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Financial Analysis > 02 Corporate Finance > Flashcards

02 Corporate Finance Flashcards

1
Q

What is Cost of Capital used for?

A

Cost of capital are used in discounted cash flow analysis as the proper discount rate r to determine the value of a cash flow stream

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2
Q

Cost of Capital - Discount rate r

A

The discount rate reflects the opportunity costs associated with the investment and establishes equivalence in terms of

  • Time value
  • Risk
  • Purchasing Power
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3
Q

What does Cost of Capital theoretically and practically depend on/how is it derived?

A
  • In theory, cost of capital are depending on the investor and his opportunities, his attitude towards risk and his expectations
  • In practice, cost of capital are derived from the market, its opportunities, risk attitude and expectations
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4
Q

Components of Cost of Capital (3)

A
  • Cost of Debt
  • Cost of Preferred Stocks
  • Cost of Equity and Retained Earnings
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5
Q

Components of Cost of Capital: Cost of Debt

A

The costs of debt (after-tax) result from the interest rate (CD) minus tax savings

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6
Q

Components of Cost of Capital: Cost of Preferred Stocks

A

The cost of preferred stocks (CPS) result from the preferred dividend obligation

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7
Q

Components of Cost of Capital: Cost of Equity and Retained Earnings

A

The cost of equity and retained earnings (CEQ) is the rate of return the company’s stockholder require as opportunity costs in an investment with the same risk level.

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8
Q

How can the Cost of Equity and Retained Earnings be determined? (3)

A
  • Risk premium or bond yield approach
  • Implied cost of capital (via market prices) or dividend yield approach
  • Capital Asset Pricing Model (CAPM)
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9
Q

Estimating Cost of Equity: Bond Yield Approach

A
  • Ad-hoc approach that estimates the required rate of return by adding a risk premium to the interest rate of the firm’s long-term debt
  • Risk premium usually lies between 3-5%
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10
Q

Estimating Cost of Equity: Dividend Yield Approach

A
  • Estimate the expected constant future growth rate (g) of dividends
  • The current price of stock implies the cost of capital
  • The growth rate can be assessed via the product of retention rate and return on capital
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11
Q

Estimating Cost of Equity: CAPM Approach - Steps

A

Step 1: Estimate risk-free rate
Depending on the context, the short-term treasury bill or the long-term rate is used

Step 2: Estimate the stock’s beta
Via regression of weekly or monthly returns with a market index (e.g. MSCI World)

Step 3: Estimate the Market Risk Premium
A constant factor is used based in historical analysis or the annual return of a broad index against the risk-free rate is calculated

Step 4: The CAPM equation yields the required rate of return

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12
Q

Cost of Newly Issued Capital

A
  • The cost of newly issued or external equity will be higher than existing cost of equity (CEQ) due to flotation costs. Whereas f is the percentage of flotation costs within the selling price
  • The sale of new equity is by itself not dilutive. -> The dilution occurs only if the new funds are not invested as to cover the required return
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13
Q

How is the Financing Cost Structure reflected?

A

The financing cost structure is reflected by the weighted average cost of capital (WACC)

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14
Q

Weighted Average Cost of Capital (WACC)

A
  • The cost of equity can be divided into cost of preferred shares and cost of common shares
  • The weights (w) should be based on the market value of the security
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15
Q

Marginal Cost of Capital (MCC)

A

The marginal cost of capital (MCC) is the cost of the last dollar of new capital raised by the firm and is likely to be higher than WACC

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16
Q

What is the target (optimal) financing mix?

A

The target (optimal) financing mix minimizes the cost of capital and therefore maximizes the prize of the firm’s stock

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17
Q

Factors that influence the average cost of capital (5)

A

Under the control of the firm

  • Capital Structure
  • Dividend policy
  • Investment policy

Not under the control of the firm

  • Interest rate
  • Tax rate
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18
Q

Capital Budgeting

A

Capital Budgeting is the process of determining and selecting the most profitable long-term investment project

  • With the purchase of long-term assets the firm sacrifices some degree of flexibility
  • The budgeting decision is always based on expected future cash flows
  • The budgeting decision follows the firm’s strategy

Capital budgeting is based on cash flows not accounting income. Where depreciation is usually the largest noncash charge for a firm

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19
Q

Capital Budgeting: Classification of capital proects (5)

A
  • Replacement decisions to maintain the business
  • Replacement decisions for cost reduction
  • Existing product or market expansion
  • New products or markets
  • Mandatory investments (e.g. safety-related) often accompany new projects
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20
Q

