BUS 342 Final
Profitability Index (PI)/aka
The present value of an investment's future cash flows divided by its initial cost. Also called the benefit-cost ratio.
what are difficulties with applications from chapter 8?
The single biggest difficulty, by far, is coming up with reliable cash flow estimates. Determining an appropriate discount rate is also not a simple task. These issues are discussed in greater depth in the next several chapters. The payback approach is probably the simplest, followed by the AAR, but even these require revenue and cost projections. The discounted cash flow measures (NPV, IRR, and profitability index) are only slightly more difficult in practice.
in words how should you go about valuing the subsidy on a subsidized stafford loan?
The subsidy is the present value (on the day the loan is made) of the interest that would have accrued up until the time it actually begins to accrue.
how are YTM and IRR similar/different?
The yield to maturity is the internal rate of return on a bond. The two concepts are identical with the exception that YTM is applied to bonds and IRR is applied to capital budgeting.
problems with IRR
When cash flows are not conventional or when we are trying to compare two or more investments to see which is best
Should lending laws be changed to require lenders to report EARs instead of APRs? Why or why not?
Yes, they should. APRs generally don't provide the relevant rate. The only advantage is that they are easier to compute, but, with modern computing equipment, that advantage is not very important
relevant cash flows
a change in the firm's overall future cash flow that comes about as a direct consequence of the decision to take that project
sunk cost
a cost that has already been committed and cannot be recovered -NOT RELEVANT
Accelerated Cost Recovery System (ACRS)
a depreciation method under U.S. tax law allowing for the accelerated write-off of property under various classifications (1981)
net present value profile
a graphical representation of the relationship between an investment's NPVs and various discount rates
average accounting return rule
a project is acceptable if its average accounting return exceeds a target average accounting return
PI rule
accept project if PI>1
what are not explicitly considered in depreciation calculation?
actual expected economic life and expected salvage value
what does including change in NWC to our calculations do? and what is the effect of doing so?
adjusts for discrepancy between accounting sales and costs and actual cash receipts and payments -cash outflow like the initial investment
annuity due and two steps
an annuity for which the cash flows occur at the beginning of the period 1. calc the present/future value as if an ordinary annuity 2. multiply by (1+r)
Payback Period Rule
an investment is acceptable if its calculated payback period is less than some pre-specified number of years
IRR rule
an investment is acceptable if the IRR exceeds the required return. It should be rejected otherwise.
Average Accounting Return (AAR)
an investment's average net income divided by its average book value
perpetuity and what are they also known as?
annuity in which cash flows continue forever (aka consols in Canada and UK)
in our cap budgeting analysis thus far...
assume the project is static
Interest Only Loan
borrower pays interest each period and repays the entire principal at some point in the future -corporate bonds use this method
As you increase the length of time involved, what happens to the present value of an annuity? What happens to the future value?
both will rise
Reinvestment Approach (MIRR)
compound all cash flows (positive and negative) except the first out to the end of the project's life and then calculate the IRR.
diff between compound and simple interest
compound: interest on interest simple: interest earned only on principle
key fact to grasp about cost of capital
cost of cap associated with an investment depends on the risk of that investment *the cost of capital depends primarily on the use of the funds, not the source*
what is irrelevant to cost of debt?
coupon rate on firm's outstanding debt because it tells us what was not what is right now
Security Market Line (SML)
depends on risk free rate, market risk premium, and beta coefficient
why must taxes be paid?
diff in market and book val is excess dep and it must be recaptured when sold
APR vs EAR (difference itself and difference significance)
difference wont be big when interest rates are small. Can be a huge difference when interest rates are large. ex: payday loans
unlike cost of equity, cost of debt can be observed...
directly and indirectly
Discounting Approach (MIRR)
discount all negative cash flows back to the present at the required return and add them to the initial cost. Then calculate IRR.
another term for IRR rule
discounted cash flow or DCF return
drawbacks to what-if analyses
does not tell us whether or not to take the project/what to do about possible errors
Dividend Growth Model
easiest way to estimate cost of equity
Advantages of Dividend Growth Model
easy to understand and use
Suppose two athletes sign 10-year contracts for $80 million. In one case, we're told that the $80 million will be paid in 10 equal installments. In the other case, we're told that the $80 million will be paid in 10 installments, but the installments will increase by 5 percent per year. Who got the better deal?
