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Time Value of Money > Resource Allocation Decisions > Flashcards

Resource Allocation Decisions Flashcards

1
Q

What are the two types of decision criteria in resource allocation?

A

NPV and IRR

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2
Q

If NPV is greater than 0, what do you do?

A

Accept the project!

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3
Q

If IRR is greater than Cost of Capital, What do you do?

A

Accept the project!

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4
Q

When given the choice, do you use NPV or IRR?

A

NPV

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5
Q

What do you need in order to use NPV and IRR?

A

Expected free cash flow and the cost of capital

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6
Q

What are the 5 Cash Flow drivers?

A 
Revenue
Cash Costs
Taxes
Capital Expenditure
Changes in Working Capital
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7
Q

What are the two different types of expenditures you can have?

A

Expense items

Capital items

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8
Q

What is the difference between expense and capital items

A

Expense items have a life of less than a year

Capital items have a life of more than a year

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9
Q

What is amortization?

A

If you buy an intangible asset, the investment must be similarly spread over its tax life

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10
Q

Is depreciation for tangible or intangible assets?

A

TANGIBLE

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11
Q

What is CapEx

A

The amount spent to acquire fixed capital items

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12
Q

What are fixed capital items

A

Tangible and intangible assets

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13
Q

What are examples of fixed capital?

A 
Plant
Equipment
Building
Land
Intangible assets
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14
Q

What is working capital

A

Receivables less payable
Inventory
Operating cash

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15
Q

Why do you need working capital?

A

If the company collects from customers later than when it has to pay various parties
If there is a timing gap between when customers pay you compared to when you have to pay

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16
Q

What are accounts receivable?

A

The amount owed by the customers to the company

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17
Q

What are the 3 different types of inventory?

A

Raw material inventory
Work in process inventory
Finished goods inventory

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18
Q

What are accounts payable?

A

Amount owed to the supplier

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19
Q

What is the calculation of working capital?

A

Working capital = current operating assets - current operating liabilities

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20
Q

What is operating cash?

A

Cash needed for day-to-day operations such as paying temporary labor

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21
Q

What are the components of working capital?

A 
Operating Cash
Accounts Receivable
Inventory
Pre-paid Expenses
Accounts Payable
Customer Advances
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22
Q

Salvage value

A

Value that a buyer is willing to pay

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23
Q

How do you calculate profit from asset sales?

A

Salvage value - book value

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24
Q

What are the non cash items that affect taxes?

A

Depreciation

Profit from asset sales

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25
Q

What does NOPAT stand for?

A

Net operating profit after tax

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26
Q

How do you calculate wealth created by a project?

A

NPV (DO) - NPV (DONT)

27
Q

What is a perpetuity?

A

A steady stream of equal cash flow expected to last forever

28
Q

What is the equation for a perpetuity?

A

PV = c/r

29
Q

What is an annuity?

A

A steady stream of equal casbah flows that has a finite life

30
Q

Constant growth perpetuity

A

Cash flows grow at a constant rate in perpetuity

31
Q

Constant growth perpetuity equation

A

PV = c1/r-g

32
Q

What is NPV?

A

The change in shareholder wealth

33
Q

What is cost of capital?

A

The rate of return that investors can earn elsewhere at the same risk

34
Q

What is IRR?

A

Measures the expected average annual rate of return of an investment

35
Q

Return on assets

A

The ratio of net income to total assets — not based on cash flow

36
Q

What is the definition of fixed capital?

A

Cash spent to acquire fixed assets

37
Q

What are free cash flows?

A

Total cash flows of the project

38
Q

Cost of equity =

A

Risk free rate + risk premium

39
Q

Risk free rate =

A

Real rate of interest + expected rate of inflation

40
Q

What type of risk does a fully diversified investor face?

A

Market risk

41
Q

What is the cost of capital?

A

The rate of return that investors can expect to earn for equivalent risk investments in the financial market

42
Q

What does real rate measure?

A

The “cost of money” in an economy

43
Q

What does the cost of capital of a firm reflect?

A

Its cash flows

44
Q

What is a hurdle rate?

A

When a firm adds a premium to the cost of capital - it’s usually set greater than the cost of capital to make sure only projects that significantly add value are undertaken.

45
Q

What are the 2 broad classes of capital?

A

Debt and Equity

46
Q

What four parameters do you need to compute WACC?

A

Tax Rate
Proportion of debt or equity
Cost of debt
Cost of equity

47
Q

What is beta?

A

The sensitivity of market risk

A stock with a beta of 1 has the same risk as the market
A stock with a beta of less than 1 has less risk than the market
A stock with a beta of more than 1 has more risk than the market

48
Q

Can betas change over time?

A

Yes

49
Q

What is the Capital Asset Pricing Model (CAPM)?

A

Cost of Equity = risk-Free rate + beta x market risk premium

50
Q

What market risk premium are we using in this class?

A

6%

51
Q

Why do small firms command a greater risk premium than the estimate using beta?

A

Small stocks have less liquidity
Small stocks have limited trading
Small stocks have greater default risk

52
Q

How do you calculate the Weighted Average Cost of Capital (WACC)?

A

After-tax cost of debt x proportion of debt + cost of equity x proportion of equity

53
Q

What is the debt ratio formula?

A

Debt/(Debt + Equity)

54
Q

What is the equity ratio?

A

E/(D+E)

55
Q

Are WACC of a company and a project the same?

A

NO!

56
Q

What is a pure-play?

A

A publicly-traded company with the same business risk as our project or company

57
Q

How do you handle multiple pure-plays?

A

Compute the WACC of each and use the average of them as the project’s WACC

58
Q

What types of risk do stockholders face?

A

Business Risk

Financial Risk

59
Q

What is business risk?

A

Risk that arises from the business operations and includes demand risk, price risk and technology risk

60
Q

What is financial risk?

A

It is a type of risk that arises from debt - since stockholders have lower priority than lenders, they bear additional risk as a company starts borrowing

61
Q

If a company has no debt, what kind of risk do shareholders bear?

A

Only business risk

62
Q

If a company has some debt, what kinds of risk do shareholders bear?

A

Both business and financial risk

63
Q

What happens to stockholder risk as debt increases?

A

It increases because business risk stays the same and financial risk increases

64
Q

What is cost of preferred stock?

A

The preferred stock dividend divided by its market value

Time Value of Money (1 decks)

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