Finance Skills for Managers - D076 Unit 6
Which NPV value indicates that the IRR has been reached?
$0.00
Why is there always a cost for bringing funds into a business?
A business must compensate investors for the risk that they are taking to invest in the business. Correct! Investors need a reason to part with their money.
An investor just purchased a bond for $973 that has a par value of $1,000. What type of bond is this?
A discount bond
dividends in arrears
A feature of preferred stock specifying that if a company ignores preferred stock dividends, it cannot pay anything to its common stockholders.
perpetuity model
A formula used to value preferred stock that is based on the calculation of a perpetuity.
bond cash flows comprise two distinct parts:
A stream of semi-annual interest payments (an annuity) A final principal repayment (a lump sum)
Which scenario is an example of an opportunity cost that is not associated with cash flows?
Albert decides to stay home and study for his test instead of going to the movies. Correct! The opportunity cost is going to the movies.
Gordon growth model
An economic model to compute the value of a stock assuming the stock will have constant dividend growth.
Why is it important to have an accurate, carefully calculated required rate of return as part of the NPV?
An inaccurate required rate estimate could cause a firm to reject good projects or accept bad projects.
What are incremental cash flows?
Any additional cash flows, whether in or out of the firm, that are created as a result of accepting a project
What is the name for the process of evaluating and planning for purchases of long-term assets?
Capital budgeting
In what way is preferred stock different from bonds?
Companies are allowed to skip payments to preferred stockholders but not to bondholders.
aggressive assets
Companies or securities with high betas (beta > 1)
There are a few advantages of using PI. Four of them are the same as the NPV method, and the last one is unique. The PI method:
Considers the time value of money Takes into account the risk of future cash flows through the cost of capital Includes all future cash flows Indicates whether an investment will create value for the company
There are multiple advantages of the NPV method, three of which will be discussed in this lesson. The NPV method:
Considers time value of money Calculates value added to the firm Considers risk and required return
The Gordon growth model makes two simplifying assumptions in order to make the dividend discount model usable:
Dividends are paid every year Dividends grow at a constant rate forever
Talia is comparing four mutually exclusive projects. In order to choose the best project to optimize the goal of the firm, which capital budgeting method should Talia use?
Net present value (NPV)Correct! When you compare mutually exclusive projects, you should look at how much value is added by each project, because you can do only one of them. Therefore, you should use the NPV method to choose a project.
Should a firm accept a project that has a PI of 0.8? Why?
No, because the project would be generating cash inflows that are 20% short of the initial investment.
Which capital investment evaluation method is presented as a ratio?
Profitability index (PI)
A company is considering five projects that are not mutually exclusive. However, the company does not have enough money to do all of them. In order to prioritize projects that fit within the company's budget, which capital budgeting method should be used?
Profitability index (PI) Correct! The PI should be used first to compare the projects and then to rank them to maximize the value of the firm.
Similar to the NPV method, IRR also considers the time value of money.
The purpose of calculating the IRR is to look for the exact rate at which the sum of all the discounted future cash flows is equal to the initial investment. In the IRR calculation, the timing of every future cash flow is considered and discounted appropriately.
In addition, management does not have to estimate the required rate of return to calculate the IRR.
The required rate of return can be difficult to calculate, and is often subjective based on the assumptions made in terms of the value added, alternative opportunities, and how risky analysts feel the project is. To calculate the NPV, for instance, you must first calculate an appropriate and accurate required rate of return, which can take substantial time and effort.
coupon rate
The stated interest rate of a bond; also known as coupon yield.It is contractually set when the bond is issued and cannot be changed at any time during the life of the bond.You can find the bond's yearly coupon, or interest, payment by multiplying the coupon rate by the par value. If a $1,000 bond has a coupon rate of 9%, the annual coupon or interest is $1,000 x 0.09 = $90. If the bond pays the coupon semiannually, the firm will pay $90/2 = $45 every six months.
Face Value
The sum of money that a corporation promises to pay at the expiration of a bond; also called par value.For corporate bonds in North America, the par value is almost always $1,000.
corporate governance
The system of rules, practices, and processes by which a firm is directed and controlled.
Why is the IRR a poor valuation method for a project with unconventional cash flows?
There are multiple sign changes in the calculation resulting in multiple IRRs, and it is impossible to tell which IRR is the correct one.
