CFA 4_Corp Finance Flashcards
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.
Profitability index
PI = PV of future cash flows / CF0 [initial cash outlay]
Closely related to NPV, and follows same decision rules. If PI > 1.0 accept project.
Crossover rate
Discount rate that makes NPVs of multiple projects equal. To find it, take the difference of each CF of two projects, and then take the IRR of those. That IRR is the crossover rate.
NPV
PV of expected future cash flows. If NPV > 0 accept project.
NPV is the only acceptable criterion when ranking multiple 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.
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.
IRR
Discount rate that makes PV of expected cash inflows equal to initial cost of project (ie makes NPV = 0). If IRR > required rate of return, accept the project. IRR can be misleading due to 1) cash flow timing; 2) project size; 3) assumption of how project cash flows are reinvested. In an unconventional CF pattern there can be multiple or no IRR(s).
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) + weighted cost of preferred stock + weighted cost of common stock (equity). Weighting should be based off target capital structure. WACC should be used as discount rate in NPV calculations, and reference rate for IRR consideration. Kd = YTM
Determine weight of debt from D/E ratio
Wd = (D/E) / (1 + D/E)
Cost of preferred stock
Kps = preferred dividend [Dps] / market price of preferred share [P}* P = Dps / Kps
Capital Asset Pricing Model (CAPM) for determining cost of equity capital
Kce = RFR + B*(E(Rm) - RFR)
Where E(Rm) is the expected RoR on the market. E(Rm) - RFR is the equity risk premium.
Dividend discount model for determining cost of equity capital
Kce = (D1/P0) + g
Where P0 is current price and D1 is next year’s dividend.g = (1 - payout rate [retention rate])*(ROE)
Bond yield plus risk premium approach for determining cost of equity capital
Kce = bond yield + risk premium
Calculating project beta (pure-play method)
Basset = Bequity * [1 / (1 + ((1 - t) * d/e)]
This is a comparable company’s D/E ratio and tax rate. Unlevers.
Bproject = Basset * [1 + ((1 - t) * d/e)]
This is the subject’s D/E ratio and tax rate. Re-levers.
CAPM adjusted for country risk premium
Kce = RFR + B*(E(Rm) - RFR + CRP)
Only difference from normal CAPM is “+ CRP” (country risk premium)
CRP = SYS * (annualized SD of equity index of developing country / annualized SD of sovereign bond market in terms of USD market)
Sovereign Yield Spread = difference b/w yield of govt bonds in developing country and similar Treasury bonds
Calculation of break points (point when a component of a company’s WACC changes)
break point = amount of capital at which component’s cost of capital changes / weight of that component
How flotation costs affect capital decisions
Flotation costs should be treated as an initial cash outflow that affects the NPV calculation.They should NOT directly adjust the cost of equity, because they are not an ongoing expense for the firm.
Degree of operating leverage (DOL)
DOL = % change in EBIT / % change in sales
DOL is higher at lower levels of sales, and declines at higher levels of sales.
Degree of operating leverage (DOL) for particular level of unit sales
DOL = (Q * (Price - Variable cost p unit)) / (Q * (Price - Variable cost p unit) - Fixed costs)
ie: DOL = Q * Contribution margin / Q * Contribution margin - FC
nb if you subtract Interest from denominator above it calculated for DTL
which becomes
DTL = (Revenue - TVC) / (Revenue - TVC - FC)*nb: DTL = (Rev - TVC) / (Rev - TVC - FC - I)
Degree of financial leverage (DFL)
DFL = % change in EPS [or net income] / % change in EBIT
Degree of financial leverage (DFL) for particular level of operating earnings
DFL = EBIT / (EBIT - interest)
Degree of total leverage (DTL)
DTL = DOL * DFL
DTL = % change in EPS [net income] / % change in sales
DTL = (Q * (P - VC)) / (Q * (P - VC) - FC - I)DTL = (Rev - TVC) / (Rev - TVC - FC - I)
Breakeven quantity of sales
Level of sales a firm must generate to cover all of its fixed and variable costs.
Qbe = (fixed operating costs + fixed financing costs) / contribution margin
contribution margin = price - variable cost per unit
OPERATING breakeven quantity of sales = fixed operating costs / contribution margin
Operating doesn’t include fixed financing costs.
Operating breakeven quantity of sales
fixed operating costs / contribution margin
NB: doesn’t include fixed financing costs.
Components of business risk
Sales risk: uncertainty about firm’s sales
Operating risk: uncertainty about EBIT caused by fixed operating costs
Effect of dividend payment on firm
Reduces assets (cash) and equity (retained earnings). Result is increased debt/asset ratio and increased debt/equity ratio.
