Finn Theory & Practice 11-12

The lower the firm’s tax rate, the lower will be its after-tax cost of debt and WACC, and other things constant

False

Suppose now that there is not enough internal cash flow and the firm must issue new shares of stock. Qualitatively speaking, what will happen to the WACC?

r_s and the WACC will increase due to the flotation costs of new equity.

Capital

Preferred stock, Long-term debt, Common stock

Capital Structure

The relative proportions of debt, equity, and other securities that a firm has outstanding

Cost of Capital

Indicates how the market views the risk of those assets

Cost of Debt

The required return that lenders require on the company’s new debt

The lower the firm’s tax rate, the higher will be its after-tax cost of debt and WACC, and other things held constant

True

Suppose the Debt ratio (D/TA) is 50%, the interest rate on new debt is 8%, the current cost of equity is 16%, and the taz rate is 25%. An increase in the Debt ratio to 60% would decrease the WACC

True

The cost of equity must be adjusted to an after-tax figure because 50% of dividends received by a corporation may be excluded from the receiving corporation’s taxbable income

False

The company uses the CAPM to calculate its cost of equity, and its target capital structure consists of common stock,, preferred stock, and debt. Which of the following events would reduce its WACC

The market risk premium declines

Assume a company’s target capital structure is 50% debt and 50% common equity.

The cost of equity is always equal to or greater than the cost of debt

The cost of equity must be adjusted to an after-tax figure

Only loans and debt

Capital Budgeting

The process of identifying, evaluating, and selecting long-term investments that contribute to the firm’s goal of maximizing owners’ wealth

Net Present Value (NPV)

The measure of the difference between the market value (benefit) of an investment and its cost

Internal Rate of Return (IRR)

On an investment is the required return that results in a zero NPV when it is used as the discount rate.

IRR Rule

Accept any investment if the IRR is greater than the requried return

Reject any investment if the IRR is less than the required return

NPV Profile

How NPV of an investment project changes at varying discount rates

NPV depends on cost of capital

IRR is the rate where NPV is equal to zero

NPV approach

Implicitly assumes that the firm can reinvest intermediate cash inflows at the cost of capital (more realistic)

IRR approach

Assumes that the firm reinvests intermediate cash inflows at a rate equal to the project’s IRR

NPR vs. IRR

Whenever there is a conflict between NPV and another decision rule, always use NPV

Profitability Index

Measures the benefit per unit cost, based on the time value of money

Present value of the future cash flows divided by the initial investment (very similar to NPV)

Also called the benefit-cost ratio (the value created per dollar invested)

Decision Rule for Profitability Index

Accept the project if the profitability index is more than 1

Reject the project if the profitability index is less than 1

Payback Period

The time it takes to generate cash inflows sufficient to recover the initial cost of the investment

Based on the notion that an investment pays back the initial investment quickly, it is good

Estimate the cash flows from the project

Subtract the future cash flows from the initial cost

Decision Rule for Paypack Period

Accept the project if the payback period is less than the preset limit

Reject the project if the payback period is more than the preset limit

Payback Period ignores the time value of money

Discounted Payback Period

Finds the point in time at which the project reaches a zero NPV

Find the PV of each cash flow

Use the discounted cash flows to find the Payback Period

Modified Internal Rate of Return (MIRR)

Controls for some problems with IRR (such as multiple rates)

Discounting Approach

Discount future cash outflows to the present and add to the initial cash outflow

Combination Approach

Discount future cash outflows to the present and add to the initial cash outflow

Compound all future cash inflows to the end

Reinvestment Approach

Compound all future cash flows to the end

Replacement Chain (Common Life)

Repeat (replicate) each project in the future so that they will both terminate in a common year

Calculate NPV using the adjusted cash flows for both projects

Equivalent Annual Annities (EAA)

Convert the unequal annual cash flows of a project into a constant cash flow stream (an annuity) whose NPV is equal to the NPV of the initial stream

Do for both projects and compare the annuities

Economic Life

The number of years a project should be operated to maximize its Net Present Value (often less than the maximum potential life)

Finding Economic Life

Consider all cash flows (including salvage value from the sale of assets

Find the project’s NPV under different assumptions about how long it will be operated

Physical Life

Projects are normally evaluated under the assumption that the firm will operate them over their full physical lives

May be better to terminate a project before the end of its potential life (EX, because of high maintenance costs)

Yield-to-Maturity (YTM)

Return bond purchasers would earn if they held the debt to maturity and received all the payments as promised

Capital Structure Weights

Weights of each source of funds

Always use the target weights (if not available, use market values)

A firm’s market value is the sum of the market value of each capital

The Weighted Average Cost of Capital (WACC)

Represents the overall return the firm must earn on its existing assets to maintain the value of the firm

The required return on the firm’s assets, based on the market’s perception of the risk of those assets

Do not find the dollar amount; it should be a percentage

Decrease debt, increase equity, tax goes up, tax savings will be less

Uncontrollable Factors WACC

Market conditions (especially interest rates)

The market risk premium

Tax rates

Controllable Factors WACC

Capital structure policy

Dividend policy

Investment policy

Firms with riskier projects generally have a higher cost of equity

Pure Play Approach

Find one or more companies that specialize in the product or service that we are considering

Compute (or research) the beta for each company and take the average of the betas

Use that beta along with the CAPM to find the appropriate return for a project of that identical risk

Subjective Approach

Consider the project’s risk relative to the firm overall

If the project has more risk than the firm, use a discount rate greater than the WACC

If the project has less risk than the firm, use a discount rate less than the WACC

Floatation costs increase the cost

A project’s IRR is independent of the firm’s cost of capital. In other words, a project’s IRR doesn’t change with a change in the firm’s cost of capital.

True

The primary reason that the NPV method is conceptually superior to the IRR method for evaluating mutually exclusive investments is that multiple IRRs may exist, and when that happens, we don’t know which IRR is relevant.

False

The NPV and IRR methods, when used to evaluate two independent and equally risky projects, will lead to different accept/reject decisions and thus capital budgets if the projects’ IRR are greater than their cost of capital.

False

The regular payback method is deficient in that it does not take account of cash flows beyond the payback period. The discounted payback method corrects this fault.

False

Assume that a project has normal cash flows. Which one is correct?

The higher the cost of capital used to calculate the NPV, the lower the calculated NPV will be

Which one is correct?

One defect of the IRR method is that it can be subject to the multiple IRR problem for some proejcts

Which one is correct?

The IRR method is appealing because it gives an estimate of the rate of return on projects that summarizes the merits of a project and only depends on the cash flows

After-tax

A company’s after-tax cost of providing the required rate of return on debt

Cost of Preferred Stock

The return required by the firm’s preferred stockholders. The cost of preferred stock, rps, is the cost to the firm of issuing new preferred stock. For perpetual preferred, it is the preferred dividend, Dps, divided by the net issuing price per share after flotation costs.

Dividend Growth Model (DGM)

Formula for the present value of an infinite stream of constantly growing dividends. Sometimes called the constant dividend growth model. Also called the Gordon model

NPV Rule

Accept any investment that has a positive NPV (NPV > $0)    

Reject any investment that has a negative NPV (NPV < $0)

Non-Conventional Cash Flows

Cash flow sign changes more than once

Multiple rates of return problem

Mutually Exclusive Projects

Taking one investment prevents the taking of another

The scale of investments is substantially different

The timing of cash flows is substantially different

Will not reliably rank projects