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FMGLOBEP2 Flashcards

1
Q

What is NPV?

A

Net present value = the difference between an investment’s market value and it’s cost.

⇒ Is the investment worth undertaking? The gain higher than the cost?

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2
Q

What is DCF valuation?

A

Discounted cash flow valuation = the process of valuing an investment by discounting its future cash flow.

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3
Q

What is the payback rule?

A

A method used to assess potential investments from the amount of time it takes for an investment to generate cash flows sufficient to recover its initial cost.

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4
Q

What is the shortcomings of the payback rule compared to NPV?

A
  • The payback rule does not discount, thus ignoring the time value of money
  • Does not include any risk differences (same calculation for very risky and less risky investments)
  • It is very hard to come up with the “right” cutoff period
  • Biased against long-term investments such as R&D and large-scale projects as they will pay back over longer time. If the NPV or IRR is better does not matter when using the payback rule.
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5
Q

What is the idea of the discounted payback rule?

A

First, compute the PV of each cash flow and then determine how long it takes to pay back on a discounted basis.

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6
Q

What is the main reason why the discounted payback rule most often is not used?

A

If you have to discount the cash flows anyway, the discounted payback rule is no longer faster than NPV, wherefore NPV is used as the best choice.

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7
Q

What are the shortcomings of the discounted payback rule?

A
  • May reject positive NPV investments
  • Requires an arbitrary cutoff point
  • Ignores cash flows beyond the cutoff point
  • Biased against long-term projects such as R&D and new large-scale projects
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8
Q

What is the AAR and how do you calculate it?

A

Average Accounting Return

Definition used in the book (definitions differ from book to book):

Average net income / Average book value

(average book value is inevitably affected by the choice of depreciation method)

Just as correct answer, you DO NOT CALCULATE it. Too many serious problems for AAR to be used.

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9
Q

What are the shortcomings/drawbacks of the AAR rule?

A
  • It is not a true rate of return (ROR). It is instead a ratio of two accounting measures
  • Ignores time value of money
  • Arbitrary benchmark: The target AAR is a number drawn up from a hat like the payback period
  • Instead of cash flow and market value it uses net income and book value (poor substitutes) ⇒ It looks at the wrong things.

DO NOT USE.

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10
Q

What is the IRR?

A

The internal rate of return.

The discount rate that makes the NPV = 0.

In other words, the IRR on an investment is the required return that results in a zero NPV when it is used as the discount rate.

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11
Q

How do you calculate the IRR?

A

By trial and error, using a financial calculator or using Excel’s IRR function.

You try to figure out what return rate you should discount at for the NPV to be zero.

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12
Q

What should you be aware of regarding IRR results?

A

You are solving for the root of an equation. The equation can lead to two roots (crossing the x-axis more than once) and will thus give multiple IRRs.

⇒ Use NPV

  • Non-conventional cash flows
  • When projects are not mutually exclusive
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13
Q

In which cases is the decision using NPV and IRR the same and different?

A

Always the same UNLESS

  • The cash flow is not conventional meaning that it starts with one negative cash outflow followed by purely positive inflows ⇒ Nonconventional cash flows
    • In such cases the IRR rule breaks down completely and should be avoided as multiple rates can give NPV = 0
  • The cash flow is not independent. If the decision on one investment affects the decision on another investment, the decision using the two different approaches will most likely not be the same ⇒ Not mutually exclusive projects
    • The decision will depend on the required return as investment B can be better than A and vice versa at different required return rates due to different payback times ⇒ Again… Stay with NPV
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14
Q

For what reason is the IRR rule often preferred to the NPV rule?

A

IRR focuses on rates of return whereas NPV gives dollar values.

Rates of return are often easier to use for calculations.

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15
Q

What are the MIRR approaches?

A

Modified internal rate of return

  1. The discounting approach
    a. discount all negative cash flows back to the present as the required return and add them to the initial cost (making the numbers conventional)
  2. The reinvestment approach
    a. Compounds all positive cash flows to the end of the project’s life and then calculate the IRR.
  3. The combination approach
    a. A combination of method 1 and 2 above
    b. Negative cash flows are discounted back to the present, and positive cash flows are compounded to the end of the project.
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16
Q

What is the profitability index?

