Finance Final Exam
Firms can accumulate capital through a number of sources
1. Debt (long-term) 2. Preferred stock 3. Retained earnings (current year earnings not paid out as dividends) 4. Common stock (cost of retained earnings adjusted by flotation costs)
Retained Earnings (rs) can be found one of three ways
1. Using the security market line equation (capital asset pricing model way) 2. Using the dividend yield plus capital gains equation (discounted cash flow model) 3. By taking the bond yield plus risk premium approach
If two mutually exclusive projects were being compared, would a high cost of capital favor the longer-term or the shorter-term project? Why? If the cost of capital declined, would that lead firms to invest more in longer-term projects or shorter-term projects? Would a decline (or an increase) in the WACC cause changes in the IRR ranking of mutually exclusive projects?
A high cost of capital favors a shorter-term project. If the cost of capital declined, it would lead firms to invest more in long-term projects. With regard to the last question, the answer is no; the IRR rankings are constant and independent of the firm's cost of capital
Modified internal rate of return
Adjusts the IRR calculation to have cash flows reinvested at WACC, not IRR, equates the present value of the cash outflows with the future value of the cash inflows
Payback period
Amount of time it takes project to recover initial investment, advantage is that it is easy to explain and understand and It provides an indication of the project's liquidity, disadvantage is that it ignores the time value of money and it ignores cash flows after payback, no obvious decision rule
Assume that the risk-free rate increases, but the market risk premium remains constant. What impact would this have on the cost of debt? What impact would it have on the cost of equity?
An increase in the risk-free rate will increase the cost of debt. Remember: r = rrf + DRP + LP + MRP. Thus, if rrf increases so does r (cost of debt) Similarly, if the risk-free rate increases so does the cost of equity. From the CAPM equation, rs= rrf + (rm -rrf)b. Consequently, if rrf increases, rs will increase too
Purpose of financial statements
Assess past performance and current position, assess future potential and the risk associated with it, plan steps to improve firm's future performance
Four basic financial statements
Balance sheet, income statement, statement of retained earnings, statement of cash flows
How does the deductibility of interest and dividends by the paying corporation affect the choice of financing (i.e. the use of the debt versus equity)?
Because interest paid is tax deductible but dividend payments are not, the after-tax cost of debt is lower than the after-tax cost of equity. This encourages the use of debt rather than equity
Profit margins and turnover ratios vary from one industry to another. What differences would you expect to find between the turnover ratios, profit margins, and DuPont equations for a grocery chain and steel company?
Differences in the amounts of assets necessary to generate a dollar of sales cause asset turnover ratios to vary among industries. For example, a steel company needs a greater number of dollars in assets to produce a dollar in sales than does a grocery store chain. Also, profit margins and turnover ratios may vary due to differences in the amount of expenses incurred to produce sales. For example, one would expect a grocery store chain to spend more per dollar of sales than does a steel company. Often, a high turnover will be associated with a low profit margin, and vice versa.
What does double taxation of corporate income mean? Could income ever be subject to triple taxation?
Double taxation refers to the fact that corporate income is subject to an income tax, and then stockholders are subject to a further personal tax on dividends received. In fact, because of double taxation congress was motivated to reduce the tax rate on dividends to the same rate as long-term capital gains.
How should capital structure weights used to calculate the WACC be determined?
Each firm has an optimal capital structure, defined as that mix of debt, preferred, and common equity that causes its stock price to be maximized. A value-maximizing firm will determine its optimal capital structure, use it as a target, and then raise new capital in a manner designed to keep the actual capital structure on target over time. The target proportions of debt, preferred stock, and common equity, along with the costs of those components, are used to calculate the firm's weighted average cost of capital, WACC. The weights could be based either on the accounting values shown on the firm's balance sheet (book values) or on the market values of the different securities. Theoretically, the weights should be based on market values, but if a firm's book-value weights are reasonably close to its market-value weights, book-value weights can be used as a proxy for market-value weights. Consequently, target market-value weights should be used in the WACC equation.
What is free cash flow? If you were an investor, why might you be more interested in free cash flow than net income?
Free cash flow is the amount of cash that could be withdrawn without harming the firm's ability to operate and to produce future cash flows. It is calculated as after-tax operating income plus depreciation less capital expenditures and the change in net operating working capital. It is more important than net income because it shows the exact amount available to all investors (stockholders and debtholders). The value of a company's operations depends on expected future free cash floes. Therefore, investors ought to focus on cash flow rather than accounting profit
Internal rate of return method
IRR os the discount rate that forces the NPV to be zero, easiest to solve with a financial calculator, IRR is independent of the discount rate assumed, assume cash flows are reinvested at the IRR
Suppose a firm estimates its WACC to be 10%. Should the WACC be used to evaluate all of its potential projects, even if they vary in risk? If not, what might be "reasonable" costs of capital for average, high or low risk projects?
