FIN 331 EXAM 4
What subjective risk factors should be considered before a decision is made?
Numerical analysis sometimes fails to capture all sources of risk for a project. • If the project has the potential for a lawsuit, it is more risky than previously thought. • If assets can be redeployed or sold easily, the project may be less risky than otherwise thought.
Internal rate of return
Project's IRR is the discount rate that forces the PV of its inflows to equal its cost. *The discount rate that causes the NET present value of a project to= zero* SIMILAR TO YTM OF A BOND
Real option analysis
The right but not the obligation to take some future action; managers can take positive actions after the investment has been made that alter the cash flow stream, and opportunities for such actions are called "real" options passive investments would be things like stocks and bonds, once the investment has been made most investors can take no actions that influence the CFs they produce; capital budgeting projects are not passive investments and involve real options *real options are valuable but this value is not captured by conventional NPV analysis so it is considered separately
advantages and disadvantages of sensitivity analysis
Advantage - Identifies variables that may have the greatest potential impact on profitability and allows management to focus on these variables. Disadvantages - Does not reflect the effects of diversification. - Does not incorporate any information about the possible magnitude of the forecast errors
How might issuing new stock (besides incurring flotation costs) cost more than retained earnings?
Might send a bad signal to capital market and lower stock price
Depreciable basis
cost o equipment including any shipping or installation cost
retained earnings
that part of the current year's earnings not paid out as dividends and hence available for reinvestment in the business this year ex. Allied retained $60 million of its 2014 income. This $60 was the new equity from retained earnings that was used along with some additional debt to fund the 2014 capital budgeting projects
Cost of preferred stock
the rate of return investors require on the firm's preferred stock; rp is calculated as the preferred dividend per share/current price per share rp=Dp/Pp
Why is it difficult to measure rs?
whereas debt and preferred stocks are contractual obligations whose costs are clearly stated within the contracts, stocks have no comparable stated cost rate, which makes it difficult to measure rs
How do we find the IRR?
(replace the term "r" in NPV equation with "IRR") Set NPV equal to zero and solve for the rate of return
When should a firm pay dividends rather than retain earnings to reinvest in other projects (aka what is the significance of rs)?
*If the firm cannot invest retained earnings to earn at LEAST rs, or the required rate of return on investments of similar risk, it should pay those funds to its stockholders and let them invest directly in stocks or other assets that will provide that return* remember that stocks are normally in equilibrium, with expected and required rates of return equal: r hat s= rs Thus, stockholders expect to be able to earn rs on their money
Types of real options
1. Abandonment= the option to shut down a project if operating cash flows turn out to be lower than expected. This option can both raise expected profitability and lower project risk 2. Investment timing= project can be delayed until more info about demand or costs can be obtained 3. Expansion= project can be expanded if demand turns out to be stronger than expected 4. Output flexibility= output (products) of project can be changed if the market conditions change 5. Input flexibility= inputs used in the production process (say, coal vs. natural gas for generating electricity), can be changed if input prices and/or availability
When a firm plans to raise capital by issuing some new common stock, two approaches can be used to account for flotation costs: 1. 2.
