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
