FINC 443 FINAL (Needs post Long Quiz 1 Formulas)

Why does the concept of portfolio beta matter when thinking about how systematic risk links to returns?

Portfolio beta allows us to see the effect of the common shock in our portfolio in terms of the market movement. Projects with higher betas expose you to larger amounts of systematic risk and projects with lower betas reduce the amounts of systematic risk.

What are potential components of the initial investment in a project?

Potential components of the initial investment in a project include price, shipping/transportation costs, installation and modification costs, changes in NWC, and impact of salvaging old assets (depreciation matters)

Explain how you could incorporate the well-known liquidity discount into a discount rate. Be sure to use a formula in your answer.

Private companies often need to have a discount rate due to the difficulty of being sold since they are less liquid. This liquidity discount rate typically ranges from 20-30%. The formula for this would be: Revised E.V. + cash - interest bearing debt = Equity Value (EV)

Changes in Net Salvage Value

SV go - SV no go

Net SV - Profit

Salvage Price -(BV) = Profit from Salvage - Tax Burden = Net Profit from Salvage + BV = Net CF from Salvage

Net SV - Loss

Salvage Price -(BV) = Profit from Salvage - Tax Shield = Net Profit from Salvage + BV = Net CF from Salvage

Carefully examine the description of WACC at the link below. Tell me everything you find wrong with it.

Takes into account non-systemic risk when WACC should only consider systemic risk Adding alpha to WACC

What is the importance of viewing the balance sheet picture of the firm in a 'sealed box'?

The 'sealed box' illustrates how Assets will always equal liabilities plus equities, although it is not entirely true as the government takes from the sealed box in the form of taxes.

What are the two main drivers or determination of equity beta?

The 2 main drivers of equity beta are increasing the leverage or debt of a firm (increasing the equity beta) and the asset mix of a firm which decreases the equity beta if the asset mx is not as risky.

In the Avco example, why did the WACC method and the APV method give the same for the value of the project and the NPV? Will that always be true?

The WACC and the APV method give us the same value as the NPV because our D/V is constant. When the D/V is constant they will always be the same

How do the XNPV and XIRR functions in Excel differ from the NPV and IRR functions? Be able to write the inputs in the correct format to use the functions.

The XNPV function is considered better because it incorporates the actual dates of the cash flows, allowing it to recognize the odd timing of cash flows. It differs in Excel because you put Cash flow zero in the actual range as opposed to outside of the range. In Excel, it would be written as =XNPV(r, CF0:CFN, date0:dateN). The XIRR function is better than the IRR function for the same reason and functions the same way. It would be written as =XIRR(CF0:CFN, date0:dateN, [guess]).

How does one calculate firm free cash flows? Equity free cash flows.

The calculation begins with Net Operating Income less taxes to get to NOPAT. Then you account for changes in deferred taxes, add back depreciation, subtract CAPEX, and change in NWC to get to your firm free cash flows from operations. Add all non operating income post tax to get to the bottom line firm free cash flow available for all investors.

Under the flow to equity method, which cash flows and discount rate is used to calculate value? In the Avco example, which value did the flow to equity "match?"

The cash flows that are strictly to the equity or shareholders. And the cost of equity is used to discount the cash flows paid to the shareholders. The NPV matched the FTE method.

Why does the cost of debt not equal the yield to maturity?

The cost of debt does not equal the yield to maturity because the yield to maturity is the best expected case for an investment. The YTM is essentially a fantasy number since it assumes you will reach the maturity date, get all your money back, and be able to reinvest at a coupon rate while the cost of debt is realistic. Cost of debt is calculated with a probability of what can go wrong to get our cost of debt in relation to our estimated return on debt.

We used three different discount rates when discounting in the Avco example. What were they and when was each used?

The cost of equity was used in the FTE approach, the After-Tax WACC was used in the WACC approach, and the Pre-Tax WACC for the APV method since the D/V is constant.

What is the difference between the direct and indirect methods of estimating cash flows? How does that relate to the "sealed box" view of a firm?

The difference between the direct and indirect methods of estimating cash flows depend on which side of the sealed balance sheet box you are looking at. If you are looking from the left side (asset side) you would use the direct method. If you are using the right side or the equity side and liability, you use the indirect method.

What types of things go into creating expected costs of financial distress?

The difficulties associated with the inability to attain suppliers and customers due to having too much debt and thus too much risk. Increasing debt, for example, would increase the value and distress costs. You would then do a cost benefit analysis to see if value or costs increase more.

In the market, what type of investors get to set the discount rate? Why?

The investor who is willing to pay the most gets to set the rate. This is usually the diversified investor because if their portfolio is diversified they eliminate unique risk and do not require as large of a return as an undivided investor and are able to pay more which allows them to set the rate.

