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Capital Budgeting Process Definitoin?
Process of identifying and evalutaitng capital projects, projects where the cash flow to the firm will be received over a period longer than a year.
4 Steps in the capital budgeting process?
- 1. Idea Generation
- 2. Analyzing project proposals
- 3.Create the firm-wide capital budget
- 4. Monitoring decisions and conducting a post-audit
Five key principles of the Capital budgeting process?
1. Decisions are based on cash flows, not accounting income. Relevant cash flows are INCREMENTAL cash flows. Sunk costs that cannot be avoided, even if project is not undertaen, shoud not be included in firms analysis.Externalities, the effect the acceptance of a project may have on other firm cash flows like cannibalization should be factored in.
2.Cash flows are based on opportunity costs.Opportunity costs shoudl be included in project costs. For example if firm owns land, and wants to build a plant. The firm should charge the cost of the land to the project bc it could technically be sold if it wasn't used.
3. Timing of cash flows is important, bc of time value of money
4. Cash flows are analyzed on an after tax basis.
5.Financing costs are reflected in the project's requried rate of return. Only projects expted to return more than cost of capital need to be funded.
Conventional Cash flow pattern vs unconventional?
Conventionl the sign on cash flows changes only once. Unconvetional happens multiple times.
What is IRR Decision Rule?
IF IRR is greather the Required rate of return, Accept. IF IRR is less than Requried rate of return, reject.
Amount of time it takes to payback costs. Do not take into account time value of money or cash flow beyone payback period. Payback period discounted and regualr payback is found on Calculator as PB or DPB
What is Profitability Index?
Profitability index is taking the present value of a project's future cash flows divided by the intitial outlay. NPV total/CF0. IF Profitability index is above 1 accept, if below, reject.
NPV Profile?Crossover Rate?
Graph that shows a project's NPV for different discount Rates.
Crossover Rate is the discount rate at which the NPV's of two projects are equal. To see the crossover Rate, take the differnces between the two projects cash flows and enter them into calc and get IRR.
Advantages of NPV vs. IRR
Advantage of NPV is that it is a direct measure of expected increase in value of firm. Theoretically is best method, however, does not take into account the size of the project.
Key advantage of IRR is that it measures profitabilty as a percentage and shows return on each dollar invested. IRR provids information on margin of safety, meaning how much over the IRR is then the requried rate of return.
Disadvantages of IRR are 1. possibility of produc ing rankings of mutually exclusive projects from those from NPV analysis.This can be bc of cash flow differences. Additionally if IRR for two investments of different sizes and one investment is higher for the smaller investment, but the NPV added is greater for the larger investment, you would take the larger investment regardless of the smaller IRR.
IRR also assumes that you reinvest earnings at the firms IRR. However, NPV assumes they can be reinvested at the discount rate used to caluclate NPV, bc you can use cash to pay off debt and lower the cost of capital.
An additonal issue with IRR, is that an unconventional cash flow can produce multiple IRR's.
Popularity of capital budgeting methods in certain areas/ situation
1. Location - European countreis tend to use payback period method as much or more than IRR and NPV
2.Size of company - Larger companies are more likely to use NPV and IRR
3. Public vs. Private - Private companies use payback period more ofthan than public. Public tend to prefer discounted cash flows.
4. Managemnt education: the higher the level of education the more discounted cash flow techniques (NPV/IRR) are used.
Company Stock Price and NPV.
Company's stock price is based on expectation of a firm's NPV proojects. However in an ideal world you can just take the NPV and add it to the pirice per share times shares outstanding.
Weighted Average Cost of Capital is the cost of financing firm assets. It is the weight put on preferred equity, common equity and Debt. Debt rate is multiplied by (1-Tax Rate)
The weight should be based on firms target capital structure. In absecnce of info about firm's target capital structure, analyst may simply use firm's current capital structure.
What happens to WACC as larger amount of caiptal are raised?Which way does marginal cost of capital curve go?
it goes up bc there is more risk.
Marginal cost of capital goes up, bc cost of raising more capital goes up as more money is raised.
Investment opprtunity schedule goes down as more capital is raised.
The optimal capital budgt is the intersection fo these two
Marginal cost of capit's role in determining net present value of project.
WACC is appropriate discount rate for projects that have APPROXIMATLEY same level of risk as the firm's existnig projects. To evaluate a project with greater than average risk, a discount rate greater than the firm's existing WACC shoudl be used.
There is also an assumption that capital structure will remain at the target capitla structure over the life of the project.
These complexities aside, we use the marginacl cost of capital for the firm aka WACC.
How do you compute after tax cost of debt? What do you use for the yield?
interest rate multiplied by (1-tax rate). The interest rate is the Yield to maturaty on new debt, not the coupon rate on firms existing rate. CFA will provide with both rates.
Cost of preferred Stock?
Take Dividends/ Market Price
Three major ways to determine Price of commone equity?
