Finance 3

Question 1

what is net present value

Answer 1

• net present value is an investments net contribution to wealth
• its the measure of how much value is created or added by undertaking an investment

Question 2

what is the worded formula for net present value, NPV

Answer 2

• NPV = present value of cash flows - initial cost of investment (cash outlay)

Question 3

what is the formula for NPV

Answer 3

• NPV = [Σ C_t / (1+r)^t] - C0
• the Σ term is the PV of all cash flows
• C0 = initial cash outlay

Question 4

what is the significance of NPV in making investment decisions

Answer 4

• if NPV > 0 then the investment is worth accepting
• if NPV < 0 then the investment should be rejected

Question 5

what is cash flow

Answer 5

• cash flow is the amount of cash being received and spent by a business during a defined period of time

Question 6

what are incremental cash flows

Answer 6

• incremental cash flows are changes in the firms cash flows that occur as as direct consequence of accepting an investment

Question 7

what are incidental effects

Answer 7

• incidental effects are side effects that new investments cause on a company’s future cash flows

Question 8

regarding incidental effects, what is the difference between erosion and synergy

Answer 8

• erosion is when a new investment reduces the sales and hence the cash flows of existing investments
• synergy is when a new investment increases sales and hence the cash flows of existing investments

Question 9

what are sunk costs

Answer 9

• costs that have already been incurred in the past

Question 10

what does opportunity cost mean in this context

Answer 10

• if an asset is used on a new investment, potential revenues from alternative uses are lost
• these lost revenues can be reviewed as opportunity costs

Question 11

what are the 3 elements that contribute to calculating cash flow in one period

Answer 11

• cash flow from operations
• capital expenditure (capex)
• change in working capital
• all of these added up equal cash flow in one period

Question 12

what are cash flows from operations

Answer 12

• the amount of income produced by a project

Question 13

what is the formula for net operating profit after taxes, NOPAT

Answer 13

• NOPAT = EBIT*(1-T)
• EBIT = earnings before interest and taxes
• T = tax rate

Question 14

what is the formula for cash flow from operations, CFO

Answer 14

• CFO = NOPAT + D + A
• D = depreciation
• A = amortization

Question 15

how is the change in working capital calculated

Answer 15

• the difference between accounts receivable and accounts payable in one year
• the difference between them in the next year
• subtract the next year value from previous year

Question 16

what is the relationship between the change in working capital and cash flow

Answer 16

• a negative change in working capital means tied up cash is released so cash flow is increased
• a positive change in working capital means cash is tied up so cash flow is decreased

Question 17

what are the 5 key considerations that you should be mindful of when calculating free cash flows (4 of them were discussed)

Answer 17

• 1: only count incremental cash flows
• 2: include incidental effects
• 3: forget sunk costs
• 4: include opportunity costs
• 5: treat allocated costs appropriately

Question 18

what is the premise of discounted cash flow, DCF

Answer 18

• the value of an asset today is a function of all the future benefits that asset will generate for the owner
• since all those benefits are in the future we have to discount them to present to get their equivalent PV terms
• and the sum of all those discounted future cash flows should be the value, or max price, that should be paid for the asset

Question 19

what is the formula for EBIT

Answer 19

• EBIT = EBITDA - D - A

Question 20

what are the 5 steps for the discounted cash flow method

Answer 20

• 1: calculate the cash flow from operations for each year
• 2: calculate the capital expenditure
• 3: calculate the change in working capital
• 4: calculate the free cash flows each year
• 5: calculate the NPV by discounting the derived free cash flows

Question 21

in the context of firm valuation, what are the 3 key inputs that need to be considered

Answer 21

• the WACC (weighted average cost of capital)
• the beta (measure of the systemic risk of a security via its volatility)
• the growth rates