Finance 301

Cash flow patterns

"conventional" cash flow patterns only have one sign change typical pattern is an outflow at time zero followed by a series of cash inflows "nonconventional" at least 2 sign changes is an additional IRR for each sign change

What are the implications of risk

Business risk is inherent in every operating decision made the higher a firm's business risk, the more caution the firm must take in establishing its capital structure firms with higher levels of business risk tend to use less debt and vice versa keep in mind that lenders assess the riskiness of potential borrowers and will adjust the cost of debt accordingly

Net Present value

Does the investment create or destroy value? NPV= PV of inflows-PV of outflows if NPV is positive, project creates wealth decision rule: if inflows >= outflows, accept (if NPV >=0, accept) if NPV is positive, project creates wealth

Conflicts in Ranking capital budgeting tools

Each capital budgeting tool will lead to a accept/reject decision however, NPV and IRR can result in different rankings due to underlying assumptions and a little quirk in IRR math NPV is superior IRR is used more often

Discounted Payback

How long will it take to recoup our initial investment in todays dollars? Plus: adjusts to changing required returns (discount rate) Minus: still ignores cash flows beyond the discounted payback period Decision Rule: if payback is <= maximum allowable period, accept

Payback

How long will it take to recoup our initial investment? Pluses: easy to compute, gives insight to liquidity Minuses: Ignores TVM, ignores cash flows beyond the payback period, biased against long term projects Decision rule: if payback is <= maximum allowable period, accept

Capital Budgeting, Budgeting refers to

Implies an expenditure plan

what is the solution for IRR

Modified IRR (MIRR) the precise interest rate that equates the PV of a projects outflows with the PV of the project's inflows when reinvested at the cost of capital Decision Rule: if MIRR > cost of capital, accept

Under lying assumptions in capital budgeting tools

NPV assumes that as cash flows are received over the life of a project, they are reinvested at the same discount rate used to calculate NPV IRR assumes the cash flows are reinvested at the IRR whats more realistic? NPV- more realistic

Projects with unequal lives

Old days "chaining" was used today we use a technique called Annualized net present value approach (ANPV)

Investment Opportunity Schedule (IOS)

Ranking projects by either IRR or MIRR allows you to see graphically the logical order in which projects should be done Bar graph creates IOS IOS can be super imposed upon a WACC graph and this shows the entire capital budgeting situation for a firm

Profitability Index

Relative size of the PV of a projects inflows to the PV of its outflows (aka bang for the buck) Useful when explaining results to people who don't understand TVM PV of inflows/PV of outflows decision rule: if PI >= 1.00, accept

What are the different types of projects?

Replacement of old or obsolete equipment expansion of current operations expansion into new products or markets non revenue or mandatory projects independent vs. mutually exclusive projects

Impacts on other parts of the firm (capital budgeting CF)

Side effects: may be either positive or negative, often occur in firms with multiple product lines, a new product might increase or erode the sales of existing products

Signaling Theory

Since a firm's management knows more about a firm's prospects than investors do (asymmetric info) some investors believe that managers choices of financing provide a signal to the firm's stock value debt financing is seen as a positive signal that management feels the firm's future cash flows are strong and the firm's stock is undervalued an equity issue is inversely seen as a negative signal

Cash Flow costs

Sunk costs: outlays of cash that have been made prior to a capital budgeting decision and should not be included in incremental CF for a given project Opportunity costs: CF that could be realized from the "next best" alternative for using an owned asset and should be included in determining a projects incremental CFs

Internal Rate of Return

The precise interest rate that equates the PV of the inflows w/ the PV of the outflows (gives us NPV of 0) Cost of capital is generally also the required rate of return the sign of NPV is important relative to IRR decision rule: if IRR>cost of capital (that financed the project), accept if NPV is positive, the IRR will be > than discounted rate if NPV is negative, IRR will be < discount rate

What is the "bottom line" for capital budgeting techniques

To ensure that each projected undertaken will produce a positive value to the firm most firms have limited funds and thus are subject to capital rationing

Risk and Capital Budgeting

Two ways to incorporate risk into the analysis: Risk-adjusted discount rate (RADR) Certainty equivalent cash flows (CE) RADRs increase over the life of a project

"Project" (in capital budgeting)

a generic term for long term expenditures

Capital Structure

a mix of long term debt and equity it utilizes effective capital structure decision can lower a firm's cost of capital Lower costs of capital can lead to: higher projected NPVs, a greater number of acceptable projects, increased value of the firm (and shareholders)