What is the key thing to remember about the growth parameter in a growing perpetuity of cash flow calculation? Why?

The key thing to remember about the growth parameter is that it cannot grow faster than the economy. The typical economy growth rate is 7% (3% for inflation and 4% actual growth). The growth parameter cannot grow faster than the economy growth rate because if it did then it would essentially just become the economy, which is not possible.

What are the main factors you must consider in assessing how long a period of abnormally high growth (in the planning period) should be?

The main factor that should be considered when assessing the length of a period of abnormally high growth is when the company will reach perpetual growth. Once perpetual growth is reached, the company's capital structure will become constant which allows you to use the after tax method of WACC within the APV method.

Suppose that I am going to replace an old machine with a new machine. On a timeline, explain which salvage value calculations go where?

The salvage value of the old machine goes at the left end of the timeline, or the point of time when a new machine is purchased, and the salvage value of the new machine goes at the right end of the timeline, or the salvage date of the new machine.

Explain the single broad concept or rule that permits us to classify cash flows as relevant or irrelevant.

The single broad concept would be the 'go or no go' idea. Essentially, you would only go forward with a new product, idea, service, etc. if it proves to generate more cash flows than if you did not go.

What are the differences between the statement of cash flows and "firm free cash flows"?

The statement of cash flows begins with the net income because it wants to exclude interest expense by subtracting it in the calculation to get NI, but the firm free cash flows start with net operating income to keep interest expense in the calculations.

What type of risk(s) should be reflected in the discount rate or cost of capital?

The systematic or common risk should be reflected in the discount rate or cost of capital. This is because an investor can cut out the other unique risk by diversifying their portfolio, so they should only be compensated for the risk they cannot cut out.

How does one calculate the tax bill associated with salvaging an asset?

The tax bill associated with salvaging an asset is calculated by subtracting the book value from the salvage value to get a profit or loss. From there you either subtract the tax if it was a profit or add the tax shield if it was a loss. This brings you to the net profit/loss. You then add the book value back to the net proft/loss to arrive at your net cash flow.

Explain how to calculate the value of the control premium. What is a critical question to ask when conducting that calculation?

There will be at least 30% control premium when an acquisition occurs because of the added benefits and synergies that come from control valuations. The calculation for control premium is value with control - value without control. The amount of control premium paid will depend on the bargaining positions of the buyer and seller. So the critical question to ask would be how much bargaining power do the buyer and seller have?

How does one estimate enterprise value using the APV method?

To calculate the EV using the APV method you must take the PV of the sum value of the unlevered cash flows and the value of the interest tax savings minus the expected costs of financial distress.

What steps does one go through to compute MACRS depreciation expenses?

To compute MACRS, determine the depreciable base which will allow for maximum depreciation expense that is allowed by tax regulations. Next, determine the number of years you will be using MACRS and the associated percentages to depreciate the asset to 0.

Equity CF Risk > Debt CF Risk

True

Why do we estimate WACC? Give examples of common mistakes people make when they misunderstand why we estimate WACC.

We estimate WACC to get a good idea of the risk and estimated return on assets. A common mistake associated with WACC estimates would be using the book value of debt and equity with a market value of an asset. The more valuable the project, the bigger the gap between market and book value.

When is it appropriate to use the cost of debt to discount interest tax savings?

When debt is not tied to value and we know there is debt, we use Kd to discount ITS because it is the same as interest expense.

When is it appropriate to use the unlevered WACC to discount interest tax savings?

When we have unlevered cash flows to discount back and get the PV. Usually all situations where we do not see debt.

i = r + p dot + r*p dot

i = nominal rate r = real rate p dot = expected inflation (1+i) = (1+r) * (1+p dot)

Ri

summation of Wi*Ri

PV@ t = 0:

(CFt + 1) / r - g *Population and productivity growth can cause global economic growth

2 types of adjustments in the FCF

1.) add back thing subtracted that don't represent cash outflow 2.) need to subtract thing that were cash outflows

Kd = E(Rd):

= (1-p)*y + p*(y-L) = YTM - prob(default)*expected loss rate P: probability of default L = loss rate

Net PPE 2016

= Net PPE 2015 Year end - Depreciation Expense in 2016 + CAPEX in 2016

CAPEX 2016

= Net PPE 2016 - Net PPE 2015 + Dep 2016

E(Ri)

= Rf +Bi (Rmkt - Rf) Real world: (Ri - Rf) = ai + Bi (rmkt - rf) + ei

Value

= Sum of Discounted CF's

Bp

= Summation of Wi*Bi

Ba

= We*Be + Wd*Bd

WACC

= We*Ke + Wd*Kd*(1-t)