1. Add flotation costs to a project's costs -Add the total flotation costs (sum of flotation costs for the debt, preferred, and common stock used to finance the project) to the initial cost of the investment (project) 2. Increase the cost of capital (better if the firm plans to continue using the capital in the future) -Based on this logic: if there are flotation costs, the issuing firm receives only a portion of the capital provided by investors, with the remainder going to the underwriter/investment banker. To provide investors with their required rate of return on the capital they contributed, each dollar the firm ACTUALLY receives in capital must "work harder"; that is, each dollar must earn a higher rate of return than the investors' required rate of return Example: suppose investors require a 13.7% return on their investment, but flotation costs represent 10% of the funds raised. Therefore, the firm actually keeps and invests only 90% of the amount that investors supplied. In that case, the firm must earn about 14.3% on the available funds in order to provide investors with a 13.7% return on their investment. This higher rate of return is the flotation-adjusted cost of equity. -DCF approach is used to estimate effects of flotation costs
3 flaws of payback To counter the first criticism, analysts developed the _____
1. All dollars received in different years are given the same weight (i.e. time value of money is ignored) 2. CFs beyond the payback year are given no consideration regardless of how large they might be 3. Unlike NPV, which tells us how much wealth a project adds, and the IRR, which tells us how much a project yields over the cost of capital, the payback merely tells us when we will recover our investment DISCOUNTED PAYBACK: the length of time required for an investment's cash flows, discounted at the WACC, to cover its cost
Steps to capital budgeting
1. Estimate cash flows (inflows and outflows) 2. Assess riskiness of cash flows 3. Determine the appropriate cost of capital 4. Find NPV and/or IRR 5. Accept if NPV > 0 and/or if IRR > WACC
Problems with the CAPM approach for estimating cost of equity
1. If a firm's stockholders are not well diversified, they may be concerned with stand alone risk rather than just market risk. In that case, the firm's true investment risk would not be measured by its beta and the CAPM estimate would understate the correct value of rs 2. If the CAPM theory is valid, it is hard to obtain accurate estimates of the required inputs because 1. There is controversy about whether to use long or short-term Treasury yields for rRF, 2. It is hard to estimate the beta that investors expect the company to have in the future and 3. it is difficult to estimate the proper market-risk premium
new common equity is raised in what 2 ways?
1. retaining some of the current year's earnings -Cost of retained earnings= the rate of return required by stockholders on a firm's common stock 2. issuing new common stock -Cost of new common stock= the cost of external equity; based on the cost of retained earnings, but increased for flotation costs necessary to issue new common stock *equity raised by issuing new stock has a higher cost than equity from R/E due to flotation costs required to sell new common stock. Therefore, once firms get beyond the start-up stage, they normally obtain all of their new common equity by retained earnings
3 ways to measure stand-alone risk
1. sensitivity analysis= percentage change in NPV resulting from a given percentage change in an input variable (units sold, sales price, variables to do only with the specific project), other things held constant *most commonly used type of risk analysis by firms -begins with base case situation, where project's NPV is found using case case value for each input variable (equipment cost, change in NOWC, sales price, tax rate, WACC, etc.) -then sensitivity analysis to answer "What-if" questions *essentially, all variables are set at their expected values except for the one that is allowed to fluctuate, then change in NPV is recorded -ONE variable changes at a time 2. scenario analysis= similar to sensitivity analysis but measures more than 1 variable at a time; "good" and "bad" sets of financial circumstances are compared when a most likely "base case" situation -base case scenario -best case scenario= all input variables are set at their best reasonably forecasted values -worst case scenario= all input variables are set at their worst reasonably forecasted values 3. Monte Carlo simulation- done by computer
Risk analysis in capital budgeting: 1. Stand-alone risk 2. Corporate risk 3. Market risk
1. stand-alone: project's risk assuming A. that it is the only asset a firm has and B. that the firm is the only stock in each investor's portfolio. It is measured by the variability of the project's expected returns and *diversification among firm's projects and investors' diversification among firms are totally ignored* -usually measured by standard deviation or coefficient of variation 2. corporate: project's risk when considering the firm's other projects i.e. diversification within the firm; the project's risk to the corporation as opposed to its investors -Corporate risk is a function of the project's NPV and standard deviation and its correlation with the returns on other firm projects -Measured by project's impact on uncertainty about the firm's future returns 3. market: the project's risk to a well-diversified investor -measured by project's beta and considers both corporate and stockholder diversification
A flotation cost of 10% means what?
10% of the funds raised for new capital represent flotation costs (aka will be paid to the underwriter when issuing new stock), so only 90% of the funds raised are used for capital= P0(1-F)= the net price per share received by the company
Impact on an increase in the cost of capital on A. Long term project (where inflows don't come in for awhile) B. Short-term project (where inflows come in quickly)
A. Increase in WACC will cause a larger DECLINE in NPV B. Increase in WACC will not cause as much of a decline in NPV *If a project has most of its cash flows coming in later years, its NPB will decline sharply if the cost of capital increases; but a project whose cash flows come earlier will not be severely penalized by high capital costs*
Replacement analysis is complicated by the fact that almost all of the cash flows are incremental. Explain
All of the cash flows are incremental, found by subtracting the new cost numbers from old numbers Ex. the field bill for a more efficient new trick is 10,000 whereas the old one was 15,000. The 5,000 savings is the incremental cash flow that would be used in the analysis
The incremental cash flows analyzed in replacement projects are also called
DIFFERENTIALS (between old and new project) incremental cash flows are thus the changes from the old to new situation
2 types of projects can be distinguished: Expansion Replacement Examples?