CAPM Formula = RF+Beta(Expected rate of return on market - RF Rate)
- Dividend discount Approach =
- Required rate of return on equity = (Next Year Dividend/Current Price)+firm's expected constsatn growth Rate. If this year's dividend is presented, multiply by firm's expected constant growth rate, and use that as the dividend part of the forumla.
To find growth rate, Multiply (1-Payout Ratio)(ROE)
The last way is the Bond yield plus risk premium approach. It is just Bond Yield +Risk Premium.
What is Project Beta? What is the pure-play method to determin Beta? What happens to beta as the firm's reliance on debt is increased.
Project Beta is the systematic or market risk of a project.
To find Project Beta we begin with using the beta of a firm that is engaged in purely the same businesses as the firm.
Asset Beta = Beta of external firm (1/(1+(1-t)(D/E) The debt to equity ratio and the tax rate of external firm.
Then we take the calculated Asset Beta(1+(1-t)(D/E) tax rate and Debt to equity of actual firm. Then you plug that in as the Beta in the CAPM formula. Using the D/E ratio of firm you get capital structure. if it is 2, 2 parts Debt, 1 part equity. 3/3.
As firm's reliance on debt is increased, so does Beta
Challenging issues with Beta
- -Bet is estimated using historical returns data. Estimate sensitive to length of time used and frequency
- -Estimate affected by which index is chosen to represent market reture
- -Betas belived to rever to 1 over time
- -smaller companies must increase beta bc of more risk
CAPM using country risk premium?Why do we use it? Formula for CRP and CAPM adjusted.
We use it because some countries carry additional risk.
The CAPM formula with country risk is RF+Beta(ERMkt-RF+CRP)
- CRP = Soverign Yield Spread*(Annualized standar devation Equity Index/Annualized standar devation of Bond Market)
- Soverign yield spread = Difference between yields of government bonds in devleoping country and Treasury bonds of similar maturities.
Marginal cost of capital schedule breaking points.
Breaking point = Amount of capital which componet's cost of capital changes/weight of componet in capital structre.
For example if we want to see if the price will change, we look at the range raised caiptal. For example Equity Capitl is 0-99$ is 4% and 100 to 199 is 6%. We have a 70-30 equity-debt ratio. We want to see if we raise 200 million total, will our equity rate be 6%? We take 200*.7 = 140. We see that the equity rate is 6 %. IF we want to see the break point at which it changes from .4 to .6 we take 100/.7 and we get 142. 100 is the value at which the rate changes.
Incorrect Treatment of Flotation Costs?Correct Treatment?
The incorrect way is to directly incorporate fotation costs into the cost of capital by increasing cost of external equity. Using dividend model we multiply the price by 1-flotation cost percent. For example 1-.045% would be denominator, and numerator would be next year dividend value, then add growth.
The correct way to account for flotation costs would be to adjust the inital project cost. After WACC is figured out, you add it to the beginning negative cash flow when you do the NPV formula.
not in debt, but in the sense that refers to amount of fixed costs a firm has. Could be operating expenses, fixed financing, debt, etc. Greater leverage leads to greater variabliity of firm's after tax0operating earnings and net income.
Business Risk? What are two components of Business Risk and explain them?Financing Cost?
Business risk revers to risk associated with a firm's operting income and is result of uncertainty about a firm's revenues and expenditures necessary to produce those revenues.
Combination of Sales and Operating Risk.
Sales Risk is uncertainty about a firms sales.
Operating Risk is additional uncertaity about opearing earnings caused by fixxed oeparting costs. Greater portion of fixed costs to variable costs the greater a firm's operating risk
Financial risk refers to additional risk that firm's common stockholders mut bear when a firm uses fixed cost financing (debt)
Degree of Operating Leverage? Equation?
Defined as percent change in operaing income that results from a given percentage change in sales.
To calculate take Sales-TVC/Sales-TVC-Fixed Costs
Denominator is EBIT
If DOL is 2.5, a 10% increase in sales equates to a 25 % in EBIT.
DOL is highest at low levels of sales and declines at higher levels of sales.
Degree of financial leverage? Equation?
is ratio of percentage change in net income to percent change in EBIT.
For a particular level of operating earnings, DFL is EBIT/EBIT-Interest.
IF DFL is 1.43,an Increase in EBIT of 10% is a 14.3 change in Earnings.
What is DOL AND DFL when there are not fixed and interest costs respectivley?
DOL and DFL is equal to 1. This should be easy and help memorize formulas. There is no leverage or fixed costs. n/n
What is Degree of Total Leverage?
Combines degree of operating leverage and finnacnila leverage. DTL measures sensitive of EPS to change in sales. DTL=DOL*DFL.
If Degree of total leverage is 2.38, a 10% change in sales will increase EPS by 23.8%
Is ROE higher or lower using leverage?
ROE is higher using leverage than without it. BC less Equity is used.ROE is also more volatile when leverage is uesed.
What is Breakeven Quanity of Sales and Operating Breakeven Quantity of sales? How do they Differ
Operating does not take into account financing costs.
