Idk Flashcards
What is corporate finance
Investment
Financing
Liquidity
What is corporate finance
Investment
-Choose best projects
-capital budgeting
What is corporate finance
Financing
-choose the source of financing for investment
-capital structure
What is corporate finance
Liquidity
-Ensure you have enough cash and inventory
-short term financial planning
Responsibilities of a financial manager
Responsible for
Investment
Decisions
Responsible for
Financing Decisions
Responsible for
Short-Term
Financial Planning
Oversee
Accounting and
Audit Function in
Firm
Ensure the
Financial Welfare
of the Firm
Goal of financial management
-manage risk
-maximise share price
-avoid financial distress
Primary Markets
-Securities are sold to investors
-Money that is raised goes to issuing firm
-First share issue is called an InitialPublic Offering
Secondary markets
-Investors trade securities with each other
-Money that is raised goes to seller of securities
-Share Prices
NPV investment rule
Accept if NPV>0 Decline if NPV<0
Strengths of NPV
Uses CashFlows
• Cash Flows are better than Earnings
Uses all CashFlows
• Other approaches ignore cashflows beyond a certain date
DiscountsCash Flows
• Fullyincorporatesthe TimeValue ofMoney
The payback period method
Accept if payback period is less than benchmark ———— Reject if payback period is greater than benchmark
Advantages of Payback Period
-Very small scale investments
-Firms with severe capital rationing
-Exceptionally Simple to Understand
Problems with the Payback Period
-Timing of Cash Flows
-Payments after the Payback Period
-Arbitrary Standard for the Payback Period
Strengths and Weakness of Discounted Payback Period
——Strengths
• Simple
• Uses Time Value of Money
—-Weaknesses
• Ignores Cash Flows beyond benchmark
• Arbitrary Benchmark
Strengths and Weaknesses of the
Average Accounting Return
Strengths
• Simple return- based measure Weaknesses
• Does not use cash flows
• Does not use time value of money
• Arbitrary target rate
The Internal Rate of Return
-Accept if the Internal Rate of Return is greater than the discount rate
-Reject if the Internal Rate of Return is less than the discount rate
Independent Project
An independent project is one whose acceptance or rejection is independent of the acceptance or rejection
of other projects
Mutually Exclusive projects
With mutually exclusive projects, you can accept A or you can accept B or you can reject both of them, but you cannot accept both of them
Normal Cash Flow Pattern (First Cash Flow Negative, Remaining Cash Flows Positive)
Rules:
Number of IRRs: There is usually only 1 IRR.
IRR Rule:
Accept if IRR > Required Rate of Return (R).
Reject if IRR < Required Rate of Return (R).
NPV Rule:
Accept if NPV > 0.
Reject if NPV < 0.
First Cash Flow Positive, Remaining Cash Flows Negative
Number of IRRs: There is usually just 1 IRR in this case.
IRR Rule:
Accept if IRR < Required Rate of Return (R). (This is the opposite of the usual investment decision.)
Reject if IRR > Required Rate of Return (R).
This is because a lower IRR in this context would mean lower repayment costs or a better loan deal.
NPV Rule:
Accept if NPV > 0.
Reject if NPV < 0.
First Cash Flow Positive, Remaining Cash Flows Negative
Number of IRRs: Typically, there may be more than 1 IRR, or sometimes no valid IRR at all. The reason is that the IRR equation may have multiple solutions or no real solution, depending on the specific pattern of cash flows.
IRR Rule: In this case, because of potential multiple IRRs, relying on IRR alone can be misleading. Therefore, IRR might not be a valid criterion.
Scale of cash flows and IRR
IRR Doesn’t Account for Project Size: A small project could have a very high IRR but still contribute less value overall than a larger project with a lower IRR.
Incremental IRR
When scale is an issue, calculate the incremental
cash flows and IRR from them
Profitability Index
Accept if Profitability Index is Greater than 1
Reject if Profitability Index is Less than 1
Profitability Index: Capital Rationing
-Capital Rationing occurs when there is not enough cash to invest in all positive NPV projects
-Under Capital Rationing you cannot rank projects according to NPV
-Should use Profitability Index or Incremental NPV
Sunk Costs
Definition
• A sunk cost is a cash flow that has already occurred
RULE
• Ignore all sunk costs
Opportunity Costs
Definition
• Opportunity costs are lost revenues that you forego as a result of making the proposed investment
Rule
• Incorporate Opportunity Costs into your analysis
Side Effects in Corporate Finance
EROSION AND SYNERGY
A side effect is classified as either erosion or synergy
Erosion: When a new project reduces cash flows of existing products (cannibalization).
Synergy: When a new project increases cash flows of existing products.
Rule: Always include side effects in project evaluation.
Example:
Erosion: A new product reduces sales of an older one.
Synergy: A new product boosts sales of existing products.
Allocated Costs in Corporate Finance
Definition: Accounting measure that distributes expenses or asset use across the company.
Rule: Treat as a cash outflow only if it’s an incremental cost directly tied to the project.
Cash Flow and Inflation
-NOMINAL AND Real cash flow
Nominal Cash Flow: The actual amount of money paid or received, without adjusting for inflation.
Real Cash Flow: The purchasing power of cash, adjusted for inflation.
Rule for Discounting Cash Flows
Nominal Cash Flows: Discount using the nominal rate (includes inflation).
Real Cash Flows: Discount using the real rate (excludes inflation).
To Estimate Cost of Equity Capital you need
to know
The Risk- Free Rate
The Market Risk Premium
The Company Beta
Problems and Solutions in Estimating Betas
Problems
Betas may vary over time: The beta of a security can change due to market conditions.
Sample Size may be inadequate: Insufficient data can lead to unreliable beta estimates.
Betas are influenced by changing financial leverage and business risk: Variations in a firm’s capital structure or operational risks can impact beta
Solutions
For the first two problems: Use better statistical methods to improve the estimation of betas.
For the third problem: Adjust for business and financial risk to obtain a more accurate beta.
Consider average beta estimates: Analyze the average betas of several comparable firms within the same industry to derive a more stable beta estimate.