equal installments
two considerations when deciding whether to publish essentralized version
erosion and competition
Base-Case NPV
estimate NPV based on our projected cash flows
pro forma financial statements
financial statements projecting future years' operations
how to calculate cost of debt
find the YTM
what does the size of the bonus was 50% mean?
firm could take dep deduction of 50% in first year and dep remaining using MACRS schedule
what happens to future value if you increase the rate, r? present value?
future value rises; present value falls
what happens to the future value of an annuity if you increase the rate, r? present value?
future value will rise and present value will fall
As you increase the length of time involved, what happens to the future values? What happens to present values?
future values grow; present values shrink
when is it good to use payback method?
good for large and sophisticated companies to when they are making relatively minor decisions ex: two year payback on $10000 investment
relationship between required return and cost of cap
higher risk = higher required return cost of cap is greater than the risk free rate
difference between interest and dividends paid
interest is tax deductible but dividends are not
loan amortization schedule (interest paid, beginning balance, principal, ending bal
interest paid is beginning bal x interest rate beginning bal is given by ending bal from previous period, principal is total pmt-interest paid, ending bal is beg bal-principal paid)
Sensitivity Analysis
investigation of what happens to NPV when only one variable is changed
When does a capital gain occur?
market price exceeds original cost
depreciation is what type of deduction?
non cash -has cash flow consequences because it influences the tax bill
what is implicitly assumed about when cash flows occur?
occur at end of the period
managerial options
opportunities that managers can exploit if certain things happen in the future -aka real options
strategic options
options for future, related business products or strategies
how to interpret a PI of 1.1
per dollar invested, $1.10 in value or $0.10 in NPV results (measure the "bang for the buck")/(value created per dollar invested)
preferred stock is a essentially a
perpetuity
when determining cost of debt does it make a diff if private vs publicly traded?
privately can look to other firms and still figure out cost of debt publicly has more than one issue outstanding and they do not have the same yield probably
what happens to firms who use WACC as a cutoff?
reject profitable projects with risks less than those of the overall firm -make unprofitable investments with risks greater than those of the overall firm
defense against forecasting risk/key factor
sources of value -are we certain its better than competition? -can we truly manufacture at a lower cost/distribute more effectively/identify undeveloped market risks? key factor: degree of competition in market
in general what is the relationship between a stated interest rate and an effective interest rate? which is more relevant for fin decisions?
stated is the specified rate written on agreement. effective is the true rate which accounts for compounding EFFECTIVE
contingency planning
taking into account the managerial options implicit in a project -what actions will we take if this actually occurs
what does ongoing soft rationing mean?
that we are bypassing positive NPV investments
beta coefficient
the amount of systematic risk present in a particular risky asset relative to that in an average risky asset
Payback Period
the amount of time required for a firm to recover its initial investment in a project, as calculated from cash inflows
stand-alone principle
the assumption that evaluation of a project may be based on the project's incremental cash flows -we can view the project as a minifirm
pure discount loan/when are they common
the borrower receives money today and repays a single lump sum at some time in the future -common when loan term is short
Erosion
the cash flows of a new project that come at the expense of a firm's existing projects
Scenario Analysis
the determination of what happens to NPV estimates when we ask what-if questions (best case and worst case are commonly used) (more accurate to say optimistic and pessimistic)
incremental cash flows
the difference between a firm's future cash flows with a project and those without the project -consist of any and all changes made to a firm's future cash flows as a result of taking the project
Net Present Value (NPV)
the difference between an investment's market value and its cost -how much value is created or added today by undertaking an investment
internal rate of return
the discount rate that makes the NPV of an investment zero
Annual Percentage Rate (APR)
the interest rate charged per period multiplied by the number of periods per year
Effective Annual Rate (EAR)
the interest rate expressed as if it were compounded once per year
what do we mean when we say a company's cost of equity capital is 16%?
the investors require a return of 16%
opportunity cost
the most valuable alternative that is given up if a particular investment is undertaken
how to determine which mutually exclusive investment is best?
