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When is it comes to things that makes a business successful, what is the most important factor?
Customer satisfaction
Which part of the Value Creation Process does the financial person focus on?
Investment Decisions
Aside from investments, what other decisions does a financial manager make for a corporation?
Accessing financial capital in terms of debt and equity
What is a debt holder?
Someone who invested in the company and still needs to be paid the principle and interest by the company
What are the owners of the corporation?
The focus of the financial manager. These are the people who are the equity owners once the debt holders have been accounted for
Describe the flow in the Value Creation Process that involves financing decisions
Financial Markets (Stockholders and Bondholders) → Corporation
Describe the flow in the Value Creation Process that involves investment decisions
Corporation → Factor Market (Land, Labor, and Physical Capital)
Describe the flow in the Value Creation Process that involves dividends and interest
Corporation → Financial Markets (Stockholders and Bondholders)
Describe the flow in the Value Creation Process that involves profits
Describe the flow in the Value Creation Process that involves products or services
Factor Market (Land, Labor, and Physical Capital) → Product Market (Customers)
Investment decisions are also sometimes called ______
Operating decisions
What is supposed to be the outcome of making operating decisions?
To increase internal capital (resource allocation), also by acquisitions and divestitures. This in turn should also increase expected cash flows.
What happens alongside the operating decisions?
The financing decisions
What is the outcome of financing decisions?
Focusing on improving capital structure (debt and equity), as well as managing risk and the payout policies. Results in decrease cost of capital.
Which branch in the role of finance involves valuation and monitoring?
Operating decisions and performance evaluation
Which branch in the role of finance involves strategy formulation and implementation?
Financing decisions
What is the number one goal of financial management?
Maximizing shareholder wealth
What are some special qualities about shareholders?
They are residual claimants and the owners of a corporation
What payments need to happen prior to the shareholder receiving money?
Supplier paid
Wages to workers paid
Interest to bondholders paid
Taxes paid
What are firms constantly interacting with?
Financial Markets
What does IPO stand for?
Initial Public Offering
What is IPO?
It’s when investors in the market give money to the firm, then the firm gives securities to the investors.
If a company is successful, what two things can it generate profits and cashflows through?
Debt and Equity
Cashflows are returned to ____ and debt repayments to ____
Equity holders and debt holders
Aside from paying equity and debts, what third payment happens between firms and financial markets?
Tax payments to the government
Cash flows from the firm must _____ the cash flows from the financial markets
Exceed
What is capital budgeting?
The process of determining exactly which assets to invest in and how much to invest
What are the four steps, in order, of the decision making process for investments?
Identification
Evaluation
Selection
Implementation
Describe the Identification step in Investment Projects
Finding out opportunities and generating investment proposals
What type of investments fall under the identification step?
Required
Replacement
Expansion
Diversification
Describe the evaluation step in Investment Projects
Estimating the project’s relevant cash flows and appropriate discount rate
What type of investments fall under the evaluation step?
Expected cash-flow stream
Discount rate
Discount rate is also sometimes known as ____
Cost of capital
Describe the selection step in investment projects
Choosing a decision making rule (accept / reject criteria)
List the types of investments that fall under the selection step
Net present value
Profitability index
Internal rate of return
Payback period
Describe the implementation step in investment projects
Establishing an audit and a follow-up procedure
List the types of investments that fall under the implementation step
Monitor the magnitude and timing of cash flows
Check if the project still meets the selection criterion
Decide on a continuation or abandonment
Review previous steps if failure rate is high
Money received in the future is _____ than money received today
less
Define opportunity cost
Rate of return sacrificed on the next best alternative
What is the formula for finding the future value FV of an investment of PV dollars today
FV = PV*(1+r)^t
What is the present value
The amount of money you would need to invest today in order to duplicate some future dollar amount
What excel formula allows you to calculate the number of periods it will take for a future value to be achieved?
NPER
What is the formula for calculating payments of an amount with an interest rate?
PMT
What rule is usually used for forecasting the benefits and costs of an investment project?
Net Present Value (NPV)
What is the formula for Net Present Value (NPV)?
NPV= C0 + C1/(1+r) +…+ Ct/(1+r)^t
What condition needs qualifies a project to be accepted when using NPV?
If NPV > 0, the the project will increase shareholder value and should be accepted
What is an independent project?
Acceptance or rejection is independent of the acceptance or rejection of other projects
What is a mutually exclusive project?
Can accept “A” or you can accept “B” or you can reject both -- you cannot accept both
What is the payback period?
The number of periods required for the sum of the project’s expected cash flows to equal its initial cash outlay
What are some of the consequences of the payback period?
Penalizes long-term projects
Difficult to know who decides the period
Ignores cashflows after the period
What is the internal rate of return?
It is the discount rate that makes the net present value of the project equal zero
What is the criteria for an acceptable project using the internal rate of return?
