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Final Exam Study Guide Notes

Final Exam Study Guide Notes - Final Exam Study Guide...

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Unformatted text preview: Final Exam Study Guide Guidelines for Capital Budgeting, A Philosophy for Decision Making: 1. Use cash flows rather than accounting profits a. Principle – cash, not profits, is king b. Depreciation is the problem c. True timing of benefits is what’s important 2. Think Incrementally a. Principle – Incremental Cash Flows, It’s only what changes that counts b. Micro economic way of thinking – “It’s only what changes that counts” 3. Beware of cash flows diverted from existing products 4. Look for Incidental or Synergistic Effects 5. Work in Working Capital Requirements a. Inventory – part of the initial outlay, recapture when the project is terminated 6. Consider Incremental Expenses a. Training, sales training, Re‐Engineering 7. Remember that Sunk Costs are not incremental cash flows 8. Account for opportunity cost a. The cost you assign to any asset you own should be its most profitable alternative 9. Decide if overhead costs are truly incremental cash flows a. Administrative costs 10. Ignore interest payments and Financing flows a. When we discount cash flows back to present we account for “cost of money” and if we subtracted out interest than we would count it again Measuring the Cash Flows Our interest is only in the incremental, or differential after‐tax cash flows, for the company as a whole that are attributable to the proposed investment The importance of considering incremental cash flows to the company as a whole cannot be over emphasized 1. Initial Outlays a. Installed cost of assets b. Working capital requirements c. After tax expense items (training/installation/re‐engineering) d. If a replacement project, sales value of old machine (+‐ taxes) 2. Estimating differential cash flows a. Added revenues less expensive Project Ranking and Capital Rationing 1. Importance of project ranking: Why not just take all projects with a NPV >= 0, PI >= 1.0, IRR >= K? a. Why you might accept a project with NPV <0 i. Real Options: Value created by project flexibility ii. Mutually exclusive projects: Acceptance of one project means rejection of another iii. Capital Rationing: A limit on capital spending 2. Real Options: Allowing for adjustments we can make in the project after it is accepted a. Option to expand b. Option to abandon c. Option to Delay (Timing Options) d. Real life example: Toyota and Honda initially lost money on hybrid cars Capital Rationing 1. We have implicitly been saying that the size of the capital budget is determined by the supply of available proposals 2. If constraint imposed a. Positive NPV projects are rejected b. How do you deal with projects that aren’t divisible 3. Since the firm always has an opportunity to raise additional finds in market, why would capital rationing ever exist? a. Poor: Management may feel that adverse market conditions are temporary b. Good: Manpower constraints (High tech) c. Bad: Fear or loss of control 4. Is capital rationing a rational move? a. It depends upon the reasoning and the extent of rationing 5. Project selection under capital rationing a. Select the max NPV subject to the budget constraints Problems Encountered in Project Ranking 1. Size disparity problem a. Consider 2 mutually exclusive projects (cost of capital 10%) b. Which is the better project? IT DEPENDS! i. If no capital rationing then take the project with the highest NPV that way the shareholders wealth is maximized ii. If capital rationing then the question becomes what can be done with the money freed up if a smaller as opposed to a larger project is accepted 2. Time disparity problem a. Consider 2 mutually exclusive projects (Required rate of return 10%) b. You can solve this problem by using the MIRR or modified internal rate of return which allows you to specify a reinvestment rate c. Which project is better? (It is caused by different reinvestment rate assumptions) i. IRR assumes cash flows over the life of the project are reinvested at the IRR ii. NPV assumes cash flows over the life of the project are reinvested at the required rate of return 3. Different lives: comparability problem key a. Are all future profitable projects being affected by this decision included in the analysis? Capital Budgeting Under Uncertainty 1. Types of Risk ‐ What counts? a. For a project there are three types of risk involved: i. Stand alone risk (standard deviation) ii. Project contribution to firm risk iii. Systematic risk b. Is total variability of a project’s cash flows the relevant risk measure? i. NO c. Is the risk that the project contributes to the firm’s total risk the relevant risk measure? i. Not in theory, but maybe in practice 2. Capital Budgeting and Systematic Risk: Is that all there is to it? a. What CAPM sys to do i. In theory, yes (It’s tough moving from theory to practice) b. Measurement problems i. No market returns (projects don’t sell in this market place) ii. If a new project there’s nothing historical c. Problems of misspecification i. The CAPM appears to be misspecified, that is, factors other than systematic risk appear to play a role in explaining security returns. They include 1. Size 2. Seasonality 3. Market to bad rates d. Dealing with undiversified shareholders i. Bill Gates – unsystematic risk counts e. Problems introduced by bankruptcy costs i. The CAPM assumes there are no bankruptcy costs ii. If there are no bankruptcy costs then the firm diversification holds no advantage over individual diversification iii. In the real world there are costs associated with bankruptcy 1. Lawyers fees, assets sold for less that true value 2. Opportunity cost with delays in sales 3. Lemons problem: good workers leave and bad ones stay 4. Lost sales due to warrants and replacement part concerns 5. Lost in trade credit What Counts – Both 1. As long as bankruptcy costs exist unsystematic risk is important 2. To what