A

The present value of an investment’s future cash flows divided by its initial cost.

PV of cash flows / Initial cost

PV cash inflows / PV cash outflows

Benefit-cost ratio.

(problematic with mutually exclusive investments)

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17
Q

What does a PI index of 1.23 imply?

A

That for every $1 invested, we create an additional 23 cents in value.

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18
Q

What are the advantages and disadvantages of the Profitability Index?

A
  • Advantages
    • Closely related to NPV (generally identical decisions)
    • Easy to understand and communicate
  • Disadvantages
    • May lead to incorrect decisions in comparisons of mutually exclusive investments
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19
Q

What are the differences between debt and equity?​

A
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20
Q

What is incremental cash flows?

A

The difference between a firm’s future cash flows with a project and those without a project ⇒ Also means cash flows that are independent of the decision of the specific project are irrelevant.

“any and all” changes in the firm’s future cash flows as a direct consequence of taking the project.

Fx. keeping old machine vs. buying new

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21
Q

What is the stand-alone principle?

A

You evaluate a project based on its incremental cash flows ⇒ Completely independent from everything else.

You see the project as a “minifirm” and look at its cash outflow and inflow.

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22
Q

What are classic pitfalls when evaluating projects and their incremental cash flows?

A
  • Including sunk costs in the calculation
  • Forgetting opportunity costs
  • Forgetting side effects (spillover effects, both good and bad)
  • Forgetting costs to additional net working capital
  • Including financing costs: interest, dividends, principal (this will be done when discounting the cash flow)
  • Thinking “accrued”. We are using cash-based accounting to look at investment projects as we are interested in their cash flows.
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23
Q

What is erosion?

A

The cash flows of a new project that come at the expense of a firm’s existing projects.

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24
Q

What are pro forma financial statements?

A

Financial statements projecting future years’ operations

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25
Q

How do you calculate project operating cash flow (OCF) for each year?

A

EBIT (Earnings before interest and taxes)

  • Taxes

+ Depreciation

(and for the last year we also subtract the change in net working capital; we get the money “back” maybe with slight difference due to sales on credit or costs we have not yet paid) ⇒ subtract so if the change is negative it will be minus minus = plus

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26
Q

When is something a tax on capital gain?

A
  • Bottom-up approach:
    • Net income and then add any non-cash deductions such as depreciation
      • Only useful if interest expense has not been subtracted from net income
      • OCF = EBIT * (1- T) + Depreciation
  • Top-down approach
    • Sales - Costs - Taxes
    • Start at the top of the income statements and work down by adding and subtracting net cash flow
      • OCF = Sales - Costs - Taxes (Do not subtract non-cash deductions)
  • The Tax Shield Approach
    • OCF = (Sales - Cost) * (1 - T) + Depreciation * T
      • T = tax rate (34 % = 0.34)
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27
Q

What does depreciation tax shield mean?

A

The tax savings that results from the depreciation deduction, calculated as “Depreciation * T”

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28
Q

What is EAC?

A

Equivalent annual cost (EAC)

The present value of a project’s costs calculated on an annual basis (makes it possible to compare equipment options)

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29
Q

What is ACRS?

A

Accelerated cost recovery system

A depreciation method under U.S. tax law allowing for the accelerated write-off of property under various classifications.

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30
Q

What is after-tax salvage?

A

The value of an asset’s salvage value AFTER taxes have been deducted from the capital gain.

Example:

Your investment is 100,000. You depreciate with straight line method over 5 years (20,000 a year) and expect a salvage value of 17,000 for the machine/equipment. Tax rate is 40 %.

Book value in year 5 = 100,000 - 5*(20,000) = 0

After-tax salvage = Salvage - Tax rate*(Salvage - Book value) = 17,000 - 0.4(17,000 - 0) = 10,200.00.

