Finance Topic 1, 2, 3 Flashcards
Time value of money
grows over time
future value
annuity
same amount money received
every year for T years
start 1 year from now (first payment in 1 year from today)
present value
perpetuity
same amount money received
every year FOREVER
starting 1 year from now
capital investment
expenditure today = generate cash inflow tomorrow
cost < benefit
Investment appraisal techniques
- NPV
- IRR
- payback
- ARR
Payback
yrs to recover initial
target - less than and shortest
screening method
+ - imminent cf, simple, cf based
- time value, size/time of cf, outside period cf
NPV
discounted cf - cost of capita/ target rate of return - discount rate
-cost + sum of future cash inflows
+ primary obj, DCF model, time value, account all cf
- understand, estimate discount rate (not constant) , capital is scarce
primary objective
maximise SHs wealth
IRR
cost of capital/discount rate when applied = NPV of 0
IRR > target rate (higher is better), mkt rate < discount = +ve IRR
return rate < cost of borrowing = won’t do it
dont know the correct IRR
multiple IRR
non normal cash flows = more than 1 change in cf direction
project calls for large cash outflow during end of life
goal of a finance manager
maximise SH wealth
-select project that maximises firm value
-detailed analysis of project and aspects
-international = more factors to analyse
9 issues of international
- financing arragements
- risk adjustment
- foreign exchange
- remittance
- taxation
- project vs parent cash flow
- uncertain salvage value
- blocked funds
- inflation
multinational capital budgeting
- evaluate international projects
- NPV
- c.f in more than 1 currency
- subsidiary = manage daily
- parent = finances project
capital investment decision stages
- estimate expected cash flow
- cost of capital
- NPV
estimating cash flows
- estimate future
- incremental
- cash
(working capital)
inflow = +
outflow = -
parent view = max MNC value, cf remitted to parent = shows perf, determine financial viability
incremental cash flow
relevant, because// all incremental, non cash items not considered
1. sunk costs (exclude) - cant be recovered e.g cost of financial analysis
2. opportunity costs (include) - cash flow without the project, benefits forgone because of the project
3. externalities (include) - 2 product linked e.g. cannibalisation, new product add or take away from existing
whether to include
incremental cash flow
would the cash flow be influenced by the investment decision
YES - include in analysis
NO - dont include it
working capital
CHANGES to cash flow
CA - CL
decrease = inflow = money loosen from asset
increase = outflow = money tied up in asset
project cash flow
- initial inv
- operating rev & expense
- profit from subsidiary
- post tax profit
- remittance to parent
- parent may rely on dividend received to cover central expenses
sources of finance
- kd - before tax cost of debt
- ke - cost of equity
firms use both E & D to finance - weighted average cost of capital
cost of capital = discount rate = reflect risk and type of cf = increase cost of borrowing = increase risk = political and foreign exchange uncertainty
kd
interest firm pays to borrow from bank or bond market to fund project
before tax cost of debt
after tax = kd(1-t)
ke
cost of equity
return (expected) return on equity firm pays investors
CAPM
ke = kf + beta(km - kf)
= risk free rate + systematic risk (expected return on mkt portfolio
Cost of capital
Methods of determining cost of capital
- Convert foreign project cash flows into home currency
- predict future ER
- discount home currency discount rate - NPV calc in foreign currency
- discount to NPV foreign discount rate
- translate foreign NPV into home NPV @spot
Home vs foreign cost of capital
computing NPV
currency exchange
1. interest rate parity
2. purchasing power parity
interest rate parity
F/S = (1+Rhome) divided by (1 +Roverseas)
difference in interest rates in any 2 countries = same as difference between forward and spot rate (of respective currencies)
arbitrage
buy in 1 market and sell in another at higher price
purchasing power parity
arbitrage
based on law of 1 price
home per foreign -
F0/S0 = 1 +Rh divided by 1 + Rf
forward ER/Spot ER = 1 + home interest rate / 1 + foreign interest rate
S1/S0 = 1 + ih divided by 1 + if (inflation)
expected spot rate divided by current spot rate
exposure to international risk
- international = decrease MNC risk to home eco conditions
- ER movements
- Foreign exchange conditions
- political risk
foreign exchange risk
- variability of firm value due to uncertain exchange rate (volatile/fluctuate) = risk
- MNC = inflow and outflow exchange currency daily
- Transaction
- Translation
Transaction risk
risk of change = expected value of contract between signing and execution = result of unexpected changes in foreign E.R
translation risk
gain and losses from ER
occur due to converting financial statements from 1 currency to another = consolidate
foreign economies risk
demand of product in foreign country = dependent on economic conditions in market
goal of MNC
- max SH wealth
- max firm value
profit max - SHs, employee rights, creditors, ST & LT
political risk
uncertain activities in host gov
action/instability = difficult for efficient operations = not operating at full capacity = max profit in unstable turbulence = negative influence on c.f.
e.g terrorism and war
agency theory
conflict of interest between principals (SHs) & agents (manager/employees)
- regarding profit, dividends and retaining
-self interested behaviour
self interested behaviour
imperfect labour & capital markets
managers max own utility = expense of corporate SH
managers = consume corp resource, risk averse = outside inv see decisions are made contrasting best interest
agency costs
costs borne by SHs = encourage managers to max SH wealth rather than own self interest
- monitor managers
- structuring organisation
- opportunity costs from SHs, restrictions = limit manager ability to max wealth
management style of MNC
- centralised = direct control of foreign subsidiaries = reduce agency costs - everything back to parent
- decentralised = max wealth of MNC SHs = max overall MNC wealth, agency more significant
depreciation
straight line method
cost - scrap value divided by useful life
tax deductible not cash flow
2 methods
- convert foreign - home, predict future ER, discount @ home currency discount rate (cost of capital)
- NPV call in foreign currency, discount NPV at foreign discount rate, translate foreign NPV to home at spot rate
taxable profit
operating cash flow (inflows) - depreciation
NPV
sum of present values
discount factor
1 divided (1 + r) to power of t
Double taxation
levying of tax by 2 or more jurisdictions on same declared income (income taxes) , asset (capital taxes) or financial transaction (sales taxes)
double liability often mitigated by tax treaties between countries
methods of double taxation
- deduction
- exemption
- credit
deduction
allow tax as expense
tax on net tax after profits not original - pay tax on the amount after other country has taxed
exemption
making foreign income exempt
country of residence doesnt tax foreign income of residents
credit
country of residence gives credit for foreign tax paid
refund what paid in foreign
