Midsem + random Exam Prep Flashcards
The firm’s unlevered (asset) cost of capital is:
the weighted average of the equity cost of capital and the debt cost of capital.
When appraising mutually exclusive investments in plant and equipment, financial managers calculate the investments’ equivalent annual costs and rank the investments on this basis. Why is this necessary? Why not just compare the investments’ NPVs?
Comparing PVs can be misleading when projects have different economic lives and the projects are part of an ongoing business. Eg, a machine that costs $100,000/year to buy and lasts 5 years is not necessarily more expensive than a machine that costs
$75,000/ year to buy but lasts only three years. Calculating the machines’ equivalent annual costs allows an unbiased comparison.
for deciding on different NPV projects, how do you figure out which one to do?
Find EAC: = PV CFs/(annuity factor)
why should you avoid fudge factors?
Avoid adding to discount rate to offset things that could go wrong with the proposed investment, it’s better to adjust cashflow forecasts first.
• They make long term project look much worse than quick-payback projects, this is due to the compounding of the fudge factor by the discount rate.
• They can seriously undervalue projects!!
what is the COC based on?
the average beta of the assets (which is based on the proportions of D & E funds in each asset)
How to allow for possible bad outcomes
- Find the probabilities of the possible cash flows
- Multiply possible CF with probability to get probability weighted CFs
- Add all of the probability weighted CFs to get an unbiased forecast
- Divide unbiased forecast by discount rate to find PV
fudge factors particularly penalise
long term projects due to the compounding of the fudge factor by the discount rate such that they’re significantly undervalued
real rate formula
= [(1+nominal)/(1+inflation rate)]-1
fudge factors are smaller for more
more distant projects/projects that operate for longer time periods, because with more distant cash flows, a smaller addition to the discount rate has a larger impact on present value.
Compensation schemes that depend on stock returns do not depend on accounting data. Is that an advantage? Why or why not?
It is not necessarily an advantage to have a compensation scheme tied to stock returns. For example, in addition to the problem of expectations discussed in Part a, there are numerous factors outside the manager’s control, such as federal monetary policy or new environmental regulations. However, the stock price does tend to increase or decrease depending on whether the firm does or does not exceed the required cost of capital. To this extent, it is a measure of performance.
economic value added
residual income = income earned – income required
= income earned – [COC x investment]
how should managers be compensated
• Pay should be:
o 1. Reasonable (not excessive)
o 2. Linked to performance
• Every dollar paid to manager should be tied to every dollar they bring in, reduces agency costs.
does growth in earnings mean shareholders are better of?
Not always. instead of having growth in earnings (which can lead to depletion of firm value for projects with small growth), they want projects whose expected returns exceed the COC)
advantages of accounting measures of performance
- Based on absolute performance instead of performance relative to investor’s expectations
- They make it possible to measure the performance of junior managers whose responsibility extends to only a single division or plant
Disadvantages of accounting measures of performance
- Managers whose pay/promotion depends on short-term profits cut back on training, advertising, R&D etc. Fails to add value which would be achieved in long-term. They cut back on spending leaving subsequent managers to deal with the problems
- Accounting earnings/rates of return can be increasingly biased measures of true profitability
when calculating profits available after taxes to shareholders and the firm is financed by debt (not really relevant here) and preferred stock, do you include the dividend payments (ie, required yield of preferred stock onto dividend payments)?
no. Calculate the income first and any other costs, then calculate tax for that. You then subtract the dividend payment from the firm and you’re left with the retained earnings for shareholders.
opportunity value of a right
Opportunity value = (rights on price – issue price) / (N + 1)
MM theory: Does borrowing always increases firm value if there is a clientele of investors with a reason to prefer debt?
no: value increases only if clientele is not satisfied. You need excess demand to push equilibrium price up.
A clientele with preference = demand
A clientele with preference that is not satisfied yet = excess demand
MM theory does borrowing does not increase financial risk and the cost of equity if there is no risk of bankruptcy.
(debt amplifies variations in equity income).
Does MM’s proposition 2 assumes that increased borrowing does not affect the interest rate on the firm’s debt?
No. the formula rE = rA + (D/E)(rA - rD) does not require rD to be constant). Only rA has to be constant
Does MM’s proposition 1 says that corporate borrowing increases earnings per share but reduces the price–earnings ratio?