Expansion= firm makes an investment such as a new Home Depot store Replacement= firm replaces existing assets generally to reduce costs; example: if Home Depot is considering replacing some of its delivery trucks, the benefit would be lower fuel and maintenance expenses, and the shiny new trucks might improve the company's image and reduce pollution
True or false: debt is riskier to investors than preferred stock
FALSE Preferred stock is more risky; company not required to pay preferred dividend. • However,firms try to pay preferred dividend. Otherwise, (1) cannot pay common dividend, (2) difficult to raise additional funds, (3) preferred stockholders may gain control of firm.
True or false: the majority of a firm's preferred dividends are subject to taxation
FALSE: firms own most of its preferred stock, so as much as 70% of a firm's corporate dividends are excluded from corporate taxation
True or false: it is easy to quantify projects' within-firm (corporate) and beta (market) risk
FALSE: managers usually end up dealing with these risks subjectively or judgmentally rather than quantitatively
True or false: managers generally prefer the NPV method over the IRR method
FALSE: managers want to know the expected rate of return on investments, so they prefer the IRR, but use MIRR as a measure instead
If the cost of external equity= 14.1% and the investors' required rate of return is 13.5%, what does this mean?
If Allied earns 14.1% on funds obtained from selling new stock, the investors who purchased that stock will end up earning 13.5%- their required rate of return- on the money they invested. If Allied earns more than 14.1%, its stock price should rise, and if it earns less, then its stock price should fall
Independent vs mutually exclusive projects Example of each?
Independent: projects with cash flows that are not affected by the acceptance or non-acceptance of other projects Mututally exlcusive: a set of projects where only one can be accepted; investment in project A prohibits you from investing in project B Independent example: Walmart is considering a new store in Boise and another in Atlanta, the projects are independent and if both had positive NPVs, Walmart should accept both Mutually exclusive: A conveyor belt system to move goods in a warehouse and a fleet of forklifts used for the same purpose- accepting one implies rejecting the other
Investors assume what about the market value of equity and debt? *TARGET CAPITAL STRUCTURE*
Investors are more concerned about the current market value of the company's debt and equity (not necessarily its book value) When calculating WACC, we will generally assume that the market value of debt equals the book value of debt (i.e. that its average outstanding debt is trading at par value) market value of equity= the number of shares of stock outstanding times the current stock price Target capital structure= the mix of debt, preferred stock, and common equity the firm plans to raise to fund its future projects -the percentages of debt, preferred stock, and common equity should maximize the firm's value
What type of risk is most relevant? True or false: corporate risk can be ignored True or false: stand alone risk is the easiest to measure and firms often focus on this risk when making capital budgeting decisions
Market risk because management's primary goal is shareholder wealth maximization False: corporate risk affects creditors, customers, suppliers, and employees TRUE
Which method, NPV or IRR, should is best? Which should be used to decide between mutually exclusive projects?
NPV (also there can be multiple IRRs that both make NPV= 0)
What criteria do companies use for deciding to accept or reject projects?
NPV, IRR, MIRR, Regular payback, Discounted payback
Summary of NPV decision rules- when do we accept projects? 1. Independent projects: 2. Mutually exclusive projects: Summary of IRR decision rules- when do we accept projects? 1. Independent projects: 2. Mutually exclusive projects:
NPV: accept always when NPV is positive accept the project with the greater positive NPV. If neither project has a positive NPV, reject them all IRR: accept when IRR exceeds the project's WACC; reject when IRR is less than WACC accept project with the highest IRR, provided that IRR is greater than WACC; reject all projects if even the best IRR does not exceed WACC
The NPV calculation is based on the assumption that cash inflows can be reinvested at ____ whereas the IRR calculation is based on the assumption that cash flows can be reinvested at _____ Which is more realistic? Why?