Capital Budgeting: Mutually Exclusive vs. Independent Projects

A
  • Mutually exclusive means that only one project within a set will be accepted
  • Independent projects are unrelated to each other including unlimited funds
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21
Q

Payback Period (PBP)

A
  • The Payback Period (PBP) is the number of years it takes to recover the initial costs of an investment
  • The Discounted Payback Period discounts the cash flows by the projects cost of capital
  • PBP gives an introduction of project’s liquidity and risk since distant cash flows are risikier
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22
Q

Payback Period - Decision Rules

A

Independent alternatives:
The project should be executed if PBP is smaller than the payback period of the benchmark

Mutually exclusive projects
Prefers the one with the shorter payback period

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23
Q

Payback Period - Assumptions

A
  • The annual cash flows are assumed to be linear
  • PBP ignores cash flows beyond the payback period
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24
Q

Capital Budgeting: Net Present Value (NPV)

A

The NPV is the wealth increment produced by a project, investment or generally by a cash flow

  • Applying cost of capital a NPV positive project increases shareholder wealth
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25
Q

Capital Budgeting: Net Present Value (NPV) - Discount rate r

A

Depending on the objective the discount rate r can be the cost of capital, the required rate of return or a hurdle rate

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26
Q

Capital Budgeting: Net Present Value (NPV) - Decision Rules

A

Independent alternatives:
NPV > 0

Mutually exclusive alternatives:
NPV(A) > NPV(B)

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27
Q

Difficulties applying the NPV Method (2)

A
  • Assessment of the expected cash flows
  • Determination of the appropriate discount rate r
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28
Q

Capital Budgeting: Internal Rate of Return

A
  • The IRR is defined as the discount rate for which the NPV equals zero or the PV of inflows equals the PV of outflows
  • It is the compound rate of return
  • IRR is not depending on the discount rate, hence less depending on the investor
  • For non-normal cash flow patterns (CFt becomes negative), a project may have multiple IRRs
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29
Q

Capital Budgeting: Internal Rate of Return - Decision Rules

A

Independent alternatives:
IRR > hurdle rate

Mutually exclusive alternatives:
IRR(A) > IRR(B)

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30
Q

NPV vs. IRR

A

NPV

  • Considered to be the best measure because it maximizes shareholders wealth.
  • Main weakness: Does not measure the size of the project

IRR

  • Measures profitability as a percentage, showing the return of each dollar invested
  • Disadvantages:
    -> Potentially conflicting decisions compared to NPV for mutually exclusive projects
    -> Multiple IRR problem

NPV/IRR conflicts arise for mutually exclusive projects when cost of capital become smaller than the crossover rate -> When such conflict occurs go with the NPV

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31
Q

Incremental Cash Flows

A

Capital budgeting decisions are based on incremental cash flows only -> the cash flows which occur only when the project is accepted

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32
Q

Types of Incremental Cash Flows (4)

A
  • Sunk Cost
  • Opportunity Costs
  • Externalities
  • Shipping and Installation Costs
33
Q

Types of Incremental Cash Flows: Sunk Cost

A

Sunk cost is cash outflow that already has occurred and should not be included in the analysis (e.g. marketing research or consulting fees)

34
Q

Types of Incremental Cash Flows: Opportunity Costs

A

Opportunity costs are cash flows the firm is passing up by investing in the project. -> These cashflows should be charged to the project (e.g. owned land, building a plant)

35
Q

Types of Incremental Cash Flows: Externalities

A

Externalities such as cannibalization should be taken into account

36
Q

Types of Incremental Cash Flows: Shipping and Installation Costs

A

Shipping and installation cost must be added to the depreciably basis (purchase price)

37
Q

Incremental Cash Flow Classification (3)

A
  • Initial investment outlay
  • Operating cash flows: (revenue – cost – depreciation) * (1-t) + depreciation
  • Terminal year cash flow
38
Q

Other Topics in Capital Budgeting - Replacement Decisions

A

Replacement decisions (compared to expansion decisions) have to include the cash flows from the old asset

39
Q

Other Topics in Capital Budgeting - Adjustment of Mutually Exclusive Projects

A

Mutually exclusive projects need to be adjusted for unequal lives when they are compared to each other

Methods:
Replacement chain or common life method assumes the replacement of the shorter-lived asset until a common life is obtained. Finally, the NPVs are compared