. True (as long as the return earned by the company is greater than the interest payment, earnings per share increase, but the P/E falls to reflect the higher risk).
rules of NPV
- Use CF not accounting income
- Estimate CFs on incremental basis
3, Treat inflation consistently (use nominal rates to discount real CFs and real rates for real CFs) - Separate investment and financing decisions (don’t include the costs of financing in the CFs, since CFs are to do with operating activities not financing activities)
real discount rate
=[(1+nominal discount rate)/(1+inflation rate)] - 1
Problems when calculating doing NPV
- investment timing decision
- Choosing btw projects
- Replacement decisions
- investment timing decision
o Some projects are more valuable if undertaken in the future
o Examine start dates (t) for investment and calculate net future value for each date
Discount net values back to present, whichever is the higher go with that!
- Choosing btw projects
do EAC
• If the 2 machines produce exactly the same product, the only way to assess is on the basis of cost
1. Calculate NPV
—> The costs should be calculated as after-tax costs
2. Calculate EAC
—> It’s better to calculate EAC with real terms
(Note that EAC implicitly assumes no inflation, but practically, buying and operating machines likely to rise with inflation (ie, nominal costs rise, but real costs constant))
—> Must always think about the implicit assumptions in the comparison
Equivalent Annual Cash Flow - The cash flow per period with the same present value as the actual cash flow as the project.
= PV CFs/annuity factor
effective rate formula
=(1+interest/no. compounding periods)^no. periods*total no. periods
certainty equivalent formula
CEQt=[CFt(1+rf)^t]/(1+r)^t.
Essentially the formula converts the risky CFs to riskless (Thus, certain) CFs which are then discounted via the risk-free rate.
What is the agency problem?
The principal-agent problem is a conflict in priorities between the owner of an asset and the person to whom control of the asset has been delegated.
how does agency problem affect capital budgeting
• Reduced effort if no incentives
- empire building - managers just focus on building their power, not on the benefits to the firm
- entrenching investments –> just invest in safer investments to survive, don’t want to take extra risk and just go for projects that only they have the skills for so that they’re needed and have purpose in the firm
- reduced risk - because it could damage their jobs/pay = loss of innovation
Managers and risk taking
- Managers must take some risks along the way
- Managers compensated with stock options have incentive to take risk (it’s myopic & biased short term incentive, they’re encouraged to take risk for higher stock price return to profit, unsustainable in the long run, affects long term shareholders)
- Gambling for redemption (if managers on bad side of exec, they want to take more risk)
- Organizations hesitate to curtail successful risky activities (why stop if economy is doing well? means firms fail to reassess projects leading to loss. In GFC, banks were making massive profit, but to succeed economy has to continue doing well)
if there’s too much pressure to perform?
can make managers risk averse
how to reduce agency costs?
- monitoring - board of directors (elected to represent shareholders interests), auditors, banks (who lend have incentive bc they want to make sure they’ll be paid back), rival companies (who may want to takeover firm)
what’s the solution to compensating managers?
Solution isn’t to link manager rewards to performance, but have managers bear some of the risk beyond their control and shareholders bear some of the agency costs if managers fail to maximise firm value
why is it bad to link manager performance to stock prices
- Note that linking performance to stock price is problematic bc stock price depends on expectations of future earnings, rate of returns depend on how well firm performs relative to expectations, so if a manager just produces returns that were expected (even if they’re higher than before) they don’t receive extra compensation bc the stock price stays the same
- Also, incentive plans could tempt managers to withhold bad news/manipulate earnings to boost prices, or even defer valuable investment projects that would depress earnings in the short run
- Stock options also encourage excessive risk taking, ie if their value falls, managers may be tempted to take risky actions to salvage the option values.
good features of manager pay
• Pay should be:
o 1. Reasonable (not excessive)
o 2. Linked to performance
• Every dollar paid to manager should be tied to every dollar they bring in, reduces agency costs.
EVA (residual income)
= income earned – income required
= income earned – [COC x investment]
EVA (residual income)
= income earned – income required
= income earned – [COC x investment]
managers who are compensated with stock options have
an incentive to take more risk. since, the value of an option increases when the risk of the firm increases.
managers sometimes have nothing to lose by taking on risks. Why?
Suppose that a regional office suffers large, unexpected losses. The regional manager’s job is on the line, and in response he or she tries a risky strategy that offers a small probability of a big, quick payoff. If the strategy pays off, the losses are covered and the manager’s job may be saved. If it fails, nothing is lost, because the manager would have been fired anyway. This behavior is called gambling for redemption.
organizations often hesitate to curtail risky activities that are delivering–at least temporarily–rich profits. because
they’re too focused on achieving short term profits to increase their annual compensation and for personal benefit instead of for the long term benefit of the firm
net investment
=capex - depreciation
net return on investment
= net profit/total investment
economic income
=CF - economic depreciation