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31
Q

How do you calculate after-tax salvage?

A

If fully depreciated:

After-tax salvage = Salvage value * (1 - tax rate)

If not yet fully depreciated:

Salvage value - Tc * (Salvage value - book value)

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32
Q

How do you calculate net capital spending? (net investment outflow)

A
  • Purchase price of new asset
  • MINUS selling price of existing asset
  • PLUS Cost of site preparation, delivery, setup, start-up etc.
  • PLUS/MINUS increase/decrease in tax liability due to sale of old asset as other than book value
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33
Q

What does erosion refer to?

A

A form of cannibalism.

New project revenues gained at the expense of existing products/services.

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34
Q

What is net working capital?

A

Incremental investments in cash, inventories and receivables that need to be included in cash flows of new projects if they are not offset by changes in payables.

Later, as projects end, this investment if often recovered (still important to include due to time value of money)

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35
Q

Why don’t we include financing costs when computing cash flows?

A

As they are reflected in the discount rate used to discount the project cash flows.

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36
Q

What is EAC and EAA?

A
  • Equivalent Annual COST
  • Equivalent Annual ANNUITY

PV of a project’s cash flow calculated on an annual basis.

The idea is that any asset will have to be renewed/replaced when the life-time is over.

You should accept the project with the lowest EAC.

37
Q

What is NWC?

A

Net working capital

38
Q

What is WACC and what is it used for?

A

Weighted average cost of capital

Used to find the appropriate discount rate for a project’s NPV to make the right decision (right discount rate depending on cost of capital).

39
Q

What does the cost of capital primarily depend on?

A

The USE of the funds - how risky investments you make.

Thus, not the source of the funds.

40
Q

Which ways can you calculate the cost of equity, Re?

A
  • Dividend growth model
  • SML (CAPM)
41
Q

What is the dividend growth model and how can you rearrange the equation to find the cost of equity, Re?

A
42
Q

If the dividend growth model is unknown, how can you estimate it?

A
  • Use historical dividend growth
  • Use analysts’ estimates and take an average of that (see finance portals)
  • Assume that ROE and retention rate are constant such that g = ROE*Retention rate
    • Retention rate = the percentage of profits withheld by the company
43
Q

What is the cost of equity?

A
44
Q

How can you calculate Re (return required by equity holders) with the dividend growth model?

A

P0 = D1 / Re - g

rewritten to

Re = (D1 / P0) + g

P0 and D0 is available for publicly traded companies. growth rate of dividends, g must be estimated and D1 can be calculated by taking D0 * (1+g).

Remember D1 = D0 * g ⇒ The dividend * the growth rate (fx. 6 % = Dividend * 1.06)

45
Q

How do you go about estimating the dividend growth rate, g when using the dividend growth model to calculate Re?

A

Either using:

  • Historical dividend growth rates or
  • By using analysts future growth rate forecasts
  • Assume that ROE and retention rate are constant such that g = ROE*Retention rate
    • Retention rate = the percentage of profits withheld by the company
46
Q

Which 3 factors does the security market line (SML) approach take into account?

A
47
Q

What is the SML equation for return on equity?

A

Expected return on the company’s equity, E(Re) = Rf + βe * (E(Rm) - Rf)

Rewritten to: Re = Rf + βe * (Rm - Rf)

48
Q

What is Rd?

A
49
Q

How can the cost of preferred stock be calculated?

A

Always pays dividend (essentially like a perpetuity) and thus simply; Rp = D / P0

D = the fixed dividend

P0 = current price per share

50
Q

What is the equation for WACC?

A
51
Q

What is the equation for WACC?

A
52
Q

What is the pure play approach?

A

An approach in which we try to use a WCAA that is unique to a particular project and based on companies in similar lines of business.

We basically try to find companies that focus as exclusively as possible on the type of project that we are interested in undertaking.

Used if a company has multiple business units with very different risk levels such that the company’s average WCAA does not make sense to use.

53
Q

What is the subjective approach?

