Resource Allocation Decisions Flashcards
What are the two types of decision criteria in resource allocation?
NPV and IRR
If NPV is greater than 0, what do you do?
Accept the project!
If IRR is greater than Cost of Capital, What do you do?
Accept the project!
When given the choice, do you use NPV or IRR?
NPV
What do you need in order to use NPV and IRR?
Expected free cash flow and the cost of capital
What are the 5 Cash Flow drivers?
Revenue Cash Costs Taxes Capital Expenditure Changes in Working Capital
What are the two different types of expenditures you can have?
Expense items
Capital items
What is the difference between expense and capital items
Expense items have a life of less than a year
Capital items have a life of more than a year
What is amortization?
If you buy an intangible asset, the investment must be similarly spread over its tax life
Is depreciation for tangible or intangible assets?
TANGIBLE
What is CapEx
The amount spent to acquire fixed capital items
What are fixed capital items
Tangible and intangible assets
What are examples of fixed capital?
Plant Equipment Building Land Intangible assets
What is working capital
Receivables less payable
Inventory
Operating cash
Why do you need working capital?
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
What are accounts receivable?
The amount owed by the customers to the company
What are the 3 different types of inventory?
Raw material inventory
Work in process inventory
Finished goods inventory
What are accounts payable?
Amount owed to the supplier
What is the calculation of working capital?
Working capital = current operating assets - current operating liabilities
What is operating cash?
Cash needed for day-to-day operations such as paying temporary labor
What are the components of working capital?
Operating Cash Accounts Receivable Inventory Pre-paid Expenses Accounts Payable Customer Advances
Salvage value
Value that a buyer is willing to pay
How do you calculate profit from asset sales?
Salvage value - book value
What are the non cash items that affect taxes?
Depreciation
Profit from asset sales
What does NOPAT stand for?
Net operating profit after tax
How do you calculate wealth created by a project?
NPV (DO) - NPV (DONT)
What is a perpetuity?
A steady stream of equal cash flow expected to last forever
What is the equation for a perpetuity?
PV = c/r
What is an annuity?
A steady stream of equal casbah flows that has a finite life
Constant growth perpetuity
Cash flows grow at a constant rate in perpetuity
Constant growth perpetuity equation
PV = c1/r-g
What is NPV?
The change in shareholder wealth
What is cost of capital?
The rate of return that investors can earn elsewhere at the same risk
What is IRR?
Measures the expected average annual rate of return of an investment
Return on assets
The ratio of net income to total assets — not based on cash flow
What is the definition of fixed capital?
Cash spent to acquire fixed assets
What are free cash flows?
Total cash flows of the project
Cost of equity =
Risk free rate + risk premium
Risk free rate =
Real rate of interest + expected rate of inflation
What type of risk does a fully diversified investor face?
Market risk
What is the cost of capital?
The rate of return that investors can expect to earn for equivalent risk investments in the financial market
What does real rate measure?
The “cost of money” in an economy
What does the cost of capital of a firm reflect?
Its cash flows
What is a hurdle rate?
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.
What are the 2 broad classes of capital?
Debt and Equity
What four parameters do you need to compute WACC?
Tax Rate
Proportion of debt or equity
Cost of debt
Cost of equity
What is beta?
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
Can betas change over time?
Yes
What is the Capital Asset Pricing Model (CAPM)?
Cost of Equity = risk-Free rate + beta x market risk premium
What market risk premium are we using in this class?
6%
Why do small firms command a greater risk premium than the estimate using beta?
Small stocks have less liquidity
Small stocks have limited trading
Small stocks have greater default risk
How do you calculate the Weighted Average Cost of Capital (WACC)?
After-tax cost of debt x proportion of debt + cost of equity x proportion of equity
What is the debt ratio formula?
Debt/(Debt + Equity)
What is the equity ratio?
E/(D+E)
Are WACC of a company and a project the same?
NO!
What is a pure-play?
A publicly-traded company with the same business risk as our project or company
How do you handle multiple pure-plays?
Compute the WACC of each and use the average of them as the project’s WACC
What types of risk do stockholders face?
Business Risk
Financial Risk
What is business risk?
Risk that arises from the business operations and includes demand risk, price risk and technology risk
What is financial risk?
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
If a company has no debt, what kind of risk do shareholders bear?
Only business risk
If a company has some debt, what kinds of risk do shareholders bear?
Both business and financial risk
What happens to stockholder risk as debt increases?
It increases because business risk stays the same and financial risk increases
What is cost of preferred stock?
The preferred stock dividend divided by its market value
