Finance Exam 3
Calculating Project Cash Flows The Performing Arts Center is evaluating a project to increase the number of seats by building some new box seating areas and adding seats. The initial capital expenditure is $10 million and the investment in working capital is $1M.
$10,000,000 (capital exp) 0 + 1,000,000 + (NWC) $11,000,000 (Initial Cash OUTFLOW)
Juniper, Inc. is evaluating a new, independent project. The financial manager has determined that the after-tax cash flows for the project will be as follows: Year Cash Flows 0 ($30,000) 1 $10,000 2 $12,000 3 $15,000 What is the IRR for this project?
$30,000=$10,000/(1+𝐼𝑅𝑅)^1+ $12,000/(1+𝐼𝑅𝑅)^2 + $15,000/(1+𝐼𝑅𝑅)^3 =10.49%
Common Stock Valuation, negative growth Example Assume a company just paid a dividend of $2 on its common stock and dividends are expected to decline at a constant rate of 4% a year, indefinitely. What is today's value of the company's stock, assuming a required rate of return of 13%?
0-----1----2----3---- 1.92 1.84 1.76 Po=D1/r-g= $2.00(1-.04)/0.13-(-.04) =$11.29
CH 11 learning objectives
1. Be able to find the depreciable basis of an asset. 2. Be able to calculate free cash flows (Exhibit 11-1). 3. Be able to calculate initial cash outflows (t = 0), after-tax operating cash flows (t = 1 to T = N) and after-tax, terminal year cash flows (includes non-operating cash flows). (Exhibit 11-3). 4. Understand how to calculate depreciation tax savings. 5. Know how to find the book value of an asset. 6. Understand how to calculate after-tax salvage value if an asset sells for more or less than its book value. 7. Understand how to calculate marginal tax rates and average tax rates.
CH 10 Learning Objectives
1. Understand the difference between a current expenditure and a capital expenditure. 2. Explain the benefits of using the net present value (NPV) method to analyze capital expenditure decisions and calculate the NPV for a capital project. 3. Describe the strengths and weaknesses of the payback period (PB) and the discounted payback period (DPB) as capital expenditure decision-making tools and be able to compute both. 4. Compute the internal rate of return (IRR) for a capital project and discuss the conditions under which the IRR technique and the NPV technique produce different results. 5. Compute the modified internal rate of return (MIRR) and profitability index (PI).
CH 13 learning objectives
1.Be able to calculate the cost of debt, cost of preferred stock and cost of common equity for a firm. 2. Be able to calculate the after-tax cost of debt. 3. Understand how to include flotation costs in the calculation of the cost of preferred stock and common equity. 4.Understand how to use CAPM and the constant growth dividend model to estimate the cost of common equity. 5. Understand how to find the weights for each component of the cost of capital. 6. Be able to calculate the WEIGHTED AVERAGE COST OF CAPITAL for a firm and understand why it is used as the discount rate when evaluating projects.
Ch 9 Study Objective
1.List and describe the four types of secondary markets. 2.Be able to describe what is meant by an efficient market. 3.Explain how preferred stock is similar to a bond and how it is similar to common stock. 4. Describe the characteristics of preferred stock. 5. Be able to estimate the value of a share of common stock at some future time period, assuming it pays a dividend that is growing at a constant rate. 6. Be able to calculate a share of common stock with constant growth in dividends, no growth in dividends and dividends that are declining at a constant rate. 7. Be able to calculate a share of common stock whose dividends are growing at a non-constant growth rate.
Payback Period Problem Juniper, Inc. is evaluating a new, independent project. The financial manager has determined that the after-tax cash flows for the project will be as follows: Year Cash Flows 0 ($30,000) 1 $10,000 2 $12,000 3 $15,000 What is the project's payback?
2+8000/15000=2.53 years
Reading the Tax Table What is the marginal tax rate of a company with taxable income of $420,000? Calculate how much the company will pay in taxes if it has $420,000 in taxable income.
A company with taxable income of $420,000 has a marginal tax rate of 34% because each dollar earned over $420,000 will be taxed at 34%. The company will pay $142,800 in taxes. $113,900 + (.34 * $85,000) = $142,800 Note: $85,000 = difference between $420,000 and $335,000
Modified Internal Rate of Return weakness
A major weakness of the IRR compared to the NPV method is the reinvestment rate assumption IRR assumes that cash flows from a project are reinvested to earn the IRR while NPV assumes that they are reinvested and earn the firm's cost of capital. This optimistic assumption in the IRR method leads to some projects being accepted when they should not. The reinvested cash flows cannot earn the IRR.
