Book 3: Corporate Finance Flashcards
What are the principles of capital budgeting?
1) Decisions based on CFs, not accounting income. Consider the incremental after-tax cash flows.
Sunk costs are not considered.
Externalities are considered (affect on existing products; eg cannibalization of sales of an existing product). A positive externality is when a project would have a positive effect on existing sales.
2) CFs are based on opportunity costs. Eg if developing land, include the cost of that land to consider what could have realised through eg sale.
3) Timing matters. Have to account for TVM.
4) CFs are analysed after-tax.
5) Financing costs are reflected in project’s required RoR. This means that financing costs are NOT subtracted from cash flows in an NPV or IRR analysis.
What depreciation method should be considered for capital budgeting purposes?
The method used for tax purposes (generally MACRS in the US). This is because we are concerned about incremental after-tax CFs in capital budgting.
The depreciable basis is equal to the purchase price plus any shipping or handling and installation costs. The basis is not adjusted for salvage value (regardless of whether accelerated or straight-line method is used).
What three ways can incremental CFs for capital projects be classified?
1) Initial investment outlay
outlay = FCInv + NWCInv
FCInv (up-front costs) = price (including shipping or handling and installation costs)
NWCInv (net working capital investment) = change in non-cash current assets - change in non-debt current liabilities
2) After-tax operating CF over project’s life
CF = (S - C - D)*(1 - T) + D; or
CF = (S - C)(1 - T) + (TD)
S = Sales C = Cash operating costs (eg variable costs and fixed overhead) D = Depreciation T = marginal tax rate
Note (S - C - D) = EBIT
Note, depreciation tax savings is calutated as tax rate * depreciation. (no T - 1).
Note, sometimes you’ll only receive a cost savings, in which case it’s a negative cost, so do the calculation as 0 (sales) - (-cost)…
3) Terminal-year after-tax non-operating CFs. Combination of after-tax salvage value and return of net investment in working capital.
TNOCF = Sal(t) + NWCInv - T*(Sal(t) - B(t))
Sal(t) = pre-tax cash proceeds from sale of fixed capital (salvage value) on termination date
B(t) = Book value of fixed capital sold on termination date
NWCInv: note if originally project had reduced need for NWC, would have to subtract this amount out in the TNOCF calculation.
How to compute initial investment outlay for capital projects?
1) Initial investment outlay
outlay = FCInv + NWCInv
FCInv (up-front costs) = price (including shipping or handling and installation costs)
NWCInv (net working capital investment) = change in non-cash current assets - change in non-debt current liabilities
If NWCInv is positive, additional financing is required and represents a cash outflow, b/c cash must be used to fund the net investment in current assets.
How to compute after-tax operating CF over project’s life for capital projects?
2) After-tax operating CF over project’s life
CF = (S - C - D)*(1 - T) + D; or
CF = (S - C)(1 - T) + (TD)
S = Sales C = Cash operating costs (eg variable costs and fixed overhead) D = Depreciation T = marginal tax rate
Note (S - C - D) = EBIT
Accelerated depreciation creates higher after-tax CFs for project earlier in project’s life, resulting in a higher NPV.
How to compute terminal-year after-tax non-operating CFs for capital projects?
3) Terminal-year after-tax non-operating CFs. Combination of after-tax salvage value and return of net investment in working capital.
TNOCF = Sal(t) + NWCInv - T*(Sal(t) - B(t))
Sal(t) = pre-tax cash proceeds from sale of fixed capital (salvage value) on termination date
B(t) = Book value of fixed capital sold on termination date T = marginal tax rate
If initial investment in NWC is positive (use of cash resulting in a cash outflow), then terminal value effect will be a cash inflow. Had investment in NWC been negative (project freed up working capital), the terminal value effect would be a cash outflow.
What are the two key differences for analysing a replacement project (vs. an expansion project)?
