Unit 5 - Evaluating Investment Opportunities and Stock Valuation Flashcards
Principle 1
Record cash flows when the money actually moves, not when the accountant using accrual concepts says they occur
Principle 2
Imagine two worlds, one in which the investment is made and one in which it is rejected. All cash flows that are different in these two worlds are relevant to the decision, and those that are the same are irrelevant.
Sunk Costs
Not relevant for present decision
Test Marketing Costs
Marketing research expenses expanded
Erosion Costs
Cash flow transferred to a new project from sales and customers of other products of the firm
Opportunity Costs
Lost revenues from alternative uses of the asset
Depreciation
Non-Cash expense. Add depreciation back to income after tax to calculate the investment’s after-tax cash flow (ATCF)
ATCF =
(Revenue - Costs - Depreciation) (1 - Tax) + Depreciation
Working Capital (Def)
Changes that are the result of an investment decision are relevant to the decision.
- Beginning of project - Cash outflows.
- End of project- Cash inflows
Factors to Consider when making cash flow estimates
Price, Volume Variable Costs Fixed Costs Capital Expenditure Working Capital
Price/Volume
- Competition from existing products
- Competition from technological advances
- Values to customer
Variable Costs
- Labor, Material, Energy
Fixed Costs
- Marketing (sales, advertising)
- Information Technology
- Account Management
Capital Expenditure
Property, Plant & Equipment
Working Capital (Types)
- Inventory
- Accounts Receivable
- Accounts Payable
Nominal Return
Percentage change in the amount of money you have
Real Return
Percentage change in the amount of stuff you can actually buy
The Fisher Effect
1 + R = (1+r) x (1+h)
- R = Nominal
- r = Real
- h = Inflation
Depreciation always expressed in…
nominal terms
Sensitivity Analysis
- Target Market Share
- Cost Overrun
- Inflation
- Competition
- Discount Rate
- Valuable Options
Net Present Value is the…
most preferred technique
Capital budgeting must be done on an…
incremental basis - (sunk costs must be ignored, opportunity costs and side effects must be considered)
Inflation must be correctly handled
Express both cash flows and the discount rate in nominal terms (other approach is to express in real terms)
Uncertainty in forecasts can be addressed by…
conducting sensitivity analysis or simultion
Stock Ownership produces cash flows from:
- Dividends
- Capital Gains
Valuation of Different Types of Stocks
- Zero Growth
- Constant Growth
- Differential Growth (Real World)
Zero Growth
Div1/(1+R)^1 + Div2/(1+R)^2…
Constant Growth
Div2 = Div1(1 +G) = Div0(1+G)^2
G
Growth Rate
Just paid =
Last dividend
Differential Growth assumes that…
Dividends grow at different rates
g =
Retention ratio x Return on retained earnings
Retention Ratio =
1 - (Dividend per share/Earnings per share)
Discount Rate 2 parts
- Dividend yield
- Growth Rate
P =
EPS/R + NPVGO
An increase in retention rate will:
- Reduce the diviend paid to the shareholders
- Increase the firm’s growth rate
Comparables are used to…
value companies based primarily on multiples
Common multiples include:
- Price to earnings
- Enterprise value ratio
Price-Earnings Ratio =
Price per share/Earnings Per Share
Enterprise Value =
Market value of equity + Net Debt
Net Debt =
market value of debt - cash
