ways is it similar to common stock?
Preferred stock is similar to long-term debt in that dividends on preferred stock, like interest on debt, usually remain constant over time. Likewise, both securities have a fixed claim on the assets of the firm in the event of bankruptcy. Thus, preferred stock and long-term debt are considered fixed income securities. Preferred stock is similar to common stock in that it is part of stockholders' equity. Also, holders of preferred stock receive returns in the form of dividends rather than interest.
Explain the Profitability Index decision model as well as its advantages and disadvantages. When will it generate conflicting conclusions to the NPV model?
Profitability index is a relative measure of project performance that uses the ratio of present value of expected net cash flows to net investment to determine whether a project should be accepted or rejected. It can be interpreted as the present value return for every dollar of initial investment. PI = PVNCF/NINV. Decision rule: Accept projects with PI greater than or equal to 1. Reject projects with PI less than 1. It will make the same accept/reject decision as NPV model for two independent projects with normal cash flow structures, but when there are mutually exclusive projects, conflict may arise, especially when the projects have very different net investments. If there is no limit on funds available for the projects, then NPV is preferred, but if capital rationing exists, then PI is preferred.
Draw the simplified capital budgeting model and explain the different curves and variables.
Refer to textbook. Expected/required rate of return (%) is on the y-axis. Investment ($) is on the x-axis. MCC (Marginal Cost of Capital) - the incremental cost of capital incurred by a firm through the issuance of financial assets (bonds, preferred stock, common stock). Increases with investment. IOC (Investment Opportunities Curve) - the additional expected required rate of return generated by accepting a new project. Projects are ranked in descending order of profitability. Most importantly, under the maximisation of shareholder wealth principle, firms should stop accepting projects where MCC intersects IOC. Specifically, firms should only accept projects with MCC less than or equal to IOC (i.e. when k is less than or equal to r hat). Firms should reject projects with MCC > IOC (i.e. when k > r hat). If IOC = MCC, NPV remains the same. If IOC < MCC, NPV decreases. If IOC > MCC, NPV increases.
How does the net present value model complement the objective of maximising shareholder wealth?
The net present value method computes the present worth of a project's benefits over its costs, evaluated using the firm's cost of capital. If a project has a positive net present value, it means that investors are receiving more than the minimum required rate of return. This positive net present value is an additional increment to shareholder wealth.
Cash flows for a particular project should be measured on an incremental basis and should consider all the indirect effects of the project. What does this involve?
The objective of capital budgeting analysis is to estimate the total change in the firm's cash flows that result from acceptance of a project. Hence, indirect effects on the costs and/or revenues associated with a firm's other projects that occur as a result of accepting the new project must be considered when estimating the incremental cash flows to the firm. Indirect effects of accepting projects include product cannibalisation, which occurs when the introduction of a new product decreases sales of another of the firm's product.
Discuss the meaning of an optimal capital budget.
The optimal capital budget occurs at the point where the investment opportunities curve and the marginal cost of capital curve intersect. In other words, the optimal capital budget includes all projects whose expected returns exceed the marginal cost of capital and excludes all projects whose expected returns are less than the marginal cost of capital.
What are the primary objectives of the investment project post-audit review?
The post-audit process is a vital part of the capital budgeting process. It is a review of investment projects after they have been implemented which can provide useful information on the effectiveness of the company's selection process. It consists of comparing actual cash flows generated from an accepted project with projected cash flows that were estimated when the project was being evaluated. The objectives of a project post-audit review are: a. To identify systematic biases or errors in the cash flow estimates by individuals, departments, or divisions. This analysis enables decision makers to make better evaluations of investment proposals submitted in the future. b. To determine whether a project that is failing to meet its expected performance should be either abandoned or modified.
Describe how the profitability index approach may be used by a firm faced with a capital rationing investment funds constraint.
The profitability index defines the number of dollars of present value benefits that are received for each dollar of net investment. Hence, it provides a measure of relative profitability. This measure can be used to guide ranking of investment projects in a capital rationing situation. It is a modification to the NPV approach and therefore considers magnitude and timing of all cash flows associated with the project, as well as assuming these cash flows are reinvested at the project's cost of capital.
Describe the rights of common stockholders.
Voting Rights - Stockholders have the right to vote on stockholder matters such as the selection of board directors, whether to increase the number of shares authorised, merges, etc. by means of either a majority or cumulative voting procedure. The number of shares an investor owns in a company determines their voting power in the company. Voting rights are relatively uncommon nowadays. Pre-emptive rights - When new shares in a company are issued, existing stockholders are given first chance to participate proportionally. This helps maintain an investors percentage share in a company, even when more shares are sold over time. If the investor elects to accept, % share will be maintained, If elected to not accept, % share will decrease. Pre-emptive rights are extremely rare nowadays. Dividend rights - Given that a company pays dividends, all common stockholders have the right to receive dividends on a per-share basis. It is important to note that not all firms pay dividends, as there is no contractual obligation. Asset rights - Common stockholders have the right to residual claims on the remains of a company's assets and earnings in the event of bankruptcy or liquidation. Their claim is subordinated to those of debtholders and preferred stockholders respectively. Common stockholders have the highest seniority risk of the three.
Explain how each of the following factors would affect the valuation of a firm's common stock, assuming that all other factors remain constant: a. The general level of interest rates shifts upward, causing investors to require a higher rate of return on securities in general. b. Increased foreign competition reduces the future growth potential of the firm's earnings and dividends. c. Investors reevaluate upward their assessment of the risk of the firm's common stock as the result of increased South American investments by the firm.
a. An upward shift in interest rates and investors' required rates of return would cause an investor's required rate of return (ke) to increase and the price of the firm's stock (P0) to decrease. b. A reduction in the future growth potential of the firm's earnings and dividends due to increased foreign competition would lower the firm's future dividends and hence decrease the stock price. c. An increase in the riskiness of the firm's common stock due to larger South American investments by the firm would increase an investor's required rate of return and hence decrease the stock price unless the growth potential of these investments outweighed the increase in risk.