1) Reflect the sale of the old asset in calculation of initial outlay:
outlay = FCInv + NWCInv - Sal(t) + T*(Sal(t) - B(t))
FCInv (up-front costs) = price (including shipping or handling and installation costs)
NWCInv (net working capital investment) = change in non-cash current assets - change in non-debt current liabilities
Sal(t) = pre-tax cash proceeds from sale of fixed capital (salvage value)
B(t) = Book value of fixed capital sold T = marginal tax rate
2) Calculate incremental operating CFs as CFs from new asset minus CFs from old asset:
Change in CF = (Change in S - Change in C)(1 - T) + Change in DT
S = Sales C = Cash operating costs (eg variable costs and fixed overhead) D = Depreciation T = marginal tax rate
When calculating depreciation, need to decrease the new asset’s depreciation expense by the depreciation that would have occurred with the old asset (opportunity costs).
Note that the INCREMENTAL CFs are what is important, so we are considering what the CFs will be compared to CFs with the current project.
How does inflation affect capital budgeting?
1) Nominal CFs reflect impact of inflation, but real CFs don’t include inflation effects (ie are adjusted downward). Either can be used, but must match with the appropriate discount rate (ie nominal with nominal discount rate).
(1 + nominal rate) = (1 + real rate)*(1 + inflation rate)
2) Inflation affects project profitability (higher than expected inflation makes future CFs worth less).
3) Inflation reduces tax savings from depreciation (higher than expected inflation effectively increases real taxes paid because deprecation shelter is less valuable)
4) Inflation decreases the value of payments to bondholders, effectively transferring wealth from bondholders to issuing firm
5) Inflation may affect revenues and costs differently.
What are the two approaches to evaluating mutually exclusive projects with different lives?
With mutually exclusive projects, may only choose one (but not both).
1) Lease common multiple of lives approach (replacement chain):
a) Find the LCM of years (eg a 3 year and 6 year project, 6 is the LCM).
b) Extend the NPV calculation for the projects up to the LCM (eg replace the 3 year project at the 3 year mark). Make sure to subtract cost of new asset from appropriate period (ie the last period right before it’s purchased, not the period in which it’s purchased!)
c) Now compare those NPVs
2) Equivalent annual annuity (EAA) approach (assumes continuous replacements can and will be made each time asset’s life ends).
a) Find each project’s NPV
b) Find an EAA that equates to project’s NPV over its individual life at the WACC
-PV = -NPV
-FV = 0
-N = number of years
-I = WACC
Solve for PMT
PMT is the EAA.
c) Select the project with the highest EAA. (this trumps the higher NPV project because it’s mutually exclusive with unequal lives)
What is the goal of capital rationing?
Maximize the overall NPV within the capital budget. That doesn’t necessarily mean selecting the individual projects with the highest NPV.
Hard capital rationing: funds allocated to managers cannot be increased.
Soft capital rationing: managers are allowed to increase their allocated capital budget if they can justify that additional funds will create shareholder value.
What’s the difference between a sensitivity analysis, scenario analysis, and a simulation analysis (all stand-alone risk analysis methods)?
Sensitivity analysis: Change one input (independent) variable to see effect on output (dependent) variable (eg NPV).
Scenario analysis: Consider sensitivity of an output variable (eg NPV) to an input variable, and the likely probability distribution of the input variables. Allows for changes in multiple input variables at once.
Simulation analysis (Monte Carlo simulation): results in probability distributions of NPV outcomes, rather than just a limited number of outcomes as with other analyses. This can be useful for estimating a project’s stand-alone risk, and is capable of using probability distributions for variables as input data.
What’s the difference between systematic and unsystematic risk?
Unsystematic risk: Risk that can be eliminated through diversification. AKA unique, diversifiable, or firm-specific risk. Unsystematic risk is not compensated for in equilibrium because we assume it can be diversified away for free. Equilibrium security returns depend on a portfolio’s systematic risk (beta), NOT its total risk.
