Corporate Finance Flashcards
What is NPV
The net benefit or loss of benefit in present value terms from an investment opportunity.
Positive NPV = Accept project
Negative NPV = Reject Project
Advantages of NPV
Advantages: Considers time value of money, considers cashflows, it considers the whole life of a project
Disadvantages of NPV
Disadvantages: Relatively complex to calculate, not well understood by non-financial managers, it may be difficult to determine the cost of capital.
What is Internal Rate of Return (IRR)
The rate of return (discount factor) at which the project has an NPV of zero. To calculate IRR you first need to have calculated 2 NPVs Using 2 Discount rates.
Formula for IRR
IRR= Ldf + (Hdf - Ldf) x (NPVLdf / (NPVLdf - NPVHdf))
when to accept IRR
If the IRR is greater than the cost of capital the project should be accepted
Advantages of IRR
Advantages: Considers the time value of money, as a percentage return it is easily understood by non-financial managers, considers cashflows, considers the whole life of the project, can be calculated without reference to the cost of capital.
Disadvantages of IRR
Disadvantages: It is not a measure of absolute profitability ( it is a percentage return), fairly complicated to calculate, interpolation only provides an estimate of the true IRR, the IRR of projects may conflict with the NPV if so the NPV takes precedence.
What is The Payback Period?
This is the time which elapses until the invested capital is recovered. Unlike DCF techniques it is assumed that cashflows occur evenly throughout the year.
When to accept The Payback Period
Compare the payback period to the company’s maximum return time allowed and if the Payback is quicker the project should be accepted.
Formula for The Payback Period
Payback Period= Amount to be invested / estimated annual net cashflow
Advantages of Payback Period
Advantages: Simple to understand, a project period with a longer payback period is riskier than one with a short payback period, simple measure of risk, uses cashflows not subjective accounting profits, emphasises the cashflows from earlier years, firms selecting projects on the basis of payback periods may avoid liquidity problems.
Disadvantages of Payback period
Disadvantages: Ignores the time value of money, it is not an absolute measure (not a cash amount), does not take into account cashflows beyond the payback period.
What is the Accounting Rate of Return (ARR) ?
ARR = Average annual profit / Average investment x100
The ARR method also known as ROI or ROCE reflects the percentage rate of return expected on an investment or asset.
When to accept the ARR
The ARR for a project may be compared with the companies target return from an investment if it meets the target or exceeds it then accept.
Formula for ARR
ARR= (Average annual profit / Average value of investment ) x 100
Average annual profit = Net cashflow less depreciation (before tax) / No. of years
Average value of investment = Initial investment plus residual value / 2
Advantages of ARR
Advantages: Simple to understand, widely used and accepted, it can be obtained through readily available financial accounting data, it considers the whole life of the project.
Disadvantages of ARR
Disadvantages: Ignores the time value of money, not a measure of absolute profitability, measures profit not cashflows which includes depreciation and other accounting adjustments.
Working capital formula
Defined as: Current assets - current liabilities
Current assets = inventory, receivables and cash
Current liabilities = Payables
Working Capital
Treated at the start of the project.
Only the change in WC is treated as a cashflow.
WC does not qualify for tax relief - so is ignored in capital allowance calculations
At the end of project WC is ‘released’ this is treated as a cashflow at the end of the project.
NPV and Inflation
Consistency, Either:
Discount money (nominal) cashflows at the money discount rate ie. inflate the cashflow then discount the money (nominal) cost of capital.
Terminology: Money/nominal = inflation is adjusted for
OR
Discount real (current) cashflows at the real discount rate ie. do not inflate the cashflows (leave them expressed in real or current terms) and then discount at the real rate.
