INTRO 2 FINANCE: modules 7-9 key terms

break even example: Assume we have total fixed costs of $22,000 and a product that we sell for $52 a unit. If variable costs are $31 a unit, what is our break-even level of units and our sales revenue? In other words, at what point do we recover all our costs?

BE units = $22,000/($52 - $31) = 1,047.62 units Because we can't make and sell 0.62 unit, we round up to 1,048 units. We need to sell and produce 1,048 units to cover all our fixed and variable costs.

mortgage bonds

Bonds that do have some asset pledged as collateral

overhead costs

(expenses such as heat, light rent, occur whether a given project is accepted or rejected) only fraction of overhead that should be allocated to the new project is the change in overhead costs you expect to incur if you accept the new project.

Modified Internal Rate of Return (MIRR)

(pg 322) the discount rate that equates the present value of the project's future free cash flows with the terminal value of the cash inflows

payback period : what it tells you

- how long it'll take to recapture the initial investment -shorter the better -if less than max acceptable payback period it is accepted

capital budgeting project category MUTUALLY EXCLUSIVE

-Mutually exclusive projects are projects that are all designed to accomplish the same goal. -If you accept one mutually exclusive project, you automatically reject the others. - The equipment replacement project mentioned earlier is a good example of a mutually exclusive project. -If you select one piece of equipment to replace your existing machinery, then you have no need for the other options.

dis. payback period : what it tells you

-how long it'll take to recapture the initial investment from dis. cash flows -shorter dis. payback period the better -less than max acceptable dis. payback period it is accepted.

preferred stock advantages over common stock: 2 ares: RECEIPT OF DIVIDENDS

-receipt of dividends: preferred is also a cumulative—if a firm skips a preferred dividend one year, it must catch up and pay all the preferred dividends to date before paying a common stock dividend. preferred dividends do not fluctuate but, instead, remain the same year after year. This certainty of a known dividend distribution is similar to the annual interest distribution (coupon payment) of a bond. However, preferred stock has no maturity date.

Initial Outlay (IO)

-typically easiest cash flow to id. -amount includes the cost of the new equipment plus any setup costs required to begin operations

Assume you have evaluated a project and the present value of the project's cash flows is $12,321. The initial outlay required for the project is $10,000. What are the project's NPV and PI?

NPV = $12,321 - $10,000 = $2,321 Because the NPV is positive, the decision rule is to accept this project. The PI for this project is: PI = $12,321/$10,000 = 1.23

If the present value of the cash flows is greater than the initial outlay

NPV is positive and the project should be accepted.

expansion of existing production: questions should help you identify whether these costs are incremental costs:

1. Will expanding production require a larger fraction of expenses be devoted to marketing to generate the new sales? 2. Will the additional product need to be shipped a greater distance? 3. Do you have excess production capacity and is it currently being used for other products?

to calculate EAA need only project's NPV and then determine what annual annuity (PMT) it is equal to

1. calculate NPV 2. calculate EAA by using the NPV as the project's present value (PV)

positive features of payback period

1. deals with cash flows not accounting profits (focuses on the true timing of project's benefits/costs) 2. easy to visualize, quickly understood, easy to calculate 3. payback period may make sense for non-capital-constrained firm -rough screening device to eliminate projects who's returns don't materialize until later yrs.

opportunity cost (incremental cost)

cash flows that are lsot bc a given project cosumes scarce resources that would have produced cash flows if that project had been rejected.

EXPANSION

common capital budgeting project is an expansion of existing production.

primary methods used to calculate the value of common stock is the

constant growth model. assumes that the cash flows from a share of stock occur forever.

bond holders depend on

continued financial solvency of the firm to receive the bond's cash flows

mutually exclusive projects EXAMPLE step 2

convert the cash flows to an annual amount. Project APV = -$8,433.70n = 10I/Y = 10 CPT PMT = $1,372.55 Project BPV = -$6,035.12n = 5I/Y = 10CPT PMT = $1,592.05

sunk costs

costs that have already been incurred; they are not relevan incremental costs exampls: test marketing expenses for a certain product, or the drilling of a test well for a petroleum exploration company.

variable costs

costs that vary directly with the level of production raw materials, direct labor, utilities, and selling costs. per-unit cost. Therefore, your total variable costs are the number of units produced multiplied by the variable cost per unit.