NPV: reinvest inflows at project's risk-adjusted WACC IRR: reinvest cash flows at project's IRR Assuming CFs are reinvested at the "opportunity cost" of capital is more realistic, so NPV method is the best and should be used when deciding between two mutually exclusive projects: 3 reasons- 1. If firm has good access to capital market, it can raise all the capital it needs at the going rate 2. Because the firm can obtain capital at 10% (example), if it has investment opportunities with positive NPVs, it should take them on and can finance them at a 10% cost 3. If the firm uses internally generated cash flows from past projects (R/E) rather than external capital, this will save it the 10% cost of capital. *Thus, 10% is the OPPORTUNITY COST of the cash flows, and that is the effective return on reinvested funds*
Negative within-firm externalities Positive within-firm externalities Environmental externalities
Negative- the new project produces positive cash flows, but its existence reduces some of the firm's other cash flows Ex. HD opens a new store too close to another one of its stores, so it takes customers away from its existing store Also called *cannibalization*: new products compete with old ones Positive- occurs when a new project is *complementary* to an old one, in which case cash flows in the old operation will be increased when the new one is introduced -Ex. Apple opening iTunes music store boosted sales of the iPod Environmental- government rules and regulations constrain what companies can do
How do we measure the cost of equity from retained earnings (rs)?
Required rate of return= expected rate of return rs= rRF+RP = D1/P0 + g= r hat s Methods: -CAPM approach (most common) -Bond yield plus risk premium approach (if reliable inputs for CAPM are not available- as would be true for closely held company) -Discounted cash flow approach
Some have argued that retained earnings should be "free" because they represent the money that is "left over" after dividends are paid. While it is true that no direct costs are associated with retained earnings, this capital still has a cost. Explain.
Retained earnings still has a cost called an *opportunity cost* the firm's after tax earnings belong to it stockholders. Bondholders are compensated by interest payments; preferred stockholders by preferred dividends. But the net earnings remaining after paying interest and preferred dividends belong to the common stockholders, and these earnings serve to compensate them for the use of their capital. The managers work for the stockholders and can either pay out the money in the form of dividends or retain earnings for reinvestment in the business. When managers make this decision, they should recognize there is an opportunity cost involved- stockholders could have received the earnings as dividends and invested this money in other stocks, bonds, real estate, etc. *Therefore, the firm needs to earn at least as much on any earnings retained as the stockholders could earn on alternative investments of comparable risk*
True or false: when considering independent projects, the three methods NPV, IRR, and MIRR all reach the same accept/reject conclusion, so all 3 are equally good when evaluating these types of projects True or false: MIRR is the best method for evaluating mutually exclusive projects
TRUE FALSE
True or false: empirical studies suggest that the risk premium on a firm's stock over its own bonds generally ranges from 3-5 percentage points True or false: The bond yield plus risk premium approach is a more subjective way to measure rs
TRUE TRUE
True or false: the before and after tax costs of preferred stock and common stock
TRUE- preferred dividends are not tax deductible and returns on common stock (dividends and capital gains) are not either
How is payback calculated?
Take the cost (negative) and add up the project's successive inflows for each year until the cummulative cash flow turns positive-- the payback year= year prior to full recovery + fraction equal to the shortfall at the end of that year/cash flow during full recovery year Payback= # of years PRIOR to full recovery + (unrecovered cost at start of year/CF during full recovery year)
Taxes paid of salvaged assets=
Tax rate x (salvage value-book value)
NPV profile with the steeper slope indicates what?
That if the cost of capital increases (x axis) its NPV will decline much more than the NPV profile less steep
The IRR generally overstates a project's true return. Explain What is the solution?
The IRR is based on the assumption that projects' cash flows can be reinvested at the IRR. This assumption is generally incorrect and causes the IRR to overstate the projects true return. MODIFIED IRR
flotation costs
The costs incurred by a publicly traded company when it issues new securities. Flotation costs are paid by the company that issues the new securities and includes expenses such as underwriting fees, legal fees and registration fees. Companies must consider the impact these fees will have on how much capital they can raise from a new issue.
Two basic conditions cause NPV profiles to cross and thus lead to conflicts: 1. 2.