In general, failing to adjust for differences in risk would lead the firm to accept too many risky projects and reject too many safe ones. Over time, the firm would become more risky, its WACC would increase, and shareholder value would suffer. The cost of capital for average-risk projects would be the firm's cost of capital, 10%. A somewhat higher cost would be used for more risky projects, and a lower cost would be used for less risky ones. For example, we might use 12% for more risky projects and 9% for less risky projects. These choices are arbitrary.
Liquidity ratios
Measures the company's short-term debt paying ability
Discounted payback period
Modification of the regular payback period, calculated based on discounted cash flows instead of raw cash flows, adjusts the TVOM issues, but not cash flows after payback or decision rule, rough estimate of liquidity and riskiness of project
Net present value method
Most theoretically correct method, can be used to screen and rank projects
If a "typical" firm reports $20 million of retained earnings on its balance sheet, could its directors declare a $20 million cash dividend without any qualms about what they were doing?
No, because the $20 million of retained earnings would probably not be held as cash. The retained earnings figure represents the reinvestment of earnings by the firm over its life. Consequently, the $20 million would be an investment in all of the firm's assets
Do we need to adjust preferred stock or common stock for taxes? Yes or no? If no, why?
No, we do not need to adjust preferred stock or common stock for taxes because dividends paid are not tax deductible
Stockholders are interested in after-tax cash flows, so when should all of the various component costs should be expressed?
On an after tax basis
Capital budgeting decision rules
Payback period Discounted payback period Net present value Internal rate of return Modified internal rate of return
Why might it be rational for a small firm that does not have access to the capital markets to use the payback method rather than the NPV method?
Payback provides information on how long funds will be tied up in a project. The shorter the payback, other things held constant, the greater the project's liquidity. This factor is often important for smaller firms that don't have ready access to the capital markets. Also, cash flows expected in the distant future are generally riskier than near-term cash flows, so the payback can be used as a risk indicator
Project X is very risky and has an NPV of $3 million. Project Y is very safe and has an NPV of $2.5 million. They are mutually exclusive, and project risk has been properly considered in the NPV analysis. Which project should be chosen?
Project X should be chosen over Project Y. Because the two projects are mutually exclusive, only one project can be accepted. The decision rule that should be used is the NPV. Since Project X has the higher NPV, it should be chosen. The cost of capital used in the NPV analysis appropriately includes risk
If a firm's ROE is low and management wants to improve it, explain how using more debt might help
ROE is calculated as the return on assets multiplied by the equity multiplier. The equity multiplier, defined as total assets divided by common equity, is a measure of debt utilization; the more debt a firm uses, the lower its equity, and the higher the equity multiplier. Thus, using more debt will increase the equity multiplier, resulting in a higher ROE.
Capital Budgeting
Relates to analyzing additions to fixed assets, important because it determines future course of business (tie up assets for a relatively long period of time as a result of these decisions), conceptually the same as an investment decision for an individual (estimate the cash flows, access the riskiness of the cash flows, determine the appropriate discount rate to use, find the present value of the expected future cash flows, or the expected rate of return)
Balance sheet
Shows assets, liabilities and owners' equity accounts, assets shown in order of liquidity, liabilities shown in order due, snapshot of an entity at a particular point in time
Statement of retained earnings
Shows changes in the components of equity for the period, shows results of activity for a period of time, retained earnings are earnings that have been reinvested in the business, rather than being paid out to shareholders in the form of dividends, retained earnings is not a big pile of cash
Income statement
Shows revenues, expenses, gains and losses, may have several intermediate income figures, when we refer to net income we mean net income available to the common shareholders, net income on a per share basis is one of the most closely followed measures of firm's performance, shows results of activity for a period of time
Statement of cash flows
Shows sources and uses of cash, composed of the three sections: operating, investing and financing, explains the change in the cash balance for the year, bottom line of this statement should equal the balance in the "cash" account on the balance sheet
Taxes on an corporate level
Structure is simpler than individual structure, interest income received by a corporation is treated as ordinary income, 30% of the dividend income received by a corporation is taxable as ordinary income, interest paid by a corporation is tax deductible to a certain extent, dividend paid by a corporation are not, if a corporation incurs a tax loss for the year, they can carry the loss forward to reduce future taxes
Taxes on an individual level
Taxable income is gross income less exemptions, marginal tax rate paid on your next dollar of taxable income, average ta rate is total tax paid/taxable income, don't forget about SS and medicare taxes, tax system is progressive, most interest income received by an individual is treated as ordinary income, dividends are taxed at a lower rate than ordinary income
common stock adjusts _______________________________
The DCF model to account for the flotation costs of new equity (brokers' fees, underwriters' fees, etc)
What reinvestment rate assumptions are built into the NPV, IRR, and MIRR methods?