Net working capital is defined as

current assets minus current liabilities current assets less current liabilities. Current assets such as accounts receivable, accruals, and inventory typically increase with sales.

Individual investors evaluate stocks and bonds to

determine if investments will meet their goals, preferences, and risk tolerance.

asset valuation

determining how much an asset is worth

Preferred stock dividends are quoted as

either as a fixed amount or as a percent of par value.

IRR discount rate

equates present value of the inflows iwth tpresent value of the outflows, IRR is the point at with the NPV is equal to zero

Any project with a positive NPV will have a PI that

exceeds one

Stock Valuation Assuming No Growth: Example

except now with zero growth. Find the value of a stock that is expected to pay a dividend next year of $2.10, assuming your required return is 14%. Vo = $2.10 / 0.14 = $15

capital budgeting projects fall into two categories:

expanding current production or replacing old equipment.

Most capital budgeting involves either

expansion or replacement decisions

three components determine the value of a bond:

face value, also known as par value; coupon rate, or interest that the bond pays; and maturity date, or when you receive the face value of your money back.

Net present value (NPV)

financial evaluation tool that is calculated by taking the present value of the projected cash flows and subtracting out the initial outlay

A bond

financial instrument that is essentially an IOU.

To make replacement and expansion decisions

financial managers must forecast relevant cash flows because cash is necessary to expand production or replace equipment

after the break-even point is reached

firm is more profitable because the variable costs per unit are lower than an option with less fixed costs.

evaluate investment proposals

first set guidelines by which you measure the value of each proposal use free cash flows NOT ACCOUNTING PROFITS as measurement

most difficult part of valuing a stock is

forecasting the dividend.

break-even analysis

how many units we need to produce to break even break-even number depends on cost structure

preferred stock

hybrid security with characteristics of both stocks and bonds.

Identifying current and potential cash flows is

important when capital budgeting

Replacement decisions

include ones like replacing an outdated piece of equipment,

upgrade causes the value of an outstanding bond to A downgrade has the opposite market impact and results in

increase in value because it is now less risky those bonds decreasing in value.

another factor that can be used to increase accuracy when capital budgeting

incremental cash flow, which means looking at discrete sections, such as potential differences in transportation, shipping, marketing costs, or opportunity costs.

test marketing expenses/ drilling of a test provide useful info and help us predict future cash flows, so they should not be included in the analysis because they are not

incremental cash flows. We do not incur these cash flows if the project is accepted. They have already been incurred.

when measuring free cash flows think

incrementally (only incremental after-tax free cash flow matter )

initial outlay

initial cost of the project, the cost of the equipment, and other elements, such as tax implications

payback example Assume you have a capital budgeting project that has the following forecasts of cash flows: yr 1: 3,000 yr 2: 3,000 yr 3: 3,000 project's level of risk warrants a required return of 12%, and the initial outlay, or cost, of this project is $7,200. If our firm has established a maximum payback period of two years, should you undertake this project?

initial outlay is $7,200, and we recover $3,000 in the first year. This leaves us $4,200 of initial investment that still not recovered after one year. 2nd yr, we recover another $3,000. This leaves $1,200 of initial investment that has still not been recovered. yr 3: , we recover the remaining $1,200, Our payback is 2 years + $1,200/$3,000 = 2 + 0.4 = 2.4 years Because this exceeds our two-year maximum, we would reject this project using the payback period.

The coupon rate

is expressed as a percentage, and then the interest payment to the bond holder is determined by multiplying the coupon rate by the face value of the bond.

capital rationing effect on the firm

is negative

primary problem with the payback period

it does not take the timing of the cash flows into consideration.

