Unit 3 quiz

chapters 10, 13, and 14

incremental cash flow

the difference between a firm’s future cash flows with a project and those without the project

the standard principle

the assumption that evaluation of a project may be based on the project’s incremental cash flows

incremental cash flows

• sunk cost

• opportunity cost

• erosion

• net working capital

sunk cost

a cost that has already been incurred and cannot be removed and therefore should not be considered in an investment decision

opportunity cost

the most valuable alternative that is given up if a particular investment is undertaken

erosion

the cash flows of a new project that comes at the expense of a firm’s existing project

How does net working capital change over the course of a project

• at the start you pay into it to start the project

• at the end it’s recovered since the project is now completed

do we include financing costs in cash flows

no, they should be analyzed seperatly (includes interest paid)

pro forma financial statements

financial statements projecting future years’ operations

in a pro forma financial statement do you recognize interest expense

no because interest expense is a financing expense not an operating expense

asset’s 3 components

1. operating cash flows

2. capital spending

3. changes in net working capital

project cash flow formula

project CF = operating CF - change in net working capital - capital spending

formula for project operating cash flow

op CF = EBIT + Depreciation - taxes

what happens to taxes if we sell and the market value is grater than the book value

pay taxed on the difference between them because it represents the excess depreciation that should have been paid (paid too little on taxes earlier now have to pay it)

What happens to taxes if we sell and the market value is less than the book vaue

we ca get tax savings instead o paying more (paid too much at the start, get it back now)

what are some alternative ways to find OP CF

• bottom-up approach

• top down approach

• tax shield approach

what is the bottom up approach to find OCF

• start at NI (bottom) and add back non-cash deductions

• OCF = NI + Depreciation

what is the top down approach to find OCF

• most obvious way to calculate OCF

• OCF = Sales - Cost - Taxes

what is the Tax shield approach to finding OCF

• OCF = (sales * cost) x (1 - TC) + Depreciation x TC

• 2 parts:

  • what cash flows would be if there were no depreceation expense

  • depreciation times the tax rate

expected return

the return on a risky asset expected in the future

formula for risk premium

risk premium = expected return - risk-free rate

portfolios

a group of assets such as stocks and bonds held by an investor

portfolio weights

the percentage of a portfolio’s total value that is invested in a particular asset

how to calculate portfolio expected returns

E(Rp) = x1 * E(R1) + x2 * E(R2) + … + xi * E(Rn)

• n = any number

• xi = % of money in assets

possible sources for unexpected returns information

• news about flyers research

• government figures released on the GDP

• results from the latest arms control talks

• news that sales figures are higher than expected

• sudden unexpected drop in interest rates

how to find total returns

• total return = expected return + unexpected return

• R = E +U(R)

systematic risk

a risk influenced large number of assets (market risk)

unsystematic risk

a risk that affects at most a small number of assets (unique or asset-specified risk)

the principle of diversification

spreading an investment across a number of assets will eliminate some, but not all of the risk

how do we reduce risk in a portfolio

by diversifying stock, unsystematic risk can be eliminated, it reduces risk by only a certain amount

the systematic risk principle

the expected return on a risky asset depends only on the asset’s systematic risk

beta coefficient

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

classification of beta risks measures

• risk of 1 relevant to itself

• .5, half as much risk as average

• 2 twice the risk compared to average

reward-to-risk ratio formula

slope = E(Ra) - Rf / Ba

the security market line (SML)

positively sloped straight line displaying the relationship between expected return and beta

SML slope formula

SML slope = [E(Rm) - Re] / Bm

market risk premium

slope of SML which is the difference between the expected portfolio and the risk-free rate

capital asset pricing model (LAPM)

the equation of the SML showing the relationship between expected return and beta

LAPM formula

E(Ri) = Rf + [E(Rm) - Rf] * Bi

expected return for an asset depends on 3 things

1. the pure time value of money

2. the reward for bearing systematic risk

3. the amount of systematic risk

alpha

the excess of return an asset earns based on the level of risk taken

to accept an investment:

the expected return should be no worse than what financial markets offer for the same risk

the cost of capital

the minimum required return on a new investment (firm needs to earn this to break even)

cost of equity

the return that equity investors require on their investment in the firm

dividend growth method approach formula

Re = D1 / P0 + g

advantages and disadvantages of dividend growth model

advantages

• it is simplistic

disadvantages

• only applicable to companies that pay dividends and dividends grow at a constant rate

• very sensitive to estimated growth rate

• does not explicitly cover risk

approaches to find cost of equity

• dividend growth model

• the SML approach

3 things the return on risky investment depend on

1. the risk-free rate of Rf

2. market risk premium E(Rm)-Rf

3. systematic risk of the asset relative to the average B

SML approach formula

Re = Rf + Be * (Rm - Rf)

advantages and disadvantages of the SML approach

advantages

• adjusts for risk

• applicable to companies without steady dividend growth

disadvantages

• need estimates on B and market risk premium

• rely on past to predict the future

cost of debt (Rd)

return that lenders require on the firm’s debt

formula for the market value of the firm’s equity

E = number of shares outstanding * price per share

formula for the market value of the firm’s debt

D = market price of bond * number of bonds outstanding

formula for value in weighted average cost of capital

V = E + D

• can divide both sides by V to get % of total capital represented by D and E

• use market value unless privately owned or can’t get an estimate

for WACC does the discount rate need to be before or after tax

needs to be after tax since we’re concerned with the after-tax cash flow

after tax rate formula

after tax rate = Rd * (1-TC)

weighted average cost of capital (WACC)

the weighted average cost of equity and the after tax cost of debt

WACC formula

WACC = (E/V) x Re + (D/V) x Rd x (1-TC)

• if there is preferred stock involved add (P/V) x Rp before debt value

what are some possible draw backs to using WACC as a cutoff for projects

• reject profitable projects with risks less than the overall firm

• my accept overly risky projects because the WACC will look attractive