Finance 300 Critical Thinking Questions Chapter 8, 9, 10

If a project with conventional cash flows has a payback period less than the project's life, can you definitively state the algebraic sign of the NPV? Why or why not? If you know that the discounted payback period is less than the project's life, what can you say about the NPV?

A payback period less than the project's life means that the NPV is positive for a zero discount rate, but nothing more definitive can be said. For discount rates greater than zero, the payback period will still be less than the project's life, but the NPV may be positive, zero, or negative, depending on whether the discount rate is less than, equal to, or greater than the IRR. The discounted payback includes the effect of the relevant discount rate. If a project's discounted payback period is less than the project's life, it must be the case that NPV is positive.

Under what circumstances might a company choose not to pay dividends?

Companies that need the cash will often forgo dividends since dividends are a cash expense. Young, growing companies with profitable investment opportunities are one example; another example is a company in financial distress.

In evaluating the Cayenne, would you use the term erosion to describe the possible damage to Porsche's reputation?

Definitely. The damage to Porsche's reputation is definitely a factor the company needed to consider. If the reputation was damaged, the company would have lost sales of its existing car lines.

"When evaluating projects, we're concerned with only the relevant incremental aftertax cash flows. Therefore, because depreciation is a non-cash expense, we should ignore its effects when evaluating projects." Evaluate this statement.

Depreciation is a noncash expense, but it is tax-deductible on the income statement. Thus depreciation causes taxes paid, an actual cash outflow, to be reduced by an amount equal to the depreciation tax shield TCD. A reduction in taxes that would otherwise be paid is the same thing as a cash inflow, so the effects of the depreciation tax shield must be added in to get the total incremental aftertax cash flows.

Given the choice, would a firm prefer to use MACRSS 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.

Suppose a project has conventional cash flows and a positive NPV. What do you know about its payback? Its discounted payback? Its profitability index? Its IRR?

If a project has a positive NPV for a certain discount rate, then it will also have a positive NPV for a zero discount rate; thus, the payback period must be less than the project life. Since discounted payback is calculated at the same discount rate as is NPV, if NPV is positive, the discounted payback period must be less than the project's life. If NPV is positive, then the present value of future cash inflows is greater than the initial investment cost; thus the PI must be greater than 1. If NPV is positive for a certain discount rate R, then it will be zero for some larger discount rate R*; thus the IRR must be greater than the required return.

One of the assumptions of the two stage growth model is that the dividends drop immediately from the high growth rate to the perpetual growth rate. What do you think about this assumption? What happens if this assumption is violated?

If this assumption is violated, the two-stage dividend growth model is not valid. In other words, the price calculated will not be correct. Depending on the stock, it may be more reasonable to assume that the dividends fall from the high growth rate to the low perpetual growth rate over a period of years, rather than in one year.

When it comes to voting in elections, what are the differences between U.S. political democracy and U.S. corporate democracy?

In a corporate election, you can buy votes (by buying shares), so money can be used to influence or even determine the outcome. Many would argue the same is true in political elections, but, in principle at least, no one has more than one vote in political elections.

In the chapter, we mentioned that many companies have been under pressure to declassify their boards of directors. Why should investors want a board to be declassified? What are the advantages of a classified board?

In a declassified board, every board seat is up for election every year. This structure allows investors to vote out a director (and even the entire board) much more quickly if investors are dissatisfied. However, this structure also makes it more difficult to fight off a hostile takeover bid. In contrast, a classified board can more effectively negotiate on behalf of stockholders, perhaps securing better terms in a deal. Classified boards are also important for institutional memory. If an entire board were voted out in a single year, there would be no board members available to evaluate the company's direction with regards to previous decisions.

In the context of capital budgeting, what is an opportunity cost?

In this context, an opportunity cost refers to the value of an asset or other input that will be used in a project. The relevant cost is what the asset or input is actually worth today, not, for example, what it cost to acquire the asset.

A substantial percentage of the companies listed on the NYSE and NASDAQ don't pay dividends, but investors are nonetheless willing to buy shares in them. How is this possible?

Investors believe the company will eventually start paying dividends (or be sold to another company).

Some companies, such as Alphabet, have created classes of stock with no voting rights at all. Why would investors buy such stock?

