Topic 5 - Risk and Returns in Corporate Finance Flashcards
What is capital budgeting?
the process of determining which long-term investments the company should undertake
What are the 5 steps in capital budgeting?
- id potential investments
- estimate incremental cash flows (in/out)
- estimate fair rate of return given risk
- analyse and prioritise investments
- implement and monitor
What characteristics does management desire in a capital budgeting technique?
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
NPV
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
EVA
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
State NPV decision rule
NPV > 0 , invest
NPV < 0 do not invest
How much will a share price rise if a NPV project is positive?
Divid project NPV with # of outstanding shares
NPV benefits
*focuses on cash, not accounting earnings
* makes appropriate adjustment for TMV
*can properly account for differences between projects
NPV drawbacks
- doesn’t capture managerial flexibility
*lacks some intuitive appeal compared to simpler methods
Economic Profit
A profit that exceeds a normal, competitive rate of return in an industry or line of business
What does it mean if a project has a NPV of $1m
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
IRR
the compound annual rate of return on a project given its up-front costs and subsequant cash flows
IRR decision rule
if IRR > hurdle rate, accept project
if IRR < hurdle rate, reject project
IRR hurdle rate examples
cost of capital
required rate of return discount rate
IRR advantages
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
IRR disadvantages
- non conventional cash flows eg. lending v borrowing, multiple IRRs
- mutually exclusive projects eg. scale bias, timing of cash flows
What is a conventional cash flow?
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
What is a non-conventional cash flow
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
NPV and IRR relationship
What is the payback period
the amount of time required for the company to recover its initial investment
advantages of payback period
- computational simplicity
- easy to understand
- focus on cash flow
disadvantages of the payback period
- does not account properly for TMV
- does not account properly for risk
- cut-off period is arbitrary
- does not lead to value maximising decisions
Discounted pay back period
the amount of time it takes for a projects discounted cash flows to recover the initial invsetment
Accounting rate of return - ARR
ROI calculated by dividing net income by the book value of assets
Disadvantages of ARR
- 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
Define Project Cash Flow
Project CF = Project OCF - Project change in NWC - Project NCS
where
OCF = operating cash flow
NCS = net capital spending
Why do we ignore financing costs?
They are captured in the process of discounting future cash flows
Why do we consider taxes?
Only after-tax cash flows are relevant as only these cash flows can potentially be distributed to investors or used for other purposes
Prime Cost
AKA straight line method, depreciation is a constant proportion of the reduced balance
Diminishing value method
aka reducing balance
depreciation is a constant proportion of the reduced balance
What is terminal value?
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.
What are side costs and benefits of projects
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
What is cannibilisation?
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
What is a synergy?
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
What is an opportunity cost?
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
What is a sunk cost?
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
Approaches to projects with unequal lives
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
What is capital rationing?
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