Nominal Rate

= [sum of CFs * (1+p dot)^t] / [(1+r)^t * (1+p dot)^t] = V

IRR

= irr(CF0:CFN, [guess])

NPV

= npv(r,CF1:CFN) + CF0

Discount Rate

= sum of CFs / (1+r)^t

XIRR

= xirr(CF0:CFN, date0:dateN, [guess])

XNPV

= xnpv(r,CF0:CFN, date0:dateN)

FCF

=(EBIT)*(1-t) + Dep/Amor + Changes in Deferred Taxes - CAPEX - Changes in NWC

What are the two main types of adjustments that must be made when going from net operating profit after tax to free cash flow? Give examples of each type.

After NOPAT, you need to adjust for non cash expenses and changes in net working capital. Non cash expenses would include depreciation and amortization expenses. Changes to net working capital include adding or subtracting the inverse of the direction of net working capital. For example, we would subtract an increase in net working capital because an increase in net working capital means there was a cash outflow (i.e. we bought inventory, increasing our NWC while acting as a cash outflow).

When is it appropriate to use the after-tax WACC to discount interest tax savings?

After tax WACC is never used to discount ITS because you would be double counting tax savings.

What important assumptions underlie WACC? Give examples of common mistakes people make when they ignore these assumptions.

An important assumption underlying WACC is that all weights are constant. The weights and rates need to be forward looking as well (we use WACC to discount cash flows in the future). Common mistakes include ignoring these assumptions, such as by using different weights to calculate your valuation.

BV on MACR's

BV will be the sum of the remaining year's %s and multiplying it by the depreciable basis

What is the best way to handle expected future inflation when forecasting cash flows? Be able to identify cash flow patterns that potentially create problems, and be able to explain the nature of the problem

Be consistent with handling inflation. Use nominal discount rates with nominal cash flows. Don't ever use real cash flow rates because real cash flow rates are never used in real world calculations, they are only used to teach the theory. Cash flow patterns that potentially create problems would be not taking expected inflation into account. The formula for the nominal interest rate is (1+i) = (1+r)(1+p). This is important because we will use cash flows to compute the value of a firm with the formula V = CF/(1+r)^t. If we incorrectly calculated cash flows in the previous step because of an inflation calculation error, we will have an incorrect overall value for the firm.

Explain how to defend using a metric like (enterprise value / user) to estimate the value of a user to Facebook.

By taking the enterprise value and dividing it by users, you get an accurate estimate of how much a user is worth. The calculation includes payout ratio, cost of capital, and growth factors. With those factors being a part of the calculation, it is a valid metric.

What is the link between opportunity cost and the CAPM?

CAPM estimates the return on an actual opportunity by measuring a portfolio of market index and bonds with the same beta. The link between opportunity cost and CAPM occurs because of the ability to measure an alternative project with the same beta to find the required return needed on a project with the same risk or beta. Essentially, you cannot fully and accurately value something without comparing it to something else, and that is what the CAPM does and how it incorporates opportunity cost.

What is cannibalization? Give an example.

Cannibalization is when one new product or service eats away at another. An example would be if General Mills had a well known, name brand Chocolate Flakes type of cereal, and they introduced a cheaper chocolate cereal. This cheaper cereal would generate sales, but it would 'eat away' at the sales of the name brand Chocolate Flakes. General Mills would have to look at the cash inflows and outflows from these two products to see if it is a net gain, net loss, or push.

What is common sizing of financial statements and why is it useful?

Common sizing is used to take the actual number of each statement and divide by the total number of assets or sales. This makes the numbers that are hard to decode at a quick view easier to understand as you look across years.

How should one estimate the cost of debt?

Cost of debt is the expected return of the debt. The cost of debt is estimated by subtracting the product of expected loss rate and probability of default by YTM. New YTM is calculated by (1-p)*y, with p being equal to probability of default and y is the original YTM. The probability of default multiplied by the expected loss rate can be calculated doing: p*(y-L), where L is the loss rate.

Net Working Capital (NWC)

Current Assets - Current Liabilities (CA-CL)

Starting with the P/E ratio, show the steps that demonstrate what it is equivalent to in the DCF framework. What does that mean for choosing a 'similar' firm as a comparable?

D1/E1 = Payout Ratio ----> ----> D1/EPS1 / Re - g

Starting with the Enterprise Value/EBITDA ratio, show the steps that demonstrate what it is equivalent to in the DCF framework. What does that mean for choosing a 'similar' firm as a comparable?

EBITDA M = EV/EBITDA. This gets you EVO = FCF1/Ka-g. Put that over EBITDA so you have (FCF1/Ka-g)/EBITDA. They rearrange it to have (FCF/EBITDA)/Ka-g.