A
54
Q

What is a hurdle rate?

A

The minimum required rate of return on an investment.

55
Q

What are flotations costs?

A

Costs associated with issuing, or floating, new bonds and stocks to obtain more capital for a project.

56
Q

What is included in a stock quote?

A
57
Q

Why is the cost of capital important?

A
  • Because the return on earned on assets depends on the risk of those assets
  • The return to an investor is the same as the cost to the company
  • Cost of capital provides us with an indication of how the market views the risk of our assets
  • Knowing our cost of capital can help determine our required return for capital budgeting projects
58
Q

What are the three most common ways of estimating the dividend growth rate?

A
  • Historical: taking the historical average of dividend growth (for 5 years for example)
  • Expert forecasts: looks at analysts’ forecasts and take an average of that
  • ROE*retention rate = g: this can be done ONLY WHEN you assume ROE and retention rate are constant
59
Q

What are the disadvantages of the dividend growth model?

A
  • Only applicable to companies currently paying dividends
  • Not applicable if dividends are not growing at a reasonably constant rate
  • Extremely sensitive to the estimated growth rate. An increase in g of 1 % increases the cost of equity by 1 %
  • Does not explicitly consider risk
60
Q

What is the equation for the SML approach?

A
61
Q

What are capital restructuring activities?

A

Changing the amount of leverage without changing the firm’s assets.

  • Issuing stocks to pay back debt (bonds) thereby reducing debt to equity ratio
  • Obtaining debt to buy back stocks (repurchase) thereby increasing debt to equity ratio
62
Q

When is financial leverage beneficial?

A
  • When EBIT provides a higher return than the interest rate on debt
63
Q

When choosing capital structure, which two ways can we maximize stockholder wealth?

A

Maximize firm value or minimize WACC.

64
Q

What is homemade leverage?

A

The use of personal borrowing to change the overall amount of financial leverage to which the individual investor is exposed.

The individual investor can thus control his/her own capital structure to increase or decrease risk.

65
Q

What is included in the three different cases? (capital stucture)

A

1. No taxes or bankruptcy costs

a. No optimal capital structure

2. Corporate taxes but no bankruptcy costs

a. Optimal structure is almost 100 % debt
b. Each additional dollar of debt increases the cash flow and value of the firm

3. Corporate taxes AND bankruptcy costs

a. Optimal capital structure is a mix of debt and equity
b. Occurs where the benefit from an additional dollar of debt is just offset by the increase in expected bankruptcy costs

66
Q

What is MM proposition 1 and 2 and how does taxes influence the result?

A
67
Q

What is the difference between business and financial risk?

A
  • Business risk: the risk associated with the nature of the firm’s operating activities
  • Financial risk: the risk associated with the firm’s debt-to-equity ratio

These are the two components that determine a firm’s cost of equity, Re.

68
Q

What is the equation for cost of equity considering CASE 1?

A
69
Q

What is the equation for WACC in CASE 1?

A

Case 1 = No taxes or bankruptcy costs.

WACC = Ra = E/V* Re + D/V * Rd

70
Q

How do you calculate the present value of ANNUAL interest tax shield?

A

PV of annual tax shield = Annual tax shield / interest rate

The Annual tax shield = Debt * r * Tc

71
Q

How do you calculate PV of an interest tax shield?

A

Annual tax shield / Interest rate

Like a perpetuity.

Fx: 24 / 0.08 = 300

PV = (Debt * Cost of debt * Tax rate) / (Cost of debt) = Debt * Tax rate

Debt * Tax rate ⇒ Fx: 1,000 in debt * 30 % = 300.

72
Q

What is the difference in value of a leveraged and unleveraged firm?

A
73
Q

How do you calculate the value of a leveraged and unleveraged firm under CASE 2?

A
74
Q

What is the equation for WACC and Re under CASE 2?

A

We now have the tax shield but no bankruptcy costs.