the one with the highest NPV (focused on shareholders)
Weighted Average Cost of Capital (WACC)
the overall return the firm must earn on its existing assets to maintain the value of its stock
multiple rates of return problem
the possibility of more than one discount rate making the NPV of an investment zero (excel will report smallest)
forecasting risk
the possibility that errors in projected cash flows will lead to incorrect decisions -GIGO (garbage in, garbage out)
time value of money
the principle that a dollar received today is worth more than a dollar received in the future
Cost of Equity
the return that equity investors require on their investment in the firm
Cost of Debt
the return that lenders require on the firm's debt
Capital Rationing
the situation that exists if a firm has positive NPV projects but cannot find the necessary financing
hard rationing
the situation that occurs when a business cannot raise financing for a project under any circumstances
soft rationing
the situation that occurs when units in a business are allocated a certain amount of financing for capital budgeting -first thing to do is to try and get a larger allocation
nominal interest rate
the stated interest rate on a loan
depreciation tax shield
the tax saving that results from the depreciation deduction, calculated as depreciation multiplied by the corporate tax rate
pure play approach
the use of a WACC that is unique to a particular project, based on companies in similar lines of business
Rule of 72
time it takes to double your money is 72/t=r% accurate for 5-20% range
what is capital budgeting all about?
trying to determine whether a proposed investment or project will be worth more than it costs once it is in place -search for investments with positive NPVs
mutually exclusive investments / non
two investments for which the acceptance of one automatically excludes the acceptance of the other (non m.e projects are independent)
one way to organize investigation
upper and lower bounds
how to address problems with IRR?
use MIRR (modified internal rate of return)
basic problem with NPV
we think positive NPV when negative and vice versa
advantages of PI
-Closely related to NPV, generally leading to identical decisions -Easy to understand and communicate -May be useful when available investment funds are limited
how to describe payback method in accounting terms?
-accounting break even measure (length of time it takes to break even)
when capital is scarce how do you organize according to PI?
-allocate capital to those with the highest PIs
Bonus Depreciation
-based Protecting Americans from Tax Hikes (PATH) Act of 2015, size of bonus in 2017 was 50%. This increased to 100% with the Tax Cuts and Jobs Act of 2017 (for 2018-2022). Drops by 20% per year until zero in 2026
three positive features of payback method
-biased toward liquidity (favor inv that free up cash for other uses more quickly) -adjusts for riskiness of future cash flows (by ignoring them altogether) -easy to understand
problem with MIRR
-different ways to calculate -unclear how to interpret
3 different MIRR methods
-discounting approach -reinvestment approach -combination approach
other redeeming qualities of IRR
-fills need that NPV does not, simple way of communication, can estimate without the discount rate (unlike NPV)
what is not included in analyzing a project?
-financing costs such as interest and dividends and principal repaid
problems with AAR (avg accting return)
-ignores time value -arbitrary cutoff period -doesn't look at the right things (worst flaw),(instead of cash flow and market value, it uses net income and book value)
two comments about NPV calculation
-it is an estimate, so it could be high or low -the task of coming up with the cash flows and rates is most important compared to the calculation
disadvantages of IRR
-may result in multiple answers with nonconventional cash flows -may lead to incorrect decisions in comparisons of mutually exclusive investments
when is PI typically used?
-measure of performance for government or other not for profit investments
possible contingencies
-option to expand -option to abandon -option to wait
when do IRR and NPV lead to the same decision?
-projects cash flows must be conventional (first cash flow is neg and the rest are positive) -project must be independent (decision to accept/reject it does not affect decision to accept/reject another) (first condition is usually met but second is not)
payback period shortcomings
-there is no discounting involved -arbitrary cutoff point -may be led to reject profitable long term investments by ignoring the future cash flows beyond the cutoff point -may be led to accept investments that are worth less than they cost by ignoring the time value of money -mostly biased toward short term investments
Tax Shield Approach
-useful variation to OCF Determine the project's cash flow without depreciation expense, then add the depreciation tax shield.
two things to watch out for with project analyzation
-we are only interested in measuring cash flow -always interested in after tax cash flow
disadvantages of dividend growth model
1) Only applicable to companies currently paying dividends 2) Not applicable if dividends aren't growing at a reasonably constant rate 3) Extremely sensitive to the estimated growth rate 4) Does not explicitly consider risk
Advantages of SML approach
1. It explicitly adjusts for risk 2. It is applicable to other companies other than just those with steady dividend growth.
advantages of IRR
1. closely related to NPV, often leading to identical decisions 2. easy to understand and communicate
what is the average book value when using straightline depreciation and zero salvage value?
1/2 initial investment
what does a PI >1 mean and <1 mean?
>1 = positive NPV <1 = negative NPV
On subsidized Stafford loans, a common source of financial aid for college students, interest does not begin to accrue until repayment begins. Who receives a bigger subsidy, a freshman or a senior? Explain.