Amsted, Inc. is considering a project that will increase revenues by $2.5 million, cash operating expenses by $700,000, and depreciation and amortization by $300,000 during 2011. For this project, the firm will purchase $800,000 of equipment during the year while decreasing its inventory by $200,000 (with no corresponding decrease in current liabilities. The marginal tax rate for Amsted is 35 percent. What is this project's incremental after-tax free cash flow for 2011? ATFCF=(Rev -OPEx-DA)*(1-Tax)+DA-Capex-AddWC
ATFCF= (2.5-.7-.3)*(1-.35)-.8 + .2= 0.675 million or 675,000
Salvage Value - firm sells an asset for less than book value Example A firm purchased an asset for $100,000, of which 70% has been depreciated. Tax rate = 40%. If the firm sells the asset for $10,000, calculate the firm's offsetting deduction and calculate the after-tax salvage value of the asset.
Book value = $100,000 - $70,000 = $30,000. If the firm sells the asset for $10,000, the firm has an offsetting deduction of (10,000 - 30,000)(.4) = ($8,000). after-tax salvage value = $10,000 + $8,000 = $18,000.
Salvage Value - firm sells an asset for more than book value Example A firm purchased an asset for $100,000, of which 70% has been depreciated. Tax rate = 40%. If the firm sells the asset for $40,000, calculate the firm's tax bill and find the after-tax salvage value of the asset
Book value = $100,000 - $70,000 = $30,000. If the firm sells the asset for $40,000, the firm has tax liability of (40,000 - 30,000)(.4) = $4,000. after-tax salvage value = Proceeds minus taxes = $40,000 - $4,000 = $36,000
Jamaica Corp. is adding a new assembly line at a cost of $8.5 million. The firm expects the project to generate cash flows of $2 million, $3 million, $4 million, and $5 million over the next four years. Its cost of capital is 16 percent. What is the internal rate of return that Jamaica can earn on this project? (Do not round intermediate computations. Round final answer to the nearest percent.)
CFo= -8,500,000 CF1= 2,000,000 CF2= 3,000,000 CF3= 4,000,000 CF4= 5,000,000 =19.87 =20%
Capital expenditure-
Capital expenditure - represents large cash outlay, long-term commitment, not easily reversed. Current expenditure - an expense that appears during one cycle - appears on the income statement
Champagne, Inc., had revenues of $12 million, cash operating expenses of $8 million, and depreciation and amortization of $1.5 million during 2008. The firm purchased $700,000 of equipment during the year while increasing its inventory by $500,000 (with no corresponding increase in current liabilities). The marginal tax rate for Champagne is 30 percent. Free cash flow: What is Champagne's cash flow from operations for 2008?
Champagne, Inc. Revenue $12,000,000 -Operating Ex 8,000,000 EBITDA $4,000,000 - D&A 1,500,000 EBIT $2,500,000 x (1 - t) 70% NOPAT $1,750,000 +D&A 1,500,000 CF Opns $3,250,000
Learning Objective 3 Answer 3.Explain how preferred stock is similar to a bond and how it is similar to common stock.
Common Stock Represent ownership interest in a corporation; Stockholders have some control because they vote for the Board of Directors who hires CEO. Dividend payments do not affect a firm's taxes and are not guaranteed Limited liability and have right to a firm's residual assets after creditors, preferred stockholders Preferred Stock: Debt or Equity? Viewed as a perpetuity because no maturity date; no voting rights, so no control Dividends are "promised" Preferred stock is equity but a strong case can be made that it is a special type of debt (pays fixed dividend) Why is common stock more difficult to value? The size and timing of dividends are less certain compared to coupon payments The rate of return on common stock cannot be observed directly from the market Common stock is a true perpetuity because it has no maturity date
Payback Period
Computing the Payback Period To compute the payback period, estimate a project's cost and its future net cash flows Pay Back=PB= Years before cost recovery + REMAINING COST TO RECOVER/ CASH FLOW DURING THE YEAR
Investment Outlays at t = 0
Cost of "new" asset + Capitalized expenditures + (-) Increase (decrease) NWC = Projected cash outflow Note: The cost + Capitalized expenditures = depreciable basis
HW Practice Problem Johnson Corporation has just paid a dividend of $4.45. The company has forecasted a growth rate of 8 percent for the next several years. If the appropriate discount rate is 14 percent, what is the current price of this stock? (Round to the nearest dollar.)
D0 = $4.45; g = 8%; R = 14% Po=D1/R-g= Do(1+g)/R-g = $4.45(1.08)/.14-.08=$4.806/.06 =$80.10
Example: Constant-Growth Dividend Model Big Red Automotive paid a dividend of $4.81 this year. The dividend is expected to increase by 4% annually and investors who own stock in similar firms require a return of 18%. What is the market value of the firm's stock?
