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Corporate Finance Flashcards

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1
Q

Capital Budgeting

5 assumptions of capital budgeting

A

Capital Budgeting Assumptions

  • Use cash flows not accounting income
  • Cash flow timing is critical
  • Opportunity cost should be charged against a project
  • Expected future cash flows should be measured on after-tax basis
  • Ignore how project is financed - So ignore interest payments, debt finance costs included in the cost of capital used to discount
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2
Q

Capital Budgeting

What are externalities?

What are the two types?

A

Externalities are the effects of a project on cash flows in other parts of the firm.

They can be either positive (new dept increases customers in existing depts) or negative (new brach cannibalizes some of the customers of existing branch).

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3
Q

Capital Budgeting

What are conventional and non-conventional cash flows?

A

Conventional cash flows means there is an initial outflow followed by a sequence of inflows over the life of the project.

Non-conventional is anything else, typically an initial outflow followed by inflows and outflows in the future.

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4
Q

Capital Budgeting

Profitability Index

Formula

Interpretation

A

PI = PV of future cash flows / initial investment

= 1 + (NPV / initial investment)

Index greater than 1.0 is acceptable, the higher the better. Lower than 1.0 is not acceptable.

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5
Q

Capital Budgeting

NPV vs IRR

For independent projects, how does decision differ between NPV and IRR methods?

A

Independent projects means the decision to go ahead with each is independent, i.e. could do one or the other or both.

IRR and NPV give the same result in this case since for a single project NPV > 0 means IRR > cost of capital.

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6
Q

Capital Budgeting

NPV vs IRR

Difference between NPV and IRR for mutually exclusive projects

A

Mutually exclusive projects means only one can be chosen, not both.

NPV and IRR can give different results since one project may have a higher rate of return but a lower NPV if it is smaller than the other project.

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7
Q

Capital Budgeting

NPV vs IRR

What is the condition for NPV and IRR to given the same result for mutually exclusive projects?

A

The cost of capital must be greater than the crossover rate (the rate at which NPV of the two projects is the same).

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8
Q

Cost of Capital

Should you use current or target capital weightings for WACC calc?

A

Use target weightings if they are given since these will be the long run weightings, otherwise assume the current weightings are the target.

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9
Q

Cost of Capital

Investment Opportunity Schedule

Definition

A

This is a list of potential projects ordered by IRR in order to decide which to undertake, given a limited available level of capital.

Note that the available level of capital may increase but with a higher marginal cost, i.e. after an initial amount of capital at WACC is exhausted by the most profitable projects, higher cost capital may become available which may still be cheap enough to fund the less attractive projects.

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10
Q

Cost of Capital

Cost of Equity

CAPM equation

What is equity risk premium?

A

re = RF + [E(RM) - RF]ßi

Where E(RM) is the expected rate of return on the market, therefored [E(RM) - RF] is the equity risk premium (ERP).

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11
Q

Cost of Capital

Cost of Equity

4 methods of estimating Equity Risk Premium (ERP)

A

ERP = E(RM) - RF

Historical ERP approach examines historical data, returns of a countrys market portfolio in the past.

Dividend discount model (or implied risk premium) uses Gordon growth model, re = (D1/P0) + g, where g is expected div growth rate.

Survey approach.

Bond yield + risk premium approach, uses the companies own bond yields plus a premium for equity risk.

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12
Q

Cost of Capital

Equity Beta

Formula for Levered Beta, ßL

How is it used?

A

ßL = ßU * (1 + [(1-T)*D]/E)

This is used to extract the unlevered beta (i.e. beta if the company was 100% equity) from the real (levered) beta.

It can then be applied to your company using your companies leverage, if other features of the company are similar.

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13
Q

Cost of Capital

Country Risk

What is the impact of this?

Methods of considering it

A

Equity beta alone doesn’t account for the additional risk for companies in developing countries. Need to add a country spread (or country equity premium) to the market risk premium in the CAPM model.

Can use the sovereign yield spread, difference between the countries US$ bond yield and US treasury yields.

Or multiply that sovereign yield spread by annualised σ of equity index / annualised σ of local US$ bond market to scale it up.

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14
Q

Cost of Capital

Flotation Costs

Why do they need to be taken into account?

How do you take them into account?

A

The costs of issuing new equity are significant (unlike debt) therefore the cost of equity needs to be increased to reflect this cost.

re = D1/(P0 - F) + g

Adjust the amount of equity raised (P0) by the flotation costs.

Might be more accurate to include this as a cash flow in the NPV rather than as a percentage adjustment, but this isn’t always possible.

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15
Q

Leverage

Business Risk Definition

Impact on optimal debt ratio

Two components

A

Business risk is the uncertainty/variability around projections of future operating earnings.

It is the most important determinant of capital structure. The lower a firms business risk, the higher its optimal debt ratio.

  • Sales risk is the uncertainty of the price and quantity of goods sold, depends on market demand
  • Operating risk uncertainty caused by the operating cost structure, higher if a high percentage of costs are fixed
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16
Q

Leverage

Degree of Operating Leverage

Formula

A

DOL = % change in EBIT / % change in sales

= Q(P-V) / [Q(P-V) - F]

= (S - VC) / (S - VC - F)

Note (P-V) is contribution per unit, (S-VC) is contribution margin.