Investors buy such stock because they want it, recognizing that the shares have no voting power. Presumably, investors pay a little less for such shares than they would otherwise.

Is it unfair or unethical for corporations to create classes of stock with unequal voting rights?

It wouldn't seem to be unfair or unethical. Investors who don't like the voting features of a particular class of stock are under no obligation to buy it.

In our capital budgeting examples, we assumed that a firm would recover all of thee working capital it invested in a project. Is this a reasonable assumption? When might it not be valid?

It's probably only a mild oversimplification. Current liabilities will all be paid, presumably. The cash portion of current assets will be retrieved. Some receivables won't be collected, and some inventory will not be sold, of course. Counterbalancing these losses is the fact that inventory sold above cost (and not replaced at the end of the project's life) acts to increase working capital. These effects tend to offset one another.

Suppose a financial manager is quoted as saying, "Our firm uses thee stand-alone principle. Because we treat projects like mini-firms in our evaluation process, we include financing costs because they are relevant at the firm level." Evaluate the statement.

Management's discretion to set the firm's capital structure is applicable at the firm level. Since any one particular project could be financed entirely with equity, another project could be financed with debt, and the firm's overall capital structure remains unchanged. Financing costs are irrelevant in the analysis of a project's incremental cash flows according to the stand-alone principle.

Porsche was one of the last manufacturers to enter the sports utility vehicle market. Why would one company decide to proceed with a product when other companies, at least initially, decide not to enter the market?

One company may be able to produce at lower incremental cost or market better. Also, of course, one of the two may have made a mistake!

A project has perpetual cash flows of C per period, a cost of I, and a required return of R. What is the relationship between the project's payback and its IRR? What implications does your answer have for long-lived projects with relatively constant cash flows?

Payback=I/C And the IRR is: 0=-I+C/IRR So, IRR=C/I So, IRR=I/PB For long-lived projects with relatively constant cash flows, the sooner the project pays back, the greater is the IRR.

In evaluating the Cayenne, what do you think Porsche needs to assume regarding the substantial profit margins that exist in this market? Is it likely they will be maintained as the market becomes more competitive, or will Porsche be able to maintain thee profit margin because of its image and the performance of the Cayenne?

Porsche would recognize that the outsized profits would dwindle as more product comes to market and competition becomes more intense.

When is EAC analysis appropriate for comparing two or more projects? Why is this method used? Are there any implicit assumptions required by this method that you find troubling? Explain.

The EAC approach is appropriate when comparing mutually exclusive projects with different lives that will be replaced when they wear out. This type of analysis is necessary so that the projects have a common life span over which they can be compared; in effect, each project is assumed to exist over an infinite horizon of N-year repeating projects. Assuming that this type of analysis is valid implies that the project cash flows remain the same forever, thus ignoring the possible effects of, among other things: (a) inflation, (b) changing economic conditions, (c) the increasing unreliability of cash flow estimates that occur far into the future, and (d) the possible effects of future technology improvement that could alter the project cash flows.

Suppose a company has a preferred stock issue and a common stock issue. Both have just paid a $2 dividend. Which do you think will have a higher price, a share of the preferred or a share of the common?

The common stock probably has a higher price because the dividend can grow, whereas it is fixed on the preferred. However, the preferred is less risky because of the dividend and liquidation preference, so it is possible the preferred could be worth more, depending on the circumstances.

Evaluate the following statement: Managers should not focus on the current stock value because doing so will lead to an overemphasis on short-term profits at the expense of long-term profits.

The current stock value reflects the risk, timing, and magnitude of all future cash flows, both short-term and long-term. If this is correct, then the statement is false.

Under what two assumptions can we use the dividend growth model presented in the chapter to determine the value of a share of stock?

The general method for valuing a share of stock is to find the PV of all expected future dividends. The dividend growth model presented in the text is only valid (a) if dividends are expected to occur forever, that is, the stock provides dividends in perpetuity, and (b) if a constant growth rate of dividends occurs forever.

What are the difficulties in using the PE ratio to value stock?

The major difficulty in using price ratio analysis is determining the correct benchmark PE ratio. In a previous chapter, we showed how the sustainable growth rate is determined. Although not exact measures, the growth rate and required return have a solid economic basis. With the PE ratio, like any other ratio, it is difficult to determine the correct value for the ratio. Since a small difference in the PE ratio can have a significant effect on the calculated stock price, it is easy to arrive at an innocent valuation.