How does allocated overhead affect the selection of capital investment projects?
These cash flows are not a direct result of a specific project but are a general cost to the firm.
Why is the timing of cash flows an important characteristic of capital investment?
Timing of cash flows is related to the opportunity cost associated with those cash flows.
Why might a firm seek capital investment?
To purchase long-term assets for future growth
This concept of incremental cash flows is important for at least two reasons:
When you perform capital budgeting analysis, you want to understand the overall impact of the project on the company. The idea of incremental cash flows will prevent others from allocating cash flows (especially expenses) to your project.
Why is it important to consider all relevant cash flows in an ideal evaluation method for capital investment?
Without considering every cash flow of a potential project, you do not know how the project will enhance the value of a firm.
When the bond is traded at premium, the
YTM of the bond is lower than its coupon rate.
A company called Bobby's Books is considering purchasing a new bookbinding machine. The company calculates the hurdle rate of the project to be 9% and the IRR to be 11%. Should the company purchase the bookbinding machine?
Yes, because the IRR exceeds the cost of capital.
Opportunity cost should also be accounted for in capital budgeting for a capital investment because
a company loses its ability to use the same assets somewhere else.
Preferred stock
a hybrid security, meaning that it has some elements that resemble equity and others that resemble debt.Like bonds and loans, the payments (or dividends) from preferred stock are fixed, and preferred shareholders typically do not have voting rights.Unlike debt payments, however, companies are allowed to skip payment of preferred stock dividends without it constituting default.
The key is that the intrinsic value is an estimate,
a quantitative measure to help you make decisions.
stocks/equity
a share of ownership in a company, equity represents actual ownership in a firm—that is, when you buy a share of a company's stock, you literally become a partial owner of that company. With that ownership comes certain rights
Affirmative covenants
describe things the company pledges itself to do. Examples include paying taxes on time, maintaining a certain level of working capital, and maintaining a certain debt ratio.
Beta
describes how the price of a security varies with the market. By definition, the market has a beta of 1. A riskless asset has a beta of 0. If the market goes up by 10%, the value of the riskless asset does not change.
The capital asset pricing model is used to
determine the required return for stock
One of the major advantages of stock is that it
does not require a fixed interest payment or return of the principal to investors.
Even if projects are seemingly the same,
each project has different inherent risks that change the cost of capital to the firm.
Mathematically, the IRR is the rate of return that makes the NPV of the project....
equal to zero.This is because it is the rate of return that makes the present value of the cash inflows exactly equal the present value of the cash outflows
These unconventional cash flows could be the result of
future relicensing, maintenance, or environmental or restoration obligations, among other things.
bond indenture
governs the relationship between the firm and the bondholders.
You may recognize a pattern:
if YTMs are high, then prices are low, and if YTMs are low, then prices are high. We refer to this as the inverse relationship between prices and yields
cumulative
if a company skips payment of a preferred stock dividend one year, it is still required to pay that dividend sometime in the future before paying any common dividends.
Consider the advantages of the IRR method. The IRR:
is easy to interpret, considers time value of money, and does not require use of required rate of return.
There are several disadvantages of the IRR method. The IRR:
is not a good indicator of the amount of value created, ignores mutually exclusive projects, assumes reinvestment at the IRR rate, cannot be used to compare projects with different durations, and requires conventional cash flows.
The Gordon growth model, derived from the dividend discount model,
is used to find the intrinsic value of common stock.
NPV (net present value)
it is the sum (or net) of the present values of all of the project's expected cash inflows and outflows. (The term net refers to what is left over after all costs are deducted).
If a company does not comply with the covenants in its bond indentures,
it stands in default, which means that it has failed to meet its debt obligation.
When a company first issues equity for sale,
it will do so through an initial public offering (IPO) on the primary market.
The required rate of return for the investors is the cost of capital to the firm,
or the cost of raising cash for capital investment.
covenants
outline things the company is obligating itself to do or not do in order to protect bondholders.
The biggest advantage of PI is that it is useful for
ranking multiple projects when the budget is limited.
Common stock
represents equity, or ownership, in a firm. When someone says, "I own stock in Company X," they usually mean they own common stock. Ownership of common stock usually comes with the right to vote at shareholder meetings.the lowest position
There are two main disadvantages of the PI. The PI method:
requires calculation of cost of capital and is not useful for mutually exclusive projects.