Terminology: Real/current = inflation is not adjusted for
Working Capital and Inflation Formula
To find the real rate of return : ( 1 + r ) = ( 1 + m ) / ( 1 + i )
Where : r = the real rate
m = the money rate (ie. the interest rate)
i = the inflation rate
This may be arranged as : ( 1 + m ) = (1 + i ) x ( 1 + r )
Proforma for IA Project evaluation
Time 0 1 2 3 4 5 6
Cash flows ($000)
Cost of equipment (xxx)
Residual Value xxx
Working capital (W2) (xxx) (xxx) (xxx) (xxxx) (xxxx) xxxxx
Operating CFs (+4%) 390 405.6 421.8 438.7 456.2
Tax on cash flows (128.7) (133.8) (139.2) (144.8) (150.5)
Tax relief on CAs (W1) 99.0 74.3 55.7 41.8 31.3
(1,300) 285 259.4 246.8 220. 1,223.0 (119.2)
16% DF 1 0.862 0.743 0.641 0.552 0.476 0.410
PV (1,300) 243.1 192.7 151.8 121.6 582.1 (48.9)
NPV = (57.6) $000
Return On Capital Employed (ROCE) %
ROCE = ( PBIT / Capital employed ) x 100
Capital employed = Debt + Equity
Return On Equity (ROE) %
ROE = ( PAT / Equity funds ) x 100
PAT = Earnings
Earnings Per Share (EPS) £
EPS = ( PAT - Preference shares ) / No. ordinary shares
No. of ordinary shares = value of equity / par value of that share
Dividends Per Share (DPS) £
DPS = ( Ordinary dividends / No. ordinary shares )
Dividend Cover
Dividend Cover = ( PAT / Ordinary dividends )
Dividend Yield %
Dividend Yield = ( Dividend / Share price at the beginning of the period ) x 100
Price Earnings per Share (P/E ratio)
P/E = Current share price / EPS
EPS = Earnings per share
Total Stakeholder Return (TSR)
TSR =
( Dividend + Change in share price ) / Share price at the beginning of the period x 100
Financial Gearing (Using Book values OR Market values)
Financial Gearing = Debt / ( Debt + Equity ) x 100
OR
Financial Gearing = Debt / Equity x 100
Book value = Figures from SoFP
Market values = Currently trading at
Interest Cover
Interest Cover = ( PBIT / Interest )
Liquidity Ratio (Current Ratio)
Current ratio ( Liquidity ratio ) = Current assets / Current liabilities
Quick ratio (Acid Test ratio)
Acid test ratio ( Quick ratio ) = ( Current assets - Inventory ) / Current liabilities
Capital allowances (tax depriciation)
Government allows companies to write-off the cost of their assets in order to reduce company tax. Capital allowance is allowed on the cost of plant and machinery at the rate of 25% on a reducing balance basis unless told otherwise.
Balancing Allowance (or Charge)
When the plant is eventually sold there may be a difference in the reducing balance amount and the selling price of the asset. ( Purchase price - final value )
Timing of tax saving associated with capital allowance
Corporation tax is often paid one year in arrears (after), therefore the benefit of tax saved from capital allowances is only received when the corporation tax should have been paid.
Proforma for IA dealing with Taxation
Year WDV Tax saved
yr 1 CA 25% XXX x Tax % = XXX
Balance XXX
Y2 2 CA 25% XXX x Tax % = XXX
Balance
Working Capital formula
Working Capital = Current assets - Current liabilities
Where:
Current assets = Inventory, receivables and cash
Current liabilities = Payables
Working Capital
Treated at the start of a project , any additional WC requirements are invested when required, only the change in WC is treated as a cashflow i.e incremental cashflow. WC does not qualify for tax relief - so ignored in the capital allowance calculations. WC ‘released’ and treated as a cashflow at the end of the project.
Inflation
If money is invested in an account it will earn interest. However inflation will have the effect of reducing the value of the return.
Note: Inflation reduced the value of future cash.
Inflation Rate of Return formula
( 1 + r ) = ( 1 + m ) / ( 1 + i )
Where :
r = the real rate
m = the money rate ( i.e the interest rate)
i = the inflation rate
This may be arranged as : ( 1 + m ) = ( 1 + i ) x ( 1 + r )
NPV and inflation
Be Consistent, Either :
1. Discount money ( nominal ) cashflows at the money discount rate i.e inflate the cashflow then discount st the money ( nominal ) cost of capital.
Terminology: Money/Nominal = inflation is adjusted for !
OR
2. Discount real ( Current ) cashflows at the real discount rate i.e do not inflate the cashflows ( leave them expressed in real or current terms ) and then discount at the real rate.
Terminology: Real/Current = inflation is not adjusted for !