The IRR needs to be greater than the cost of capital
What is the profitability index?
It is the present value of an investment’s future cash flows divided by its initial cost
What is another name for the profitability index?
Benefit / cost ratio
How do you calculate the profitability index?
(CF + NPV) / CF
What is the criteria for accepting the profitability index?
PI > 0 means you accept the project
What are some of the issues with IRR?
Multiple IRRs can exist
Scale issue
Timing issue
What happens to cause multiple IRRs?
There is more than one change of sign of the cashflows (positive to negative and negative to positive)
What is the crossover rate?
NPVa = NPVb
What two evaluation methods will generally give the same decision?
NPV and IRR
Why would NPV and IRR not produce the same outcomes?
Non-conventional cashflows (flow signs change more than once)
Mutually exclusive projects
Initial investments are substantially different
Timing of cash flows is substantially different
What is the most popular capital budgeting method?
IRR and NPV
What is the difference between discounted and undiscounted payback periods?
Undiscounted means that the payments shown already are adjusted to incorporate the time value of money, whereas discounted means you need to make that adjustment
If you want to determine the amount of capital expenditures a company made during the previous year, you should find the company’s most current ____ and look under the caption ________
cash flow statement; cash flow investments
When combining investment IRR, the combined IRR will be _____ the two individual IRRs
between
Conventional cash flows must be ______ for the NPV and IRR methods to be consistent in accept / reject decisions
independent
What are the two principle for recording relevant cash flows:?
Record cash flows when the money actually moves
Cash flows that are different in both scenarios (accepting or rejecting an investment) are relevant to the decision, and those that are the same are irrelevant
Define Sunk Costs
Something you’ve already spent -- not relevant for decision making
Define test marketing costs
These are the marketing research expenses expended
Define erosion costs
Taking away costs from an existing location -- Cash flow transferred to a new project from sales and customer of other products of the firm
Define Opportunity Costs
Lost revenues from alternative uses of the asset
What kind of an expense is depreciation?
Non-cash
How do you calculate the after-tax cash flow (ATCF)?
ATCF = (revenue - costs - depreciation)(1- tax) + depreciation
What is working capital?
Changes in the current assets that are the result of the investment decision -- this is relevant to the decisions
What is working capital considered (directionally) at the start and end of a project?
Start: cash outflows
End: cash inflows
What are the three groups to consider when making cash flow estimates?
Price, volume
Variable costs
Fixed costs
Capital expenditure
Working capital
What are the factors to consider with Price, Volume?
Competition from existing products
Competition from technological advances
Values to customer
What are the factors to consider with variable costs?
Labor, material, energy
What are the factors to consider with fixed costs?
Marketing (sales, advertising), information technology, accounting management
What are the factors to consider with capital expenditure?
Property, plant and equipment
What are the factors to consider with working capital?
Inventory, accounts payable, accounts receivable
What does the operating margin consist of?
Revenues (price, volume) and costs (variable and fixed)
What does the operating cash flow consist of?
The operating margin and taxes
What does the capital requirement consist of?
Capital expenditure, working capital (accounts receivable/payable, inventory)
What does the free cash flow consist of?
Operating cash flow and capital requirement
What does the cost of capital consist of?
Cost of debt and cost of equity
What does the net present value (NPV) consist of?
Free cash flow and cost of capital
The goal of the company is to ______ free cash flow and _______ cost of capital
maximize; minimize
What is a nominal return?
The percentage change in the amount of money you have
What is the real return?
The percentage change in the amount of stuff you actually buy
What is the Fisher Effect?
1 + Nominal = (1+Real) * (1+Inflation)
Describe the two methods you can use to account inflation and estimation of cashflows
Express cash flows in real terms and discount them at the real interest rate
Convert real cash flows to nominal cash flows by allowing them to grow at rate of inflation and discount them at the nominal rate
Cost of capital is expressed in ______ terms
Nominal
Depreciation is expressed in ______ terms
Nominal
When is it important to account for inflation/
When dealing with long horizons and high inflationary times
How can you do sensitivity analysis?
Ask what if questions:
Target Market Share
Cost overrun
Inflation
Competition
Discount rate
Valuable options
What are the steps?
Identify each key variable and the probability distribution associated with it
Base case
Revenues
Growth
Operating Margin
Working Capital
Draw one outcome for each variable
Estimate PV and IRR
Repeat steps 2 and 3 many times (~5000)
Use the distribution of NPV to answer the following questions:
What is the likelihood that this will be a bad project?
What is the worst case and best case scenarios?
Can you try to build linkages in the simulations?
What is the most preferred technique for capital investment analysis?
Net Present Value (NPV)
Capital budgeting must be done on an _____ basis
Incremental
In regards to capital budgeting, what costs are ignored and what costs are considered?
Sunk costs are ignored; opportunity costs and side effects are considered
Note
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