NVP Profiles

an NPV profile is a graphical representation of the relationship between a projects NPVs and various discount rates for mutually exclusive projects, NPV profiles illustrate the conflicts in ranking that occur between IRR and NPV

Pecking order theory

an alternative to the trade-off theory this theory assumes that managers create "financial slack" to finance new investments the hierarchy of financing sources is retained earnings, debt, and new equity firms switch sources when they run out of funds higher in the hierarchy

EBIT-EPS Appraoch

based upon the assumptions that the firm, by the attempting to maximize EPS, will also maximize the owners wealth this approach is believed to be indirectly consistent with wealth maximization because EPS and share price are believed to be closely related it is used to select the best number of possible capital structures, rather than to determine an "optimal capital structure" this technique can be graphed or solved with algebra

Total risk

business risk is the risk that the firm will be unable to cover its operating costs. three factors affecting business risk are the use of fixed operating costs (operating leverage), revenue stability and cost stability financial risk is the risk that the firm will be unable to meet required financial obligations. the more fixed costs components in a firm's capital structure (debt, leases and preferred stock) the greater its financial leverage and financial risk the total risk of a firm is a combination of business risk and financial risk and determines the firms probability of leverage

MIRR

can easily handle nonconventional cash flows all positive CFs are compounded at the end (FV) all negative CFs are compounded at the beginning (PV) MIRR will rank projects the same as NPV, but has the ease of understanding of IRR

Capital Budgeting, Capital refers to

capital refers to long term financing used to acquire fixed assets or fund any long term project

Steps in the ANPV process

determine the relevant cash flows for each option: Initial investment, operating cash flows and after tax salvage value (terminal cash flow) using the CF worksheet, calculate each options NPV using the TVM, the NPV becomes the PV (change sign) enter the # of years of the option as N and the discount rate as I/Y finally CPT PMT (PMT is the ANPV)

Depreciation (for capital budgeting CF)

financial reporting a firm is free to use any of FASB's depreciation methods for tax purposes, must use modified accelerate of cost recovery system (MACRS) where assets, (primarily equipment) are automatically assigned to certain classes and their economic lives are pre-determined

Capital Budgeting

is the decision area of financial management that establishes criteria for investing resources in long term projects

Leverage

leverage refers to the effects that fixed costs have on the returns that shareholders earn; higher leverage generally results in higher but more volatile returns generally, leverage magnifies both returns and risk

Changes in net working capital

net working capital changes that result from a project must be included in analysis new projects often require incremental investments in cash, inventory and/or receivables that are rarely perfect off set by changes in payable and thus relevant to the capital investment decision

Perfect market includes

no taxes, no flotation costs, symmetric information, and investors able to borrow at the same rate as corporations. Assuming perfect markets, the capital structure that a firm chooses does not affect its value

"stand alone" principle

only CF that matter are those that are associated with each proposed project firm will have its "regular" costs and revenues if it does not take on any new projects will have additional costs and revenues if it does undertake any new projects only these additional costs and revenues that we consider in the capital investment decision because they only exist as the result of "accepting" a project

types of leverage

operating leverage is concerned with the relationship between the firm's sales revenue and its earnings before interest and taxes (EBIT) or operating profits ( financial leverage is concerned with the relationship between the firm's EBIT and its common stock earning per share (EPS) total leverage is the combined effect of operating and financial leverage. it is concerned with the relationship between the firm's sales revenue and EPS

Taxes on the sale of an asset

tax implications for selling an asset depend upon the sale price of the asset, book value no taxes if sold at book value tax credit if sold for less than book value (reduces initial investment) taxes owed if sold for more than book value (increase initial investment)

Capital Budgeting CFs

techniques for evaluating capital budgeting projects are only as accurate as the cash flows used as inputs bias is likely and errors are possible

Capital budgeting cash flows

the initial investment is the beginning after tax outflow for a project Purchase price of new asset +installation costs +/- sales price of existing asset +/- changes in net working capital = initial investment

Incremental Cash Flows

the operating cash flows are the benefits accrued during a projects economic life and are stated in after tax dollars formula: (changes in revenues-changes in expenses-changes in depreciation)*(1-T)+change in depreciation=OCF

Optimal capital structure

the value of a firm is maximized when its cost of capital is minimized it is virtually impossible to know exactly what the optimal amount of debt is for a firm so most firms are presumed to operate within an acceptable range of debt this lends support to the idea of target capital structure