Finance exam 3

WACC

You can not just assume debt and equity are equal-mix

Wa: weight of debt in cap structure

Kd (1-T): AT cost of new debt (tax deductible)

Wps: weight of pref stock in cap structure

Kps: cost of new pref stock

Wce: weight of CE in cap structure

Ks: cost of RE in coming year; not (1-T) because div not tax deductible

RE BE point

Amount of total new capital available to spend prior to RE running out

= RE for coming year / wt. of CE in cap structure = RE₁ / W_ce = NI₁ (1 - d) / W_ce

RE vs issuing CS

RE is less pricy, so we always use RE to support CE position (60%) of cap structure

Internal ROR

ROR / yr compounded annually

Controlled aspects

Cap structure, div payout ratio (d), alternating cap budget decision rules

Not controlled aspects

IR in econ and general level of stock prices

Depreciation-generated funds

Largest single source of capital; about = RE mixed w/ low cost debt (WACC₁); the tax deduction for having dep

Privately-owned firms

How do you measure cost of equity for firm not publicly traded?

Measurement problems

Difficult to get good input data for CAPM variables

Costs of capital for projects of diff risk

Hard to measure risk of project

Cap structure weights

Hard to establish target cap structure

Cap budgeting evaluation techniques

• Payback period

• Discounted payback period

• Net present value

• Internal ROR

• Modified ROR

Indep vs ME projects

Independent: I can take on all profitable projects, they are not dependent on each other

ME: I can take on one project, not both; budget constraints

Normal vs nonnormal projects

Normal: only one sign change (usually - outflows to + inflows)

Nonnormal: 2 or more sign changes; ex) building a well → - outflow, some + inflows, then it caps

Crossover

Graph NPV profiles

Payback period

Expected # of years required to recover a project’s cost; assume CF trickles out to you

• Pro: Easy, shows relative safety (we want $ back sooner)

• Con: Does not address all CF or TVM, does not measure profit

Discount payback period

Expected # of years required to recover project’s cost when all CF in today’s $

• Pro: Uses TVM, shows relative safety, easy

• Con: Does not measure profitability, does not necessarily use all CF

Internal ROR

Average ROR for project / year; discount rate forces PV of a project’s inflows to = PV of its outflows (NPV=0); return of project expressed fully as a % of return, leaving no return to be expressed as NPV $ → NPV = $0

• Pro: Uses all CFs and TVM, measures return, % communicates well

• Con: Uses IRR as reinvestment rate (infeasible), can not trust IRR to choose value-adding project when given diff sizes and ME

IRR reinvestment rate assumption

CF reinvested at IRR

IRR in indep vs ME

Indep: take both

ME: accept the bigger IRR

Profit in IRR

If IRR > k → profit!

Affect of cost of cap changing on IRR

Cost of cap changes → IRR not affected

NPV

PV of inflows + PV of outflows = PV of all CF

• Pro: Uses TVM and all CF, measures profitability, uses k as reinvestment rate (feasible), ME diff sizes → NPV chooses value-adding one (max P₀)

• Con: Can not be used directly when projects have diff lengths of life

Profit in NPV

If NPV > 0 → profit!

NPV in indep vs ME

Indep: accept both

ME: accept greater NPV

NPV reinvestment rate assumption

CF reinvested at k

Modified IRR

• Pro: ME = sizes → chooses same project NPV would, reinvestment risk is k (feasible)

• Con: ME diff sizes → can not trust MIRR

Net cash flow

NI + D = EBT (1 - T) + D; more depreciation → less NI → more NCF

NCF ignores int exp

Ignored when determining OCF because when we put CF onto line, we discount cost of all cap out, so we need to not have taken out the cost of debt because we need entire OCF on there and then pull out cap debt and equity at the solve time

Incremental CF

Change in firm’s total CF occurs as direct result of accepting the project; ex) replace equipment → old gave us $20, new gives us $50, incremental is $30

Sunk cost

Outlay not affected by decision under consideration

Externalities

Effects of a project on other parts of the firm; cannibalism of sales from an existing project; new ndlpt canvas makes others not sell as well

Positive externalities w/in firm

Company’s financial / ops decisions (R&D, training, cap investments) generate uncompensated economic benefits for third parties; social benefits exceed private returns