Timing differences: if most of the cash flows from one project come in early while most of those from the other project come in later, the NPV profiles may cross and lead to conflict Project size (or scale) differences: if the amount invested in one project is larger than the other, this too can lead to profiles crossing and a resulting conflict
If a company's project has an abandonment option, does this affect the WACC needed for the project? How?
Yes, if a firm has the option to abandon a project during its operating life, it lowers the risk and thus lowers the WACC it also increases expected profitability and raises NPV
Are all three types of risk highly correlated?
Yes, since most projects the firm undertakes are in its core business, stand-alone risk is likely to be highly correlated with its corporate risk. In addition, corporate risk is likely to be highly correlated with its market risk.
Sunk cost Opportunity cost
a cash outlay that has already been incurredd and that cannot be recovered regardless of whether the project is accepted or rejected *not relevant in capital budgeting analysis the best return that could be earned on assets the company already owns if those assets are not used for the new project -ex. Home Depot owns land with a market value of 2 million. It's considering building a new store on the land and only another 15 million would be required if they go through with the project. Does this mean that HD should use 15 million as the cost of the new store? NO. The whole cost is 17 million. 2 million is the opportunity cost, something that HD would not receive if they went through with the project. Therefore, 2 million must be charged to the new project or else the NPV would incorrectly be overestimated. If opportunity cost > NPV of project, reject
NPV profile At 0 cost of capital, NPV=? What is the graph's y-intercept? What is the x-intercept? crossover rate
a graph showing the relationship between a project's NPV and the firm's cost of capital we plot NPV at a number of different discount rates and then plot those values to create a graph at 0 cost of capital, the NPV is simply the NET total of the un-discounted cash flows (so if we had CF 0 of -1000 and CF 1, 2, 3, and 4 of 500, 400, 300, 100, then our NPV at 0% cost of capital would be 1,300-1000= *300=y-intercept*) the IRR is the discount rate that causes NPV to equal 0, so if NPV is our vertical axis, then the point at which the profile line crosses the horizontal axis is the IRR crossover rate= the %cost of capital at which the NPV profiles of two projects cross and, thus, at which the projects' NPVs are equal
If project S has a WACC of 10% and IRR (estimated return)= 14.489%, it provides...
an additional return of 4.489% above its cost of capital
externalities
an effect on the firm or the environment that is not reflected in the project's cash flows Ex. Home Depot's new product line decreases sales on another one of its products
Discounted cash flow approach (DCF), or dividend yield plus growth rate approach How do we determine proper growth rate?
another means of estimating cost of common equity the price and expected rate of return on a share of common stock depend ultimately on the stock's expected cash flows rs= D1/P0 + g *since stock prices fluctuate, the dividend yield varies from day to day which leads to fluctuations in the DCF cost of equity *also, it is difficult to determine the proper growth rate -if past growth rates in earnings and dividends have been relatively stable and if investors expect a continuation of past trends, g may be based on the firm's historic growth rate -HOWEVER, if the company's past growth has been abnormally high or low due to a unique situation or because of economic fluctuations, investors will not project historical growth rates into the future, so growth rates must be estimated in another manner (security analysts forecast growth based on a number of factors for a 5-year horizon)
ways to raise capital When calculating WACC, our concern is with the capital lather must be provided by ____ What capital is excluded and why?
banks, bonds, stock investors: *interest-bearing debt, preferred stock, and common equity* A/P and accruals are not taken into account when calculating WACC because they are not directly supplied by investors (they are bank supplied, etc.)
Why is the after-tax cost of debt lower than its before-tax cost?
because interest is tax-deductible the interest rate on newly issued debt is the component cost of debt in the WACC equation (specifically, the after-tax component cost of debt)
As the cost of the investment increases, the expected rate of return....
decreases Consider a project costing an initial $100 million without flotation costs. After 1 year, the project is expected to produce a cash inflow of 115 million. Therefore its expected rate of return= 115/100-1= 15%. If the project requires the company to raise 100 million of new capital and incur 2 million of flotation costs from issuing new stock, the total up-front cost of the project rises to 102 million. The expected rate of return is now 115/102-2= 12.75%
Why is Re rarely a relevant consideration in calculating WACC?
