Finance 3 Flashcards
what is net present value
- 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
what is the worded formula for net present value, NPV
- NPV = present value of cash flows - initial cost of investment (cash outlay)
what is the formula for NPV
- NPV = [Σ C_t / (1+r)^t] - C0
- the Σ term is the PV of all cash flows
- C0 = initial cash outlay
what is the significance of NPV in making investment decisions
- if NPV > 0 then the investment is worth accepting
- if NPV < 0 then the investment should be rejected
what is cash flow
- cash flow is the amount of cash being received and spent by a business during a defined period of time
what are incremental cash flows
- incremental cash flows are changes in the firms cash flows that occur as as direct consequence of accepting an investment
what are incidental effects
- incidental effects are side effects that new investments cause on a company’s future cash flows
regarding incidental effects, what is the difference between erosion and synergy
- 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
what are sunk costs
- costs that have already been incurred in the past
what does opportunity cost mean in this context
- 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
what are the 3 elements that contribute to calculating cash flow in one period
- cash flow from operations
- capital expenditure (capex)
- change in working capital
- all of these added up equal cash flow in one period
what are cash flows from operations
- the amount of income produced by a project
what is the formula for net operating profit after taxes, NOPAT
- NOPAT = EBIT*(1-T)
- EBIT = earnings before interest and taxes
- T = tax rate
what is the formula for cash flow from operations, CFO
- CFO = NOPAT + D + A
- D = depreciation
- A = amortization
how is the change in working capital calculated
- 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
what is the relationship between the change in working capital and cash flow
- 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
what are the 5 key considerations that you should be mindful of when calculating free cash flows (4 of them were discussed)
- 1: only count incremental cash flows
- 2: include incidental effects
- 3: forget sunk costs
- 4: include opportunity costs
- 5: treat allocated costs appropriately
what is the premise of discounted cash flow, DCF
- 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
what is the formula for EBIT
- EBIT = EBITDA - D - A
what are the 5 steps for the discounted cash flow method
- 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
in the context of firm valuation, what are the 3 key inputs that need to be considered
- the WACC (weighted average cost of capital)
- the beta (measure of the systemic risk of a security via its volatility)
- the growth rates
