Capital Budgeting & Firm Valuation: Cash Flows, Depreciation, and Investment Analysis

Where are the 2 places we see NWC in capital budgeting?

1) Initial Outlay; 2) Terminal Cash Flow.

What is the difference between event time and event study?

Event Time measures time relative to an event; Event Study analyzes stock price returns around events.

What is the calculation for initial outlay?

IO = Purchase price + Shipping & installation + Investment in NWC +/− After-tax proceeds from sale.

How are assets evaluated using the replacement method?

Tangibles are evaluated via appraisal or market comparables, while intangibles are much harder to value.

What are examples of tangible and intangible assets?

Tangibles include physical property and equipment; intangibles include copyrights, patents, brand names, goodwill, and customer lists.

How can Ke be calculated?

Ke can be calculated using the Gordon Growth Model (GGM), Book Value proxy, or CAPM.

What is the comparing multiples method?

It values the firm by applying financial ratios from a comparable public firm to the target firm's financials.

What is GGM a simplified version of?

GGM is a simplified DCF: P0 = Σ CFt/(1+r)^t.

What would be the price of Sam's Club if its earnings were $24B and Costco's P/E was 35.8?

V_Sams = $24B × 35.8 = $859.2B.

What is a unicorn in finance?

A private firm valued at over $1 billion.

What should buyers understand about financing options?

Shop 2-3 lenders and compare origination vs. discount points.

What is the 27/36 rule?

Front-end ratio = Mortgage / Gross Income ≤ 28%; Back-end ratio = Total Debt / Gross Income ≤ 36%.

What is the difference between defined contribution plans and defined benefit plans?

Defined Contribution: self-directed with no guaranteed payout; Defined Benefit: guaranteed fixed payout.

How does diversification reduce risk in the stock market?

It reduces overall portfolio risk through time and asset diversification.

What are incremental cash flows?

Cash flows that change because of the project.

What are incidental cash flows?

A type of incremental cash flow that affects the rest of the firm.

What are sunk costs?

Costs already incurred regardless of the project decision; ignore them.

What is straight line depreciation?

Annual Depreciation = (Cost − Salvage) / Life.

What is simplified straight line depreciation?

Depreciate to zero; Annual Dep = Cost / Life.

What is MACRS?

Modified Accelerated Cost Recovery System, IRS-mandated depreciation.

What if the problem gives you a salvage value and also says to take it to 0?

You can depreciate to 0 even if salvage > 0.

What depreciation method is better for taxes and why?

MACRS is better because it front-loads depreciation, reducing taxable income sooner.

What is capital gains tax?

Tax on the difference between market value and book value of an asset.

What is NWC?

Net Working Capital = Current Assets − Current Liabilities.

Where are the 2 places we see tax impacts in capital budgeting cash flows?

1) Differential cash flows; 2) Asset sales.

What are we taxing when we have a new project?

Tax = (Inc. Revenue − Inc. Costs − Depreciation) × tax rate.

What creates a tax shield?

Depreciation > 0 reduces taxable income.

What are the 2 sets of books?

1) IRS Books; 2) Investor/Shareholder Books.

What is the calculation for differential cash flows?

Inc. Revenue − Inc. Costs − Depreciation = EBT.

What is the requirement for NPV and IRR?

Must use all cash flows: IO, differential CFs, Terminal CF.

What is the calculation for terminal cash flow?

TCF = Realizable Salvage Value +/− Tax on capital gain/loss + Recapture of NWC.

What is the terminal value?

TV = Last year's Differential CF + Terminal Cash Flow.

What is the difference between realizable salvage value and regular salvage value?

Realizable SV is the market price; Regular SV is the expected value used in depreciation.

What are the 3 steps of capital budgeting?

1) Evaluate Cash Flows; 2) Assess Project Risk; 3) Accept or Reject.

What is the value of a firm also known as?

Enterprise Value.

What is a growth stock?

Market/Book > 1, expected to grow above book value.

What is a value stock?

Market/Book < 1, trading below book value.

Why do people prefer M&A over IPO?

M&A offers faster exit, immediate cash/hybrid/stock payment, less market risk, higher return, and a control premium of 30-35%.

What does 'harvest' mean in finance?

Harvest refers to the exit strategy for firm founders/owners, cashing out their investment via M&A, IPO, or other liquidity events.

What is the replacement method?

The replacement method, also called the Cost Method, values the firm by summing the replacement cost of all assets.

Which type of companies benefit most from the replacement method?

Privately held, smaller firms with mostly tangible/real assets benefit the most because they are easier to appraise.

What is the DCF method?

The Discounted Cash Flow (DCF) method calculates the present value of future free cash flows to the firm, discounted at WACC.

What is the FCFF Vf equation?

Vf = Σ [FCFF_t / (1+WACC)^t].

What is the FCFF equation?

FCFF = EBIT − Taxes + Depreciation − ∆NWC − CAPEX.

What is the general equation for valuing a firm?

Vf = V_equity + Market Value of Debt.

What is the FCFE Vf equation?

V_equity = Σ [FCFE_t / (1+Ke)^t].

What is the FCFE equation?

FCFE = NI + Depreciation − CAPEX − ∆NWC + Net New LTD.

What is the terminal value (TV) and how is it calculated?

