Finance II (2 of 2)

What are 2 key points about the use of debt financing?

1) A business's use of debt financing increases the expected rate of return on equity to owners. (*Certain conditions must be present for leveraging to be successful: inherent return on the business must be greater than the interest rate on the debt) 2) At the same time that return is increased, the use of debt financing also increases owner's risk.

What are the effects of taxes on capital structure?

Debt financing creates a tax benefit bc interest expense is tax deductible. Most common to include tax benefit in cost-of-capital estimate (after-tax cost of debt). Not-for-profit: tax-exempt debt will be incorporated directly into the cost estimate.

What is financial flexibility?

Defined in a capital structure context as the ability to access alternative forms of capital under reasonable terms. it is the desire to maintain a reserve borrowing capacity that leads managers to set a target capital structure that uses less debt financing than theoretically optimal.

What is capital structure theory?

Developed for investor-owned businesses, attempts to resolve the dilemma of debt financing decisions with higher returns & higher risk.

What is the purpose of placing capital projects into categories such as mandatory replacement or expansion of existing products, services, or markets?

Dividing capital projects into different categories allows businesses to strategically allocate time and resources toward making the most critical capital budgeting decisions. Some projects warrant a more in depth analysis before making a decision, whereas other projects are required and don't require much, if any, analysis.

What does it mean if there are significant difference of a firm's capital structure from the rest of the industry?

Either there are unique circumstances or they picked the wrong target structure.

What are inflation effects?

Embedded into the company's corporate cost of capital in the form of an inflation premium, so inflation effects also must be accounted for in cash flow estimates.

What is the most critical and most difficult step in analyzing a project?

Estimating the incremental cash flows that the project will generate.

What are 3 types of project risk?

1. *Stand-alone risk* - present in a project whenever there is a chance of a return that is less than the expected return. In effect, a project is risky whenever its cash flows are not known with certainty. Only relevant when a not-for-profit business is evaluating its first project. 2. *Corporate risk* - is relevant when the project is part of a not-for-profit business's portfolio of projects. It is measured by corporate beta and depends on the context (the firms other projects) 3. *Market risk* - generally viewed as the relevant risk for projects being evaluated by large, investor-owned businesses. It should be defined a measured from the owners' perspective, the riskiness of the individual project, as seen by a well-diversified owner, is its contribution to the riskiness of a well-diversified stock portfolio

What are the 3 primary methods to estimate the cost of equity to large, publicly traded businesses?

1. CAPM 2. Discounted cash flow (DCF) model 3. Debt cost plus risk premium model [not mutually exclusive]

Risk analysis is composed of what 3 elements?

1. Defining the type of risk relevant to the project 2. Measuring the projects risk 3. Incorporating the risk assessment into the capital budgeting decision process.

What are the 4 steps of capital budgeting financial analysis?

1. Estimate the expected cash flows 2. Assess the riskiness of those flows 3. Estimate the appropriate cost-of-capital discount rate 4. Determine the project's profitability and breakeven characteristics

How can you mitigate the disadvantages of payback?

1. Ignores time value ---- discount the projected cash flows to get time value of money so you know it. 2. Ignores all cash flows that occur after the payback period ---- extend timelines out to appropriate length.

What are the limits of sensitivity analysis?

1. In general, a project's stand-alone risk, which is what a sensitivity analysis measures, depends on both the sensitivity of its profitability to changes in key input variables and the ranges of likely values of these variables. Because sensitivity analysis considers only the first factor, it can give misleading results. 2. Does not consider any interactions among the uncertain input variables.

What are the deficiencies of payback when used as a project selection criteria?

1. It ignores all cash flows that occur after the payback period. 2. It ignores the opportunity costs associated with the capital employed.

What are the limitations of scenario analysis?

1. It only considers a few states of the economy, so it provides info on only a few potential profitability outcomes of the project. 2. Scenario analysis, at least as normally conducted, implies a definite relationship among the uncertain variables; that is, the analysis assumed that the worst value for volume would occur at the same time as the worst value for salvage value (aka *extreme profitability problem*).

What are the pros of sensitivity analysis?

1. Provides profitability info for the project's uncertain variables. 2. Sensitivity analysis identifies those input variables that are most critical to the analysis. 3. Can be useful after a project has ben initiated.

What are the 2 methods for incorporating project risk into the capital budgeting decision process?

1. The certainty equivalent method 2. The risk-adjusted discount rate method

Stand-alone risk is often used as a proxy for corporate and market risk for what 2 reasons?

1. corporate and market risk are often impossible to measure 2. the 3 types of risk are usually highly correlated

In what 3 ways do tax laws affect investor-owned firms?

