FI 410 Exam 2

There is an ________ associated with using retained earnings, hence they are not "free"

"Opportunity cost"

Rationale for the NPV method

-NPV = PV inflows - cost -This is net gain in wealth, so accept project if NPV > 0 -Choose between mutually exclusive projects on basis of higher positive NPV. Adds most value

The three approaches to estimate the component cost of retained earnings

1. CAPM 2. Discounted cash flow(DCF) or dividend-yield-plus-growth rate approach 3. Bond-yield-plus-risk-premium approach

Opportunity cost

A cash flow that a firm must forgo in order to accept a project. For example, if the project requires the use of a building that could otherwise be sold, then the market value of the building is an opportunity cost of the project

Assume a project has normal cash flows. All else equal, which of the following statements is correct?

A project's NPV increases as the WACC declines

Jefferson City Computers has developed a forecasting model to estimate its AFN for the upcoming year. All else being equal, which of the following factors is most likely to lead to an INCREASE of the additional funds needed (AFN)?

A sharp increase in its forecasted sales

Which of the following assumptions is embodied in the AFN equation?

Accounts payable and accruals are tied directly to sales

If a typical U.S. Company correctly estimates its WACC at a given point in time and then uses that same cost of capital to evaluate all projects for the next 10 years, then the firm will most likely

Become more risky and also have an increasing WACC. Its intrinsic value will not be maximized

Define AFN

Forecasts the additional financing needed by the operating plan · Basic idea: o Estimate new assets required o Subtract new spontaneous liabilities (i.e. accounts payable and accruals) o Subtract reinvested profit (net income minus dividends)

The term "additional funds needed (AFN)" is generally defined as:

Funds that a firm must raise externally from non-spontaneous sources, i.e., by borrowing or by selling new stock, to support operations

Spontaneously generated funds are generally defined as:

Funds that arise out of normal business operations from its suppliers, employees, and the government, and they include spontaneous increases in accounts payable and accruals

The IRR method assumes that cash flows will be reinvested at the _______

IRR

Which of the following statements is correct? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows

If a project's NPV is less than zero, then its IRR must be less than the WACC

Westchester Corp. is considering two equally risky, mutually exclusive projects, both of which have normal cash flows. Project A has an IRR of 11%, while Project B's IRR is 14%. When the WACC is 8%, the projects have the same NPV. Given this information, which of the following statements is CORRECT? a. If the WACC is 13%, Project A's NPV will be higher than Project B's. b. If the WACC is 9%, Project A's NPV will be higher than Project B's. c. If the WACC is 6%, Project B's NPV will be higher than Project A's. d. If the WACC is greater than 14%, Project A's IRR will exceed Project B's. e. If the WACC is 9%, Project B's NPV will be higher than Project A's.

If the WACC is 9%, Project B's NPV will be higher than Project A's

One defect of the IRR method:

It assumes that the cash flows to be received from a project can be reinvested at the IRR itself, and that assumption is not often valid

Preffered stock is ________ risky to investors than debt

MORE

Suppose Tapley Inc. uses a WACC of 8% for below-average risk projects, 10% for average-risk projects, and 12% for above-average risk projects. Which of the following independent projects should Tapley accept, assuming that the company uses the NPV method when choosing projects? a. Project A, which has average risk and an IRR = 9%. b. Project B, which has below-average risk and an IRR = 8.5%. c. Project C, which has above-average risk and an IRR = 11%. d. Without information about the projects' NPVs we cannot determine which one or ones should be accepted. e. All of these projects should be accepted.

Project B, which has below-average risk and an IRR = 8.5%

What are the three types of risk?

Stand-alone risk Corporate risk Market risk

Which of the following is NOT a relevant cash flow and thus should NOT be reflected in the analysis of a capital budgeting project?

Sunk costs that have been expensed for tax purposes

One defect of the IRR method VS the NPV method is:

The IRR does not take proper account of differences in the sizes of projects

A company expects sales to increase during the coming year, and it is using the AFN equation to forecast the additional capital that it must raise. Which of the following conditions would cause the AFN to INCREASE?

The company increases its dividend payout ratio

The WACC that should be used in capital budgeting:

The firm's marginal, after-tax cost of capital

Sales growth (g)

The higher g is, the larger AFN will be—other things held constant.

Capital intensity ratio (A0*/S0)

The higher the capital intensity ratio, the larger AFN will be—other things held constant.

Spontaneous-liabilities-to-sales ratio (L0*/S0)

The higher the firm's spontaneous liabilities, the smaller AFN will be—other things held constant

Profit margin (Net income/Sales)

The higher the profit margin, the smaller AFN will be—other things held constant.

Payout ratio (DPS/EPS)

The lower the payout ratio, the smaller AFN will be if other things held constant.

The NPV method assumes that cash flows will be reinvested at the _______

WACC

When calculating the cost of debt...

a company needs to adjust for taxes, because interest payments are deductible by the paying corporation

What is a sunk cost?

a cost that was incurred and expensed in the past and cannot be recovered if the firm decides not to go forward with the project

Example of externality:

a situation where a bank opens a new office, and that new office causes deposits in the bank's other offices to DECLINE

Sunk Costs

an outlay related to the project that was incurred in the past and that cannot be recovered in the future regardless of whether or not the project is accepted. Therefore, sunk costs are not incremental costs and thus are not relevant in a capital budgeting analysis

If a company's tax rate INCREASES, then, all else equal, its weighted average cost of capital will _______

decline

Controllable factors that affect WACC

o Capital structure policy. o Dividend policy. o Investment policy. Firms with riskier projects generally have a higher cost of equity

Normal cash flow project

o Cost (negative CF) followed by a series of positive cash inflows. o One change of signs.