established firms rarely issue new stock (instead we calculate Rp), so Re is rarely a relevant consideration except for very young rapidly growing firms
Factors that affect the WACC factors the firm cannot control: factors the firm can control:
factors firm cannot control: 1. interest rates in the economy 2. general level of stock prices 3. tax rates -if interest rates in economy rise, cost of debt increases b/c firm must pay bondholders more when it borrows -if stock prices in general decline, pulling the firm's stock price down, its cost of equity will rise (needs to pay higher return to make investors want to invest) factors firm can control: 1. changing its dividend payout ratio -as a general rule, other things held constant, an increase in target debt ratio tends to lower the WACC because the after-tax cost of debt is lower than the cost of equity 2. changing its capital structure 3. altering its capital budgeting decision rules to accept projects with more or less risk than projects previously undertaken -we implicitly assume when calculating WACC that new capital will be invested in assets that have the same risk as existing assets, but if a firm decides to invest in an entirely new and risky line of business then its component costs of debt and equity and thus WACC will increase
When must external equity be used?
firms should utilize retained earnings to the greatest extend possible but if a firm has more good investment opportunities than can be finance with retained earnings plus the debt and preferred stock supported by those retained earnings, it may need to issue new common stock *retained earnings breaking point*= the total amount of capital that can be raised before new stock must be issued
CF0 includes what?
fixed assets and any necessary investments in working capital
What does it mean that analyzing capital expenditure proposals is not costless? Accordingly, what types of analyses are involved in the following categories of projects? 1. Replacement: needed to continue current operations 2. Replacement: cost reduction 3. Expansion of existing products or markets 4. Expansion into new products or markets 5. Safety and/or environmental projects 6. Mergers
for certain types of projects, an extremely detailed analysis may be warranted (some simpler projects require much simpler procedures) 1. Expenditures to replace worn out or damaged equipment required in the production of profitable products- if firms want to continue to use same production processes then the project will be approved without much analysis 2. This category includes expenditures to replace serviceable but obsolete equipment and thereby to lower costs. These decisions require a detailed analysis 3. Expenditures to increase output of existing products or to expand retail outlets or distribution facilities in markets now being served. Expansion decisions are complex b/c they require explicit forecasts of growth in demand, so detailed analysis is required. 4. Investments relate to new products or geographic areas and involve strategic decisions that could change the nature of the business, so a detailed analysis is required 5. Safety/environmental projects: expenditures needed to comply with government orders, insurance policy terms, labor agreements, etc. Usually accepted without much analysis. 6. Require a lot of analysis.
Incremental cash flows
in capital budgeting, incremental cash flows= cash flows that occur if and only if the firm takes on a project investments in builgings, equipment, and working capital needed for project, sales revenues and operating costs associated with the project are all examples
The principal way firms maximize shareholder's value is by... A project will be accepted when...
investing in projects that earn more than their cost of capital a project's future cash flows will be forecasted and then discounted to find their present value. If the PV of future cash flows exceeds the project's cost, the firm's value will increase if the project is accepted *the discount rate is the firm's WACC*
At the end of a project, a company will sell its fixed assets and inventory and receive cash. In some respects, we can think of this as a _______ capital expenditure because... Salvage value
negative capital expenditure (usually negative) instead of using cash to purchase fixed assets, the company is selling the assets to generate cash the price that the company receives for a fixed asset at the end of the project (the company will also have to pay taxes if the asset's salvage value exceeds its book value)
Payback methods provide information about ___ and ___
liquidity and risk other things held constant, the shorter the payback, the greater the project's liquidity cash flows expected in the distant future are generally riskier than near-term cash flows, so the payback is used as one risk indicator
Normal vs non-normal cash flow stream
normal= Cost of investment (CF0 is negative) followed by a series of positive cash inflows. ONE change of signs. *One or more cash outflows (-) followed by a series of cash inflows (+) non-normal= TWO OR MORE changes of signs. Most common: cost of investment (CF0 is negative), then stream of positive cash inflows, then cost (negative) to close the project -Ex. nuclear power plant, strip mine, etc. where a company spends money to purchase the property and prepare the site for mining, has positive inflows for several years, then the company spends more money to return the land to its original condition ^in such a case the project might have two IRRs, that is, multiple IRRs