D1=D0*(1+g)^1=$4.81*(1.04)=$5.00 Po=D1/R-g=$5.00/.18-.04=$35.71
Example: Supernormal-Growth Dividend Model Suppose a company's expected dividends are $1, $2, and $3 for the next three years and are expected to grow at a constant rate of 6% per year thereafter. What should the current price be if the required rate of return is 15%?
D4=D3*(1+g)^1= $3.00*(1.06)^1=$3.18 P3=D4/R-g= $3.18/.15-.06=$35.33 Po= $1.00/(1.15)^1 + $2.00/(1.15)^2 + $3.00/(1.15)^3 +$35.33/(1.15)^3 =$27.58
Suppose a firm's expected dividends for the next three years are as follows: D1 = $1.10, D2 = $1.20, and D3 = $1.30. After three years, the firm's dividends are expected to grow at 5.00 percent per year. What should the current price of the firm's stock (P0) be today if investors require a rate of return of 12.00 percent on the stock? (Do not round intermediate calculations. Round off final answer to the nearest $0.01)
D4=D3*(1+g)^1=1.30*(1+.05)=1.37 P3=D4/R-g=1.37/.12-.05=19.50 Po= D1/1+R + D2/(1+R)^2 + D3/(1+R)^3 + Dt/(1+R)^t =1.10/1.12 + 1.20/(1.12)^2 + 1.30/(1.20)^3 + 19.50/(1.12)^3 =16.74
Example: Constant-Growth Dividend Model Ace, Inc. paid a dividend of $2.50 today. Similar stocks yield 15% and g is 5%. Estimate the stock price five years from today.
D6=Do*(1+g)^6=$2.50*(1.05)^6 =$3.35 P5=D6/R-g=$3.35/.15-.05 =$33.50 The constant-growth dividend model is only valid when the required rate of return is larger than the expected growth rate, R>g
Capital Budgeting -
Deciding which long-term productive assets will create the most wealth for a firm's owner(s).
Depreciation Expense A company purchases a piece of machinery for $400,000. The machine falls in the seven-year property class. Assume the company uses MACRS depreciation method. How much will the company deduct as depreciation expense at the end of year seven? This is the amount that will be deducted on the Income Statement for that year. What will be the book value of the machine at the end of the third year? This is the net amount that will be shown on the Balance Sheet
Deprecation Expense at the end of year seven: $400,000 X 8.93% = $35,720. Note: The company's taxable income in year 7 is reduced by $35,720, so it's depreciation tax savings equals $35,720 *Tax Rate. Book value at the end of third year = Cost - accumulated depreciation = $400,000 - (56.27% of $400,000) = $174,920
Depreciation Tax Savings
Depreciation is a non-cash expense that lowers taxable income. The amount of taxes saved = Depreciation Expense X Tax Rate
Learning Objective 1 Answer 1.List and describe the four types of secondary markets.
Direct Search A buyer and seller must find each other without assistance. Transactions are infrequent; least efficient market Examples: 1. sale of small private company's common stock 2. private placement of common stock Broker Brokers earn a fee, a commission, for bringing buyers and sellers together; brokers have extensive information about prices Paying a commission may be less than the cost of direct search. Dealer Has an advantage over a broker because a broker cannot guarantee prompt execution of an order while a dealer holds inventory of securities Eliminates time-consuming searches for a fair deal through immediate sales or purchases NASDAQ is the best-known dealer market Dealer markets are called "over the counter" or OTC markets Auction Buyers and sellers interact with each other in a group and bargain over price. The auctioneer, or specialist, is designated by the exchange to be a dealer for certain securities and fill orders by public customers. The NYSE is the best-known auction market. The NYSE is the most efficient equity market in the U.S.
Internal Rate of Return Problem Assume a project will cost $100 today and will generate $10 in cash flows next year, $60 in year 2 and $80 in year 3. What is the rate of return on this project? What discount rate makes the present value of the future cash flows equal $100?
Enter CFs into the calculator's CFLO register. CF0 = 100 +/- CF1 = 10 CF2 = 60 CF3 = 80 Press IRR and then press CPT to get IRR = 18.13%.
Cortez, Inc., is expecting to pay out a dividend of $2.50 next year. After that it expects its dividend to grow at 7 percent for the next four years. What is the present value of dividends over the next five-year period if the required rate of return is 10 percent? (Do not round intermediate calculations. Round final answer to two decimal places.)
