Intermediate Finance Final
Two major applications of forecasted financial statements
1. Free cash flows can be used to estimate the impact that changes in operating plans have on the firm's estimated intrinsic value of operations and stock price. 2. forecasted financing surplus or deficit allows the firm to identify its future financing needs.
Several factors influence a firm's capital structure. These include its: (1)___, (2)___, (3)_____, (4)____, (5)____
1. business risk 2. tax position 3. financial flexibility 4. managerial conservatism or aggressiveness 5. growth opportunity
______is the risk inherent in the firm's operations if it uses no debt. A firm will have little business risk if the demand for its products is stable, if the prices of its inputs and products remain relatively constant, if it can adjust its prices freely if costs increase, and if a high percentage of its costs are variable and hence will decrease if sales decrease. Other things the same, the lower a firm's business risk, the higher its optimal debt ratio
Business Risk
____ is an important type of externality that occurs project leads to a reduction in sales of an existing product
Cannibalization
______is the extent to which fixed-income securities (debt and preferred stock) are used in a firm's capital structure
Financial leverage
____is the added risk borne by stockholders as a result of financial leverage.
Financial risk
____ shows the effect of financial leverage on beta follows:
Hamanda equation b= bU[1+(1-T)(D/S)]
____ is a risk analysis technique that uses a computer to simulate future events and thereby estimate a project's profitability and riskiness
Monte Carlo simulation
___ is important because it affects the discount rate used in capital budgeting; in other words, a project's WACC depends on its risk
Risk
____ affect cash flow analysis in two ways: (1) taxes reduce operating cash flow and (2) tax laws determine the depreciation expense that can be taken in each year
Tax laws
If there are no corporate or personal taxes, Modigliani and Miller showed that the value of a levered firm is equal to the value of an otherwise identical but unlevered firm:
VL= VU
If there are only corporate taxes, Modigliani and Miller showed that a firm's value increases as it adds debt due to the interest rate deductibility of debt:
VL= VU + TD
If there are personal and corporate taxes, Miller showed that:
VL= VU + [1 - (1-Tc)(1-Ts)/ (1-Td)] D
____ is the ability to discontinue a project if the operating cash flow turns to be lower than expected. It reduces the risk of a project and increases its value. Instead of total abandonment, some options allow a company to reduce capacity or temporarily suspend operations
abandoment option
profitability index (PI)
calculated by dividing the present value of cash inflows by the initial cost, so it measures relative profitability that is amount of the present value per dollar of investment
additional funds needed(AFN)
can be used to forecast additional external financing requirements, but only for 1 year ahead and only if all asset-to-sales ratios are identical, all spontaneous liabilities-to-sales ratios are identical and all cost-to-sales ratios identical
Excess capacity adjustments
can be used to forecast asset requirements institutions in which assets are not expected to grow at the same rate as sales
_____ occurs when management places a constraint on the size of the firms capital budget during a particular period
capital rationing
____ is important because it influences the firm's ability to use low-cost debt, to maintain smooth operations over time, and to avoid crises that might consume management's energy and disrupt its employees, customers, suppliers, and community. Also, a project's corporate risk is generally easier to measure than its market risk. Because corporate and market risks usually are generally correlated, corporate risk can often serve as a proxy for market risk
corporate risk
considers risk among the firm's own assets
corporate risk
____ shows how different decisions during a project's life can affect its value
decision tree
internal rate of return(IRR)
defined as the discount rate that forces project's NPV to equal zero. The project should be accepted if the greater than the cost of capital.
payback period
defined as the number of years required to recover a project's cost. The regular payback method has three flaws: It ignores cash flows beyond the payback period, it does not consider the time value of money, and it doesn't give a precise acceptance rule. The payback method does, however, provide an indication of a project's risk and liquidity, because it shows how long the invested capital will be tied up.
NPV method
discounts all cash flows at the project's cost of capital and then sums those cash flows. the project should accepted if the NPV is positive because such a project increases shareholders value.
Adjustments must be made if ______ exist in the use of assets, if ______ exists, or if growth must occur in large increments( lumpy assets)
economies of scale; excess capactiy
determine AFN
estimating the amount of new assets necessary to support the forecasted level of sales and then subtracting from this amount of the spontaneous funds that will be generated from operations
The most important and difficult step in analyzing a capital budgeting a project is _______ the project will produce.
estimating the incrental after-tax cash flows
____ which the investment generates new sales
expansion projects
forecasted financial statements(FFS)
financial planning ofrecasts the entire set of financial statemnts. It usually begins with a forecast of the firm's sales and then projects many items on the financial statements as a percent of sales
____ is the option to modify operations depending on hwo conditions develop during a project's life, especially the type of output produced or the inputs used
flexibility option
____ occurs if an investment creates the opportunity to make other potentially profitable investments that would not otherwise be possible. These include: (1) options to expand the original project's output, (2) options to enter a new geographical market, and (3) options to introduce complementary products or successive generations of products.
growth option
its possible for a project....
have more than one IRR if the project's cash flows change sign more than once.
