Finance 4010 Exam 2

IRR is the same as

Hurdle Rate

Terminal Value

when project is longer and company has an infinite timeline

What are sources of value and why are they significant?

whenever you are considering cash flows remember where the source of value is created. + Economies of scale/scope --> in production, marketing +Unique of differentiated products --> patents, trademarks, brand identity, reputation +Absolute cost advantage --> control of scarce resources, expertise/technology +Unique distribution channels (example Walmart, Amazon) +Switching costs for customers (Facebook) +Government policy or regulatory protection (Ex: BP, enterprise small scale refineries to export crude)

Net Present Value Method

ACCEPT PROJECT IF NPV>0 (this translates to the amount being returned to you is greater than your risk) theoretically NPV is the amount of wealth that a project generates for shareholders, if NPV is positive then it increases the shareholder wealth, the opposite is true as well --> higher the NPV the better the project.

What problem remains with the discounted payback method?

Discounted payback does discount cash flows back to their present value HOWEVER, the method still has an arbitrary cutoff and still ignores cash flows after the cut off.

Firm A and firm B have identical assets and operation, but firm B has 30% more leverage in its capital structure. Firm A is an all equity firm with a beta of 1.5. The beta of firm B is _____________ than that of firm A, ___________________. Accordingly, the cost of equity (Re) of firm B is ____________________ than that of firm A.

Higher; since firm B is more levered ; higher Correct! Firms with leverage have a higher beta and a higher cost of equity. This happens because firms with leverage are subject not only to product risk but also to financial risk.

How are NPV and IRR related?

IRR is the discount rate that makes NPV zero, The NPV method results in a dollar value that a project will produce, while IRR generates the percentage return that the project is expected to create. Purpose. The NPV method focuses on project surpluses, while IRR is focused on the breakeven cash flow level of a project.

Why can you have multiple IRR solutions?

If there are irregular cash flows then there can be multiple IRR's.

When you have multiple IRR solutions which one do you pick or do you not use the IRR rule?

If there are multiple solutions then you can trace the problem back to the cash flow and put the negative cash flow in the last year and then move the numbers to that year in cash flow with TVM, however some projects do not have a real IRR solution.

In calculating weights in the WACC formula you would ideally use:

Market values of debt and equity

What are the problems with the payback method? Why do firms still use it?

Problem with payback period include the fact that the length of time to recover the initial period is determined by an arbitrary number, it also oversimplifies the complexities of the calculation by not taking into account cash flows after the cut off point and does not discount $ back to the present value

How do the 'scale problem' and the 'timing problem' create discrepancies in NPV and IRR decision rules?

SCALE PROBLEM would you rather make 100% or 50% on your investment? what if the 100% return is on a $1 investment while the 50% return is on a $1,000 investment? TIMING PROBLEM project 1 has a higher IRR but doesn't increase shareholders wealth the way that project 2 does

When do NPV and IRR disagree?

They do not always agree, this is due to the scale problem and timing problem. SCALE PROBLEM would you rather make 100% or 50% on your investment? what if the 100% return is on a $1 investment while the 50% return is on a $1,000 investment? TIMING PROBLEM project 1 has a higher IRR but doesn't increase shareholders wealth the way that project 2 does

A firm's WACC of 12% means that 12% is the minimum rate of return that this firm must earn overall on its existing asset base to produce value for its creditors, owners, and other providers of capital. If the firm earns less than 12% on the overall portfolio of products/projects they will invest elsewhere. However, if it earns more than this, value is created.

True

When computing a firm's Weighted Average Cost of Capital (WACC) we use an after-tax figure for the cost of debt because interest is tax deductible. We do not use an after-tax figure for the cost of equity because there is no difference between the pre-tax and after-tax equity costs, since dividends are paid from Net Income.

True

Conclusion on Payback and Discounted Payback

Used because they are easy to understand and calculate and for firms that have limited access to financial capital may be useful, also tells about firm liquidity, however disadvantages countinue to be +ignoring the TVM +requirement of arbitrary number +biases against long term projects +ineffectiveness when cash flows are irregular +do not necessarily maximize shareholder wealth

See capital budgeting review slide for what to include or not include in capital budgeting.

ch 10- capital budgeting

What cash flows do you consider during capital budgeting?

incremental cash flows

This is a "free" question, no points associated with it. Firm A and firm B have identical assets and operation, but firm B has 30% more leverage in its capital structure. Accordingly, the weighted average cost of capital (WACC) for firm B will be __________ the WACC for firm A. (Hint: Think about cost of equity (Re) and cost of debt (Rd) for both firm A and firm B. What is generally higher Re or Rd? Think about the WACC formula for firm A and B and how the weights for debt and equity would influence WACC for firms A and B)

lower than Correct! Generally Rd is (much) lower than Re (due to risk and priority rules in bankruptcy). The firm with leverage, firm B will have a higher cost of equity, Re, than firm A because Re of firm B will be subject to both product and financial risk, while Re of firm A will be subject only to product risk. When calculating WACC, firm A will have 100% equity, and firm B will have 30% debt and 70% equity. Remember, Rd is lower than Re, as such firm B's WACC will be lower than firm A's, as 30% will be financed with the cheaper cost of capital (debt) for which we will account for on after-tax basis.

Mutual Exclusive vs Independent Investment Decisions

mutually exclusive means that you can select only one project and that project has to have highest NPV/IRR or lowest payback time and Independent investment decisions means that accepting or rejecting one project does NOT affect the decision of the other project.

Opportunity Cost of Capital

the discount rate that firms use for projects are for typical risks called COST OF CAPITAL +generally if the firms line of business is not very broad then most of all its investment opportunities will have roughly the same level of risk, in this case the firm would use its cost of capital as its discount rate +HOWEVER, if the project has a higher level of risk than the typical project, the firm should use a discount rate that is higher than the typical cost of capital.