Preferred Stock

o Flotation costs for preferred are significant, so are reflected. Use net price o Preferred dividends are not deductible, so no tax adjustment. Just rps o Nominal rps is used

Rationale for the IRR method

o If IRR > r, then the project's rate of return is greater than its cost-- some return is left over to boost stockholders' returns o Example: r = 10%, IRR = 15% --- So this project adds extra return to shareholders

Debt

o Interest is tax deductible, so calculate after tax cost of debt o Use the nominal rate o Flotation costs are small, so ignore

Uncontrollable factors that affect WACC

o Market conditions, especially interest rates. o The market risk premium. o Tax rates.

The reinvestment rate assumptions for NPV and IRR

o NPV does not have a reinvestment rate assumption, so reinvestment will not change the final outcome of NPV of a project. IRR does consider reinvestment rate assumption. The IRR assumes that the company will reinvest cash inflows at the rate of return for the entire lifetime of the project

Nonnormal cash flow project

o Two or more changes of signs. o Most common: Cost (negative CF), then string of positive CFs, then cost to close project. o For example, nuclear power plant or strip mine

EAA (Equivalent Annual Annuity)

o Use to compare mutually exclusive projects with different lifespans. Convert the unequal annual cash flows of a project into a constant cash flow stream (i.e., an annuity) whose NPV is equal to the NPV of the initial stream. Do for both projects and compare the annuities o Converting the PV into a stream of annuity payments with the same PV o Higher EAA = better project

replacement chain (common life) approach

o a capital budgeting decision model that compares two or more mutually exclusive capital proposals with unequal lives. The replacement chain method involves repeating shorter projects multiple times until they reach the lifetime of the longest project o A method of comparing mutually exclusive projects that have unequal lives. Each project is replicated so that they will both terminate in a common year. If projects with lives of 3 years and 5 years are being evaluated, then the 3-year project would be replicated 5 times and the 5-year project replicated 3 times; thus, both projects would terminate in 15 years

If a project has "normal" cash flows, then it can have only ______

one real IRR

One drawback of the payback criterion is that this method does not____________

take account of cash flows beyond the payback period

Corporate risk (within-firm risk)

the variability the project contributes to the corporation's returns, considering the fact that the project represents only one asset of the firm's portfolio of assets and so some of its risk will be diversified away by other projects within the firm

What are the capital components?

· Capital components are sources of funding that come from investors · Debt, preferred stock, and common equity o Most firms use long term debt · Accounts payable, accruals, and deferred taxes are NOT sources of funding that come from investors, so they are not included in the calculation of the cost of capital o We do adjust for these items when calculating the cash flows of a project, but not when calculating the cost of capital

When do multiple IRRs occur?

· If a project's cashflow have a nonnormal (i.e., the cash flows have more than one sign change), it is possible for the project to have more than one positive IRR · If the sign changes more than once, don't even calculate the IRR because it is at best useless and at worst misleading

What are flotation costs?

· The commissions, legal expenses, fees, and any other direct costs that a company incurs when it issues new securities

What is the self-supporting growth rate?

· The maximum growth rate the firm could achieve if it had no access to external capital · Self-supporting growth rate is influenced by the firm's capital intensity ratio. The more assets the firm requires to achieve a certain sales level, the lower its sustainable growth rate will be

Capital Budgeting

· The whole process of analyzing projects and deciding whether they should be included in the planned expenditures on fixed assets · A firm's ability to remain competitive and to survive depends on a constant flow of ideas for new products, improvements in existing products, and ways to operate more efficiently. Therefore, it is vital for a company to evaluate proposed projects accurately

Why is the cost of new common equity higher than the cost of retained earnings?

· When a company issues new common stock, they also have to pay floatation costs to the underwriter · Issuing new common stock may send a negative signal to the capital markets, which may depress stock price

Stand-alone risk

· due to the variability of its cash flows. It is the risk that a company would have if the company had only this one project o Assumes that project is isolated; does not take diversification into effect

Options to eliminate a financing SURPLUS

· occurs when additional financing is greater than additional assets · If surplus, eliminate it by paying a special dividend

Options to eliminate a financing DEFICIT

· occurs when additional financing is less than additional assets · If deficit, draw on a line of credit. The line of credit would be tapped on the last day of the year, so it would create no additional interest expenses for that year

NPV profile

· shows the sensitivity of a project's NPV (net present value) for different discount rates

Crossover rate

· the discount rate at which the NPVs of both the projects are equal

Externalities

· the effects of a project on other parts of the firm or on the environment. As explained in what follows, there are three types of externalities: negative within-firm externalities, positive within-firm externalities, and environmental externalities o Positive externalities increase your cash flows o Negative externalities decrease your cash flows

Market risk (beta risk)

· the risk of the project as seen by a well-diversified stockholder who owns many different stocks o Best but more difficult to estimate

Cannibalization

· type of negative within-firm externalities; A type of externality in capital budgeting in which introduction of a new product causes the sales of existing products in the firm to decrease

When should a firm accept a project?

· when estimated (expected) return exceeds the cost of capital