Time value of money can help firms and individuals compare the relative value of projects of varying scope,
size, and duration, including different capital investment opportunities.
The size of the fixed interest payments for bonds depends upon the
stated interest rate (called the coupon rate) and the amount of the principal (called the par value or face value).
The net present value is calculated by
summing the present values of all expected cash inflows and then subtracting the present value of expected cash outflows such as the initial outlay, which is the cost of doing the project today. The resulting net present value tells you how much value is created in today's dollars after accounting for the cost of doing the project.
tax shield
that interest expenses reduce the taxable income and therefore the overall taxes that the company pays.reduce the cost related to both bank mortgages and bonds
Bonds are often called fixed-income securities, meaning
that the borrower pays a fixed interest payment to bondholders each year. Contrast these with stocks, which have dividends that may vary from year to year.
premium bond
the bond is selling above its par value (normally $1,000 in the U.S. corporate world)
par bond
the bond's price is exactly equal to its face value.For a par bond, the YTM of the bond and the coupon rate are exactly the same as well. Because the bond provides exactly the return (coupon) required by the market (YTM), the price of the bond will equal its face value.
incremental cash flows
the cash flows that result from accepting a project.any additional cash flows, whether in or out of the firm, that are created as a result of our accepting the project. They include any additional revenue, expenses, taxes, or other costs.
Sunk costs
the costs that have already been incurred and are irrelevant to the project evaluation.
Time value of money functions are used to calculate
the current value, or price, of a bond and a bond's yield to maturity YTM.
Maturity
the date at which the bond expires. The number of years from when the bond is issued to when it expires is its original maturity. Bond maturities may be as short as 3 months or as long as 30 years or more. In some cases, companies have issued bonds with extremely long maturities—100 years, for example.
The highest quality bond rating from the three credit rating agencies is AAA, while
the lowest quality rating these agencies give is D for bonds that are in default
The YTM has an inverse relationship with the price of the bond: if the YTM increases,
the price of the bond decreases.
If the YTM decreases,
the price of the bond goes up.
discount bond
the price of the bond is below its par value. For a discount bond, the YTM is higher than its coupon rate
Capital budgeting
the process of evaluating and planning for purchases of long-term assets. As the name implies, it entails budgeting a firm's capital in a way that will increase firm value.
internal rate of return (IRR)
the rate of return that a firm earns on its capital projects.
yield to maturity (YTM)
the rate of return that investors receive on a bond if they purchase a bond today at the market price and hold it until it matures. This is the required rate of return investors demand given the maturity and risk of the bond. This demanded return is what causes the bond to trade at an acceptable price for investors.
profitability index (PI)
the ratio of payoff to an investment for a proposed project. you find the NPV, divide by the initial outlay, and then add 1. This is the same thing as dividing the present value of all future cash flows by the initial outlay.
NPV method is that it takes risk into account by considering...
the required rate of return, or cost of capital, as a discount rate. Each investment and each year of cash flows has different inherent risks.
If the expected return is lower than the required rate of return based on CAPM
the stock would be overvalued and an investor would want to sell it.
net incremental cash flow
the sum of all additional cash flows, or in other words, incremental cash in minus incremental cash out
Capital investment
the sum of money invested in a business to purchase long-term assets to further its objective of maximizing owner wealth. are needed to develop new products, increase operating capacity, invest in new technology that will cut costs, replace existing assets that are at the end of their lives, and capture a larger share in the market.
upside potential
the unlimited earnings potential of equity and ownership
Intrinsic value
the value of an investment, a company, a product, or even currency determined through fundamental analysis without referring to the asset's market value.adding up the discounted future cash flows generated by the asset. In other words, the intrinsic value is the present value of future cash flows of an asset.determine whether the business or the asset is overvalued or undervalued.
Bonds
the vehicles by which corporations raise debt capital. While individuals go to a bank to borrow money, bonds are the primary means of borrowing money in the corporate world. a debt agreement between borrowers and savers that obligates the borrower (or corporation) to make certain payments to the bondholder as repayment of the loan. It is like an IOU from a corporation to the holder of the bond. The IOU promises that if the bondholder gives the corporation a certain sum of money today, the corporation will not only return that sum in the future (at the bond's expiration) but also pay interest to the bondholder on that sum each year until the bond matures.