Expected dividends for Cortez, Inc., and their present value: D2 = D1(1 + g) = $2.50(1 + 0.07) = $2.675 D3 = D2(1 + g) = $2.675(1.07) = $2.862 D4 = D3(1 + g) = $2.862(1.07) = $3.063 D5 = D4(1 + g) = $3.063(1.07) = $3.277 Present value of the dividends = PV(D1) + PV(D2) + PV(D3) + PV(D4) + PV(D5) 2.50/1.10 + 2.675/(1.10)^2 + 2.862/(1.10)^3 + 3.063/(1.10)^4 + 3.277/(1.10)^5 =10.76
Which of the following is the best example of a sunk cost? Future payments on a leased building. Future research and development costs. Historical noncash expenses. Historical research and development costs.
Historical research and development costs.
Internal Rate of Return (IRR)
IRR is the discount rate that forces PV of cash inflows to equal the cost. 0=E CFt/(1+IRR)^t NPV = PV - ICO, so at IRR, PV = ICO and NPV = 0
Salvage Value
If the salvage value is more than its book value, the firm must pay taxes on the difference. If the salvage value is less than its book value, the firm gets an offsetting tax deduction.
Depreciable Basis
In tax accounting, the fully installed cost of an asset. This is the amount that, by law, may be written off over time for tax purposes. Depreciable Basis = Cost of Asset + Capitalized Expenditures
Modified Internal Rate of Return
In the modified internal rate of return (MIRR) technique, cash flow is assumed to be reinvested at the firm's cost of capital The compounded values are summed to get a project's terminal value (TV) at the end of its life The MIRR is the rate which equates a project's cost to its terminal value PVprojectcost=TV/(1+MIRR)^n
Net Working Capital
Include any additional investments in net working capital (NWC) NWC = any increases in current assets minus any increases in current liabilities Note: At Time 0, NWC is a cost (outflow). In the terminal year, NWC is recovered (inflow).
General rules for Incremental After-tax Free Cash Flow Calculations
Include cash flows and only cash flows. Do not include costs like overhead (executive salaries) Include the impact of the project on cash flows from other product lines Include all opportunity costs Forget Sunk costs Include only after-tax cash flows
LEARNING OBJECTIVE The Payback Period
Is the amount of time it takes for the sum of the net cash flows from a project to equal the project's initial investment Can serve as a risk indicator - the quicker a project's cost is recovered, the less risky the project Is one of the most widely used tools for evaluating capital projects Projects with shorter payback periods are more desirable. Cash flows occurring after the payback period are not considered. There is no economic rationale that makes the payback method consistent with shareholder wealth maximization.
Two ways to raise Equity
Issue new shares of common stock - called an external source of equity, re. Use Retained Earnings by not paying out all earnings as dividends - called an internal source of equity, rs.
Constant Growth Dividend Model
Model assumes cash dividends grow at a constant rate forever, which is a reasonable assumption for mature companies with a history of stable growth D1=Do(1+g)^1 Po=D1/R-g
Zero-Growth Dividend Model
Model assumes the dividend is constant This cash flow pattern describes a perpetuity with a constant cash flow, similar to the perpetuity model Po=D/R
A machine costs $1,000 and has a 3-year life. The estimated salvage value at the end of three years is $100. The project is expected to generate after tax-cash flows of $600 per year. If the required rate of return is 10%, what is the NPV of the project? (Do not round intermediate computations. Round final answer to the nearest whole number.)
NPV = PV (Project's expected future cash flows) - PV (Cost of the project) NPV = -$1,000 + ($600 / 1.10) + ($600 / (1.10)2) + ($600 + $100) / (1.10)3) = $567
Learning Objective 2. Explain the benefits of using the net present value (NPV) method to analyze capital expenditure decisions and calculate the NPV for a capital project.
NPV = Present Value of expended cash inflows and expected cash outflows. Is the best capital-budgeting technique. It is consistent with goal of maximizing shareholder wealth. The method compares the present value of expected benefits and cash flows from a project to the present value of the expected costs. If the benefits are larger, the project is feasible. The NPV calculation uses the discounted cash flow technique
NPV Example Juniper, Inc. is evaluating a new, independent project. The financial manager has determined that the after-tax cash flows for the project will be as follows: Year Cash Flows 0 ($30,000) 1 $10,000 2 $12,000 3 $15,000 The firm's WACC (discount rate) is 13%. Draw a timeline, show the formula and find the NPV for this project.
NPV= 10,000/(1.13)^1 + 12,000(1.13)^2 + 15,000(1.13)^3 - 30,0000 =1356.92 Enter CFs into the calculator's CFLO register. CF0 = 30000 +/- CF1 = 10000 CF2 = 12000 CF3 = 15000 Press NPV, enter I/YR = 13, Enter, arrow down and then press CPT NPV = -1356.92.
