GLOBEFMP2

Question 1

What is DCF valuation?

Answer 1

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

Question 2

What is the payback rule?

Answer 2

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.

Question 3

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

Answer 3

• 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

Question 4

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

Answer 4

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.

Question 5

What is the AAR?

Answer 5

Average Accounting Return

Definition used in the book (definitions differ):

Average net income / Average book value

Question 6

What are the shortcomings/drawbacks of the AAR rule?

Answer 6

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

Question 7

What is the IRR?

Answer 7

The internal rate of return.

The discount rate that makes the NPV of an investment zero.

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.

Question 8

How do you calculate the IRR?

Answer 8

By trial and error

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

Or using a financial calculator (IRR)

Question 9

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

Answer 9

Always the same UNLESS

• The cash flow is not conventional meaning that it starts with one negative cash outflow followed by purely positive inflows
  
  • 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.
  
  • 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

Question 10

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

Answer 10

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

Rates of return are often easier to use for calculations.

Question 11

What are the MIRR approaches?

Answer 11

Modified internal rate of return

1. The discounting approach
   
   • 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
   
   • Compounds all cash flows (positive and negative) EXCEPT the first out to the end of the project’s life and then calculate the IRR.
3. The combination approach
   
   • A combination of method 1 and 2 above
   • Negative cash flows are discounted back to the present, and positive cash flows are compounded to the end of the project.

Question 12

What is the profitability index?

Answer 12

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

Benefit-cost ratio.

(problematic with mutually exclusive investments)

Question 13

What are the differences between debt and equity?

Question 14

What is incremental cash flows?

Answer 14

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.

Question 15

What is the stand-alone principle?

Answer 15

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.

Question 16

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

Answer 16

• 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.

Question 17

What is erosion?

Answer 17

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

Question 18

What are pro forma financial statements?

Answer 18

Financial statements projecting future years’ operations

Question 19

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

Answer 19

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

Question 20

When is something a tax on capital gain?

Answer 20

Using a general (albeit rough) rule, a capital gain occurs only if the market price exceeds the original cost

⇒ thus not in case you have depreciated your asset too much such that book value is lower than market value (you will still pay a tax but not capital gain tax).

Question 21

What are some alternative ways to calculate operating cash flow (OCF)?

Answer 21

• 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
• Top-down approach
  
  • Sales - Costs - Taxes
  • Start at the top of the income statements and work down by adding and subtracting net cash flow
• The Tax Shield Approach
  
  • OCF = (Sales - Cost) * (1 - T) + Depreciation * T
    
    • T = tax rate (34 % = 0.34)

Question 22

What does depreciation tax shield mean?

Answer 22

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

Question 23

What is EAC?

Answer 23

Equivalent annual cost (EAC)

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

Question 24

What is ACRS?

Answer 24

Accelerated cost recovery system

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

Question 25

What is WACC and what is it used for?

Answer 25

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).

Question 26

What does the cost of capital primarily depend on?

Answer 26

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

Thus, not the source of the funds.

Question 27

What is the cost of equity?

Answer 27

the return that equity investors require on their investment in the firm.

Usually estimated by:

• The dividend growth model or
• the security market line approach (SML)

Question 28

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

Answer 28

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).

Question 29

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

Answer 29

Either using:

• Historical dividend growth rates or
• By using analysts future growth rate forecasts

Question 30

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

Answer 30

• The risk-free rate, Rf
• The market risk premium, E(Rm) - Rf
• The systematic risk of the asset relative to average, which we called its beta coefficient, β

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

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

Question 31

What is the SML equation for return on equity?

Answer 31

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

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

Question 32

what is Rd?

Answer 32

The cost of debt

Can be seen from the interest rate the company pays on borrowings or of the current yield in the marketplace of their bonds.

Question 33

How can the cost of preferred stock be calculated?

Answer 33

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

D = the fixed dividend

P0 = current price per share

Question 34

What is the equation for WACC?

Answer 34

Weighted average cost of capital

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

If it includes preferred stock the equation gets an extension to:

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

Question 35

What is the pure play approach?

Answer 35

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.

Question 36

What are flotations costs?

Answer 36

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