Topic 5 - Risk and Returns in Corporate Finance

Question 1

What is capital budgeting?

Answer 1

the process of determining which long-term investments the company should undertake

Question 2

What are the 5 steps in capital budgeting?

Answer 2

1. id potential investments
2. estimate incremental cash flows (in/out)
3. estimate fair rate of return given risk
4. analyse and prioritise investments
5. implement and monitor

Question 3

What characteristics does management desire in a capital budgeting technique?

Answer 3

Easily applied technique that considers cash flows, the time value of money, fully accounts for risk and return, and when applied leads to higher share prices

Question 4

NPV

Answer 4

the sum of the present values of all a projects cashflows discounted at a rate consistent with the projects risk. NPV is also the preferred method for VC

Question 5

EVA

Answer 5

economic value added is the method of analysing capital investments which determines whether an investment produces net cash flow sufficient to cover the company’s cost of capital

Question 6

State NPV decision rule

Answer 6

NPV > 0 , invest
NPV < 0 do not invest

Question 7

How much will a share price rise if a NPV project is positive?

Answer 7

Divid project NPV with # of outstanding shares

Question 8

NPV benefits

Answer 8

*focuses on cash, not accounting earnings
* makes appropriate adjustment for TMV
*can properly account for differences between projects

Question 9

NPV drawbacks

Answer 9

• doesn’t capture managerial flexibility
  *lacks some intuitive appeal compared to simpler methods

Question 10

Economic Profit

Answer 10

A profit that exceeds a normal, competitive rate of return in an industry or line of business

Question 11

What does it mean if a project has a NPV of $1m

Answer 11

NPV gives a direct estimate of the change in shareholder wealth resulting from a given investment and provides a straightforward way to control differences in risk among alternatives. However it does not provide a means for incorporating managerial flexibility

Question 12

IRR

Answer 12

the compound annual rate of return on a project given its up-front costs and subsequant cash flows

Question 13

IRR decision rule

Answer 13

if IRR > hurdle rate, accept project
if IRR < hurdle rate, reject project

Question 14

IRR hurdle rate examples

Answer 14

cost of capital
required rate of return discount rate

Question 15

IRR advantages

Answer 15

properly adjust for time value of money
uses cash flows rather than earnings
accounts for all cash flows
project IRR is a number with intuitive appeal

Question 16

IRR disadvantages

Answer 16

• non conventional cash flows eg. lending v borrowing, multiple IRRs
• mutually exclusive projects eg. scale bias, timing of cash flows

Question 17

What is a conventional cash flow?

Answer 17

A project has a conventional cash flow if the initial cash flow is negative, or all costs come first, then after all the cash flows are positive. There is a relationship between NPV and IRR for the project

Question 18

What is a non-conventional cash flow

Answer 18

A project has a non-conventional CF when we have both inflows and outflows during the life of the investment. We have multiple IRRs and don’t know which one is relevant

Question 19

NPV and IRR relationship

Answer 19

Question 20

What is the payback period

Answer 20

the amount of time required for the company to recover its initial investment

Question 21

advantages of payback period

Answer 21

• computational simplicity
• easy to understand
• focus on cash flow

Question 22

disadvantages of the payback period

Answer 22

• does not account properly for TMV
• does not account properly for risk
• cut-off period is arbitrary
• does not lead to value maximising decisions

Question 23

Discounted pay back period

Answer 23

the amount of time it takes for a projects discounted cash flows to recover the initial invsetment

Question 24

Accounting rate of return - ARR

Answer 24

ROI calculated by dividing net income by the book value of assets

Question 25

Disadvantages of ARR

Answer 25

• uses accounting numbers, not cashflos
• ignores TVM risk
• uses arbitrary benchmark to evaluate projects
• does not indicate whether a project adds value
• impacted by depreciation method
• impacted by the valuation of inventories

Question 26

Define Project Cash Flow

Answer 26

Project CF = Project OCF - Project change in NWC - Project NCS
where
OCF = operating cash flow
NCS = net capital spending

Question 27

Why do we ignore financing costs?

Answer 27

They are captured in the process of discounting future cash flows

Question 28

Why do we consider taxes?

Answer 28

Only after-tax cash flows are relevant as only these cash flows can potentially be distributed to investors or used for other purposes

Question 29

Prime Cost

Answer 29

AKA straight line method, depreciation is a constant proportion of the reduced balance

Question 30

Diminishing value method

Answer 30

aka reducing balance
depreciation is a constant proportion of the reduced balance

Question 31

What is terminal value?

Answer 31

It is intended to reflect the value of a project at a given future point in time. It is usually large relative to all other cash flows of the project.

Question 32

What are side costs and benefits of projects

Answer 32

In all of the examples we have used so far, the investments that we have analysed have stood alone
In practice, most investments are not independent. Taking an investment can often mean rejecting another investment at one extreme (mutually exclusive) to being locked in to take an investment in the future (prerequisite)
Most projects considered by any business create side costs and benefits for that business
The side costs include:
Costs created by the use of resources that the business already owns
Lost revenues for other projects that the firm may have
The side benefits include
Project synergies
Options embedded in projects
The returns on a project should incorporate these costs and benefits

Question 33

What is cannibilisation?

Answer 33

A very common side cost in multiproduct firms is cannibalisation or erosion
This refers to the loss of sales of an existing product when a new product is introduced and is effectively a ‘substitution’ effect
Examples:
Apple would have considered that the introduction of the iPad Mini would have had an impact on sales of its larger cousin.
Likewise, introduction of new airline flight for the same route may come at the expense of full cabins on the original route
The lost revenue from other product lines must be included into our analysis of new project cash flows

Question 34

What is a synergy?

Answer 34

A project may also provide benefits for other projects within the firm.
These benefits have to be valued and shown in the initial project analysis.
Examples:
Coffee shops in hardware stores (think Bunnings)
Motor vehicle service and repair with new car dealer

Question 35

What is an opportunity cost?

Answer 35

An opportunity cost arises when a project uses a resource that the firm already owns
This resource has to be priced on its next best alternative use, which may be:
a sale of the asset
renting or leasing the asset out
use elsewhere in the business
Examples:
Firms sometimes own office or warehouse space that can be used for a project, and the opportunity cost is the income from selling the warehouse or from leasing the space
Use of empty land the company owns to build a new facility. The opportunity cost is the selling price of land

Question 36

What is a sunk cost?

Answer 36

expenses related to a project are incurred before project analysis is undertaken. Examples:
Test marketing for a potential product prior to full investment in its production
R&D cost in biotech and pharmaceutical companies long before a product reaches the trial stage, let alone the final introduction of the product in the market

Question 37

Approaches to projects with unequal lives

Answer 37

Two basic approaches for solving this:
Project replication:
We reproduce the shorter project (and sometimes even the long project) until we obtain a common investment horizon
For example, if we compared a 2- and a 10-year project, we could replicate the shorter project 5 times in the time taken to complete the longer project
Equivalent annuity approach (benefit or cost)
We convert each project’s NPV into an annuity to better compare them
This yields the same outcome as the replication approach, but is computationally simpler

Question 38

What is capital rationing?

Answer 38

Can a company accept all investment projects with positive NPV?
Reasons why a company would not accept all projects:
Limited availability of skilled personnel to be involved with all the projects
Financing may not be available for all projects
Capital Rationing
accepting projects that maximizes shareholder wealth subject to funding constraints
Soft rationing
occurs when a business or units in a business are allocated a certain amount of financing for capital budgeting for reasons other than external financing constraints
Hard rationing
occurs when the firm is unable to raise the financing for a project under any circumstances