B3: Financial Management Flashcards
Capital Budgeting
process for evaluating and selecting the LT investment projects of the firm
Cash Flow Effects
Cash Flows Related to Capital Budgeting
Direct Effect
- when a comp pays out cash, receives cash, or makes a cash commitment directly related to the capital investment
- has immediate effect on amt of cash available
Indirect Effect
- indirectly associated w a capital project, produces cash benefits or obligations
- net proceeds on sale of old reduces cost of new
- e.g. depreciation * tax rate = dollars saving
Net Effect
- total of direct and indirect effects
Stages of Cash Flows
Cash Flows Related to Capital Budgeting
cash flows exist through the life cycle of a capital investment project, there are 3 stages
- Inception of the Project
- today’s cost = initial outflow
- both direct and indirect cash flow effects occur at the time of the initial investment
- initial cash outlay is often the largest amt of cash outflow in the investment’s life
a) working capital: net CA, current assets - current liabs
- additional working capital: “buy” WC, cash outflow
- reduced working capital: “sell” WC, cash inflow
b) disposal of replaced asset
- book value is a sunk cost
- but gain or loss, net of tax, is inflow or outflow
- selling price is inflow - Operations
- future annual OCF = inflow
- pretax CF * (1-T)
- plus, depreciation tax shields: (depr. * T)
3. Disposal of the Project SP = inflow \+ decrease in WC = inflow - gain * T = outflow \+ loss * T = inflow = net inflow
- final year has 2 inflows:
1. last OCF
2. terminal year cash flow (step 3) TYCF
Calculation of Pretax and After-Tax Cash Flows
Cash Flows Related to Capital Budgeting
Pretax Cash Flows
- investment’s value is often based on PV of future cash flows
After-Tax Cash Flows
- pretax CF * (1-T) + (depr. * T) = annual OCF **
B3-5
Objective and Components of Disc. CF as used in Capital Budgeting
Discounted Cash Flows
DCF to focus the attention of mgmt on relevant cash flows appropriately discounted to present value
Rate of Return Desired for the project
- compensation for all risk assumed
- aka hurdle rate or discount rate
- mgmt may use a weighted avg cost of capital (WACC) method
- mgmt may assign a target for projects to meet
- mgmt may recommend the disc. rate be related to the risk specific to the project
Limitation of DCF
- they freq. use a simple constant growth (single interest rate) assumption
- this assumption is unrealistic bc actual interest rates may fluctuate
- NPV allows r to change, but IRR doesn’t
Net Present Value Method (NPV)*
Discounted Cash Flows
Objective
- used to screen capital projects for implementation
- focus decision makers on initial investment amt required to purchase a capital asset that will yield returns in excess of a mgmt-designated hurdle rate
- dollar amt of return, rather than % of years like others
Calculation of NPV
a) Estimate Cash Flows: 1. initial outflow 2. annual OCF 3. final year’s CF
- ignore depreciation, UNLESS tax shield
- use of accelerated depr. increases the PV of depr. tax shield
- ignore method of funding
- NPV uses hurdle rate to discount cash flows (WACC)
b) Discount the Cash Flows
- discount all CFs to PV using hurdle rate
- NPV method assumes CFs are reinvested at same rate used in analysis
- IRR assumes CFs reinvested at IRR
pass key summary B3-8
Interpreting the NPV Method**
Net Present Value Method (NPV)
Positive Result = Make Investment
- IRR > hurdle rate
- sum of PVFCF > cost, value added
Negative Result = Do Not Make Investment
- IRR < hurdle rate
- sum of PVFCF < cost, value down
Interest Rates Adjustments for Required Return
Net Present Value Method (NPV)
NPV analysis may incorporate many types of hurdle rates
- major advantage over IRR
Adjustments to Rate
- risk ^: rate ^, PVFCF v (disc. rates increased to factor differences in risk)
- inflation: rate ^ (loss of purchasing power, risk ^)
Differing Rates
- NPV considered superior to IRR bc flexible enough to handle uneven cash flows or inconsistent rates of return
Discount Rate Applied to Qualitatively Desirable or Non-optional Investments
- B3-9
Advantages and Limitations of NPV
Net Present Value Method (NPV)
Advantages
- flexible
- no constant rate of return required each year
Limitations
- does not provide true rate of return
- purely indicates whether an investment will earn the hurdle rate used in NPV calculation
Capital Rationing
Net Present Value Method (NPV)
describes how limited investment resources are considered as part of investment ranking and decisions
Unlimited Capital
- pursue all investments w positive NPV
Limited Capital
- makes investment choices mutually exclusive
- managers allocate capital to combo of projects w max NPV
- ranking is best accomplished using profitability index
Profitability Index
Net Present Value Method (NPV)
= PVFCF / cost
- aka excess PV index or PV index
- if PI > 1, means positive NPV thus profit
- measures CF return per dollar invested; the higher the PI, the more desirable
Internal Rate of Return
Discounted Cash Flows
single discount rate that will set the PVFCF = today’s cost
- yield 0 NPV
- aka time-adjusted rate of return
Interpreting
- accept when IRR > hurdle rate
- reject when IRR < hurdle rate
Limitations
- CFs assumed to be reinvested at IRR, but if rates are wrong then inappropriate