Net Present Value
NPV= E NCFt/(1+k)^1 Where k = cost of capital (Note k = interest rate/discount rate) NCF = net cash flow n= the project's estimated life
Net Working Capital Example A new project will require an increase in inventory of $7,000 plus an increase in accounts payable of $2,000. What is the net working capital required for the project? NWC = CA - CL
NWC = CA - CL $7,000 - $2,000 = $5,000 Note: $5,000 would be an outflow in time 0, but an inflow at the end of the life of the project.
FCF Calculation
Operating Revenue -Operating Expenses =EBITDA - Depreciation Expense =EBIT X (1 - Tax rate) =NOPAT + Depreciation Expense =Cash Flow, Operations -Capital Expenditures =Free Cash Flows
Terminal Year, Operating and Non-Operating Cash Flows; t = n Find the terminal year cash flows, assuming the center is fully depreciated at the end of its useful life and there is no salvage value.
Operating cash flows $4,248,000 Return of NWC + 1,000,000 TERMINAL YEAR $5,248,000
Which of the following statements is true about common stock? Owners of common stock have the lowest-priority claim on the firm's assets in the event of bankruptcy. Common-stock holders have unlimited liability toward the obligations of the corporation. Owners of common stock are guaranteed dividend payment by the firm. Common stock is considered to have a fixed maturity.
Owners of common stock have the lowest-priority claim on the firm's assets in the event of bankruptcy.
You are interested in investing in a company that expects to grow steadily at an annual rate of 6 percent for the foreseeable future. The firm paid a dividend of $2.30 last year. If your required rate of return is 10 percent, what is the most you would be willing to pay for this stock? (Round to the nearest dollar.)
P0 = D1/R-g = Do(1+g)/R-g 2.30(1.06)/.10-.06=2.438/.04= 60.95 =61
Turnbull Corp. is in the process of constructing a new plant at a cost of $30 million. It expects the project to generate cash flows of $13,000,000, $23,000,000, and 29,000,000 over the next three years. The cost of capital is 20 percent. What is the MIRR on this project? (Do not round intermediate computations. Round final answer to the nearest percent.)
PV of costs = $30,000,000 Length of project = n = 3 years Cost of capital = k = 20% TV= CF1(1+k)^n-1 + CF2(1+k)^n-2 +...+ CFn(1+k)^n-n =13,000,000(1.20)^2 + 23,000,000(1.20)^1 + 29,000,000(1.20)^0 =18,720,000 + 27,600,00 + 29,000,000 =75,320,000 75,320,000/30,000,000=2.5107 (2.5107)^1/3= 1.3591 MIRR= .3591
Example: Zero-Growth Dividend Model Del Mar Corporation pays $5 dividend per year, and the board of directors has no plans to change the dividend. The firm's investors require a 20% return on investment. What is the expected market price on the stock?
Po=D/R=$5/.20=$25
Zephyr Electricals is a company with no growth potential. Its last dividend payment was $4.50, and it expects no change in future dividends. What is the current price of the company's stock given a discount rate of 9 percent?
Po=D/R=4.50/.09=$50.00
Ryder Supplies has its stock currently selling at $63.25. The company is expected to grow at a constant rate of 7 percent. If the appropriate discount rate is 17 percent, what is the expected dividend, a year from now? (Round the answer to two decimal places.)
Po=D1/R-g D1=Po(R-g) =63.25(0.17-.07) =6.325
Learning Objective 4 Describe the characteristics of preferred stock.
Preferred Stock: Debt or Equity? Viewed as a perpetuity because no maturity date; no voting rights, so no control Dividends are "promised" Preferred stock is equity but a strong case can be made that it is a special type of debt (pays fixed dividend)
Secondary markets defined and examples
Previously issued securities Used car lot for stocks and bonds The New York Stock Exchange (NYSE) Ranks one in total volume and total capitalization The NASDAQ is larger than the NYSE in terms of number of companies listed and shares traded daily Ranks two in total volume and total capitalization
Terminal Year Non-Operating Cash Flows; t = n
Proceeds from Sale or Salvage Value (-)+ (Tax if gain on sale) or Offsetting deduction if loss on sale + Return of NWC = Terminal Year Cash Flow
3. Contingent projects
Projects for which the decision to accept one project depends on acceptance of another project. Types of contingent projects mandatory projects optional projects
2. Mutually exclusive projects
Projects for which the decision to accept one project is simultaneously a decision to reject another project. These projects typically perform the same function.