What difficulties might come up in actual applications of the various criteria we discussed in this chapter? Which one would be the easiest to implement in actual applications? The most difficult?

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 (discounted payback, NPV, IRR, and profitability index) are really only slightly more difficult in practice.

Based on the dividend growth model, what are the two components of the total return on a share of stock? Which do you think is typically larger?

The two components are the dividend yield and the capital gains yield. For most companies, the capital gains yield is larger. This is easy to see for companies that pay no dividends. For companies that do pay dividends, the dividend yields are rarely over 5 percent and are often much less.

In 2016, automobile manufacturer BMW completed its 1 billion investment to increase production at its South Carolina plant by 50 percent. BMW apparently felt that it would be better able to compete and create value with U.S. based facilities. Other companies such as Fuji Film and Swiss chemical company Lonza have reached similar conclusions and taken similar actions. What are some of the reasons that foreign manufacturers of products as diverse as automobiles, film , and chemicals might arrive at this some conclusion?

There are a number of reasons for such investments. Two of the most important have to do with transportation costs and exchange rates. Manufacturing in the U.S. places the finished product much closer to the point of sale, resulting in significant savings in transportation costs. It also reduces inventories because goods spend less time in transit. Higher labor costs tend to offset these savings to some degree, at least compared to other possible manufacturing locations. Of great importance is the fact that manufacturing in the U.S. means that a much higher proportion of the costs are paid in dollars. Since sales are in dollars, the net effect is to immunize profits to a large extent against fluctuations in exchange rates. This issue is discussed in greater detail in the chapter on international finance.

Why does the value of a share of stock depend on dividends?

Value of any investment depends on the PV of its cash flows, i.e. what investors will actually receive. The Cash flows from a share of stock are the dividends.

In the context of the divided growth model, is it true that the growth rate in dividends and the growth rate in the price of stock are identical?

Yes, if the dividend grows at a steady rate, so does the stock price. In other words, the dividend growth rate and the capital gains yield are the same.

Are the capital budgeting criteria we discussed applicable to not-for-profit corporations? How should such entities make capital budgeting decisions? What about the U.S. government? Should it evaluate spending proposals using these techniques?

Yes, they are applicable. Such entities generally need to allocate available capital efficiently, just as for-profits do. However, it is frequently the case that the "revenues" from not-for-profit ventures are not tangible. For example, charitable giving has real opportunity costs, but the benefits are generally hard to measure. To the extent that benefits are measurable, the question of an appropriate required return remains. Payback rules are commonly used in such cases. Finally, realistic cost/benefit analysis along the lines indicated should definitely be used by the U.S. government and would go a long way toward balancing the budget!

Concerning NPV: a. Describe how NPV is calculated and describe the information this measure provides about a sequence of cash flows. What is NPV criterion decision rule? b. Why is NPV considered a superior method of evaluating the cash flows from a project? Suppose the NPV for a project's cash flows is computed to be $2,500. What does this number represent with respect to the firm's shareholders?

a. NPV is the present value of a project's cash flows. NPV specifically measures, after considering the time value of money, the net increase or decrease in firm wealth due to the project. The decision rule is to accept projects that have a positive NPV, and reject projects with a negative NPV. b. NPV is superior to the other methods of analysis presented in the text because it has no serious flaws. The method unambiguously ranks mutually exclusive projects, and can differentiate between projects of different scale and time horizon. The only drawback to NPV is that it relies on cash flow and discount rate values that are often estimates and not certain, but this is a problem shared by the other performance criteria, as well. A project with NPV = $2,500 implies that the total shareholder wealth of the firm will increase by $2,500 if the project is accepted.

