Corporate Finance Flashcards
Capital Budgeting
5 assumptions of capital budgeting
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
Capital Budgeting
What are externalities?
What are the two types?
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).
Capital Budgeting
What are conventional and non-conventional cash flows?
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.
Capital Budgeting
Profitability Index
Formula
Interpretation
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.
Capital Budgeting
NPV vs IRR
For independent projects, how does decision differ between NPV and IRR methods?
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.
Capital Budgeting
NPV vs IRR
Difference between NPV and IRR for mutually exclusive projects
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.
Capital Budgeting
NPV vs IRR
What is the condition for NPV and IRR to given the same result for mutually exclusive projects?
The cost of capital must be greater than the crossover rate (the rate at which NPV of the two projects is the same).
Cost of Capital
Should you use current or target capital weightings for WACC calc?
Use target weightings if they are given since these will be the long run weightings, otherwise assume the current weightings are the target.
Cost of Capital
Investment Opportunity Schedule
Definition
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.
Cost of Capital
Cost of Equity
CAPM equation
What is equity risk premium?
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).
Cost of Capital
Cost of Equity
4 methods of estimating Equity Risk Premium (ERP)
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.
Cost of Capital
Equity Beta
Formula for Levered Beta, ßL
How is it used?
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.
Cost of Capital
Country Risk
What is the impact of this?
Methods of considering it
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.
Cost of Capital
Flotation Costs
Why do they need to be taken into account?
How do you take them into account?
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.
Leverage
Business Risk Definition
Impact on optimal debt ratio
Two components
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
Leverage
Degree of Operating Leverage
Formula
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.
Leverage
Financial Leverage
The two factors financial risk depends on
- Cash flow volatility
- Financial leverage
Leverage
Financial Leverage
Degree of Financial Leverage formula
Interpretation
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
Leverage
Degree of Total Leverage
What is it?
Formula
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)
Leverage
Breakeven Point
Formula
Formula for Operating breakeven point
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.
Dividends
DRIPs
Definition
Advantages & Disadvantages
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.
Dividends
Holder of Record Date
Definition
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.
Dividends
Share Repurchase
Effect on shareholder wealth if shares repurchased at market price
Effect if repurchased at high price
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.
Dividends
Share Repurchase
Effect on EPS if share repurchase is funded by borrowed funds
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.
Dividends
Share Repurchase
What is the effect of share repurchase on book value per share (BVPS)?
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.
Working Capital
Liquidity
Primary sources of liquidity
Secondary sources of liquidity
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.
Working Capital
2 costs to balance in cash management
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
Working Capital
Cash management strategies
Passive
Active
Laddering Strategy
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.
Working Capital
Accounts Payable
To evaluate whether to postpone payment consider the value of the early payment discount
How is this calculated?
Corporate Governance
Board Committees
How many key committees are required?
What are the requirements around their members?
- Audit committee
- Compensation Committee
- Corporate governance/nominating committee
They are required to be comprised exclusively of independent directors
Break Points
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
Using dividend discount model to calculate cost of equity
DDM says cost of equity = growth rate + div yield
= ROE * ERR + D0*g/P
Post Audit
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.
Modified IRR method
What is it?
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).