When a company issues bonds

it typically receives the face value of the bond at the time of the sale. uses the money for various projects, such as expansion or acquisitions. The company promises to repay the face value and to make periodic payments of interest until the bond matures.

bonds are rated by independent rating agencies when they are issued, and this rating, coupled with the current market rate of interest at the time of issue

largely determines the coupon rate a bond must carry to entice investors to purchase the bond.

Any project with a negative NPV will have a PI

less than one

a higher fixed cost results in

lower labor, or variable costs. higher fixed cost option also has a higher break-even point.

mutually exclusive projects EXAMPLE step 3

make a decision. Project B generates the highest annual annuity, so it should be the project we accept. Keep in mind that many mutually exclusive replacement projects -do not generate a cost savings, -have different annual costs to operate, -and have different useful lives

many financial managers oversee the day-to-day business operations, including

managing inventory, accounts receivable, and accounts payable.

a bond's market value changes when

market rates of interest change.

Yield-to-Maturity: Semiannual Interest Payments

multiply the number of periods by 2 and divide the payment by 2. Then, solve for I/Y and mutiply that result by 2 to get the annual YTM. PV = -$1,078.44 FV = $1,000 PMT = $60/2 =$30 n = 8 x 2 = 16 CPT I/Y = (2.4037%) x 2 = 4.8075%

NPV disadvantage

need for detailed, long-term forecasts of the free cash flows accruing from the projects acceptance.

cash flows associated with a bond are the

periodic interest payments a firm sends to bond holders and the repayment of face value at maturity

capital budgeting methods summary

pg 333 (lists all the terms + formulas, uses, advantages & disadvantages)

Capital Rationing

placing a limit on the dollar size of the capital budget

Stock Valuation Assuming No Growth

plug a zero in for the growth rate Vo = present value of the stock Div1= next period's dividend k = required return

few possible incremental cash flows to consider for expansion projects are

potential differences in transportation or shipping, in marketing costs, and in opportunity costs of the facility.

preferred stock disadvantages over common stock are

preferred stock owners do not get the right to vote on company matters.

if payback period is less than the required payback period

project is accepted shorter payback periods are preferred over longer bc: the shorter the payback period, the quicker u get ur money

bond values adjust after issuance and

rarely trade at par value or face value.

Independent rating agencies

rate bonds when they are issued. The agencies continue to monitor bond issuing and may change their assessment of creditworthiness at some point.

internal rate of return (IRR)

rate of return that the project earns. for computational purposes, the internal rate of return is defined as the discount rate that equates the present value of the projects free cash flows with the project's initial cash outlay.

If the Irr is less than the firm's required rate of return/ cost of capital

reject!

Net income and earnings per share are good measures of accounting profits, but they do not

represent cash available to the firm for reinvestment or meeting obligations

idea generation

seeking product ideas to achieve organizational objectives/ potential projects -growth thru acquisition -research and invention -new markets and expansion

The net effect of the necessary increase in current assets less the spontaneous increase in current liabilities

should be factored in as a relevant incremental cash flow that may continue to change over the life of the project.

key point of opportunity cost cash flows

should reflect the net cash flows that would have been received if the project under consideration was rejected

coupon rate

simple interest rate without factoring in length of time held.

relevant costs to include in your analysis

sunk, opportunity, overhead, financing

break-even revenues

take the 1,048 units and multiply by the selling price of $52. We end up with break-even revenues of $54,496.

estimate demand for a completely new product

test markets and surveys regarding consumer interest or intent to purchase

if a bond is selling for a premium,

the YTM is lower than the coupon rate

financial managers use YTM to determine

the amount investors demand to hold our firm's debt the YTM is an important input in the weighted average cost of capital.

determine the risk of the bond by looking at

the bond rating.