A freshman does. The reason is that the freshman gets to use the money for much longer before interest starts to accrue.
subsidy
A government payment that supports a business or market
annuity
A level stream of cash flows for a fixed period of time
amortized loans
A loan in which principal as well as interest is payable in periodic installments over the term of the loan. -making regular principal reductions -consumer loans use this method
ordinary annuity
An annuity that pays at the end of each period.
net present value rule
An investment should be accepted if the net present value is positive and rejected if it is negative.
capital budgeting
Analysis of potential additions to fixed assets. Long-term decisions; involve large expenditures. Very important to firm's future; difficult to reverse
In calculating the WACC, if you had to use book values for either debt or equity, which would you choose? Why?
Book values for debt are likely to be much closer to their market values than are book values for equity.
Discounted Cash Flow (DCF)
Compares the value of the future cash flows of the project to today's dollars.
what is compounding? what is discounting?
Compounding refers to the growth of a dollar amount through time via reinvestment of interest earned. It is also the process of determining the future value of an investment. Discounting is the process of determining the value today of an amount to be received in the future.
subjective approach
Consider the project's risk relative to the firm overall -divide into low, high and moderate risk
what is the rate you actually pay?
EAR
Given the choice, would a firm prefer to use MACRS depreciation or straight-line depreciation? Why?
For tax purposes, a firm would choose MACRS because it provides for larger depreciation deductions earlier. These larger deductions reduce taxes but have no other cash consequences. Notice that the choice between MACRS and straight-line is purely a time value issue; the total depreciation is the same, only the timing differs.
disadvantages of SML approach
Have to estimate the expected market risk premium, which does vary over time Have to estimate beta, which also varies over time We are using the past to predict the future, which is not always reliable
most important alternative to NPV
IRR (internal rate of return)
what are the most commonly used capital budgeting processes?
IRR and NPV
if you were an athlete negotiating a contract, would you want a signing bonus payable immediately and smaller payments in the future or vice versa?
If the total amount of money is fixed, you want as much as possible as soon as possible. The team (or, more accurately, the team owner) wants just the opposite.
suppose you deposit a large sum into an account that earns a low interest rate and simultaneously deposit a small sum in an account that earns a high interest rate? which will have the larger future value?
It depends. The large deposit will have a larger future value for some period, but after time, the smaller deposit with the larger interest rate will eventually become larger. The length of time for the smaller deposit to overtake the larger deposit depends on the amount deposited in each account and the interest rates.
If a firm's WACC is 12%, what does this mean?
It is the minimum rate of return the firm must earn overall on its existing assets. If it earns more than this, value is created.
Tri-State Megabucks Lottery advertises a 10 million grand prize. The winner receives $500,000 today and 19 annual payments of $500,000. A lump sum option of $5 million payable immediately is also available. Is this deceptive advertising?
It's deceptive, but very common. The deception is particularly irritating given that such lotteries are usually government sponsored!
disadvantages of PI
May lead to incorrect decisions in comparisons of mutually exclusive investments
MACRS
Modified Accelerated Cost Recovery System - a type of depreciation method, typically used by the IRS. -diff percentages for each year to calc dep
what is the preferred method for assessing profitability?
NPV
Combination Approach (MIRR)
Negative cash flows are discounted back to the present, and positive cash flows are compounded to the end of the project.
diff between OCF and net income
Net Income is the result of revenues minus the expenses, taxes, and costs of goods sold (COGS). Operating cash flow is the cash generated from operations, or revenues, less operating expenses. Many investors and analysts prefer using operating cash flow as an indicator of a company's health
If you can borrow all the money you need for a project at 6 percent, doesn't it follow that 6 percent is your cost of capital for the project?
No. The cost of capital depends on the risk of the project, not the source of the money.
what does the WACC reflect?
Risk and target capital structure of the firm's existing assets as a whole. This means that WACC is appropriate discount rate only if inv is a replica of firms existing operations
stated interest rate
The interest rate expressed in terms of the interest payment made each period. Also known as the quoted interest rate.
suppose you won the tri state lottery. what factors should you take into consideration when deciding between lump sum and annuity options?
The most important consideration is the interest rate the lottery uses to calculate the lump sum option. If you can earn an interest rate that is higher than you are being offered, you can create larger annuity payments. Of course, taxes are also a consideration, as well as how badly you really need $5 million today.