Negative externalities w/in firm

Company’s production / activity imposes uncompensated, unintended costs (pollution, resource depletion, social disruption) on third parties; social marginal cost > private marginal cost

Environment externalities

Uncompensated environmental costs or benefits (carbon emissions, pollution, resource depletion) produced by econ activities left out of market prices → gap b/w private corporate costs and true social costs

Modified accelerated cost recovery system

Used for tax purposes; more appropriate for cap budgeting decisions than SLD because taxing affects DF; does NOT subtract SV to find dep basis; we want CF to be as big as possible

MACRS classes

• 3-yr: certain special mfg tools

• 5-yr: automobiles, light-duty trucks, computers, special mfg equipment

• 7-yr: most industrial equipment, office furniture, fixtures

• 10-yr: certain longer-lived equipment

• 27.5 yr: residential rental (apt)

• 31.5 yr: all nonresidential real property (industrial, commercial)

Half-year convention

Not even sure what to put

Depreciable base

Price + shipping + installation + modification; all you spend on equipment

Straight line depreciation

For SH reporting; (cost <SV> ) / life = dep / yr

Initial investment outlay

What it will cost us at t=0 to get into the project

Operating CF

Made a CF w/ working the machine

Terminal CF

Generated/lost at the end of project lifespan

Expansion projects

New, never done before

Replacement projects

Do I replace equipment or do something new?

Sensitivity analysis

What ifs; finc modeling measures how specific

Dependent vs independent output variables

DOV: NPV, IRR, EPS
IOV: SP, PC, IR
DOV change when IOV change

Scenario analysis

Estimates how portfolio, business, or investment will perform by changing multiple variables at the same time; base case, best case, worst case

Monte Carlo simulation

Computerized math predicting probability of diff finc outcomes by running a model w/ random inputs; tests wide spectrum of market conditions

Tax effect

= (MV - BV) (T); gain → tax owed, -CF; loss → tax saved, +CF

OCF

= (change rev - change costs - change dep) (1 - T) + change dep
= (change rev - change costs) (1 - T) + T (D_new - D_old)

D_new - D_old

Change in tax savings from switching machines

Degree of op lev

That FC is NOT % of sales??; an x % increase in sales → DOL * x % increase in EBIT

= (S - VC ) / (S - VC - F)

Degree of finc lev

That int did NOT stay proportional to sales; y % increase in EBIT → DFL * y % in EPS or NI
= (S - VC - F) / (S - VC - F - D)

Degree of tot lev

That FC and int did NOT stay proportional to sales; x % increase in sales → DTL * x % increase in EPS or NI
= (S - VC) / (S - VC - F - I) = DOL * DFL

EPS₁

EPS₀ (1 + DFL (increase EBIT))

Firm ops are just above BE

DOL is MASSIVE!; BE = EBIT = 0 → DOL = 120000 / 1 → 120000x

Finc risk

Additional risk placed on CSH as result of finc lev

Finc lev

• Extent to which fix-income securities (debt, pref stock) used in firm’s cap structure

• Affects EPS by magnifying gains/losses

• Int exp are fixed obligations regardless of op performance (change EBIT → big % change EPS)

• As debt to assets increases from 0, EPS increases (but will decrease at some point)

  • As D to A increases, stdev_EPS (risk amount of EPS) increases

Max EPS

We do not want to max EPS because at some point it’s too much risk

Signaling theory

When a mature company puts out equity to fund a project → negative signal; if I think a project is AWESOME, I will not want to dilute my ownership and get less money via equity

Debt and mgers

Debt constrains mgers because banks require company to maintain certain finc ratios for loans; like a GPA scholarship deal

Pecking order hypothesis of capital to use

AP and Accr (free) → RE (dilute EPS) → debt (tax-deducted) → new CS (dilute EPS)

Hamada equation

Bu; if company has beta of 1.2 w/ no debt, then takes on debt → beta changes; amount of debt increases in cap structure → beta increases to reflect extra risk

Cap structure decision checklist factors

1. Sales stability

2. Asset structure

3. Op lev

4. Growth rate

5. Profitability

6. Taxes

7. Control

8. Mgmt attitudes

9. Lender and rating agency attitudes