1. Independent projects
Projects for which the decision to accept or reject is not influenced by decisions about other projects being considered by the firm.
Provo, Inc., had revenues of $10 million, cash operating expenses of $5 million, and depreciation and amortization of $1 million during 2008. The firm purchased $500,000 of equipment during the year while increasing its inventory by $300,000 (with no corresponding increase in current liabilities). The marginal tax rate for Provo is 40 percent. Free cash flow: What is Provo's NOPAT for 2008?
Provo, Inc. Revenue $10,000,000 -Operating Ex 5,000,000 EBITDA $5,000,000 -D&A 1,000,000 EBIT $4,000,000 x (1 - t) 60% NOPAT= $2,400,000
Provo, Inc., had revenues of $10 million, cash operating expenses of $5 million, and depreciation and amortization of $1 million during 2008. The firm purchased $500,000 of equipment during the year while increasing its inventory by $300,000 (with no corresponding increase in current liabilities). The marginal tax rate for Provo is 40 percent. Free cash flow: What is Provo's free cash flow for 2008?
Provo, Inc. Revenue $10,000,000 -Operating Ex 5,000,000 EBITDA $5,000,000 -D&A 1,000,000 EBIT $4,000,000 x (1 - t) 60% NOPAT $2,400,000 +D&A 1,000,000 CF Opns $3,400,000 −Cap Exp $5,000,000 -Add WC $300,000 FCF $2,600,000
*Key Reasons for Making Capital Expenditures
Renewal: Equipment must be repaired/overhauled Replacement: Replace equipment with new equipment Expansion: Increase output of existing products Regulatory: Mandated by government
Practice: A firm is considering taking a project that will produce $12 million of revenue per year. Cash expenses will be $5 million, and depreciation expenses will be $1 million per year. If the firm takes that project, then it will reduce the cash revenues of an existing project by $2 million. What is the free cash flow on the project, per year, if the firm is in the 40 percent marginal tax rate?
Revenue $12,000,000 Cash exp (5,000,000) Deprec exp(1,000,000) Lost revenue (2,000,000) Pretax income $4,000,000 Less taxes 1,600,000 Net income $2,400,000 Add Deprec 1,000,000 Free Cash Flow/yr =$3,400,000
STEPS A COMPANY TAKES BEFORE COMMITING FUNDS
Sales Force- Most of the information needed to make capital-budgeting decisions is generated internally, often beginning with the sales force. Production Team-Next the production team gets involved, followed by accountants. Financial Managers- All the information is reviewed by financial managers who evaluate the feasibility of the project.
Learning Objective Discounted Payback Period
Same technique as regular payback, but future cash flows are first discounted at the firm's cost of capital The major advantage of the discounted payback is that it tells management how long it takes a project to reach a positive NPV
Common stock valuation - Non-Constant Growth A company recently paid a dividend of $2.00 and this dividend is expected to grow by 30% every year for three years and then grow at a constant rate of 6% every year. The investor's annual required rate of return is 13%. Find the intrinsic value of the stock.
Solution PP Slide 35
Calculating Project Cash Flows Example Each of the four boxes is expected to generate $400,000 per year, while each of the 5000 new seats will generate $2,500 in incremental annual revenue. If the incremental expenses will amount to 60% of the revenues and depreciation expense will be $1,000,000 each year, find the after-tax cash flows for n= 1 to n = 10. Assume the tax rate is 30%. Operating Cash Flows over the Project's Life; n=1 to n=10 Revenue -Op. Exp. EBITDA -D/A EBIT X(1-t) NOPAT +D/A Cash Flow, Operations
Solution PP Slide 64
MIRR Example Assume a project will cost $100 today and will generate $10 in cash flows next year, $60 in year 2 and $80 in year 3. First, find the future values of $10, $60 and $80 at the end of year 3, compounded at 10%. This is the terminal value. Next, find the discount rate that makes the value of the terminal value equal to $100. This is the MIRR.
Solution PP slide 130
Discounted Payback Period Problem Juniper, Inc. is evaluating an independent project. The financial manager has determined that the after- tax cash flows for the project will be as follows: Year Cash Flows 0 ($30,000) 1 $10,000 2 $12,000 3 $15,000 4 $10,000 What is the project's discounted payback, assuming the cost of capital = 13% ?