TV goes to infinity (perpetuity) and can be calculated using GGM, perpetuity, or comparable multiples.

What is the equity market value also known as?

Market Capitalization (Market Cap).

What is the PE equation?

PE = Price / Earnings.

What is the GGM P0 equation?

P0 = CF0(1+g) / (r − g).

What is the comparable ratio?

The ratio from a publicly traded comparable firm applied to the target's financial metric to estimate target firm value.

What should you ensure when comparing two different companies?

Ensure to compare apples to apples: same industry, similar size, and similar business model.

When would you use the P/S ratio?

When the firm has no earnings (negative or zero EPS).

What is the E/P ratio?

E/P (Earnings Yield) is the inverse of P/E, used to compare earnings return vs bond yields.

What is the P/EBITDA ratio?

P/EBITDA is a proxy for cash flow, useful for capital-intensive industries.

What does M/B stand for?

M/B (Market-to-Book) = Market Equity / Book Equity.

What is the P/FCFF ratio?

P/FCFF is the best measure as it uses actual free cash flow to the firm.

What is the salary caveat?

Owners may inflate costs by paying themselves a salary, reducing apparent earnings.

What is the liquidity discount caveat?

Private firm shares are illiquid; apply a 40-50% liquidity discount to the private firm's value.

What is the control premium?

The premium paid above market price for control when acquiring a firm, typically 30-35%.

What is V_bid?

V_bid = V_min + Premium, where V_min is the current market price of the target.

What is an example of an event study in finance?

The Twitter/Elon Musk acquisition, where stock jumped ~30-35% at the announcement.

What are the five ways that create a 'jump' in value?

1) Increase efficiency, 2) Tax credits, 3) Use unused debt capacity, 4) Downsize employees, 5) Combine facilities.

What does creating synergies mean?

Creating synergies refers to the value created through efficiencies that justify the premium paid.

What are the two methods used for appraisal?

1) Replacement/Cost Method, 2) DCF Method.

What method is not used for appraisal?

Comparable Multiples due to the dress-up/haircut problem.

How to find the value of the firm using FCFF with the DCF method?

Use the NPV function with IO = 0, entering FCFFs as CF1, CF2, ..., and use WACC as the discount rate.

What is the difference between investment and consumption in the context of home buying?

Investment is buying to rent/appreciate for financial return; consumption is buying to live in for personal use/enjoyment.

How can mortgage types impact financial planning?

Fixed vs. adjustable rates affect monthly payments and long-term costs significantly.

What does the term 'house poor' mean?

Spending too much income on housing, leaving little for other expenses.

What is the 28/36 Rule?

Front-end ratio ≤ 28% of income for mortgage; back-end ratio ≤ 36% of total debt.

What is the typical fee structure for real estate agents?

Traditional: 6% (3% for listing agent, 3% for buying agent); Deep discount: 4.5%; FSBO: 0%.

Why is due diligence important in the home buying process?

It protects buyers from overpaying or buying a defective home.

What are the initial steps in buying a house?

1) Research online; 2) Drive neighborhoods; 3) Use FSBO websites or MLS; 4) Walk through homes; 5) Due diligence; 6) Get pre-approved.

What does the process of making an offer involve?

Writing a Real Estate Purchase Contract (REPC) with price, dates, conditions, and negotiating terms.

What should be reviewed in closing documents?

Review deed/note, title insurance, and closing costs.

Why are home inspections important?

They identify hidden defects and allow buyers to cancel if problems are found.

What is the role of escrow accounts in home buying?

They collect monthly payments for insurance, taxes, and hold earnest money.

Why is understanding property taxes, insurance, and closing costs important?

They add substantially to housing costs beyond the mortgage payment.

What are prepaids in home purchases?

Prepaids are costs like hazard insurance and property taxes collected upfront into escrow.

How can buyers avoid private mortgage insurance (PMI)?

By putting down at least 20% down payment.

What should buyers know about refinancing?

You could lose money if you refinance/move before break-even.

How do interest rates impact mortgage payments?

Higher rates lead to higher monthly payments and less affordable houses.

What are examples of short-term and long-term investments?

Short-term: Checking, Savings, Money Market; Long-term: Stocks, bonds, real estate.

What are tax-sheltered investment vehicles?

Examples include Trad IRA, Roth IRA, SEP IRA, 401k.

What is the difference between Roth and Traditional IRAs?

Roth IRA: after-tax contributions, tax-free growth; Traditional IRA: pre-tax contributions, taxed upon withdrawal.

Why are employer matching contributions important in 401(k) plans?

They provide free money and an immediate return on investment.

Why is understanding penalties for early withdrawal from retirement accounts important?

Early withdrawal triggers income taxes and a 10% penalty.

What are some common investment assets?

Stocks, bonds, ETFs, mutual funds, bank accounts.

Why are index mutual funds generally more cost-effective?

They have very low administrative costs compared to actively managed funds.

Do actively managed funds consistently outperform index funds?

No, most actively managed funds underperform their benchmark index.

What does the historical performance of stocks suggest?

Stocks historically outperform all other asset classes over 10-30 year periods.

Why is understanding fees associated with investment vehicles important?

Fees compound over time and can significantly reduce investor wealth.

Still learning (14)

You've started learning these terms. Keep it up!