1. taxes reduce a project's operating cash flows 2. tax laws prescribe the depreciation expense that can be taken in any year 3. taxes affect a project's salvage value cash flow

What is discounted payback?

A breakeven measure similar to the conventional payback, except that the cash flows in each year are discounted to Year 0 by the project's cost of capital prior to calculating the cumulative cash flows and payback.

What is incremental cash flow?

A cash flow that arises solely from a project that is being evaluated and hence should be included in the project analysis. Opportunity costs must be considered, but sunk costs are not considered.

What is nonincremental cash flow?

A cash flow that does not stem solely from a project that is being evaluated. Nonincremental cash flows are not included in a project analysis.

What is a Monte Carlo simulation?

A computerized risk analysis technique that uses continuous probability distributions to represent the uncertain input variables. Results in an NPV probability distribution based on a large number of scenarios, which encompasses almost all of the likely financial outcomes.

What is a sunk cost?

A cost that has already occurred or is irrevocably committed. Sunk costs are non-incremental to project analyses and hence should not be included.

What is the risk-adjusted discount rate (RADR) method of incorporating project risk into the capital budgeting decision process?

A discount rate that accounts for the specific riskiness of the investment being analyzed. Project cost of capital = Risk-free rate + Risk premium Pro: Has a starting benchmark (the firm's CCC); ID's a project's aggregate risk Con: There's not theoretical basis for setting the size of the RADR adjustment, it's just judgment; automatically penalizes distant cash flows.

What is *internal rate of return (IRR)?*

A discounted cash flow ROI measure of a project's *percentage* profitability (ie., it's expected rate of return). Equivalent to the discount rate that forces NPV of the project to equal zero.

What is *net present value (NPV)?*

A dollar ROI measure that uses discounted cash flow (DCF) techniques, so it is often referred to as a DCF profitability measure. Given as a *dollar value*. For investor owned firms, NPV is a direct measure of the contribution of the project to owners' wealth, so NPV is considered...to be the best measure of profitability.

What is the certainty equivalent (CE) method of incorporating project risk into the capital budgeting decision process?

Follows directly from the utility theory, which is used by economists to explain how individuals make choices among risky alternatives. Under the CE approach, managers must first evaluate a cash flow's risk and then specify, with certainty, how much money would be required to be indifferent between the riskless (certain) sum and the risky cash flow's expected value. Pro: simple & neat. Con: no benchmark available

What is the taxable component cost of debt?

For a for-profit business, the effective cost of debt is calculated as: Effective cost of debt = R(Rd) x (1-T) Where: R(Rd) = before-tax cost of debt (req'd int rate) T = tax rate

What is modified internal rate of return (MIRR)?

A project ROI measure similar to IRR but using the assumption of reinvestment at the cost of capital. Calculated by: 1. Discounting project's net cash outflows back to Year 0 at the project cost of capital. 2. Compound project's net cash inflows forward to the last (terminal) year of the project, at the project cost of capital. 3. The discount rate that forces the present value of the inflow terminal value to equal the present value of costs is the MIRR.

What is *modified internal rate of return (MIRR)?*

A project ROI measure similar to IRR but using the assumption of reinvestment at the cost of capital. In contrast with IRR, MIRR is more intuitive because it expresses investments in terms of dollars instead of percentages.

What is sensitivity analysis?

A project analysis technique that assesses how changes in a single input variable, such as utilization, affect profitability. Begins with a base case developed using expected values for all uncertain variables.

What does IRR measure?

A project's *percentage* profitability (ie. expected rate of return). Simply the discount rate that forces the NPV of the project to equal zero.

What is scenario analysis?

A stand-alone risk analysis technique that considers the impact of changes in key variables on NPV, the likely range of the variable values, and the interactions among variables. The expected NPV in the scenario analysis is the same as the base case NPV.

What is the coefficient of variation?

A statistical measure of an investment's stand-alone risk calculated by dividing the standard deviation of returns by the expected return. The result is the amount of standalone risk per unit of return. Bigger = riskier CV = σ sub npv / E(NPV)

What is the classic risk/return trade off?

Higher returns can be obtained only by assuming greater risk.

What is financial risk?

In a capital structure context, the risk added when *debt financing* is used. The difference between the standard deviations of ROE with & without debt financing measures the amt of financial risk.

What is business risk?

Inherent in operations even when no debt financing is used; associated with the ability of managers to forecast future profitability. More difficult to forecast =greater inherent risk business risk that can be measured by the standard deviation of ROE assuming the firm uses no debt financing.

How do businesses raise equity capital?

