FINC 361 exam 2

equity cost of capital

determined by requires rate of return that investors demand based on expected risk of a stock... higher the risk, higher required rate of return

CAPM

way to estimate required rate of return based on investor's assessment of risk

total risk =

systematic risk + unsystematic risk

Systematic Risk

market wide news... aka common risk... investors require a premium on securities based on systematic risk

unsystematic risk

company specific news... aka independent risk

how to eliminate unsystematic risk

diversify portfolios... amount of risk removed depends on portfolios diversification... systematic risk remains

CAPM says that required rate of return on any investment is =

risk free rate + risk premium proportional to amount of systematic risk... higher systematic risk, higher required return

beta

the amount of systematic risk present in a particular risky asset relative to that in an average risky asset

security market line

the CAPM implies a linear relation between a stock's beta and its expected return...

assumptions of CAPM

- perfect markets: no taxes, transaction costs, borrowing or short selling constraints

- competition: investors are price takers

- rationality: investors tradeoff return against standard deviation

- homogenous expectations: all investors analyze securities in the same way

αi

intercept of the line... represents risk adjusted performance measure... if it is positive, stock has performed better than predicted by CAPM, and vice versa

βi

beta... represents sensitivity of stock to market risk... when market's return increases by 1%, the security's return increases by βi%

εi

error term and represents the deviation from best fitting line... 0 on average

drawbacks of using historical data

- errors of the estimates are large

- does not represent current expectations

- alternative is to solve for the discount rate that is consistent with the current level of market valuation

YTM facts

- IRR an investor will earn from holding the bond to maturity and receiving promised payments

- if there is little risk of default, the YTM is a reasonable estimate of investors' expected rate of return

- if there is high default risk, YTM will overstate investors' expected return and firm's cost of debt

debt betas

-Difficult to estimate because corporate bonds are traded infrequently

-One approximation is to use estimates of betas of bond indices by rating category

asset (unlevered) cost of capital

the expected return required by the firm's investors to hold the firm's underlying assets; the weighted average of the firm's equity and debt costs of capital

cash and net debt

- some firms maintain high cash balances... Cash is a risk-free asset that reduces average risk of assets

- since risk of EV is what we are concerned about, leverage should be measured in terms of net debt

net debt =

Debt - Excess Cash and Short Term Investments

differences in project risk

-Firm asset betas reflect market risk of the average project in a firm

-Individual projects may be more or less sensitive to market risk

- managers in multi-divisional firms should evaluate projects based on asset betas of firms in a SIMILAR LINE OF BUSINESS

Debt-equity ratio assumption

assume that the firm adjusts its leverage continuously to maintain a constant ratio of the market value of debt to the market value of equity

payback period

amount of time it takes to pay back initial investment... if payback period is less than pre-specified length of time, accept... if cash flows are received continuously, payback period can be calculated as partial years.

cons of payback rule

1. Ignores the time value of money

2. Ignores cash flows beyond the cutoff

3. Requires an arbitrary cutoff

4. Biased against long-term projects

internal rate of return

- discount rate that put NPV = 0

- accept if IRR is > cost of capital

- works best for stand alone projects if all negative cash flows come before positive cash flows

when might IRR rule disagree with NPV and be incorrect

- delayed investments

- nonexistent IRR

- multiple IRRs

no IRR exists when...

NPV is positive for all values of the discount rate

modified IRR

- used to overcome problem of multiple IRRs

- computes discount rate that sets the NPV of modified cash flows to zero

possible modifications of IRR

- bring all negative cash flows to present and incorporate into initial cash outflow... leave positive cash flows alone

- leave initial cash flow alone and compound all remaining cash flows to final period of project

choosing projects

- when only one project can be chosen, the choice is mutually exclusive...

- NPV: select project w highest NPV

- IRR: selecting the project with the highest IRR might have mistakes

differences in scale

If a project's size is doubled, its NPV will double. This is not the case with IRR. so the IRR rule cannot be used to compare projects of different scales.

timing of cash flows

IRR is a return, but the dollar value of earning a given return depends on how long the return is earned for

incremental IRR rule

Apply the IRR rule to the difference between the cash flows of the two mutually exclusive alternatives

- if the incremental IRR is greater than the cost of capital, accept the more expensive project

profitability index

used to identify optimal combinations of projects to take... can break down easily though with multiple constraints

capital budgeting

process used to analyze alternative investments and decide which to accept

incremental earnings

the amount by which a firm's earnings are expected to change as a result of an investment decision... the difference between firm's overall earnings with and without the project including any side effects

straight line depreciation formula

(cost - salvage value) / useful life

in capital budgeting decisions...

interest expense is NOT included, so we work with unlevered net income (NOPAT)

unlevered net income

NOPAT

indirect effects on incremental earnings

- opportunity cost: any cash flow that the firm gives up if it takes a project... consider the value a resource could have provided

- project externalities: project may affect profits of other business activities of the firm. cannibalization

- sunk costs: costs that have been or will be paid regardless of decision whether or not the investment is taken. SHOULD NOT BE INCLUDED IN INCREMENTAL ANALYSIS

cannibilization

a situation that occurs when sales of a new product cut into sales of a firm's existing products

sunk cost facts

- money already spend on R&D is a sunk cost and irrelevant... decision to continue or abandon project should be based on incremental costs going forward

- when developing a new product, firms might be concerned about cannibalization. but if sales are likely to decline anyways, then the lost sales are unavoidable and are considered sunk costs

capital expenditures

actual cash flows when an asset is purchased. included in calculating FCFs

depreciation

non cash expense... FCF estimate is adjusted for this expense

trade credits

difference between receivables and payables

tax loss carry forwards/backs

allow corporations to take losses during its current year and offset them against gains in nearby years... because of this, PV of tax benefits would be lower

break even analysis

break even level of an input is the level that causes the NPV = 0

sensitivity analysis

shows how NPV varies with a change in one of the assumptions

scenario analysis

considers the effect on the NPV of simultaneously changing multiple things

"equity cost of capital" =

WACC

when a firm is levered...

it has debt in its capital structure

after solving for npv... what is the value added to the firm if you choose to accept the project?

value added = npv

when comparing npv and irr (when they are different values compared to each other) why are they ranked differently?

because they are measuring different things. NPV measures value creation, and IRR measures return on investment... returns do not change with different levels of investment so the two may give different rankings when initial investments are different