WACC and Capital Budgeting Flashcards
WACC means
Weighted Average Cost of Capital
What are the 4 methods of Capital Budgeting (that Noorian cares about)
- Pay Back Method
- Net Present Value
- Internal Rate of Return
- Modified Internal Rate of Return
Total Revenue =
Quantity * Price
Is fixed cost always fixed?
NO
Contribution Margin =
Price - Variable Cost/unit
Contribution = Sales - VC
At breakeven point, fixed cost =
= Contribution * Breakeven QTY = Q*(P - VC)
At breakeven point, net profit =
net loss = 0
Personal WACC: you have the following debts: Mortgage - $500k, 4% Car Loan - $45k, 5% Credit Card - $25k, 14% What is your WACC?
$20k + $2250 + $3500 = $25750
$500k + $45k + $25k = $570k
WACC = 4.52%
Company has following balance sheet: Total Assets = $5000 Current Liabilities = $900 Total Long - Term Debt = $1800 Total Stockholder's equity = $2300
ROE (demanded by shareholder) = 16%
Interest on long term debt = 6%
Marginal tax rate = 21%
What is their WACC?
Weight of Equity = $2300/$5000 = 46%
Weight of Liability = $1800/$5000 = 36%
WACC = 46%16% + 36%6%*(1-21%) = 9.07%
WACC formula =
(weight of Equity * Cost of Equity) + (Weight of Liability * Cost of Long-term Liabilities * (1-average corporate tax rate)
Weight of Equity =
Total Equity / Total Assets
WACC for large corporations tends to be
lower
Capital budgeting is used for major expense with:
- high price
- low frequency of purchase
- significant salvage value
- significant maintenance costs
- significant service after sales required
What are positive aspects of the pay back method?
- Easy and simple
- focused on getting your money back faster so you can reinvest it earlier in other profitable projects
Payback method is a useful method in environments where
- technology is evolving rapidly
- political uncertainty
What are negative aspects of the pay back method
- doesn’t take into account the time value of money
2. doesn’t take into account the entire cash flow
What is the step by step method for calculating NPV
- find PV of each cash flow, discounted back to T0 with WACC
- sum up PVs of cash flows
- NPV = Sum of PVs - Initial investment
What are positive aspects of NPV
- take TVM into account
2. takes entire cash flow into account
What are negative aspect(s) of NPV
It does not tell you a specific annual rate of return
When calculating IRR, the numbers need to be adjusted by making NPV =
ZERO
What is the method for finding IRR, assuming you already know the NPV
Assuming NPV is positive:
1. pick a rate in the TVM table that is higher than the discount rate used with the NPV calc (required rate of return)
2. calculate new PVs with new rate, sum up
3. iteratively adjust rate until sum(PVs) = initial investment
that rate is your IRR
IRR =
Internal rate of return
What is the innate flaw with the IRR method
The reinvestment assumption: assumes that you are making this IRR every year and are able to reinvest it at the same rate
What is the MIRR method, assuming you already found IRR
- project each cash flow to the last year using the given WACC (simple FV)
- sum up all cash flows to the TERMINAL VALUE
- Find an interest rate that will discount the terminal value back to the value of your initial investment
If your terminal value = $151720 with 3 years of cash flows, and your initial investment was $100k, what is the MIRR?
15%
A capital outlay is a
Sheet used for capital budgeting
The MIRR is meant to correct the
reinvestment assumption
What factors are we currently excluding from our capital budgeting methods?
- probability that we are accurately forecasting cash flows
- tax incentives
- salvage value
For this course’s methods of capital budgeting, what is taken as a known?
the annual cash flows
Two projects are ______ if picking one eliminates the possibility of picking the other
mutually exclusive
Two projects are _____ if the acceptance of one project has no bearing on the acceptance or rejection of the other project
independent
Cost of Liabilities =
Interest rate of debt * (1 - average tax rate)
Is it preferred to use book value or market value of stock when calculating weight of equity?
Market value
For the WACC, cost of equity =
ROE
When you are dealing with an even amount of cash flow every year from a potential project, what is the payback period
Payback period = initial investment / annual cash flow
If you have a potential project with an annual cash flow of $17k, that will “live” for 28 years, and the initial investment is $280k, what is the IRR?
PVIFA = Amount of Initial Investment / Annual cash flow = $280k/$17k = 16.47
PVIFA(28 years, ?%) = 16.47»_space;> 4%
Boeing’s reports showed that their _____ from the US is going down
revenue share
About 22,000 ____ are on strike during negotiations
longshoremen
The average family income in mass is ____ the _____ in the US
$82,000
highest
China will need about ____ new planes by 2040
8700
Boeing not manuafacturing in China even though there is high demand is an example of
macro environment > political tensions between US / China
The discount rate rate set by the fed is ….
the rate that the federal reserve system charges its member banks
How many member banks does the Fed have?
4300
The rate that banks charge each other for overnight loans is the
federal fund rate
In May, the Fed raised the federal fund rate by ___ basis points, putting it at ___
25 basis points
50 basis points
The federal funds rate is set by the
FOMC
The current Federal Funds Rate in June 2022 is ___, the Fed raised it by
1.75%
75 basis points
The federal funds rate in 1980 was
15.5%
In Mass, unemployment went down by ___ to ___
- 1%
4. 7%
National unemployment rate in may 2022 was
3.6%
So far in 2022, at least ___ have raised interest rates
45
What are 4 global factors hampering growth and leading to a recession right now?
- war in Ukraine
- lockdown in China
- supply chain disruptions
- risk of stagflation
The Fed has increased rates ___ times this year
3
The American Rescue Plan had what $ value
$1.9 trillion
Profitability Index =
Total Present Value / Initial investment
(NPV + Initial Investment)/Initial investment
for a good investment project, the profitability index will be …
> 1
