Corporate Finance Test #2 Review

List the situations when might IRR yield decisions that conflict with those indicated by NPV?

1. Multiple IRR’s

2. Differences in the scale of the project

3. Differences in timing of the cash flows

Explain why IRR is biased in favor of short-term projects

because it assumes that any money you earn early can be reinvested at the same high rate as the projects IRR which is not usually true in real life

so a short project looks better just because it gives cash back sooner

In the IRR calculation there is an implicit assumption that CF’s can be reinvested at IRR if IRR > WACC then there is an overestimation of a reasonable investment rate

This will be in favor of short-term projects, since their cash flows are received earlier and assumed to be reinvested at this overstated rate

What is the implicit assumption about the reinvestment rate when calculating the IRR? How does this assumption induce a bias in the evaluation of mutually exclusive projects?

the implicit assumption when calculating IRR is that all intermediate cash flows are reinvested at the projects own IRR

it creates a bias as IRR tends to favor short term projects since the reinvestment assumption exaggerates how profitable their returns really; are even if they have lower NPV

What are the additional costs incurred by firms when raising capital externally compared to obtaining funds internally? For which types of firms will these costs be more significant? How might these costs favor the use of IRR?

the additional costs incurred by firms when raising capital externally compared to obtaining funds internally are

1. flotation costs (investment banking fees, SEC registration fees..)

2. Costs of information asymmetry between insiders (managers) and outside investors (smaller firms in high growth areas will face more serious burden of raising capital externally)

High external financing costs make firms rely more on internal funds, which favors the use of IRR

Why is interest ignored when calculating project CFs? Given this treatment of interest, how are the tax savings from interest accounted for when evaluating projects?

Interest is ignored in project cash flows because financing costs are already captured in the WACC used to discount them. The tax savings from interest are reflected in the after-tax cost of debt component of the WACC, so they’re accounted for indirectly through the discount rate. 

What is needed for firms to earn positive NPV from their investments / an IRR higher than WACC?

A firms investments need to generate returns greater than the cost of financing them. The project must create value, not just cover costs 

NPV or IRR > WACC

This is usually achieved through high returns, strong management, and sustainable competitive advantages

What are the potential reasons why leasing may be advantageous? (Be sure to discuss how competition amongst lessors ensures that the lessee benefits from leasing.

Reasons leasing may be advantageous

1. cost of obsolescence (if the lessor can handle obsolescence more efficiently than the lessee, and there is sufficient competition among lessors)

2. Cost of maintenance

3. Utilizing depreciation tax shields

How can you refine the quick ratio and the current ratio when assessing a firm’s liquidity?

You can refine the quick and current ratios by examining the quality and liquidity of current assets and the timing of liabilities

What factors influence the P/E ratio?

P/E is the price-to-earnings ratio and is influenced by factors of growth, risk, interest rates, and profitability/stability

This ratio indicates how much investors are willing to pay for each dollar of a company’s earnings (helps to see if a stock is overvalued or undervalued)

For public traded firms, why do we measure the risk of stock/project using beta rather than standard deviation?

Beta measures systematic risk and gives stocks returns based on the overall market. Since investors are assumed to hold well-diversified, only market-related risk affects expected returns, making beta the appropriate measure

How do we measure the beta of a stock?

Beta is measured by computing the covariance of the stock and market returns and divide by the variance of market returns

Is also the regressions line when plotting stocks on the y-axis and S&P market returns o

How can market risk premium (R m-R rf ) be estimated?

1. Historical average

2. Survey of finance professionals

3. r_cs = r_d + 4%

When estimating cost of equity for capital budgeting purposes, how do you assess the risk-free rate?

use the yield on a government bond that matches the projects time horizon and currency

Call provision

gives the issuing corporation the right to redeem the bonds prior to maturity under specified terms, usually at a price greater than the maturity value (the difference is a call premium)

Sinking fund

a provision that requires the corporation to retire a portion of the bond issue each year

Bond

a long-term promissory note issued by a business or governmental unit

Junk bonds

high-risk, high yield instruments issued by firms that use a great deal of financial leverage

Consol

any bond that promises to pay interest perpetually

Premium bond and discount bond

bonds sold above their face value

bonds sold below its par value

Reinvestment rate risk

the risk of an income decline due to a drop in interest rates

Indenture

a legal document that spells out the rights of both bondholders and the issuing corporation

Trustee

an official who represents the bondholders and makes sure the terms of the indenture are carried out

Lien

the right of a creditor to claim a specific asset in the event of default on the debt

proxy fight

an attempt to take over a company in which an outside group solicits existing shareholder proxies in an effort to overthrow management and take over control of business

proxy

a document giving one person the authority to act for another

entity value

the total value of a company

horizon value

the present value of all free cash flows beyond the horizon date discounted back to the horizon date

value drivers

are the subset of inputs that managers can influence through strategic choices and execution of the resulting business plans

entity multiple 

average ratio of the observed market entity value to a particular metric that applies to the whole firm such as sales