Operating = Fixed Operating Costs/(Price-Variable Costs)
Breakeven Quantiy of sales = (Fixed Operating Costs +Fixed financing costs)/ (Price - Variable Costs)
What are three types of cash dividends? What happens to stock price after dividends given out?
Liquididating dividends - When company goes out of business and distributes to shareholders.
Regular Dividends - occurs when company pays out profit on consisten scheudle.
Special Dividends - When favorable circumstancesallow a firm to make a one time cash payment to shareholders.Cyclical firms use this (car companies)
When dividend paid out, stock supposed to drop by that much.
Stock Dividend? Stock SPlit?
- -Stock Dividend paid out in new shares of stock rather than cash.
- -Stock Splits - When a Stock divideds each existing share into multiple shares
Neither of these change the value, or stake in the existing firmholders equity. Just the number of shares.
-Stock splits and dividends tend to reduce liquidity bc of higher percent of broker fees on lower price stocks
What is effect on financial ratios for a cash dividend ? Stock dividen/split/reverse split?
Cash dividend will reduce assets and owners equity (ROE). Will lower liquidity ratios, increase debt/asset ratio, and decrease debt to equity.
Stock dividend split or reverse have no effect on any ratios.
Holder of Record Date?
Decleartion Date is when dividend is anonounced. Ex-Dividend occurs two business days before holder of record date and is first day stock trades without dividend. 2 days bc takes 3 days for stock to clear. Holder of Record Date is date which fshareholders are designated to receive the diviednd. Payment date is when dividend si paid.
3 ways to repurchase shares?
- 1. Buy in open market, authorized by board of directors. Gives flexibility on timing to buy.
- 2. Buy a fixed number of shares at a fixed price. Repurchase stock at a tender offer, which is ually at a premium of market price. Shareholder may tender, but if shareholders tender more than repurchase, pro rate shares are bought from each individual shareolder depending on the % of shares in company you own. Can do a dutch auction.
Repurchase by direct negotiation. Companies may negotiate directly with a large shareholder to buy back block of shares.
Share repurchases effect on EPS. buyback equation?
If cost of debt is greater than earnings yield, then EPS goes down.
Total earnings = Shares outstanding*Earnings per share
EPS After buyback= (Total earnings-(After tax cost of funds))/New total of shares oustanding after buyback
Share repurchase effect on Book value per share.
Not very difficult. Find amount of shares purchased. then divide amount of share purchased/Book value after repurchase.
If the firm buys back stocks at a price less than the book value per share, than bvps goes up.
Primary sources of liquidity?Secondary sources?
Primary soruces = cash balances reuslt from selling oods, collectin receivables , generating cash from short term investments, trade credit from vendors and lines of credit from banks. Effective cash flow mgmt.
Secondary sources - liquidiating short term or long lived assets, negoatiating debt abgreements, filing for bankruptcy. Using this typically indicates deteriorating financinal position.
Drag on Liquidity? Pull on liquidity?
Drag onliquidity delay or reduce cash inflows, or increase borrowing costs. Examples include uncollected receivables and bad debts, obsolete inventory, and tight short term credit.
Pulls on liquidity, accelerate cash outflows examples include paying vendors sooner than is optimal and changes in credit terms that require rpayment of outstanding balances.
Cash conversion cycle?
Operating cycle is avg number of days takes to turn raw materials into cash proceeds.
Days receivable + Days of Inventory
Cash Conversion is number of days takes to turn firms cash investment in inventory back into cash.
- Days receivable+days of intenory-Days Payable.
- High cash conversion is undesirable
Discount Basis Yield?
Money Market Yield
Bond Equivalent Yield?
- DBY = (FV-Purch price/FV)(360/days until maturity)
- MMY = HPY*360/days until maturity
- BEY=HPY*360/days until maturity
Returns on firm's shor term securitys shouold be stated as bond equivalent yield. Return of portfolio should be weighted average of these yeids.
Account payable management? what does 2/10 net 60 mean? what is the cost of trade credit equation?
means if you pay in 10 days you get 2 percent discount and must pay within 60.
Equation is (1+%discount/(1-%discount))^(365/days past discount))-1
Sources of short term funding from bank?Sources of short term funding not from bank?
- from bank
- -uncommited line of credit
- -comitted line of credit
- revloving line of credit
- bankers acceptance- firms exporting goods get a guarnatee from the bank fo a firmt hat is getting the exported goods that once goods are delivered will pay. This can be discounted and sold.
Factoring 0 refers to sale of receivables at discount from face value, think credit card companies. The buyer or "Factor" takes responsibility of collecting receivables.
Non bank sources are commerical paper for large companies. Typically get a better rate than could get from bank.
WHat is financial suprlus used fo in pro format statement?
When you account for %'s sometimes the Retained earnings increases so much that assets do not equal liabs plus equitys. therefore must create financial suprlus account to adjust.
What is Share Blocking?
If share blocking restriction is part of the governance code, it prevents investors who wish to vote their shares from trading their shares during a period prior to the annual meeting.