Investor-owned: sell new common stock & use retained earnings for the firm (not as dividends) Not-for-profit: contributions & grants, utilizing excess revenues.

What is a weakness of CAPM?

Making future plans on historical data.

What is return on equity (ROE)?

Measures the dollars of earning per dollar of equity investment (best measure of return to the owners of a business).

What is optimal capital structure?

Mix of debt & equity financing that management believes to be most appropriate for the business (evaluates *quantitative & qualitative* factors).

What is capital structure?

Mix of debt and equity financing used by a business; usually measured by the structure of the liabilities & equity section of a business's balance sheet; expressed as a % of debt financing.

What is cannibalization?

Negative effects of a potential project on the firms existing business lines.

Business risk is the uncertainty inherent in a business's ____________.

Operating income (EBIT). Business risk does not consider how the business is financed. Factors: Uncertainty about sales volume, sales prices, costs, liability.

What is reserve borrowing capacity?

Preserves the ability to issue debt when conditions dictate. Practice of businesses to use less than the theoretical optimal amt of debt to ensure easy access to new debt at reasonable interest rates regardless of circumstances.

Compare NPV and IRR methods.

Projects deemed profitable by the NPV method will also be deemed profitable by IRR. NPV method generally considered to be best measure of profitability.

How do you account for differential risk?

Projects with lower than average risk must be evaluated with a higher-than-average cost of capital. Ex. If the corporate cost of capital for a project is 10%, but you assess the project to have lower than average risk, you should add percentage points to the CCC (e.g. 13%). *The risk adjustment for cash outflows is the opposite of the adjustments for cash inflows. When cash outflows are being evaluated, higher risk leads to a lower discount rate.*

What is the cost of equity?

Rate of return that investors require on the firm's common stock.

What is the Debt Cost Plus Risk Premium approach to estimating the cost of equity?

Relies on the fact that stock investments are riskier than debt investments; the cost of equity for any business can be thought of as the before-tax cost of debt to that business plus a risk premium: R(Re) = R(Rd) + Risk premium Risk premium ranged from 3 to 5 percentage points.

*How do you determine payback period?*

Set up a timeline. Show cash flows on top, cumulative cash flows on bottom, then do math where it changes from negative to positive to determine number of years. Divide last cumulative by next cash flow.

What does an NPV of zero mean?

Signifies that the project's cash inflows are just sufficient to (1) return the capital invested in the project, and (2) provide the required rate of return on that capital (opportunity cost).

What is the optimal range?

Similar to optimal capital structure. Debt / equity financing mix where managers will finance asset acquisitions in a way that keeps the firm at its optimal structure.

Compare cash flow vs accounting income.

Since financial decisions should be based on actual dollars that will flow in/out of the firm, it's true profitability, and hence its future financial condition, depends more on cash flows than on income as reported IAW GAAP.

What is the advantage of MIRR over IRR?

Accounts for proper reinvestment rate (IRR doesn't). Provides decision makers with a theoretically better measure of a project's expected return rate of return than does the IRR. Avoids potential problems when a project has non-normal cash flows.

What are flotation costs?

Administrative expenses to sell bonds (typically small on bond issues).

What are the pros and cons of the Monte Carlo simulation?

Advantages over scenario analysis: - all possible input variables are considered. - correlations among the uncertain inputs can be incorporated into the analysis Disadvantages: - much more difficult to determine what the probability distributions and correlations are for uncertain variables. - the more info a risk analysis technique requires, the harder it is to develop the data with confidence.

How do you interpret sensitivity analysis?

Steeper lines show greater risk

What is the result of a Monte Carlo simulation?

An NPV probability distribution based on a large number of individual scenarios, which encompasses almost all of the likely financial outcomes.

What is project scoring?

An approach to project assessment that considers both financial and nonfinancial factors.

What is collateral?

Assets as security for loans means lower interest rates, so those firms use more debt.

What is target capital structure?

Capital structure (mix of debt & equity) that a business strives to achieve & maintain over time. Generally the same as (or very close to) the optimal capital structure.

What is an opportunity cost?

Cash flows that are missed out on by instead investing in a project of similar risk.

What is the trade-off model?

Competing theory from capital structure; hypothesizes that a business's optimal capital structure balances the costs & benefits associated with debt financing. Balances the tax advantages of debt financing against the increased risk that arises when debt financing is used. The point at which a business's overall (average) cost of capital is minimized defines the firm's *optimal capital structure*.

Compare objective risk and subjective risk.

*Objective risk* is risk measured in a quantitative way, such as using cash flow estimates to obtain a coefficient of variation (CV) of NPV. *Subjective risk* is the risk that the objective measurement is wrong. In other words, the cash flow estimates are worthless. Highest when the investment being evaluated is using new, unproven technology or is in a new, unfamiliar line of business.