Payback
number of years required to recover funds invested in a project from its cash flows; was used as a method for capital budgeting before NPV AKA "How long does it take to get our money back?" *the shorter the payback, the better the project
Net operating working capital
operating assets- operating liabilities ex. If Home Depot is considering opening a new store that will cost 5 million in inventory to open the store, and 3 million of that is financed through new A/P and 2 million is paid in cash, what is the change in NOWC? Increase in company's current operating assets by 5 million- 3 million in operating liabilities= 2 million in cash necessary to open store
Free cash flow Net present value
represents the net amount of cash that is available for all investors after taking into account the necessary investments in fixed assets (capital expenditures) and net operating working capital Net present value= a method of ranking investment proposals using the NPV which is equal to the present value of the project's FREE cash flows discounted at the cost of capital; tell sis how much a project contributes to shareholder wealth- the larger the NPV, the more value the project adds, and added value means higher stock price *the net present value is best defined as the difference between an investment's market value and its cost*
Capital rationing
the situation in which a firm can raise only a limited, specified amount of capital regardless of how many good projects it has; The situation a firm faces when it has positive net present value projects but cannot obtain financing for those projects
Base-case NPV Expected NPV (scenario)
the NPV when sales and other input variables are set equal to their most likely ("base-case") values multiply each scenario's probability by the NPV under that scenario and then sum the products, we get the project's expected NPV
flotation cost adjustment
the amount that must be added to rs to account for flotation costs to find re aka the difference between rs and re
Modified IRR
the discount rate at which the present value of a project's cost is equal to the present value of its TERMINAL VALUE (TV), where the terminal value is found as the sum of the future values of the cash INflows, compounded at the firms WACC Modified internal rate of return (MIRR) assumes that POSITIVE cash flows are reinvested at the firm's WACC, and the initial outlays are financed at the firm's financing cost, while the internal rate of return (IRR) assumes the cash flows from a project are reinvested at the IRR. Therefore, MIRR more accurately reflects the cost and profitability of a project *similar to the regular IRR except that it is based on the assumption that cash flows are reinvested at the WACC, or the opportunity cost *good alternative to IRR because with regular IRR we can encounter multiple values, with MIRR there is only 1
before tax cost of debt after tax cost of debt
the interest rate a firm must pay on its NEW debt (estimated by asking their bankers what it will cost to borrow or by finding the YTM on their currently outstanding debt) the relevant cost of new debt, taking into account the tax deductibility of interest; used to calculate the WACC the interest rate on new debt less the tax savings that result because interest is tax deductible *thus, the government pays part of a firm's cost of debt
Capital components Increases in assets must be financed by... component cost
the investor-supplied items that make up capital: debt, preferred stock, common equity ^ in assets must be financed by increases in these capital components the cost of each component is called its component cost-- for example, Allied can borrow money at 10%, so its component cost of debt is 10% (before-tax); these costs are then combined to form a WACC
capital budgeting strategic business plan
the process of planning expenditures on assets with cash flows that are expected to extend beyond one year; analyze projects and decide which ones to include in capital budget; analysis of potential additions to fixed assets a long-run plan that outlines in broad terms the firm's basic strategy for the next 5 to 10 years
the "terminal year" refers to Terminal value
the year that the last INFLOW is received the sum of all future values of cash INFLOWS, compounded at the firm's WACC
What does it mean that we are interested in the cost of NEW debt instead of outstanding debt? *What is the best way to measure the cost of debt?*
we are interested in the cost of new debt because our primary concern with the cost of capital is its use in capital budgeting decisions. For example, would a new machine earn return greater than the cost of capital needed to acquire the machine? The rate at which the firm has borrowed in the past is irrelevant when answering this question because we need to know the cost of NEW capital. THE YIELD TO MATURITY on the firm's current outstanding debt is the best way because it reflects current market conditions; better way the measure cost of debt than the coupon rate To get a true measure of the cost of debt you should use the YTM on outstanding debt that is noncallable and not convertible to common stock-- the YTM on company's long term debt is generally used to calculate the cost of debt because more often than not, the cost of capital we're interested in is being raised to fund long term projects (so we don't want to use YTM on short-term debt)