40
Q

Other Topics in Capital Budgeting - Adjustment of Mutually Exclusive Projects: Equivalent Annual Annuity (EAA) approach - Steps

A
  • Step 1: Find each project’s NPV
  • Step 2: Find an annuity that equates to the project’s NPV over its individual life at cost of capital
  • Step 3: Select the project with the highest EAA (NPV)
41
Q

Consideration of Inflation in Capital Budgeting Decisions

A
  • NPV calculations are normally adjusted for inflation through the cost of capital
  • Future cash flows must also be adjusted upward to reflect inflation, else NPV will be biased downward
42
Q

Types of Risk in Capital Budgeting

A
  • Stand-alone risk (individual or project)
  • Corporate risk (interfirm)
  • Market risk
43
Q

Types of Risk in Capital Budgeting: Stand-alone risk

A

Variability of the project’s returns quantified irrespectively from the firm’s portfolio of assets, best assessable measure

44
Q

Types of Risk in Capital Budgeting: Corporate risk

A

The contribution of the project to the firm’s total risk (perspective of an undiversified stockholder, creditors, or small business owners)

45
Q

Types of Risk in Capital Budgeting: Market risk

A

The contribution of the project to the firms beta (perspective of well-diversified stock holder)

46
Q

Theory: Managers should focus on maximizing the value of the firm, hence beta risk is relevant, but should they diversify among capital projects?

A
  • Theoretically, diversification concerns can then be left to investors
  • Practically, investors are not necessarily well-diversified and the CAPM is not exact, management should also concentrate on project risk to eliminate risk
47
Q

Methods for incorporating Risk-Adjustment

A

Certainty equivalent approach
Cash flows are adjusted (downward) to reflect uncertainty

Risk-adjusted discount rate approach
The firm’s total cost of capital is adjusted (upward or downward) to reflect individual project risk

-> Analysts must not mix these two approaches to avoid double-counting

48
Q

Risk analysis techniques

A
  • Sensitivity Analysis
  • Scenario Analysis
  • Monte Carlo Simulation
49
Q

Risk analysis techniques - Sensitivity Analysis

A

Altering or changing an independent input variable and monitoring the changes of the depending output (e.g. NPV) -> Start with the base scenario

50
Q

Risk analysis techniques - Scenario Analysis

A
  • Possible scenarios (e.g. worst, base and best case) have to be created and probabilities assigned
  • Then, the dependent variables expected value (E(NPV)), the standard deviation (sigmaNPV) and the coefficient of variation (CVNPV = sigmaNPV / E(NPV)) can be estimated
51
Q

Risk analysis techniques - Monte Carlo Simulation

A
  • Probability distributions of input variables have to be defined
  • Via random values of input output is computed
  • The procedure has to be repeated at least 1.000 times
  • From the set of outputs a distribution function can be derived
52
Q

Measuring Beta (Risk-adjusted Approach) - Approaches

A
  • Pure Play Beta
  • Accounting Beta
53
Q

Pure Play Beta

A
  • Comparable companies with single product lines similar to the evaluated project
  • The average beta is used for estimation of the project’s beta
54
Q

Accounting Beta

A

A regression of the company’s returns on assets against the S&P return on assets.

The slope coefficient is called accounting beta and is a wiedely used estimation of the project’s cost of capital.

55
Q

Capital Structure
(Target/Optimal)

A
  • The optimal capital structure is the balance between the use of debt and equity that maximizes equity value
  • The use of debt increases the risk (and return) borne by shareholders, an increasing or depressing effect on value may occur
  • Target capital structure (debt-to-equity ratio) is maintained by issuing new debt or equity, or retaining earnings
56
Q

Influencing Factors on Capital Structure (4)

A
  • Business Risk
  • Tax Exposure
  • Financial Flexibility
  • Conservatism/Aggressiveness of Management
57
Q

Influencing Factors on Capital Structure - Business Risk

A

The greater the firm’s inherent operational risk, the lower its optimal debt ratio

58
Q

Influencing Factors on Capital Structure - Tax Exposure

A

The higher the effective tax rate the more advantageous debt becomes

59
Q

Influencing Factors on Capital Structure - Financial Flexibility

A

The firm’s ability to raise funds at reasonable terms

60
Q

Influencing Factors on Capital Structure - Conservatism/Aggressiveness of Management

A

Lower or extensive use of debt to boost profits

61
Q

Business Risk/Operational Risk

A
  • Business risk is the most important consideration when determining the capital structure
  • It is defined as the uncertainty inherent to the firm’s return on assets
62
Q

