Corporate Finance: Key Concepts, Valuation, and Decision-Making

What is the primary goal of a firm in corporate finance?

Maximize shareholder wealth by increasing stock price and long-term firm value.

What is the agency problem in corporate finance?

The conflict where managers may pursue personal goals unless incentivized to act in shareholders' interests.

What are the three core financial decisions in corporate finance?

Capital budgeting, capital structure, and working capital management.

What does capital budgeting involve?

Choosing long-term investments that align with maximizing shareholder wealth.

What is the time value of money?

A dollar today is worth more than a dollar tomorrow due to its earning potential.

What is the formula for bond valuation?

Bond Price = Present Value of coupon payments + Present Value of face value.

What does Yield to Maturity (YTM) represent?

The rate that equates bond price with future cash flows.

What is the Dividend Discount Model (DDM) used for?

Valuing stocks based on expected future dividends.

What are the key components of cash flow estimation in capital budgeting?

Initial outlay, operating cash flows, terminal cash flow, incremental cash flows, sunk costs, and opportunity costs.

What is Net Present Value (NPV)?

A method that measures the value added to the firm; accept if NPV > 0.

What is the Internal Rate of Return (IRR)?

The discount rate that makes NPV = 0; accept if IRR > required return.

What is the Payback Period?

The time required to recover the initial investment; ignores time value of money.

What is a depreciation tax shield?

The reduction in taxable income due to depreciation, increasing cash flow.

How is the depreciation tax shield calculated?

Depreciation Tax Shield = Depreciation Expense × Tax Rate.

What is Equivalent Annual Cost (EAC)?

A method to convert NPV into an annualized cost for comparing projects with different lifespans.

What does CAPM stand for?

Capital Asset Pricing Model, which calculates expected return based on risk.

What is systematic risk?

Market-wide risk that is non-diversifiable.

What is unsystematic risk?

Firm-specific risk that can be diversified away.

What does beta measure in finance?

The volatility of an asset compared to the market; β=1 indicates market risk.

What is the required return for investors?

The minimum return expected for taking on additional risk beyond the risk-free rate.

What are the basic concepts to keep in mind when calculating a project's cash flows?

Costs and benefits are measured in cash flow, expected cash flows should be after-tax, and cash flows must be incremental.

What is the significance of net working capital in capital budgeting?

It is the difference between current assets and current liabilities that should be considered in project evaluations.

What should a firm convince investors of to obtain funds from the capital market?

That they can expect to earn at least their required return.

When should nominal cash flows be used?

When the analysis includes inflation and is stated in nominal terms.

What is the purpose of using EAA (Equivalent Annual Annuity)?

To convert NPV into an annualized benefit for project comparison.

What is capital budgeting?

The process of evaluating investment opportunities to determine their profitability and allocate capital accordingly.

What are the primary tools used in capital budgeting?

Net Present Value (NPV) and Internal Rate of Return (IRR).

What is Net Present Value (NPV)?

The difference between the market value of a project and its cost, indicating how much value is created from an investment.

What are the steps to calculate NPV?

1. Estimate expected future cash flows. 2. Determine the required return (weighted average cost of capital). 3. Calculate the present value of cash flows and subtract the initial investment.

What are incremental cash flows?

Cash flows that are measured as the difference between cash flows with the project and without the project.

What should be excluded when estimating cash flows?

Interest expenses, as they are included in the cost of capital.

What is the formula for net initial investment outlay?

C0 = -I0 - (1 - T)E0 - DW + S0 - T(S0 - B0) + Ic.

What does ΔNWC represent?

The change in net working capital, calculated as Δshort-term Assets - Δshort-term Liabilities.

How does the sale of an old asset affect cash flow?

If the selling price exceeds the net book value, taxes are owed; if less, a tax credit is generated.

What is the relevant tax rate in capital budgeting?

The firm's marginal tax rate, which significantly affects incremental cash flows.

What is the after-tax cash flow formula for revenues and expenses?

After-tax revenue cash flow = (R - E) * (1 - T).

How is depreciation treated in cash flow analysis?

Depreciation creates a tax shield, adding back T * Dt to the cash flow.

What is the cash flow after tax (CFAT) formula?

CFAT = (ΔR - ΔE) * (1 - T) + TΔD.

What does the term 'non-operating cash flows' refer to?

Cash flows that are treated similarly to initial cash expenditures, adjusted for taxes.

What happens to cash flows at the end of a project?

The selling price of the asset, cleanup expenses, and recovery of net working capital are considered.

What is the impact of financing costs on cash flow calculations?

Financing costs are included in the cost of capital but not in cash flow calculations.

What is the significance of the marginal tax rate in capital budgeting?

It affects the calculation of cash flows, particularly in terms of tax liabilities and benefits.

What is the effect of cash flow timing on project value?

The timing of cash flows can significantly influence the present value and overall project valuation.

How is the initial cash expenditure calculated after tax?

Initial cash expenditure = -I0 - E0 + T * E0.

What is the role of investment tax credits in capital budgeting?

They are included in the net initial outlay calculation to reduce the overall investment cost.

What is the difference between GAAP and cash accounting in capital budgeting?

GAAP records expenses over time through depreciation, while cash accounting records the expense when cash is paid.

What is the formula for calculating the net cash flow from the sale of an old asset?

Net cash flow = Selling price - T(Selling price - Book value).

What does the term 'sunk cost' refer to in capital budgeting?

Costs that have already been incurred and cannot be recovered, which should not influence future investment decisions.

What is the importance of estimating cash flows accurately?

Accurate cash flow estimates are crucial for determining the viability and profitability of investment projects.

What are the components of cash flows at the end of a project?

Cash Flows at End of Project = S - T(S - B) - (1 - T)REX + ΔW

What categories can the net initial outlay be broken down into?

Cash expenditures for old capital assets, changes in net working capital, cash flow from the sale of old equipment.

What are the basic concepts to consider when calculating a project's cash flows?

Costs and benefits are measured in cash flow, expected future cash flows are after-tax, and cash flows must be incremental.

What is net working capital?

The difference between current assets and current liabilities, which should be considered in capital budgeting.

What must a firm demonstrate to obtain funds from the capital market?

Investors must expect to earn at least their required return.

How does inflation affect project cash flows?

Inflation increases nominal amounts of revenues and expenses, affecting the required return by investors.

What is the relationship between nominal and real cost of capital?

rn = rr + i + irr, where rn is nominal cost, rr is real cost, and i is expected inflation rate.

What happens to depreciation expense during inflation?

Depreciation expense is fixed based on historical cost, decreasing the real value of depreciation tax credits.

What is the NPV of a project?

Net Present Value, calculated by discounting future cash flows to present value and subtracting initial investment.

What is the Equivalent Annual Cost (EAC)?

The annual cash flow that has a present value equal to the total present value of costs over the life of the project.

How do you determine the optimal replacement frequency for equipment?

Consider the trade-off between the frequency of incurring new machine costs and the salvage value received.

What is the Equivalent Annual Annuity (EAA)?

A method to annualize the cost of a project over its life, used to compare mutually exclusive projects with unequal lives.

How is the EAA calculated?

EAA = NPV / Annuity factor, where NPV is the net present value and the annuity factor is based on the cost of capital.

What is the impact of inflation on NPV analysis?

NPV remains unchanged if cash flows and cost of capital are expressed in consistent terms; differences in inflation effects must be incorporated.