A project's operating cash flows include

the expected change in revenue associated with the new project less expenses. after we determine the projected net income, we add back any non-cash charges, such as depreciation, to get an overall change in operating cash flows

operating cash flows

the expected change in revenue associated with the new project minus expenses and adding in noncash charges, such as depreciation

One incremental cash flow often overlooked in capital budgeting is

the increase in net working capital requirements needed to support additional sales.

discounted payback period

the number of years it takes to recapture a project's initial outlay from the discounted free cash flows dis. payback period = number of yrs just prior to complete payback from discounted free cash flows + unpaid-back amount @ beg. of yr / dis. free cash flow in yr payback is completed

payback period

the number of years it takes to recapture a project's initial outlay/ informs financial managers how long it'll take to recover initial investment. payback period = number of yrs. just prior to complete payback + unpaid-back amount @ beg. of yr / free cash flow in yr. payback is completed

Yield to Maturity (YTM)

the rate required in the market on a bond (value bonds) interest rate investors earn on a bond if they purchase the bond at the current market price and hold it to the maturity date.

profitability index (PI) or benefit-cost ratio

the ratio of the present value of an investment's future free cash flows to the investment's initial outlay ratio calculated by taking the present value of the project's cash flows and dividing it by the initial outlay.

business risk

the risk of the firm's future earnings that is a direct result of the particular line of biz chosen by the firml

If the present value of the cash flows is less than the initial outlay

then the NPV is negative and should not be accepted.

If a bond is selling at a discount

then the YTM is higher than the coupon rate

actual financing costs should not be included because

they are implied in the discount rate used to evaluate the project

biz receives and can reinvest free cash flows but not accounting profits bc

they are shown when they are earned rather than when money is actually in hand

Financial managers perform asset valuation when

they consider company investments.

Most bonds also have a maturity date at which

time the company redeems that debt and pays the bond holders the face value of the bond.

When you value a stock, you are relying on the

time value of money concept, which asks "What is the value of money over time?" determine what a stock will be worth as time goes on.

free cash flows correctly reflect the

timing of benefits and costs, when money is received and can be reinvested and when it must be paid out

Break-even analysis formula

total fixed cost/(sale price per unit - variable costs per unit) denominator indicates how much extra we receive above our variable costs when we sell one unit.

debentures.

unsecured bonds

Forecasting cash flows also allows financial managers to

use tools—such as net present value, payback period, and internal rate of return—which make the capital budgeting process easier

Common stock valuation theories

view common stock as a cash flow stream with a determinable present value.

accept dis. payback period

whether projects discounted payback perido is less than or equal to the firm's max desired discounted payback period.

total cash flow

which includes the initial outlay, any terminal cash flows, and the operating cash flows.

Preferred stock is a hybrid

with characteristics of both equity and debt.

value any asset if

you can identify the: - cash flows -their timing - risk of receiving them (appropriate discount rate to use based on the risk of receiving those cash flows.)

incremental cash flows associated with an expansion project are often easier to identify than other capital budgeting projects because

you have an existing record of revenues and expenses associated with current production

If you included the actual interest outlay as an incremental cash flow

you would be double counting because it is already factored into the discount rate

NPV criterion is the capital-budgeting decision tool most favorable for

1. deals with free cash flows rather than accounting profits 2. sensitive to the true timing of the benefits resulting from the project. 3. recognizing the time value of money allows benefits & costs to be compared in logical manner 4. projects only accepted if a positive NPV is associated with them = acceptance of a project increases the value of the firm

Bonds typically have face values that are

$1,000 or some multiple of $1,000.

replacement projects quesitons: For replacement projects, the cash flows are very often cost savings

1. if you replace this equipment with a high-tech option, will you see a reduction in labor needs? 2. Will you need to hire a technician at a higher wage rate to run the new equipment? 3. Is there a salvage value associated with the sale of the old equipment? think incrementally. 4.What are the expected incremental changes in revenue or costs associated with each replacement option?.

3 reasons for capital rationing

1. managers may think market conditions are temporarily adverse 2. there may be a shortage of quialified managers to direct new projects 3. there may be intangible considerations (fear debt, wish to avoid interest payments, limit issuance of common stock)

preferred stock advantages over common stock are:

:firms pay preferred dividends first, and preferred stock owners have first claim to assets if a firm declares bankruptcy.

risk profile: changes the values of a bond after issuance when the firm's risk profile changes

A bond can be upgraded and deemed to have less risk after issuance, or a bond can be downgraded and deemed to be a riskier investment

evaluate potential projects in the context of how accepting that project impacts the cash flows of the overall firm.