The NPV method assumes reinvestment at the cost of capital, while the IRR method assumes reinvestment at the IRR. MIRR is a modified version of IRR that assumes reinvestment at the cost of capital
WACC is equal to ________________________
The cost of each component multiplied by the weight of each component in the firm's capital structure
Financial ratio analysis is conducted by three main groups of analysts: credit analysts, stock analysts, and managers. What is the primary emphasis of each group, and how would that emphasis affect the ratios on which they focus?
The emphasis of the various types of analysts is by no means uniform nor should it be. Management is interested in all types of ratios for two reasons. First, the ratios point out weaknesses that should be strengthened; second, management recognizes that the other parties are interested in all the ratios and that financial appearances must be kept up if the firm is to be regarded highly by creditors and equity investors. Equity investors (stockholders) are interested primarily in profitability, but they examine the other ratios to obtain information on the riskiness of equity commitments. Credit analysts are more interested in the debt to capital, TIE, and EBITDA coverage ratios, as well as the profitability ratios. Short-term creditors emphasize liquidity and look most carefully at the current ratio.
Why would the inventory turnover ratio be more important for someone analyzing a grocery store chain than an insurance company?
The inventory turnover ratio is important to a grocery store because of the much larger inventory required and because some of that inventory is perishable. An insurance company would have no inventory to speak of since its line of business is selling insurance policies or other similar financial products—contracts written on paper and entered into between the company and the insured. This question demonstrates that the student should not take a routine approach to financial analysis but rather should examine the business that he or she is analyzing before conducting a ratio analysis.
What are three potential flaws with the regular payback method? Does the discounted payback method correct all three flaws?
The regular payback method has three main flaws: (1) Dollars received in different years are all given the same weight. (2) Cash flows beyond the payback year are given no consideration whatever, regardless of how large they might be. (3) Unlike the NPV, which tells us by how much the project should increase shareholder wealth, and the IRR, which tells us how much a project yields over the cost of capital, the payback merely tells us when we recover our investment. The discounted payback corrects the first flaw, but the other two flaws still remain
What is cost of capital used for?
Used to determine which projects to accept or reject. A project should be accepted only if its expected return is greater than the cost of capital needed to finance the project. It is also used to determine the required return for residual income or economic-value added calculations. It is used to help managers decide whether to lease or purchase assets. It is also used by regulators to determine the rates charged by regulated monopolies (utilities, etc.)
WACC is influenced by:
What company cannot influence i. General level of interest rates ii. Taxes What company can influence i. Capital structure ii. Dividend policy iii. Investment policy
Do we need to adjust debt for taxes? Yes or no? If yes, explain why?
Yes, since interest payments are tax deductible
Would it be possible for a company to report negative free cash flow and still be highly valued by investors; that is, could a negative free cash flow ever be viewed optimistically by investors?
Yes. Negative free cash flow is not necessarily bad. Most rapidly growing companies have negative free cash flows because the fixed assets and working capital needed to support rapid growth generally exceed cash flows from existing operations. This is not bad, provided the new investments will eventually be profitable and contribute to free cash flow
The WACC is a weighted average of the costs of debt, preferred stock, and common equity. Would the WACC be different if the equity for the coming year same solely in the form of retained earnings versus some equity from the sale of new common stock? Would the calculated WACC depend in any way on the size of the capital budget? How might the dividend policy affect WACC?
he cost of retained earnings is lower than the cost of new common equity; therefore, if new common stock had to be issued then the firm's WACC would increase. The calculated WACC does depend on the size of the capital budget. A firm calculates its retained earnings breakpoint (and any other capital breakpoints for additional debt and preferred). This R/E breakpoint represents the amount of capital raised beyond which new common stock must be issued. Thus, a capital budget smaller than this breakpoint would use the lower-cost retained earnings and thus a lower WACC. A capital budget greater than this breakpoint would use the higher cost of new equity and thus a higher WACC. Dividend policy has a significant impact on the WACC. The R/E breakpoint is calculated as the addition to retained earnings divided by the equity fraction. The higher the firm's dividend payout, the smaller the addition to retained earnings and the lower the R/E breakpoint. (That is, the firm's WACC will increase at a smaller capital budget.)