- less reliable when alternating periods of cash inflows and outflows, it needs 1 outflow then only inflows after
- does not tell in dollars value added like NPV, just gives you a % rate of return
Payback Period Method
Discounted Cash Flows
time required for net after-tax cash inflows to recover the initial investment in a project
- focuses decision makers on liquidity and risk
- liquidity: time it will take to recover initial investment
- risk: longer time, greater risk
Calculation*
- payback period = net initial investment / increase in annual net after-tax cash flow
- lower payback period, less risk
- assumes annual annuity
CF Assumptions
- Uniform Cash Inflows: net cash inflows assumed to be constant each period, using after-tax cash flows. CFs involve following factors
- project evaluation
- asset evaluation
- depreciation tax shield - Non-uniform Cash Flows: use cumulative approach
Advantages and Limitations
- limitation: time value of money is ignored
- B3-17
Discounted Payback Method
Discounted Cash Flows
computes payback period using expected CFs that are discounted
- aka breakeven time method (BET)
Objective
- evaluate how quickly new ideas are converted into profitable ideas
1. Focus on Liquidity and Some Profit - up to when the investment is recovered
2. Evaluation Term - begins when project team is formed and ends when initial investment has been recovered
3. Common Projects Using Discounted Payback - new product development projects of comps that experience rapid technological changes
- they want to recoup their investment quickly before their products become obsolete
Advantages and Limitations
- same as payback method, except discount payback incorporates time value of money
- both focus on how quickly investment is recouped rather than overall profitability of the entire project
Leverage
use of fixed costs to amplify risk assumed and potential return
- sig. consideration as a factor in designing capital structure
- must consider both operating and financial leverage
- whether DOL or DFL, always put the larger % in the numerator bc must be greater than or equal to 1
Operating Leverage
Leverage
degree to which a company uses fixed operating costs rather than variable operating costs
- capital intensive industries have high operating leverage
- labor intensive industries have low operating leverage
Implications
- comp w high operating leverage must produce sufficient sales revenue to cover it’s high fixed-operating costs
- comps w high operating leverage will have greater risk but greater possible returns
- beyond the breakeven point, a comp w higher fixed costs will retain a higher % of add. revenues as operating income
Degree of Operating Leverage (DOL)
= % change in EBIT / % change in sales
- higher DOL, higher risk higher return
- vice versa for lower
% change in operating income = % change in sales * DOL
- if DOL goes up, so does operating income
Financial Leverage
Leverage
the degree to which a comp uses debt rather than equity to finance the company
- debt results in fixed interest costs
- equity do not increases fixed costs bc dividend payments are not required
DFL = % change in EPS / % change in EBIT DTL = DOL * DFL or % change in EPS / % change in sales
Implications
- a comp that issues debt must produce sufficient EBIT to cover its fixed interest costs
- once fixed interest costs are covered, add. EBIT will go straight to net income and EPS
- a higher degree of financial leverage implies a small change in EBIT will have a greater effect on profits and shareholder value
- companies that are highly leveraged may be at risk of bankruptcy if unable to make payments on debt
Weighted Average Cost of Capital
major link b/w long-term investment decisions associated w a corp’s capital structure and the wealth of a corp’s owners
- average cost of all forms of financing used by a comp
- WACC often used internally as a hurdle rate for capital investment decisions
- optimal capital structure is the mix of financing instruments that produces the lowest WACC
- value ^ if return on investment capital > WACC
Computing the WACC
Weighted Average Cost of Capital
WACC is average cost of debt and equity
Formula
- determined by weighing the cost of each specific type of capital by its proportion to the firm’s total capital structure
- = cost of equity multiplied by the % of equity in the capital structure + weighted avg cost of debt multiplied by the % of debt in capital structure
- after tax cost of debt*
Individual Capital Components
- include both LT and ST elements of a firm’s permanent financing mix
- After-Tax Cash Flows: cost of debt computed on an after-tax basis bc interest expense is tax deductible
- YTM * (1-T) = after tax cost of debt (relevant!)
Optimal Capital Structure- Lowest WACC
- optimal cost of capital is ratio of debt to equity that produces the lowest WACC
Application to Capital Budgeting
- historic weighted avg cost of capital may not be appropriate for use as a discount rate for a new capital project unless it carries same risk as the corp and results in identical leveraging characteristics
Cost of Capital Components
cost of capital is the cost of borrowing (interest rates on debt) and the cost of equity (return required by investors in exchange for assumed risk)