What specifically should one be cautious about when using IRR as a decision metric to make investment decisions? Note that (2) above is deliberately broad. Without much guidance, you should know the five pitfalls of IRR and be able to tell how to know if they are likely to be a problem.

Five Pitfalls of IRR Delayed Investments/Borrowing Problem - IRR will tell you to accept a negative NPV b/c the benefits occur before the cost Multiple IRRs - Multiple sign changes in cash flows result in multiple IRRs and render the IRR rule useless Nonexistent IRR - No discount rate to make NPV=0, so cannot use IRR rule Mutually Exclusive Projects - IRR ignores magnitude of project Reinvestment Rate Assumption - False assumption that all interim cash flows are reinvested at the IRR

How does a free cash flow calculation differ from an income statement calculation?

Free cash flow will only count transactions that involve the actual movement or flow of cash. For example, depreciation expense is on an income statement but not a cash flow. This is because there is no actual transaction taking place with depreciation expense. It is just the devaluation of a fixed asset.

Most fundamentally, what type of cost is a cost of capital? Explain in detail why this matters.

Fundamentally, cost of capital is an opportunity cost. This matters when deciding if you should go forward or not go forward on a project. You need to take into account the cost of what you would not be doing if you went forward with a project. For example, if going forward with Project A means you cannot do Project B, you need to take into account the missing profit of Project B and add those to the cost of capital.

What is the correct way to handle non-systematic (diversifiable, idiosyncratic, unique) risks that might affect cash flows in an investment?

If there is a unique risk we change our cash flow amounts, not our discount rate. We do this by taking the probability of each risk associated with a cash flow and getting it to a single cash flow (multiply risk times cash flow and then sum)

Which cash flows are relevant in a valuation?

If they are an incremental/marginal cash flow, and an analysis shows it makes more sense to go forward than to not go forward, it would be considered relevant.

Explain the importance of knowing how cash flows and risk are allocated in a balance sheet picture of the firm.

It is important to know that once a firm has cash flows, the firm will then pay off their debt and equity. Greater risk means greater likelihood of insufficient cash flows to pay off debts.

What would happen if we used the after-tax WACC to discount the horizon value (FCF/(K-g)) back to zero?

It would be inaccurate because you have to discount it back using the pre-tax WACC where debt is constant.

The GRC example we did in class used three different discount rates in the APV calculation. What were they, where were they used, and why?

Kd is for the ITS for the planning period to discount the ITS to get PV and is used where debt is not tied to value. Pre tax WACC is used when dealing with unlevered cash flows to get the PV. Post tax WACC gets the levered cash flows and is discounted back to get the PV and is sued when debt is ot tied to value because ITS is the same as interest expense.

WACC (with preferred)

Kd*(1-t)*Wd + Kp*Wp + Ke*We

Explain the importance of knowing the direction that cash flows and risk flow in a balance sheet picture of the firm.

Knowing the direction of cash flow and risk is important b/c it shows whether or not a firm's wealth is increasing or decreasing and whether or not the risk associated with that CF is increasing or decreasing.

Where do cash flows and risk originate in the balance sheet picture of a firm?

Left side

Should you ever just calculate one value and rely solely on it? If not, what would you do and why?

No, because relying solely on one method is very risky. It's best to use multiple methods to see if you arrive at the same solution.

Why should one always use MACRS depreciation in a valuation estimate? How does the present value of depreciation-related tax shields relate to this question?

One should always use MACRS in a valuation because it allows you to use the maximum depreciation expense allowed by tax regulations. Essentially, you can have a greater PV of the tax shield using MACRS as opposed to straight line depreciation.

Explain how one would forecast the cash flows associated with net working capital. Be precise about what constitutes a cash outflow and what an inflow.

One would forecast the cash flows associated with net working capital by looking at the changes in current assets and current liabilities. For example, if we see an increase inventory, we purchased more inventory than we sold. Therefore, cash outflow. If there is less inventory at the end of the period, we sold more inventory than we bought, therefore cash inflow.

What types of psychological biases might affect forecasts of cash flows and risks, and what are the resulting implications for value, and the relation between risk and return?

Optimism, pessimism, and overconfidence are types of psychological biases that might affect cash flows and risks. Optimism leads to over-valuing Cash Flows while pessimism has the opposite effect. In optimism, we are too excited about a project and thus do not properly evaluate the cash flow. In pessimism, we do not focus enough on the cash flows associated with the project. Overconfidence leads to underestimating risk, which then leads to overestimating value. We underestimate the risk which leads to underestimating beta which leads to underestimating WACC which leads to overestimating value.