Systematic risk: Risk that cannot be diversified away. AKA nondiversifiable, or market risk. Equilibrium security returns depend on a portfolio’s systematic risk, NOT its total risk. Assumes diversification is free. Beta is a systematic risk measure, which is appropriate for measuring risk when a company is diversified.
A positive beta indicates return of asset follows same direction as market. Lower beta = less market risk. Market beta is 1, RF beta is 0.
Total risk = systematic risk + unsystematic risk
How to use the security market line (CAPM) to estimate the discount rate for a project?
R_project = Rf + B_project * [E(Rmkt) - Rf]
The required RoR for a project using CAPM (or the security market line (SML)) is the RFR (Rf) plus a beta-adjusted market risk premium, Ba[E(Rmkt) - Rf]. E(Rmkt) is the expected market return.
SML = graphical representation of CAPM, and expresses RoR as a function of beta. CAPM shows relationship between beta and expected return. Uses beta on the x-axis, and therefore is a measure of SYSTEMATIC (non-diversifiable) risk. In CAPM, all properly priced portfolios will plot on the SML. If expected return is greater than required (CAPM) return, a stock is above the SML.
Beta is a systematic risk measure.
What are real options?
Real options allow managers to make future decisions based on real assets that change value of capital budgeting decisions today.
Timing options: allow delaying making an investment.
Abandonment options: similar to puts; allow to abandon project if PV of CFs from exiting exceeds PV of CFs from continuing.
Expansion options: similar to calls, allow company to make additional investments.
Flexibility options: choices regarding operational aspects of a projects (price-setting allows company to change price of a product; production-flexibility might include paying workers overtime or using different materials).
Fundamental options: projects that are options themselves, ie ability to open mine when metal prices are high and close when low.
To evaluate real options, can:
- Determine NPV of project w/o option: real options always add value, so if NPV is positive, then option only makes it more valuable and don’t have to futher calculate
- Add estimated real option value to NPV
- Use decision trees
- Use option pricing models
Should IRR or NPV be used when evaluating projects?
NPV is the only acceptable criterion when ranking multiple projects (and deciding between mutually exclusive projects). This is because IRR can be misleading due to 1) cash flow timing; 2) project size; 3) assumption of how project cash flows are reinvested. Also, NPV uses the most realistic discount rate (the opportunity cost of funds). In an unconventional CF pattern there can be multiple or no IRR(s).
NPV does however have the disadvantage of not considering the size of the project compared to the expected increase in value. NPV theoretically should increase stock price proportionate to the increase in firm value expected.
Weighted Average Cost of Capital (aka marginal cost of capital)
WACC = (Wd)(Kd(1 - tax rate)) + (Wps)(Kps) + (Wce)(Kce)
The weighted cost of debt (after tax, using interest rate on new debt) + weighted cost of preferred stock + weighted cost of common stock (equity).
Weighting should be based off target capital structure. Weighting should futhermore be based on MARKET weight. WACC should be used as discount rate in NPV calculations, and reference rate for IRR consideration. Kd = YTM. Financing costs are reflected in the WACC.
What’s the difference between economic and accounting income?
Economic income is the after-tax CF plus changes in the investment’s market value.
economic income = after-tax CF + (ending market value - beginning market value)
To calculate economic income, first:
1) determine after-tax CF per year:
(S - C - D)*(1 - T) + D; or
(S - C)(1 - T) + (TD)
2) Determine market values by adding after-tax CFs and discounting. Market value for time 0 is all CFs discounted, for time 1 is the CFs for the next following years until completion discounted, etc…
Accounting income is reported in net income of a company’s FSs. Accounting income differs because accounting depreciation is based on the original cost (not market value) of the investment; and financing costs are subtracted out to arrive at net income (whereas in capital budgeting financing costs are reflected in the WACC).
What is economic profit?
Economic profit is measure of profit in excess of dollar cost of capital invested in a project.