Describe payback in terms of breakeven/profitability measures.

The *expected/forecasted* number of years required to recover the investment in a project, so payback, or payback period, measures time breakeven. The post audit is key to ID what's working/not working to fix it.

What is debt capacity?

The amount of debt identified as the target capital structure/ optimal for the business businesses w large debt capacity use higher proportion of debt financing, lower capacity is lower proportion.

Is debt or equity financing more costly?

The cost of equity is appreciably greater than the cost of debt at any proportion of debt. Owners face more risk than do creditors.

What is ROI?

The estimated financial return on an investment. In capital budgeting analysis, ROI can be measured either in dollars or percentage (rate of) return.

What is salvage value?

The expected market value of an asset (project) at the end of its useful life.

What is a post audit?

The feedback process in which the performance of projects previously accepted is reviewed and actions are taken if performance is below expectations. - Improve forecasts - Develop historical risk data - Improve operations - Reduce losses

What is the capital budget?

The list of projects to be undertaken, along with the cost of each project and the total cost.

What is net present social value (NPSV)?

The present value of a project's social value. Added to the financial net present value (NPV) to obtain a project's total value. TNPV = NPV + NPSV

What is capital budgeting?

The process of analyzing potential expenditures on fixed assets and deciding whether the firm should undertake those investments.

What does a positive NPV mean?

The project is generating excess cash flows, and these cash flows are available to reinvest or pay dividends.

What does a negative NPV mean?

The project's cash flows are insufficient to compensate the firm for capital invested or possibly to recover the initial investment. Project is unprofitable.

What is the opportunity cost rate?

The rate of return expected on alternative investments similar in risk to the investment being evaluated [corporate cost of capital assessment]. Also called *hurdle rate*.

What is the opportunity cost principle?

The reason that a cost of capital must be assigned to all forms of equity financing; an investor-owned firm's net income belongs to its common stockholders.

What is the corporate cost of capital?

The ultimate goal of the cost-of-capital estimation process, represents the blended or avg cost of a business's financing. The corporate cost of capital is a weighted avg of the component financing costs; or after the component costs have been estimated and combined. Focuses on the cost of permanent capital; relevant capital components are equity and long-term debt.

What is financial leverage?

The use of fixed cost financing; typically debt financing for healthcare providers; use of debt financing increases (expected rate of return)/leverages up. Use of financial leverage not only increases owners' projected return but also increases risk.

What is strategic value?

The value of future investment opportunities that can be undertaken only if the project currently under consideration is accepted. Major source of hidden value.

What is the sole purpose of scenario analysis?

To assess a project's stand-alone risk. NOT conducted to estimate a project's profitability.

What is the ultimate goal of project risk analysis?

To ensure that the cost of capital used as the discount rate in a projects ROI analysis properly reflects the riskiness of that project.

A firm's ________, and hence it's future financial condition, depends more on its cash flows than on ______.

True profitability; income as reported IAW GAAP

Compare historical vs marginal costs.

Two different sets of capital costs can be estimated: *historical or embedded costs* (reflect the cost of funds raised in the past) and *new or marginal costs* (measure the cost of funds to be raised in the future).

What is the Discounted Cash Flow (DCF) approach to estimating the cost of equity?

Uses the dividend valuation model as its basis; uses constant growth model (established track record of paying dividends & expected to grow each year at a constant rate) to estimate the expected rate of return on the stock E(Re) = R(Re) = E(D1)/Po + E(g)

What are changes in current accounts re: cash flow estimation?

When a business is expanded, it requires additional inventories, additional patient volume, and additional accounts receivable. The increase in these current assets must be financed, just as in increase in fixed assets must be financed.

What is terminal value?

When a project's cash flows are arbitrarily truncated, an estimate of the value of the cash flows beyond the truncation point. Sometimes estimated as the liquidation value of the project at that point in time. Problem of truncating: the value inherent in the cash flows beyond the truncation point is lost to the project.

What is cash flow estimation bias?

When managers tend to overstate revenues and understate costs, which results in upward bias in estimated profitability.

What is the CAPM approach to estimating the cost of equity?

Widely accepted financial model that specifies the equilibrium risk/return relationship on common stocks; model assumes that investors consider only one factor when setting required rates of return: volatility of returns on the stock vs. volatility of a market portfolio (well-diversified stock portfolio; also just market). R(Re) = RF + [R(RM) − RF] × β Historical market risk premium falls in the range of 4 to 6 percentage points.

Stand alone risk can be measured by __________ and _________.

standard deviation and coefficient of variation