Corporate Finance Exam 3

net present value

present value of cash flows minus initial investments

opportunity cost of capital

expected rate of return given up by investing in a project

net present value rule

accept all projects with a positive net present value

internal rate of return (IRR)

discount rate at which NPV = 0. the rate of return generated by the cash flows and their timing

profitability index

ratio of net present value to initial investment

capital rationing

limit set on the amount of funds available for investments

soft rationing

limits on available funds imposed by management (picking one with the highest NPV)

hard rationing

limits on available funds imposed by the unavailability of funds in the capital market (credit rating too low so you can’t barrow anymore)

payback period

time until cash flows recover the initial investment of the project

payback rule

accept a project if its payback period is less than a specified cutoff period

market index

measure of the investment performance of the overall market

the dow

index of the investment performance of a portfolio of 30 “blue chip” stocks

S&P 500

index of the investment performance of a portfolio of 500 large stocks

how to measure risk

variance and standard deviation

variance

average value of squared deviations from mean

standard deviation

square root of variance. measurement of total risk

specific risk

risk factors only affecting that firm or industry (unique risk)

market risk

economy wide sources of risk that affect the overall stock market (systemic risk)

correlation

the tendency of the returns on two assets to move together

positive - move up and down together

negative - move in opposite directions

+1 —- 0 —- -1

when thinking about risk…

1. risk can be measured

2. some risks look big and dangerous but really are diversifiable

3. market risks are macro risks

market portfolio

all assets in the economy

beta

sensitivity of a stocks return to the return on the market portfolio (left over)

portfolio betas

equals the weighted average of betas of the securities in the portfolio

market risk premium

difference between market return and return on risk-free treasury bills

capital asset pricing model (CAPM)

theory of relationship between risk and return. states that the expected risk premium on any security equals its beta times the market risk premium

company cost of capital

opportunity cost of capital for investment in the entire firm. the company cost of capital is the appropriate discount rate for an average risk investment project undertaken by the firm

cost of capital

what is the cost of funding? the return the firms investors could expect to earn if they invested in securities with comparable degrees of risk

capital structure

the mix of long-term debt and equity financing

weighted average cost of capital (WACC)

the expected rate of return on a portfolio of all the firm’s securities, adjusted for tax savings due to interest payments

3 steps to calculating WACC

1. calculate the value of each security as a proportion of the firms market value

2. determine the required rate of return on each security

3. calculate a weighted average of the after-tax return on the debt and return on the equity

when estimating WACC…

do NOT use book value, use market value

market value of bonds

present value of all coupons and par value discounted at the current yield to maturity

market value of equity

market price per share multiplied by the number of outstanding shares

for dividend discount model (DDM)…

use cost of equity

for free cash flow to equity (FCFE)…

use cost of equity

for free cash flow to firm (FCFF)…

use WACC