extent do these two types of risk matter and how do we adjust for them? (No good answer) a. Look at GM and IBM Risk Adjusted discount rates This approach is consistent with CAPM Based on the notion that investors require higher returns for more risky ventures The discount rate is adjusted upward to compensate for the risks involved in the project o Higher risk = higher discount rate Cash flows are the expected values (risk adjustment made in discount rate, not cash flows) Summary o Consistent With the CAPM o Adjust the discount rate up for more risk o Discount the expected cash flows using the adjusted rate o Then apply the normal criteria o Real problem comes in measuring the relevant risk of a project o Still, better than nothing o Projects are frequently grouped according to the purpose of the investment Replacement decisions, expansion of product lines, new products, R&D activities o Decision criteria IRR: accept if IRR > risk adjusted opportunity rate NPV: accept if NPV > 0 PI: accept if PI > 1 Adjusting Discount Rates for Systematic Risk 1. First must estimate systematic risk a. Use accounting betas – betas estimated using profits rather than returns b. Use pure play betas – find a publically traded firm that looks like your project and use that firm’s required rate of return (after adjusting for any differences in capital structures) c. If project is different from existing firm activity, the firm will tend to reject “good” safe projects and accept “bad” risky projects Other Sources of Risk 1. Time Dependent cash flows a. Cash flows in one period are dependent upon cash flows in the previous period Summary 1. Because of bankruptcy costs both systematic and unsystematic risk appear to be relevant, although to what degree is hard to say 2. The risk‐adjusted discount rate approach is the most widely recognized method of incorporating risk into capital budgeting situations 3. The financial manager must account for risk of projects, especially if outside the “normal” operation of the firm Cost of Capital 1. Cost of capital is the rate of return that a firm must earn on funds that are currently invested to justify raising funds to finance those assets a. OR rate of return that leaves the market price of the common stock unchanged 2. Factors both inside and outside the firm determine this 3. Each source of capital has an explicit cost (basically the internal rate of return for that source of capital) a. Since we are now looking for a firm’s point of view securities have a COST associated with them not a return Equity 1. There are two ways a firm can raise equity: a. It can sell new stock b. It can retain the firms earnings i. Sort of like a form of forced reinvestment 2. Each of these methods of raising equity has a separate cost of capital 3. Cost of Retained Earnings (Internally generated equity Kcs) a. With internally generated equity we don’t need to worry about net proceeds, just the price of common stock since there are no flotation costs 4. Cost of issuing new shares of common stock (Knc) a. If new stock were sold in the market place it would have to be priced under the current market price in order for the market to clear b. Firm does not receive the selling price on new equity because of the cut that the investment banker takes c. The firm gets the selling price less the flotation costs 5. Estimating the cost of common Stock using CAPM a. Capital Asset Pricing Model b. See Equation c. No transaction costs are included Calculations of a Weighted Cost of Capital As more funds are raised the cost of capital increases It is impossible to identify specific assets with specific sources of capital Cost of capital is a percentage that describes the cost of a bundle of financing a. Used to evaluate the desirability of investing in that bundle Cost of Capital is calculated as a weighted average of the marginal costs of each of the financing sources a. Weights reflect the firms target proportions for each source of capital If current policy is consistent with past practice, then current book values are an appropriate basis for weights of investment Externally raised equity = common stock + paid in capital Determining costs: a. Marginal cost of capital to the firm shows the costs if the firm were to raise funds today b. We are valuing securities from the point of view of the firm rather than from the investor’s perspective Why does the cost of capital increase with the amount raised? a. Investors perceive there to be greater risk b. Flotation costs rise as the amount of funds to be raised increases (basically it gets harder to raise money the more you have raised) Break even point – level of funding after which funds from retained earnings are no longer available and the equity portion of the WCC will come from new equity a. The firms marginal cost of capital increases at the break point b. The cost of retained earnings will always be less than the cost of issuing new common stock i. Because issuing new common stock incurs flotation costs Leverage 2 types (both involve a trade‐off between risk and return): o Operating – the fixed costs occur in the production, sales, or management function (Take sales people and put them on salary rather than commission) o Financial – the fixed costs occur in the financing function (interest charges must be paid regardless of what sales are) Risk – in bad years you may have trouble covering fixed costs Return – your costs are limited, so in good years you do really well Contribution margin = 1 – (Variable Cost/ total sales) o This is the percent of sales that goes toward covering fixed costs and when once they are covered it the goes toward profits Optimal Capital Structure Taxes – push us to use lots of debt o Interest payments reduce taxes 9dividends don’t) this makes debts a cheaper source of capital Bankruptcy o Pushes us to use just a little debt o Too much debt means too much in the way of fixed interest payments which means in a bad year you could go under o ...
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