Solution Slide 110
Supernormal Dividend Growth Model
Some firms experience a supernormal rate of growth in dividends in the early years If the supernormal growth occurs first and is followed by constant dividend growth, we can combine equations 9.1 and 9.5 Po=D1/1+R + D2/(1+R)^2 +...+Dt/(1+R)^t + Pt/(1+R)^t
Basic Facts
Stocks are equity securities - they represent certificates of ownership in a corporation. Bonds are fixed income securities. Households hold the largest share of equity securities, more than 36% of corporate equity Institutional investors such as pension funds are largest investors in equities (21%), followed by mutual funds (20%), and foreign investors (10%)
Components of Capital
The "means" to make a company grow. Obtained from three primary sources— 1. Long-term Debt (e.g. Bonds) 2. Preferred Stock 3. Common Equity
Internal Rate of Return
The IRR technique compares a firm's cost of capital to the rate-of-return that makes the net cash flows from a project equal to the project's cost A project is acceptable if its IRR is greater than the firm's cost-of-capital The IRR is the discount rate that makes Net Present Value = 0
Profitability Index (PI)
The PI provides a measure of the value of project generates for each dollar invested in that project Useful because firms have limited resources and therefore cannot invest in all projects that have a positive NPV The PI will choose a set of projects that is consistent with the idea of shareholder wealth maximization 𝑃𝐼=𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠/𝐶𝑜𝑠𝑡𝑠 =𝑃𝑉 𝑜𝑓 𝑓𝑢𝑡𝑢𝑟𝑒 𝑓𝑟𝑒𝑒 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠/𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 =𝑁𝑃𝑉+𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑚𝑒𝑛𝑡/ 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
Learning Objective 5 Be able to estimate the value of a share of common stock at some future time period, assuming it pays a dividend that is growing at a constant rate. Computing Future Stock Prices
The constant-growth dividend model can be generalized to value a share of stock at any point in time Pt=Dt+1/R-g
The Cost of Debt
The current cost of debt for a publicly-traded bond is derived from its yield to maturity calculation. Since the interest payments are a tax deductible expense, use the after-tax cost of debt. After-tax cost of debt equals the pretax cost times 1 minus the tax rate:
Computing the terminal-year FCF: Babaloo Nightclubs, purchased a disco mirror that currently has a book value of $10,000. If Babaloo sells the disco mirror for $500 today, then what is the amount of cash that it will net after taxes if the firm is subject to a 39 percent marginal tax rate?
The loss on the sale was $10,000 - $500 = $9,500 The tax refund on the loss is: $9,500 x .39 = $3,705 Net cash flow from the sale is $500 + $3,705= $4,205
Progressive tax system
The progressive or marginal tax system used in the United States is one in which the proportion of income paid as taxes increases as the amount of taxable income increases
Marginal tax rate
The tax rate on one additional dollar of taxable income.
Example: Weighted-Average Cost of Capital
The total value of a firm's equity is $3,700,000 and the market value of its debt is $300,000. If the yield to maturity on its debt is 10% and its cost of equity is 20%, what is its weighted-average cost of capital (WACC) if the company's marginal tax rate is 40%? 𝑘𝐹𝑖𝑟𝑚=(0.075)(0.10)(1−.4)+(0.925)(0.20)=0.0995, 𝑜𝑟 9.5%
General Dividend Valuation Model
The value of a share of stock is the present value of all expected future cash dividends The model requires dividend forecasts for an infinite number of periods The model implies the intrinsic value of a share of stock is determined by the market's expectations of a firm's future cash flows The model does not include specific assumptions, such as: Whether the growth rate is constant, which is important in estimating expected future cash dividends How to forecast dividends or when a share of stock might be sold
Internal Rate of Return Mutually Exclusive Projects
There is a discount rate at which the NPVS of two mutually exclusive projects will be equal. That rate is the crossover point.
Internal Rate of Return Unconventional Cash flows
Unconventional cash flows may exhibit many patterns Positive initial cash flow followed by both positive and negative net cash flows. With unconventional cash flows, the IRR technique may provide more than one rate of return
Learning Objective Internal Rate of Return
When IRR and NPV Methods Agree The methods will always agree when projects are independent and the cash flows are conventional A conventional project has an initial outflow to begin and net inflows each year thereafter. When IRR and NPV Methods Disagree The IRR and NPV methods can produce different accept/reject decisions if a project has unconventional cash flows or projects are mutually exclusive Differences between IRR and NPV Methods IRR is a percentage rate, while NPV is a dollar amount. IRR is not the best way to select a project (lemonade stand vs. the convenience store example in book). Select project that will provide the best VALUE.
Depreciation Tax Savings Example Example: A company acquires an asset for $1M which falls in the MACRS three-year property class. If the tax rate is 35%, find the amount of depreciation tax savings for years 1 to 4.