If the present value of the benefits of a capital investment exceeds the present value of the costs of the investment,
then it will add value to the firm and shareholders.
capital raised by debt, such as mortgages and bonds, have tax shields, but
they do not produce an optimal capital structure for the firm.
Negative covenants
things the company pledges not to do. For example, a company may pledge not to sell certain assets, not to pay large dividends, or not to issue new debt with a superior claim.
given that expected return is greater than the required return,
this is a stock a smart investor would buy
If there are capital constraints when choosing multiple projects,
use the PI to rank the projects and then decide which projects to do based on the PI ranking.
The perpetuity model is used to
value preferred stock
if you analyze low-beta firms,
we will observe that these firms will generally follow the movements of the market but in a muted matter( have betas less than 1)defensive assets
capital-constrained environment
when limited amount of funds are available
mutually exclusive
when two or more events do not coincide
A share repurchase
where the firm buys back its own shares
capital asset pricing model (CAPM),
which helps you understand the return required by investors based on the risk associated with the stock.
market capitalization
which measures the market value of a company's outstanding, or issued, stock and is abbreviated market cap
A PI of 1 is the break-even point.The decision rule is as follows:
you should accept a project with a PI greater than 1, and you should reject a project with a PI less than 1. If the profitability index is exactly equal to 1, then you would be indifferent about whether you did the project or not.
If the return or the IRR exceeds the cost of capital,
you should accept the project
if the IRR is short of the cost of capital,
you should reject the project.
Which example demonstrates a financing decision in a firm?
How a company will fund its assets and operations—namely, what proportions of debt and equity the business will use Correct! This correctly characterizes a finance decision.
Fundamentally, net present value answers this question:
If NPV is positive, you should accept the project. If NPV is negative, you should reject the project. If NPV is positive, it means that the project is potentially profitable and will add value to shareholder wealth. If negative, the project will destroy shareholder wealth.
How does cannibalization factor into capital investment decisions?
If your company is planning on launching a product, and that product is going to steal some of the sales of another of the company's products, that loss of sales could be an incidental cost or revenue caused by the new product.
How are non-incremental cash flows different from incidental cash flows?
Incidental cash flows are indirect cash flows that are not explicitly revenues or costs. Nevertheless, they must be included in the analysis.
How can having more debt benefit a company?
Interest expense on debts is paid before taxes are calculated. Correct! This describes the tax shield advantage of debt.
Suppose Alice is trying to explain to her friend, who knows nothing about the time value of money, why she should invest in Alice's new company. Which method of valuation should Alice use to convince her friend to invest?
Internal rate of return (IRR)
What is an advantage of using the NPV method?
It calculates the dollar value that would be added to the firm by doing the project.
How does the PI aid in interpretation of the NPV?
It gives an idea of the return generated by a project.
one of the biggest advantages of using the IRR method is that it is easy to interpret.
It gives you the rate of return for the initial investment you put in for the project. If the IRR is calculated to be 12% on a new project with an initial investment of $150,000, it means that you will earn a 12% return on your investment of $150,000, pretty straight forward
An ideal evaluation method for capital investment includes three key attributes:
It includes all cash flows that occur during the life of the project. It considers the time value of money. It incorporates the cost of capital—or in other words, the required rate of return on the project.
What is a disadvantage of using the NPV method?
It is not an effective way to compare projects of different sizes.
What is opportunity cost as it relates to the time value of money?
It is the opportunity you forgo to invest in other options due to the time scope of an investment.
Alphabet Co. has $50,000 to spend on capital investment projects for the next year. It will do as many projects as it has cash for. Alphabet Co. calculates the potential incremental cash flows and costs of the projects as well as the NPV, IRR, and PI for each project. How should the company decide which projects to invest in if it wants to maximize the total amount of value created?
It should choose the projects with the highest PIs until all capital has been used. Correct! By choosing the projects with the highest PI, Alphabet Co. will be able to use its limited capital effectively to create the most overall value for the firm.
the NPV considers the time value of money
It takes into account the idea that today's dollar is worth more than a dollar in the future. Each and every period, cash flows are discounted to the present time so you can compare costs and benefits at different points in time as if they were at the same point in time in period 0.