WACC = (E/V)*Re + (D/V)*Rd * (1 - Tc)

Re = Ru + (Ru - Rd)*(D/E)*(1 - T)

(Ru = unlevered cost of capital)

75
Q

What happens to WACC and Re under CASE 2 when you increase D/E?

A
76
Q

What are the primary direct and indirect costs associated with bankruptcy?

A
  • Direct:
    • Administrative costs for lawyers, accountants, consultants and examiners
  • Indirect (bigger than direct costs but hard to measure):
    • Financial distress costs ⇒ either associated with going bankrupt or with experiencing financial distress
77
Q

How can you show the theory of optimal capital structure graphically? Explain the figure (CASE 3)

A
78
Q

What are the managerial implications of the interest tax shield when setting a capital structure?

A

The interest tax shield is valuable and a leverage company is thus smart to some extent.

Factors to be considered regarding the value of taxes are:

  • The tax rate (the higher, the more valuable the tax shield)
  • Accumulated losses? if a firm has enough accumulated losses to avoid paying taxes, the interest tax shield will have little effect
  • Depreciation? if a firm has enough depreciation costs to avoid paying taxes, the interest tax shield will have little effect
79
Q

What are the managerial implications of financial distress?

A
  • The greater volatility in EBIT, the less a firm should borrow
  • The costs of financial distress are higher for some firms than others depending on how easily ownership of assets can be transferred
    • If a firm has tangible assets that can be sold without losing much value, the firm will have an incentive to borrow more
    • If a firm mainly has intangible assets, they should borrow less
80
Q

What does the extended pie model include?

A

Not only

  • Bondholder claim and
  • Stockholder claim

But also

  • Tax claim
  • Bankruptcy claims
81
Q

What are the difference between marketed and non-marketed claims?

A
  • Marketed claims can be bought and sold in financial markets
    • We usually speak about marketed claims when we talk about the value of a firm
      • Bond + stock claims
  • Non-marketed claims
    • Bankruptcy claims
    • Tax claims
82
Q

What is the pecking-order theory?

A

A theory questioning why many big firms (who should be safe to borrow a lot) have very low borrowings.

Answer seems to be:

  • Internal financing is cheaper as it costs money to issue securities for raising money
  • If a firm is highly profitable it might never have shortcomings of internal finance opportunities and have no need to look for external financing
  • Insiders (managers) might find the stock undervalued and will not issue securities at the current price
    • And no… You wouldn’t issue stocks if you think the stock is overvalued as investors will see right through you and the stock price will plummet
83
Q

What are the 3 main implications of the pecking-order theory?

A
  • No target capital structure
  • Profitable firms use less debt
  • Companies will want financial slack (a stockpile of cash/reserves for projects)
84
Q

What does business failure, legal bankruptcy, technical insolvency and accounting insolvency refer to?

A
  • Business failure: a business has terminated with a loss to creditors (but even an all-equity firm can fail)
  • Legal bankruptcy: firms or creditors bring petitions to a federal court for bankruptcy
  • Technical insolvency: unable to meet its financial obligations (liquidity reasons)
  • Accounting insolvency: firms with negative net worth are insolvent on the books. Happens when liabilities exceed the book value of total assets.
85
Q

What are the two options for a firm declared bankrupt?

A
  • Liquidation: selling off the assets of the firm and close down
  • Reorganization: financial restructuring of a failing firm in an attempt to continue operations as a going concern.
86
Q

What is the difference between coupon rate, current yield and YTM?

A
  • Coupon rate
    • The firm’s promised interest payments on existing debt
  • Current Yield
    • Income portion of total return
  • Yield to Maturity
    • The same as cost of debt because it is market rate of interest that would be required on new debt issues
87
Q

How do you calculate cost of preferred stock, Rp?

A

Rp = D / P0 ⇒ Which is equal to its dividend yield

88
Q

What is unlevered cost of capital?

A

The cost of capital for a firm that has no debt.

89
Q

What is the static theory of capital structure?

A

That a firm borrows up to the point where the tax benefit from an extra dollar in debt is exactly equal to the cost that comes from the increased probability of financial distress.

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