EP = NOPAT - $WACC
NOPAT = net operating profit after tax = EBIT*(1 - tax rate)
$WACC = dollar cost of capital = WACC * capital
capital = dollar amount of investment (ie gross assets) (reduced by depreciation each year)
The NPV based on EP is called the market value added (MVA):
NPV = MVA = sum of [EP / (1 + WACC)^t]
ie do an NPV calculation using the EP each year as the input and discount at the WACC (b/c the EP approach considers returns to all suppliers of capital).
What is residual income?
Residual income focusses on returns on equity and is determined by subtracting an equity charge from accounting net income.
RI = net income - equity charge; or
RI = NI - re*B
re = required return on equity B = beginning of period book value of equity (ie assets - liabilities at start of period)
Discounting the residual income at the required RoR on equity will give the NPV of the investment.
In other words, can calculate NPV using the residual income as the input and the required RoR on equity as the discount rate.
What is the claims valuation approach?
The claims valuation approach divides operating CFs into debt and equity CFs that are valued separately then added together. It calculates only the value of a company, not a project (unlike the economic profit and residual income approaches that do both).
CFs to debtholders: interest and principal payments discounted at cost of debt
CFs to equityholders: dividends and share repurchases discounted at the cost of equity
Sum of PV of each stream equals value of company.
So, eg “the value of equity” is the PV of CFs for dividends/repurchases.
CFs to equityholders should be calculated by taking:
Net income (already accounts for interest expense) \+ depreciation = operating CF less: principal payments to debtholders = dividends
What to do when you have different probabilities of CFs in an NPV analysis?
A) Multiply each CF by its probability and add it together, then use that as the input for your calculation.
or
B) Get NPV of each scenario, then multiply each NPV from above by its probability and add that together. That is your NPV with the abandonment option.
Should always multiply the NPV by the probability!
How to do an NPV analysis with a real option, eg an abandonment option?
1) Do analysis in high CF probability scenario and low CF probability scenario separately (instead of like normal multiplying each CF by its probability and adding it together, then using that as the input for your calculation).
Usually the low CF scenario will take into account the abandonment option because the PV of future CFs won’t exceed what the abandonment would offer.
2) Multiply each NPV from above by its probability and add that together. That is your NPV with the abandonment option.
Payback period (discounted or undiscounted)
The number of years required to recover initial cash outlay for investment. Used as a measure for liquidity purposes; however is useless as measure of profitability.
Average accounting RoR
AAR = average net income / average book value
Profitability index
PI = PV of future cash flows / CF0 [initial cash outlay]
or
PI = 1 + (NPV / initial investment)
Closely related to NPV, and follows same decision rules. If PI > 1.0 accept project.
PI may be used to assist in capital rationing decision.
What is the market value added (MVA)?
MVA is the present value of EP.
The NPV based on EP is called the market value added (MVA):
NPV = MVA = sum of [EP / (1 + WACC)^t]
ie do an NPV calculation using the EP each year as the input and discount at the WACC (b/c the EP approach considers returns to all suppliers of capital).
What happens with the initial outlay of a capital project changes?
The NPV is affected by both the change in the initial outlay and the change in the depreciation tax shelter.
1) Determine tax savings as depreciation expense * tax rate.
2) Compute NPV of change in initial outlay and inputs of change in depreciation savings as cash flows. The result is how much the project NPV should change.
What did MM 1958 propose?
MM 1958 (no taxes, no costs of financial distress) proved that the value of a firm is unaffected by its capital structure. It’s like slicing a pizza pie (MM Proposition I).
IE, value of a company with leverage is equal to the value of a company without leverage (if it wasn’t, arbitrage would force it to be). ie, value of a company is determined by its CFs, not its capital structure.
MM Proposition II: the cost of equity increases linearly as company increases its proportion of debt financing. As companies increase their use of debt, the risk to equityholders increases, which increases the cost of equity. So, the benefits of debt as a source of cheaper financing (because debtholders have priority claim on assets and income) are offset, and there is no change to the WACC. The WACC remains constant regardless of structure.
required RoR on equity = unlevered cost of capital + debt/equity * (unlevered cost of capital - cost of debt)
What did MM 1963 propose?