Always think incrementally.

fixed costs

Costs that do not vary with the quantity of output produced administrative overhead, and the cost of the plant and equipment. as we produce more and more units, the fixed cost per unit decreases.

if NPV is positive

IRR must be greater than required rate of return all discounted cash flow criteria are consistent and will result in similar accept/reject decisions.

capital budgeting project category INDEPENDENT

Independent projects are standalone projects that can be evaluated in isolation. you can evaluate 10 different independent projects and accept every one of them if your analysis indicates they are projects that increase shareholder wealth. Each project is viewed independently from the others.

Internal Rate of Return example Assume you have a capital budgeting project that has the following forecasts of cash flows: yr 1: 3,000 yr 2: 3,000 yr 3: 3,000 The project's level of risk warrants a required return of 12%, and the initial outlay, or cost, of this project is $7,200. What is the project's IRR?

PV = -$7,200 PMT = $3,000 n = 3 CPT I/Y = 12.04% is our IRR IRR is also the interest rate that makes the NPV equal to zero.

preferred stock advantages over common stock: 2 ares: OWNERSHIP CLAIMS

Preferred stock has a senior equity claim on firm assets in the event of bankruptcy. If the firm fails and its assets are sold, preferred stockholders get their money before any money is distributed to common stock shareholders. Although preferred stockholders do not typically have voting rights, they may gain them at some point if the firm misses a dividend payment or has financial issues. Preferred stock dividends are quoted either as a fixed amount or as a percent of par value. Much like bonds, most preferred stock has a face value or par value. Unlike common stock par values, preferred stock par values do have some significance because dividends are often quoted as a percent of par.

mutually exclusive projects

Projects that, if undertaken, would serve the same purpose. Thus, accepting one will necessarily mean rejecting the others.

REPLACEMENT

Replacement projects are another common category of capital budgeting projects

mutually exclusive projects EXAMPLE Assume you have project A and project B and their respective cash flows. Project A costs $10,000, will last 10 years, and will generate a cost savings of $3,000 per year over your current process. Project B costs $4,200, will last five years, and generate a cost savings of $2,700 per year over your current process. If these two projects are mutually exclusive, which one should you choose?

STEP 1. The first step is to calculate the NPV of each project and then convert the NPV into an equivalent annual payment. NPV project A: PMT = -$3,000, n = 10, i/y = 10. CPT PV and then subtract the $10,000. This project's NPV therefore equals $8,433.70. NPV project B: PMT = -$2,700, n = 5, i/y = 10. CPT PV and then subtract the $4,200. This project's NPV therefore equals $6,035.12.

terminal cash flow

cash flow occurring at the end of the project.

So what is the relevant cash flow when looking at revenues?

The incremental change is the relevant cash flow.

inverse relationship between market rates of interest and outstanding bonds.

The new bonds carry the higher rate and are more attractive to investors, and the value of the old bond decreases.

Bond Valuation: What is the value of a $1,000 par value (face value) 7% coupon rate bond with 11 years remaining to maturity, assuming the current market rate on similar risk debt is now 9%? What are the cash flows?

The par value multiplied by the coupon rate gives us the annual interest payment that the bond holder receives. So, the annual payment is $1,000 x 0.07 = $70. The par value tells us how much the bond holder receives when the bond matures, which is $1,000 in this case. PMT = $70 FV = $1,000 n = 11 I/Y = 9% CPT PV = -$863.90

Bond Valuation: Semiannual Interest Payments

The simple method is to divide both PMT and I/Y by 2 and multiply n by 2. period payment is now $70/2, or $35 every 6 months. We now have 11 years with 2 payments per year, so n = 11 x 2 = 22. interest rate also needs to be adjusted to a periodic rate, so we take 9% and divide by 2, which equals 4.5% per 6-month period. The terminal value, or value we receive at maturity, is still the par value of $1,000. PMT = $35 FV = $1,000 n = 22 I/Y = 4.5% CPT PV = -$862.16

For capital budgeting, you should always use

cash flows or projections of cash flows.

