Corporate Finance: Capital Budgeting and Stock Valuation

Comprehensive practice flashcards covering Capital Budgeting (Decision Criteria, Cash Flow Estimation, Risk Analysis) and Stock Valuation (DDM, DCF, Multiples, and EMH).

How is a project's incremental cash flow defined and calculated?

A project's incremental cash flow represents the net change in corporate cash flows resulting from accepting the project, calculated as: $\text{Project's incremental CF} = \text{corporate CF w/ the project} - \text{corporate CF w/o the project}$.

How are opportunity costs, externalities, and sunk costs treated in capital budgeting cash flow estimation?

Opportunity costs and externalities (effects on other projects' cash flows, such as sales cannibalization) must be included as incremental costs. Sunk costs (unrecoverable past expenses spent in efforts to start a project) must be excluded.

What are the broad and narrow definitions of working capital?

The broad definition is: $\text{Broad working capital} = \text{current assets} - \text{current liabilities}$. The narrow definition is: $\text{Narrow working capital} = \text{A/R} + \text{Inventory} - \text{A/P}$.

How is the change in net working capital ($\Delta\text{NWC}$) treated in project cash flows?

$\Delta\text{NWC}$ is subtracted from cash flow if it is an increase (cash outflow) and added if it is a decrease (cash inflow). It can be calculated as: $\Delta\text{NWC}_t = \lambda \times (\text{sales}_{t+1} - \text{sales}_t)$, where $\lambda$ is a fixed percentage.

What is the depreciation tax shield and how is it calculated?

The depreciation tax shield is the tax saving resulting from the depreciation expense deduction, calculated as: $\text{Depreciation Tax Shield} = DA \times \tau$, where $DA$ is depreciation and amortization and $\tau$ is the corporate tax rate.

How do straight-line and MACRS depreciation calculations differ?

Straight-line depreciation is calculated as: $\text{Annual depreciation} = \frac{\text{depreciation basis} - \text{book value}}{\text{useful life of the asset}}$. MACRS depreciation is calculated as: $\text{Annual depreciation for year } i = \text{depreciation basis} \times \% \text{ of depreciation for year } i$.

What is sensitivity analysis, and what are its pros and cons in capital budgeting?

Sensitivity analysis shows how changes in a single variable (holding others fixed) affect metrics like NPV or IRR. Pros: identifies risky variables, gives break-even information, and provides insight into stand-alone risk. Cons: ignores relationships among variables, does not reflect diversification, and says nothing about the likelihood of change.

How do scenario analysis and simulation analysis differ in assessing project risk?

Scenario analysis evaluates a discrete set of outcomes by changing several variables at once (typically worst case, most likely case, and best case). Simulation analysis is a computerized extension that selects variable values from continuous probability distributions across repeated iterations to generate probability distributions for NPV and IRR.

What corporate governance rights do common stock owners possess, including preemptive rights?

Ownership implies control: stockholders elect the board of directors, and directors hire management. If granted preemptive rights, stockholders have the right to purchase newly issued shares directly at a discount before they are offered to the general public.

What is the Gordon constant growth Dividend Discount Model (DDM) formula for stock price ($P_0$)?

$P_0 = \frac{D_1}{r_e - g} = \frac{D_0 \times (1 + g)}{r_e - g}$, where $D_1$ is the next expected dividend, $r_e$ is the required return on equity, and $g$ is the constant dividend growth rate.

What is enterprise value (EV) and how is it defined algebraically?

Enterprise value represents the total value of the firm's core business operations: $EV = \text{equity} + \text{debt} - \text{cash} = \text{MV of stock} + \text{MV of bond} - \text{cash}$.

How is a comparable valuation multiple used to estimate the Enterprise Value of Company X?

$EV \text{ of } X = \text{EBITDA of } X \times \text{avg of } \left(\frac{EV}{\text{EBITDA}}\right) \text{ of comparables}$, where EBITDA is earnings before interest, taxes, depreciation, and amortization.

In Discounted Cash Flow (DCF) valuation, how do the targets and discount rates differ between FCFF and FCFE?

Free Cash Flow to the Firm (FCFF) solves for Enterprise Value ($EV$) using the Weighted Average Cost of Capital ($\text{WACC}$) as the discount rate. Free Cash Flow to Equity (FCFE) solves for the market value of equity ($S$) using the cost of equity ($r_e$) as the discount rate.

What is the formula for calculating Free Cash Flow to the Firm (FCFF)?

$\text{FCFF} = \text{EBIT} \times (1 - \tau) - \text{capex} - \Delta\text{NWC} + \text{depreciation}$, or equivalently: $\text{FCFF} = (\text{revenues} - \text{operating costs excluding depreciation}) \times (1 - \tau) - \text{capex} - \Delta\text{NWC} + (\text{depreciation} \times \tau)$.

What is the formula for Free Cash Flow to Equity (FCFE)?

$\text{FCFE} = NI - \text{capex} - \Delta\text{NWC} + \text{depreciation} + \text{net borrowing}$, where $\text{net borrowing} = \text{new debt} - \text{debt repayment}$.

How is terminal value ($TV_n$) calculated in FCFF and FCFE models under constant growth?

For FCFF: $TV_n = \frac{\text{FCFF}_{n+1}}{\text{WACC} - g}$. For FCFE: $TV_n = \frac{\text{FCFE}_{n+1}}{r_e - g}$.

How is the per-share stock price ($P_0$) determined after estimating Enterprise Value ($EV$) via DCF?