Year 1: $1M (.3333) (.35) = $116,655 Year 2: $1M (.4445) (.35) = $155,575 Year 3: $1M (.1481) (.35) = $51,835 Year 4: $1M (..0741) (.35) = $25,935
Capital Rationing-
a firm with limited funds chooses the best projects to undertake
In brokered markets: the commission charged by brokers is a lower cost to buyers and sellers than the cost of direct search. buyers and sellers are brought together for a commission. brokers build a pool of price information through their extensive contacts. all of the above are true of broker markets.
all of the above are true of broker markets.
Whenever a project has a negative impact on an existing project's cash flows, then that effect should: be ignored if the project is evaluated using the correct cost of capital. be ignored. be included if the impact is limited to noncash expenditures. be included as a negative revenue amount on the new project's cash flow analysis.
be included as a negative revenue amount on the new project's cash flow analysis.
Free cash flow (FCF) -
cash flows expected from a project. FCF is a measure of financial performance calculated as operating cash flow minus capital expenditures. Free cash flow (FCF) represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base.
Capital budgeting
decision process that managers use to identify those investment opportunities (projects) that add to the firm's value.
The least efficient of all the different types of secondary markets is the: dealer market. direct search market. broker market. auction market.
direct search market.
Capitalized Expenditures are
expenditures that may provide benefits into the future and therefore are treated as capital outlays and not as expenses of the period in which they were incurred. Examples: Shipping, Installation or Modification Costs
The cash flows used in capital budgeting calculations are based on: forecasts of net income. historical estimates. forecasts of retained earnings available for financing projects. forecasts of future cash revenues, expenses, and investment outlays.
forecasts of future cash revenues, expenses, and investment outlays.
Perpetual preferred stock
has no maturity date Dividends are fixed, g=o, and dividend payments go on forever Equation 9.2, Zero-Growth Dividend Model, is used to value perpetual preferred stock. Note: Your textbook uses "i" and "R" interchangeably. Po=D/R
Learning objective Answer: 2.Be able to describe what is meant by an efficient market. Market efficiency-
securities are correctly priced because in an efficient market, stock prices are updated constantly as new information reaches the market and is immediately incorporated into estimates of market values it is easy to find a buyer or seller transactions are completed quickly with low transaction costs
Example: FCF Calculation A new truck will increase revenues by $50,000 and operating expenses by $30,000 per year. It will be depreciated over 3 years at $10,000 per year. Your firm's marginal tax rate is 35%. Capital expenditures will be $3,000 annually but no additional working capital will be needed. Calculate the yearly free cash flow.
𝐹𝐶𝐹=($50,000−$30,000−$10,000)×(1−0.35) +$10,000−$3,000−$0 =$13,500
Operating Cash Flows over the Project's Life (Second option)
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 − 𝐹𝑖𝑥𝑒𝑑/𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡𝑠 𝐸𝐵𝐼𝑇 − 𝑇𝑎𝑥𝑒𝑠 𝑁𝑂𝑃𝐴𝑇 + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑇𝑎𝑥 𝑆𝑎𝑣𝑖𝑛𝑔𝑠 = 𝑃𝑟𝑜𝑗𝑒𝑐𝑡𝑒𝑑 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑓𝑜𝑟 𝑡ℎ𝑎𝑡 𝑦𝑒𝑎𝑟 (Note: Instead of subtracting depreciation, calculating taxes and then adding back depreciation, one can simply add depreciation tax savings. Depreciation tax savings = depreciation expense X tax rate)
Operating Cash Flows over the Project's Life
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑅𝑒𝑣𝑒𝑛𝑢𝑒− 𝐹𝑖𝑥𝑒𝑑/𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒𝐶𝑜𝑠𝑡𝑠 − 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝐸𝑥𝑝𝑒𝑛𝑠𝑒 (𝑓𝑜𝑟 𝑡ℎ𝑎𝑡 𝑦𝑒𝑎𝑟) 𝐸𝐵𝐼𝑇 − 𝑇𝑎𝑥𝑒𝑠 𝑁𝑂𝑃𝐴𝑇 + 𝐴𝑑𝑑 𝑏𝑎𝑐𝑘 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝐸𝑥𝑝𝑒𝑛𝑠𝑒 = 𝑃𝑟𝑜𝑗𝑒𝑐𝑡𝑒𝑑 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑓𝑜𝑟 𝑡ℎ𝑎𝑡 𝑦𝑒𝑎𝑟
Example: Perpetual Preferred Stock Northwest Airlines has perpetual preferred stock that pays a dividend of $5 per year. Investors required an 18% return on similar investments. What is the value of Northwest's preferred?
𝑃𝑆o=𝐷/𝑅=$5/0.18=$27.78