Influencing Factors on Operational Risk (4)

A
  • Demand (unit sales) variability
  • Sales (output) and input price variability
  • Ability to adjust output prices as input prices change
  • Operating leverage, i.e. extent to which changes in sales will cause changes in operating income
63
Q

Common Financial Ratios to Capture Operational Risk

A
  • Breakeven sales quantity, where sales equal operating costs
  • Degree of operating leverage (DOL) is the percentage of fixed costs
    -> (Sales - Variable Costs)/(Sales - Variable Costs - Fixed Costs)
    -> That implies that small changes in sales will cause large changes in operating income
64
Q

Financial Risk

A

Refers to the additional risk common stakeholders bear if the firm increases the use of fixed income financing (debt and preferred stocks)

  • As a firm’s leverage increases earnings per share (EPS) become more sensitive to changes in sale
65
Q

Common Ratio to capture Financial Risk

A

Degree of financial leverage (DFL)

  • It measures the percentage change in earnings per share given change in EBIT
66
Q

Degree of Total Leverage (DTL)

A

Operating (first stage) and financial (second stage) leverage result in the degree of total leverage (DTL), which measures to which extent a change in sales will effect EPS

DTL = DOL x DFL

67
Q

Capital Structure Theory (Modigliani/Miller I)

A

Under restrictive assumptions the value of a firm (i.e. debt plus preferred shares plus common shares) is unaffected by its capital structure and the firm’s WACC is constant

68
Q

MM I - Assumptions

A
  • No transaction and information costs
  • Taxes are nonexistent
  • There is not cost of bankruptcy
69
Q

Capital Structure Theory (Modigliani/Miller II)

A

The deductibility of tax expenses leads to an increasing value of the firm with increasing leverage

  • The optimal financing of the firm under this assumption would be 100% debt financing (“MM I” incl. taxes)
  • As debt increases the probability and the expected costs of bankruptcy increase exponentially
  • Modigliani/Miller II (MM II): Including major frictions on capital markets – taxes and cost of bankruptcy – the capital structure influences the firm’s value
70
Q

Dividend Policy

A
  • Dividend policy describes the firm’s decision process to distribute or reinvest earnings
  • Dividend policy should maximize shareholder value
71
Q

Dividend Policy - Dividend Irrelevance Theory

A

MM I argues that in a world with no taxes and no brokerage cost, payout or retention have no effect on share price

72
Q

Dividend Policy - Bird-in-the-hand Theory

A

Future capital gains from reinvested earnings are less certain than current dividend payments, therefore CEQ decreases as dividend payout increases

73
Q

Dividend Policy - Tax Preference Theory

A

Tax preference theory argues, that investors might prefer firms offering low payout

  • Capital gains are taxed at a lower rate
  • Retention allows to accumulate in a tax free environment
74
Q

Dividend Policy - Clientele Effect

A

Clientele Effect says high-tax bracket and low-tax bracket investors will select companies with the dividend policies that meet their needs -> The firms dividend policy does not matter

75
Q

Three Key Issues of Distribution (3)

A
  • Percentage of Earnings to be distributed
  • Growth rate of dividends
  • Form of dividends (cash or share repurchase)
76
Q

Three Key Issues of Distribution - Percentage of earnings to be distributed

A

The Residual Dividend Model (RDM) is used to set the target dividend payout ratio

  • Step 1: Identify the optimal capital budget
  • Step 2: Determine the amount of equity needed to finance budget for a given capital structure
  • Step 3: Meet requirements to the maximum extent with retained earnings
  • Step 4: Pay dividends with the residual earnings
77
Q

Three Key Issues of Distribution - Growth rate of dividends

A
  • Profits and cash flow change over time -> Dividends should vary
  • Due to signaling corporate officials aim at stable dividend policy increasing at a reasonable steady growth rate
    -> German firms show a higher level of “discreteness” compared to Anglo-American “smoothness”
    -> Cyclical industries follow a “low regular dividend plus extra” policy
78
Q

Three Key Issues of Distribution - Form of dividends: Stock Repurchase

A
  • Alternative way to pay dividends
  • Statement by management that their shares are undervalued
  • Often used to pay the “extra” dividend
79
Q

Dividend Payment Procedure

A
  • Declaration date: Board of directors approves the payment
  • Ex-dividend date: Cut-off date for receiving the dividend
  • Four business days later the holder of record date designates the shareholder
  • Date of payment

Financial Analysis (5 decks)

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