Key

F = fixed operating cost

V is variable cost per unit

P is average price per unit

Q is quantity

S is revenue

VC is total variable cost.

17
Q

Leverage

Financial Leverage

The two factors financial risk depends on

A
  • Cash flow volatility
  • Financial leverage
18
Q

Leverage

Financial Leverage

Degree of Financial Leverage formula

Interpretation

A

DFL = % change in net income / % change in operating income

= EBIT / (EBIT - I)

Where I = interest paid

It shows how a percentage change in EBIT per share will affect EPS

19
Q

Leverage

Degree of Total Leverage

What is it?

Formula

A

Since operating leverage affects EBIT and financial leverage shows the effect on net income of changes in EBIT, total leverage puts them together to find impact on EPS of change in sales:

DTL = DOL * DFL

= Q(P-V) / [Q(P-V) - F - I]

= (S-VC) / (S-VC-F-I)

20
Q

Leverage

Breakeven Point

Formula

Formula for Operating breakeven point

A

QBE = (F + I) / (P - V)

This is the volume of sales at which total costs equal revenues, therefore net income is zero.

QOBE = F / (P - V)

This is the volume of sales at which revenues = operating costs.

21
Q

Dividends

DRIPs

Definition

Advantages & Disadvantages

A

DRIPs are dividend reinvestment plans, where the company reinvests dividends it pays out in additional shares in the shareholders name.

Advantages for the company are getting a stable base of long term shareholders, keeping capital inside the company and allowing the company to raise additional capital.

For shareholders they allow additional share purchases to be made without commission.

Downside is that tax must be paid on divs regardless of reinvestment, and shareholders need to keep detailed records of purchases to figure out their taxes.

22
Q

Dividends

Holder of Record Date

Definition

A

This is usually 2 days after the ex-div date. If the company lists the stockholder as an owner on this date they send the dividend to them.

The ex-div date determines who is actually entitled to the dividend and is determined by the exchange rather than the company itself.

23
Q

Dividends

Share Repurchase

Effect on shareholder wealth if shares repurchased at market price

Effect if repurchased at high price

A

If the shares are repurchased at market price there is no effect. A cash dividend reduces stock price and gives cash to shareholders. Repurchase reduces cash balance but also number of shares so share price should be unchanged.

If the shares are purchased at a high price the effect will be a transfer of wealth from general shareholders to the guys who sell for a high price.

24
Q

Dividends

Share Repurchase

Effect on EPS if share repurchase is funded by borrowed funds

A

This depends on the after tax cost of the borrowing.

If the after tax cost of borrowing is below E/P (inverse of PE ratio) then the % reduction in earnings due to additional interest cost is less than the % reduction in # shares, therefore EPS increases.

Obviously if the post tax interest cost is greater than E/P the opposite occurs, EPS will fall.

25
Q

Dividends

Share Repurchase

What is the effect of share repurchase on book value per share (BVPS)?

A

This depends on the existing BVPS compared to the stock price (price paid for the repurchase).

If the price paid is greater than the previous BVPS then cash will fall by a greater magnitude than the fall in # shares, so BVPS falls.

If BVPS > share price then the cash reduction is less significant than the fall in # shares so BVPS rises.

26
Q

Working Capital

Liquidity

Primary sources of liquidity

Secondary sources of liquidity

A

Primary sources are readily accesible at relatively low cost and include cash, short-term funds and cash flow management.

Secondary sources are more expensive and may impact the financial and operating positions of the company. Examples are debt contracts, liquidating assets, filing for bankruptcy and reorganization.

27
Q

Working Capital

2 costs to balance in cash management

A

Carrying costs - The return foregone by holding short-term assets such as cash

Shortage costs - The cost of running out of short-term assets to fund operations

28
Q

Working Capital

Cash management strategies

Passive

Active

Laddering Strategy

A

Passive - One or two decision rules for daily investments, safety first, these strategies must be monitored and yield benchmarked against a standard (eg T-bill).

Active - More daily involvement and a wider choice of investments, matching of cash inflows and outflows.

A laddering strategy is where a bond is constructed to have equal amounts invested in each maturity in a given range to reduce IR risk.

29
Q

Working Capital

Accounts Payable

To evaluate whether to postpone payment consider the value of the early payment discount

How is this calculated?

A
30
Q

Corporate Governance

Board Committees

How many key committees are required?

What are the requirements around their members?

A
  • Audit committee
  • Compensation Committee
  • Corporate governance/nominating committee

They are required to be comprised exclusively of independent directors

31
Q

Break Points

A

eg REBP is retained earnings break point

These are points in the capital structure at which the MCC (marginal cost of capital) jumps. eg up to $75m WACC is 10%, over $7m jumps to 12%

MCC at $75m is very high

32
Q

Using dividend discount model to calculate cost of equity

A

DDM says cost of equity = growth rate + div yield

= ROE * ERR + D0*g/P

33
Q

Post Audit

A

This is the process of comparing actual results achieved to the capital forecasting work.

Purpose is to check forecasting ability and provide motivation for people to hit forecasts.

34
Q

Modified IRR method

What is it?

A

Same as IRR but assumes that cash receipts are reinvested at the cost of capital, not at the IRR rate as with normal IRR method (more realistic).

CFA (10 decks)

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