First compute the market value of equity: $S = EV - B + \text{cash}$, where $B$ is the market value of bonds. Then divide by the number of shares: $P_0 = \frac{S}{\# \text{ of shares}}$.

What are the two formulas provided for estimating the expected sustainable growth rate ($g$)?

1. Based on equity: $g = ROE \times \text{retention ratio}$, where $\text{retention ratio} = 1 - \frac{\text{dividends}}{\text{net income}}$.
2. Based on capital: $g = ROIC \times \text{reinvestment rate}$, where $\text{reinvestment rate} = \frac{\text{net capital expenditure} + \Delta\text{NWC}}{\text{operating income} \times (1 - t)}$.

How does preferred stock differ from debt, and what is its valuation formula?

Like bonds, preferred stock pays a fixed dividend that has priority over common stock dividends; unlike bonds, omitting preferred dividends does not force the firm into bankruptcy. Its value is: $V_{ps} = \frac{Div}{r_{ps}}$, where $r_{ps}$ is the required return on preferred stock.

What are the market conditions for an equilibrium, overpriced, and underpriced asset?

Equilibrium: $\text{fundamental value} = \text{market value}$. Overpriced: $\text{fundamental value} < \text{market value}$. Underpriced: $\text{fundamental value} > \text{market value}$.

What is the core assertion of the Efficient Market Hypothesis (EMH)?

The EMH asserts that securities are normally in equilibrium and fairly priced; consequently, investors cannot consistently 'beat the market' except through good luck or inside information.

What are the three main types of financial decisions made to maximize firm value?

1. Investment decisions (capital budgeting, FCF, WACC)
2. Financing decisions
3. Distribution of capital (dividend decisions)

What are the four sequential steps in the capital budgeting process?

1. Estimate cash flows (inflows and outflows)
2. Assess the risk of such cash flows
3. Determine the required return ($r = \text{WACC}$) for the project
4. Evaluate cash flows using capital budgeting criteria

How do independent and mutually exclusive project decision rules differ under NPV?

For independent projects, accept all projects that have $NPV > 0$. For mutually exclusive projects, select the single project with the highest positive NPV, as it adds the most value.

What is Net Present Value (NPV), and what is its decision rule?

NPV is the present value of all future cash inflows minus project costs: $NPV = PV \text{ of inflows} - \text{costs}$. Accept if $NPV > 0$; reject if $NPV \le 0$.

What two factors cause NPV profiles of competing projects to cross?

1. Size (scale) differences: High cost of capital ($r$) favors smaller projects because smaller initial investments free up funds at $t = 0$.
2. Timing differences: High $r$ favors projects with faster payback that generate larger cash flows in early years.

Why is a project with cash flows weighted toward the distant future more sensitive to changes in WACC?

Later cash flows are discounted over more compounding periods, causing a change in the discount rate ($WACC$) to have a geometrically larger impact on their present value compared to earlier cash flows.

What is the Internal Rate of Return (IRR), and what is its acceptance criterion?

IRR is the discount rate that sets the project's NPV equal to zero ($PV \text{ of inflows} = \text{costs}$). Accept the project if $IRR > \text{WACC}$; reject if $IRR \le \text{WACC}$.

Under what conditions does the standard IRR rule break down?

IRR breaks down when evaluating unconventional cash flows (which can yield multiple, nonexistent, or extreme IRRs) and when comparing mutually exclusive projects with differing scale, timing, or risk.

When the NPV rule and the IRR rule give conflicting recommendations, which should be followed?

Always follow the NPV rule (or utilize criteria like MIRR), because NPV directly measures the dollar value added to shareholder wealth.

What is the Modified Internal Rate of Return (MIRR) and what are its standard reinvestment assumptions?

MIRR is the discount rate that equates the present value of project cash outflows to the present value of its terminal value ($TV$): $MIRR = \left(\frac{FV \text{ of cash inflows}}{PV \text{ of cash outflows}}\right)^{\frac{1}{n}} - 1$. Cash inflows are compounded to the terminal year at the reinvestment rate (generally WACC).

What is the Profitability Index (PI) and what is its decision criterion?

PI measures the ratio of the present value of future cash inflows to initial costs: $PI = \frac{\sum \frac{CF_t}{(1 + \text{WACC})^t}}{I_0}$. Accept if $PI > 1$ (which corresponds to $NPV > 0$); reject if $PI \le 1$.

What are the primary strengths and weaknesses of the Payback Period (PB)?

Strengths: easy to calculate and understand; provides an indication of project risk and liquidity. Weaknesses: ignores the time value of money, ignores cash flows occurring after the payback cutoff, and lacks an objectively specified acceptable threshold.

How is the Payback Period (PB) calculated using cumulative cash flows?

$PB = t + \frac{|\text{cumulative } CF_t|}{CF_{t+1}}$, where $t$ is the year immediately prior to recovery/break-even, $\text{cumulative } CF_t$ is the unrecovered balance at year $t$, and $CF_{t+1}$ is the total cash inflow in the subsequent year.

What is the mathematical relationship between the Discounted Payback Period (DPB) and the conventional Payback Period (PB)?

$\text{DPB} \ge \text{PB}$. Discounted payback will equal the conventional payback period only when the discount rate is zero ($\text{WACC} = 0$).

Which two methods are used to evaluate mutually exclusive projects that have unequal lifespans?

1. Replacement Chains Approach: repeating projects' cash flow cycles to establish a common lifespan.
2. Equivalent Annual Annuity (EAA) Approach: converting each project's NPV into an equivalent annual annuity payment ($PMT$) over its lifespan at $r = \text{WACC}$, then selecting the higher EAA.