MM 1963 (with taxes, no costs of financial distress) recognises the tax shield debt provides in most countries. The value of a levered firm is equal to the value of an unlevered firm plus the tax shield.
Vl = Vu + (tax rate * debt in capital structure)
Under this, the optimal capital structure is 100% debt.
Second proposition: WACC is minimised at 100% debt.
required RoR on equity = unlevered cost of capital + debt/equity * (unlevered cost of capital - cost of debt) * (1 - tax rate)
What are costs of financial distress?
The increased costs a company faces when earnings decline and firm has trouble paying its fixed financing costs (ie debt interest).
Expected costs of financial distress include:
1) Costs of financial distress and bankruptcy (direct and indirect)
2) Probability of financial distress (related to leverage)
Higher costs of financial distress tend to discourage companies from using large amounts of debt (leverage) in their capital structure). (free cash flow hypothesis: more debt = less freedom to take on debt or spend cash unwisely).
What are agency costs of equity?
Agency costs of equity are the costs associated with conflicts of interest between managers and owners. Include:
1) Monitoring costs: to supervise management, and pay board of directors, uphold corporate governance
2) Bonding costs: assumed by management to ensure they are working in shareholder’s best interests, eg insurance to guarantee performance; non-compete agreements
3) Residual losses: may occur even with adequate governance because there are no perfect guarantees
Agency theory states that debt forces managers to be more disciplined with how they spend cash. So, increased leverage tends to reduce agency costs.
What are costs of asymmetric information?
Costs resulting from managers having more info about a company’s prospects than owners/creditors.
Costs of asymmetric information increase as the proportion of equity in the capital structure increases.
What is the pecking order theory?
Theory that, based on asymmetric information, managers prefer to make financing choices that are least likely to send signals to investors. The order, from most to least favoured, is:
1) internally generated equity (retained earnings)
2) debt
3) external equity
Pecking order theory predicts that capital structure is a by-product of the individual financing decisions.
What is the static trade-off theory?
Static trade-off theory attempts to consider costs of financial distress and the tax shield from using debt.
Optimal capital structure is the point where the marginal benefit provided by tax shield for taking on more debt is equal to marginal costs of financial distress incurred from the additional debt.
This minimises the WACC and maximises the value of the firm.
Vl = Vu + (tax rate * debt in capital structure) - PV(costs of financial distress)
What are the implications on management decision making for each capital structure theory?
MM 1958 (no tax) implies that any decisions on capital structure are irrelevant.
MM 1963 (with tax) implies that WACC is minimised and value of firm maximised at 100% debt.
Static trade-off theory implies that tax shield of debt reaches point where increasing cost of financial distress makes more debt nonadvantageous, and that point is the optimal capital structure.
What is the target capital structure?
The structure that the firm uses over time when making decisions on how to raise additional capital.
It may fluctuate because:
-management may choose to exploit opportunities in a specific financing source (eg issue more equity when share price is high)
-market value fluctuations may occur
How do debt ratings affect capital policy?
Managers have goals for maintaining certain minimum debt ratings when determining their capital structure policies.
How do international differences impact capital structure decisions?
Institutional and legal factors:
1) Strength of legal system: strong legal system results in less debt (less agency costs for equity) and longer maturity debt
2) Information asymmetry: high info asymmetry encourages using more debt
3) Taxes: more favourable rates influence choice
Financial markets and banking system factors:
4) Liquidity of capital markets: more liquid capital markets tend to use longer maturity debt
5) Reliance on banking system: more reliance on banking system than corporate bond markets results in the use of more debt
6) Institutional investors: more institutional investors tend to lower total use of debt and increase the maturity of debt
Macroeconomic factors:
7) Inflation: higher inflation reduces use of debt and maturity of debt, because it reduces future value of fixed interest payments
8) GDP growth: higher GDP growth tends to lower total use of debt and increase the maturity of debt