The YTM of a bond went from 8% to 7%. What can be predicted about the price of the bond?
It will increase.
capital budgeting criteria
Metrics and calculations used to determine whether a project or asset will add value and be a worthwhile investment.
In most cases, you should use,
NPV as the primary method and use the other methods to supplement when making capital investment decisions.
If you are considering only one project, the first method to check should be
NPV since it gives you the exact value added to your company
you are considering four projects. The initial cost to start each project is $500,000, and the total cash inflows generated by each project are $600,000. Each project also has the same level of risk. The only difference between these four projects is the cash flow patterns. Year 1 Year 2 Year 3 Project A $200,000 $200,000 $200,000 Project B $300,000 $200,000 $100,000 Project C $100,000 $200,000 $300,000 Project D $600,000 $300,000 -$300,000 Given the information above, which statement is correct about these four projects?
Project D should be chosen first given that the project will receive cash to sum to $600,000 the most quickly. Correct! Project D receives cash flows the most quickly of the four projects. Given the concept of the time value of money, Project D should generate the highest NPV.
How do corporations and purchasers of financial securities view returns?
Purchasers of financial securities look at returns as the amount of money they require in order to lend or give their money to the corporation that issued those securities. Correct! This is a correct description of returns from the viewpoint of investors.
While NPV is the best method to use for capital investment decisions, it has some disadvantages.
Requires calculation of appropriate cost of capital Is not useful to compare projects of varying sizes
Why might a firm prefer to raise debt capital through stocks instead of bonds?
Stocks do not require the firm to repay the par value to investors.
What indicates to a firm that a project will increase shareholder wealth?
The NPV is positive.
Which method should you use to calculate a bond value?
The PV function in Excel
What part of the NPV calculation is very important but difficult to estimate?
The cost of capital
You calculate the PI of a project to be 1 but realize that some aspect of your calculation was incorrect and needs to be adjusted. Which adjustment to the PI estimation should cause you to reject the project?
The cost of capital was underestimated, so you adjust the cost of capital to be higher.
You are evaluating a common stock. What is a key assumption for this evaluation?
The growth rate is assumed to stay the same forever.
What is the relationship between the risk and the rate of return?
The higher the risk investors have to take on, the higher return they require. Correct! Investors will take on more risk if there is potential for a higher return.
What is an opportunity cost?
The loss of the ability to use an asset toward the next best project once you have invested it in another project Correct! The concept of opportunity cost is that because you use an asset to invest in one project, you lose the opportunity to use the same asset to do a different project.
Which condition indicates that an investment will add value to a company?
The present value of the benefits of the investment outweigh the present value of the costs of the investment. Correct! If the project provides more value than it costs, then mathematically it will add value to the company.
A potential project to expand the size of an apartment complex will cost $100,000. Its calculated net present value is $5,000. Given this information, which statement is correct?
The project should be accepted because it has a positive NPV.
Another advantage of the NPV method is that it tells you how much value is....
added to the firm with the investment project. The NPV is a dollar amount, so if you calculate the NPV of $15,000, you are adding $15,000 to the firm's value by doing the project at today's value.
There are two types of bond covenants:
affirmative and negative.
Using the IRR method gives you
an idea of how far the estimated rate of return is from the cost of capital, which represents the wiggle room for misestimation of the cost of capital for the project.
Incidental cash flows
are a type of incremental cash flow that are indirectly created by a project but are not explicit revenues or costs.
Financing decisions
are made in regard to how a business will finance its assets and operations—namely, what proportions of debt and equity the business will use.
Dividend Discount Model
assumes that dividends will be the primary cash flows that the common stockholder will receive. The dividends will grow into the future, and the dividend discount model calculates the value, or price, of a share of common stock today by taking the present value of all these future dividend cash flows.
Conventional cash flows
begin with a negative initial outlay followed by a series of positive inflows.
A bond becomes "premium" or "discount" once it
begins trading on the secondary market.
Typical betas for large companies are
between 0.7 and 2.0.
The investors in a firm have different required rates of return based on what type of security they invest in:
bonds, preferred stocks, or common stocks.
NPV, IRR, and PI can be used to evaluate whether
capital investment is worth pursuing based on certain criteria.
There are two main types of stock:
common stock and preferred stock