Concerning payback: a. Describe how the payback period is calculated, and describe the information this measure provides about a sequence of cash flows. What is the payback criterion decision rule? b. What are the problems associated with using the payback period to evaluate cash flows? c. What are the advantages of using the payback period to evaluate cash flows? Are there any circumstances under which using payback might be appropriate?

a. Payback period is the accounting break-even point of a series of cash flows. To actually compute the payback period, it is assumed that any cash flow occurring during a given period is realized continuously throughout the period, and not at a single point in time. The payback is then the point in time for the series of cash flows when the initial cash outlays are fully recovered. Given some predetermined cutoff for the payback period, the decision rule is to accept projects that pay back before this cutoff, and reject projects that take longer to pay back. b. The worst problem associated with payback period is that it ignores the time value of money. In addition, the selection of a hurdle point for payback period is an arbitrary exercise that lacks any steadfast rule or method. The payback period is biased towards short-term projects; it fully ignores any cash flows that occur after the cutoff point. c. Despite its shortcomings, payback is often used because (1) the analysis is straightforward and simple and (2) accounting numbers and estimates are readily available. Materiality considerations often warrant a payback analysis as sufficient; maintenance projects are another example where the detailed analysis of other methods is often not needed. Since payback is biased towards liquidity, it may be a useful and appropriate analysis method for short-term projects where cash management is most important.

Concerning IRR: a. Describe how the IRR is calculated and describe the information this measure provides about a sequence of cash flows. What is the IRR Criterion decision rule? b. What is the relationship between IRR and NPV? Are there any situations in which you might prefer one method over the other? c. Despite its shortcomings in some situations, why do most financial managers use IRR along with NPV when evaluating projects? Can you think of a situation in which IRR might be a more appropriate measure to use than NPV? Explain.

a. The IRR is the discount rate that causes the NPV of a series of cash flows to be exactly zero. IRR can thus be interpreted as a financial break-even rate of return; at the IRR, the net present value of the project is zero. The IRR decision rule is to accept projects with IRRs greater than the discount rate, and to reject projects with IRRs less than the discount rate. b. IRR is the interest rate that causes NPV for a series of cash flows to be zero. NPV is preferred in all situations to IRR; IRR can lead to ambiguous results if there are non-conventional cash flows, and it also ambiguously ranks some mutually exclusive projects. However, for stand-alone projects with conventional cash flows, IRR and NPV are interchangeable techniques. c. IRR is frequently used because it is easier for many financial managers and analysts to rate performance in relative terms, such as "12%", than in absolute terms, such as "$46,000." IRR may be a preferred method to NPV in situations where an appropriate discount rate is unknown or uncertain; in this situation, IRR would provide more information about the project than would NPV.

Concerning discounted payback: a. Describe how the discounted payback period is calculated, and describe the information this measure provides about a sequence of cash flows. What is the payback criterion decision rule? b. What are the problems associated with using the payback period to evaluate cash flows? c. What conceptual advantage does the discounted payback method have over the regular payback method? Can the discounted payback ever be longer than the regular payback? Explain.

a. The discounted payback is calculated the same as is regular payback, with the exception that each cash flow in the series is first converted to its present value. Thus discounted payback provides a measure of financial/economic break-even because of this discounting, just as regular payback provides a measure of accounting break-even because it does not discount the cash flows. Given some predetermined cutoff for the discounted payback period, the decision rule is to accept projects whose discounted cash flows pay back before this cutoff period, and to reject all other projects. b. The primary disadvantage to using the discounted payback method is that it ignores all cash flows that occur after the cutoff date, thus biasing this criterion towards short-term projects. As a result, the method may reject projects that in fact have positive NPVs, or it may accept projects with large future cash outlays resulting in negative NPVs. In addition, the selection of a cutoff point is again an arbitrary exercise. c. Discounted payback is an improvement on regular payback because it takes into account the time value of money. For conventional cash flows and strictly positive discount rates, the discounted payback will always be greater than the regular payback period.

Concerning profitability index: a. Describe how the profitability index is calculated, and describe the information this measure provides about a sequence of cash flows. What is the profitability index decision rule? b.What is the relationship between the profitability index and NPV? Are there any situations in which you might prefer one method over the other?

a. The profitability index is the present value of cash inflows relative to the project cost. As such, it is a benefit/cost ratio, providing a measure of the relative profitability of a project. The profitability index decision rule is to accept projects with a PI greater than one, and to reject projects with a PI less than one. b. PI = (NPV + cost)/cost = 1 + (NPV/cost). If a firm has a basket of positive NPV projects and is subject to capital rationing, PI may provide a good ranking measure of the projects, indicating the "bang for the buck" of each particular project.