Preferred Stock Valuation: Example dividend is fixed: What is the value of a preferred stock with a $25 par value that pays a 5% of par dividend assuming our required return is 8%?

To calculate dividends, multiply the par value by the dividend percentage. To calculate the value, use the no-growth common stock formula. The dividend is $25 x 0.05 = $1.25 Therefore, the value is $1.25/0.08 = $15.63

Constant Growth Valuation Model: Example Find the value of a stock that is expected to pay a dividend next year of $2.10, and for which analysts forecast growth rates that will continue to be 5% a year into the foreseeable future. Assuming your required return is 14% to hold that company's stock, what is the current value?

Vo = $2.10 / (0.14 -0.05 ) = $23.33 If the market price is less than what you have calculated as the intrinsic value, then the stock might be a good buy

Preferred Stock Valuation

Vo = Div1 / (k-g) Vo = present value of the stock Div1= next period's dividend k = required return g = constant growth rate (k must be greater than g for the model to work)

constant growth model. Vo = Div1 / (k-g)

Vo = present value of the stock Div1= next period's dividend k = required return g = constant growth rate (k must be greater than g for the model to work)

Yield-to-Maturity

What is the YTM of a $1,000 face value bond that is currently selling for $1,078.44 if it has a 6% annual coupon rate and eight years to maturity? PV = -$1,078.44 FV = $1,000 PMT = $60 n = 8 CPT I/Y = 4.7963%

Improperly including sunk costs can cause

a financial manager to reject a project that would have enabled the firm to recover a portion of the sunk costs.

net present value profile

a graph showing how a project's NPV changes as the discount rate changes (pg 319)

holding everything else constant, a higher coupon payment results in

a higher bond value.

Holding everything else constant, a larger face value results in

a higher value bond.

use cash flows to decide whether to

accept a new project because cash flows rep the benefits generated from accepting a cap-budgeting proposal.

If the Irr is greater than or equal to the firm's required rate of return/ cost of capital

accpet the project

any capital budgeting project expected to increase sales also requires

additional investment in these current asset accounts. Some of the additional investment is generated by liability accounts that also automatically increase with sales. (accounts payable)

convertibility

allows bondholders to convert to equity or acquire equity at some point.

equivalent annual annuity (EAA)

an annuity cash flow that yields the same present value as the project's NPV

As a bond approaches maturity, its market value

approaches face or par value because the investor receives the face value at maturity.

Financing costs

are the one area in which we do not allocate incremental costs

Time Disparity Problem

arises because of differing reinvestment assumptions made by the NPV and IRR decision criteria

constant growth model (calculate the value of a common stock)

assumes that the cash flows from a share of stock occur forever. entering a zero for the growth rate, the same model can be used to evaluate a company's value when no growth is expected.

bond is worth less than par value because

bond values move inversely with market rates of interest. This bond has to sell at a discount to equal the investors' return with the return they would receive if they bought a new-issue, similar-risk bond.

Financial managers can make this risk adjustment

by reducing the project's cash flows or by increasing the required return on the project result is a lower acceptance rate for projects with risky cash flows.

Net present value example Assume you have a capital budgeting project that has the following forecasts of cash flows: yr 1: 3,000 yr 2: 3,000 yr 3: 3,000 project's level of risk warrants a required return of 12%, the initial outlay, or cost, of this project is $7,200 . Using the NPV criteria, should you undertake this project? NPV = PV of cash flows - initial outlay.

calculate the present value of the projected cash flows using the discounted cash flow techniques. PMT =-$3,000 n = 3 I/Y = 12% CPT PV = $7,205.43 then: NPV = $7205.43 - $7200 = $5.43

Some recent issues of preferred stock

carry a convertibility feature that allows them to be converted to a predetermined number of common shares. Firms may also issue preferred stock with a call provision that allows the firm to repurchase the stock (call it back) from shareholders for some predetermined price.