NPV and IRR methods make the same accept-reject decisions for _______ , but if projects are ______ than ranking conflicts can arise. In such cases, NPV method should generally be relied upon
independent projects; mutually exclusive
____ involves the possibility of delaying major expenditures until more information on likely outcomes is know. The opportunity to delay can dramtically change a project's estimated value
investment timing option
Many ____ and _____ can be valued using the Black-Scholes call option pricing model
investment timing options; growth options
Opportunities to respond to changing circumstances are called ___ or ____ because they give managers the option to influence the returns on a project. They are also called _____ if they are associated with large, strategic projects rather than routine maintenance projects. Finally, they are also called "real" options because they involve "real" (or "physical") rather than "financial" assets. Many projects include a variety of these _______ that can dramatically affect the true NPV.
managerial options; strategic options; embedded options
Flotation costs and increased risk associated with unusually large expansion programs can cause the _____ to increase as the size of the capital budget increases
marginal cost of capital
Assuming the CAPM holds true, ___ is the most important risk because it is the risk that affects stock prices. However, usually it si difficult to measure a project's market risk.
market risk
considers risk at the stockholder level, where stockholder's own diversification is considered
market risk
Unlike the IRR, a project never has more than one ______.
modified IRR (MIRR).
A project's ____ is different from its accounting income. Project net cash flow reflects: (1) cash outlays for fixed assets, (2) sales revenues, (3) operating costs, (4) the tax shield provided by depreciation, and (5) cash flows due to changes in net working capital. A project's net cash flow does not include interest payments, because they are accounted for by the discounting process. If we deducted interest and then discounted cash flows at the WACC, this would double-count interest charges.
net cash flow
____ is the extent to which fixed costs are used in a firm's operations. In business terminology, a high degree of operating leverage, other factors held constant, implies that a relatively small change in sales results in a large change in ROIC.
operating leverage
In determining incremental cash flows, _____ must be included, but _____ sunk costs (cash outlays that have been made and that cannot be recouped) are not included. Any _____ should also be reflected in the analysis. Externalities can be positive or negative and may be environmental.
opportunity costs (the cash flows forgone by using an asset); sunk costs (cash outlays that have been made and that cannot be recouped);externalities (effects of a project on other parts of the firm)
A firm's _____ is the mix of debt and equity that maximizes the stock price. At any point in time, management has a _____in mind, presumably the optimal one, but this target may change over time.
optimal capital structure;specific target capital structure
A project may have an ____ that is not accounted for in a conventional NPV analysis. Any project that expands the firm's set of opportunities has positive option value
option vlaie
A project's true value may be greater than the NPV based on its ____ if it can be _____ at the of its ______
physical life; terminated; economic life
_____ must be considered in project analysis. The best procedure is to build expected price changes into the cash flow estimates. Recognize that output prices and costs for a product can decline over time even though the economy is experiencing inflation.
price level changes (inflation or deflation)
There are five possible ______(1) DCF analysis only, and ignore the real option; (2) DCF analysis and a qualitative assessment of the real option's value; (3) decision-tree analysis; (4) analysis with a standard model for an existing financial option; and (5) financial engineering techniques.
procedures for valuing real options
capital budgeting
process of analyzing potential projects. Capital budgeting decisions are probably the most important ones that managers must make.
are opportunities for management to respond to changes int he market conditions and involve "real" rather than "financial" assets
real options
____ where the primary purpose of the investment is to operate more efficiently and thus reduce costs.
replacement projects
As a result, companies try to avoid having to issue stock by maintaining a ______ and this means using less debt in "normal" times than the trade-off theory would suggest.
reserve borrowing capacity
_____ is the rate used to evaluate a particular project. It is based on the corporate WACC, a value that is increased for projects that are riskier than the firm's average project and decreased for less risky projects.
risk- adjusted discounted rate or project cost of capital
The higher a firm's _______ and the higher its _______ the greater will be its need for additional financing
sales growth rate; payout rate
____ is a risk analysis technique in which the best- and worst- case NPVs are compared with the project's base-case NPV
scenario analysis
_____ is a technique that shows how much a project's NPV will change in response to a given change in an input variable, such as sales when all other factors are held constant
sensitivity analysis
A firm's decision to use debt versus stock to raise new capital sends a ____ to investors. A stock issue is viewed as a negative signal, whereas a debt issuance is a positive (or at least a neutral) signal.
signal
discounted payback
similar to the regular payback except that it discounts cash flows at the project's cost of capital. It considers the time value of money, but it still ignores cash flows beyond the payback period.
____ divides the analysis into different phases. At each phase a decision is made either to proceed or to stop the project. These decisions are represented on the decisions trees by circles and are called _____
staged decision tree; decision nodes
___ is easier to measure than either market or corporate risk. Also, most of a firm's projects' cash flows are correlated with one another, and the firm's total cash flows are correlated with those of most other firms. These correlations mean that a project's stand- alone risk generally can be used as a proxy for hard-to-measure market and corporate risk. As a result, most risk analysis in capital budgeting focuses on stand-alone risk.
stand alone risk
does not consider diversification at all
stand-alone risk
three types of risk:
stand-alone risk, corporate risk, and market risk.
MIRR requires finding the ______ of the cash inflows, compounding them at the firm's cost of capital, and then determining the discount rate that forces the present value of the TV to equal the present value of the outflows.
terminal value (TV)
______of capital structure states that debt initially adds value because interest is tax deductible but that debt also brings costs associated with actual or potential bankruptcy. The optimal capital structure strikes a balance between the tax benefits of debt and the costs associated with bankruptcy.
trade-off theory
If mutuall exclusive projects have _____, it may be necessary adjust the analysis to put the projects on an equal-life basis. This can be done using __________
unequal lives; replacement chain (common life) approach or the equivalent annual annuity (EAA) approach
A high debt ratio raises the threat of bankruptcy
which not only carries a cost but also forces managers to be more careful and less wasteful with shareholders' money. Many of the corporate takeovers and leveraged buyouts in recent years were designed to improve efficiency by reducing the cash flow available to managers
