Business Finance Review (Merriman)

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o Relevant CFs

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• CFs that come into or out of being because a project is undertaken
• Aka. Incremental cash flows- any and all ∆s in the firms future CFs that are a direct consequence of taking the project

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o Irrelevant CFs-

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CFs that are not affected by the decision to invest in a project

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o Stand-alone principle

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viewing projects as “mini-firms” with their own assets, revenues, and costs so as to evaluate investments separately

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• decision to Include/exclude in the incremental CFs of a project

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decisions should always be based on CFs- accounting numbers are only used to get CFs

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o Sunk cost

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– exclude
• A CF already paid or promised to be paid
• Sunk costs= irrelevant costs
o Opportunity cost

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opportunity cost

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Include

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o Side effects

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– include
• Projects often affect one another
• The point is to be aware of such effects in calculating incremental CFs

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o Changes to net working capital

Back 8

– include
• New projects often require incremental investments in cash, inventories, and receivables that need to be included in CFs if they are not offset by ∆s in payables (these investments are usually recovered later)

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o Financing costs

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- exclude
• Ø include CFs associated with interest payments or principal on debt, dividends or any other financing costs

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o Incremental taxes, based on marginal tax rate

Back 10

include

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o Managerial options

Back 11

include

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• Annual straight-line depreciation=

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(cost- salvage value)/ # of years to depreciate

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• Tax basis at resale date =

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cost – (annual SL depreciation x # of years depreciated)

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• Taxes on resale=

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(resale amount- tax basis)*marginal tax rate

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• Taxes of operating cast flows=

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EBIT * marginal tax rate

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o “pro forma”

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financial statements are financial statements done in advance, based on estimates and projects- e.g. budgeted income statement

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• Forecasting risk

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you made a bad estimate and it led to a wrong decision
o What if scenarios

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• Scenario analysis

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- changing various assumptions at the same time – best and worst cases
o ∆ a lot at once that way you know how bad it can be or how good it can be

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• Sensitivity analysis

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changing one assumption at a time to determine its impact and importance- allows you to determine what assumptions are critical and what do not have high impact

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• Contingency planning

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planning for various possible outcomes

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• Managerial options in capital budgeting...

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o add value, the opportunity to ∆ one’s plans based on future events

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o option to expand

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ignoring this can result in underestimated NPV because of the possibility of profitable “follow-on” projects

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o option to abandon

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ignoring this option can result in underestimating NPV because the right to quit a loser is valuable

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o option to wait

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waiting for favorable conditions or simply for some uncertainty to be resolved

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o strategic options

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possible future investments that may result from an investment under consideration

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o contingency planning

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determining what will be done if the “what if” happens

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• Soft vs. hard capital rationing

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capital budgeting rules are distorted when soft or hard rationing occurs

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o Soft rationing

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• self-imposed rationing, usually by top-level decision makers within the firm
• very common, company’s decision

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o hard rationing

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• lack of funds at any rate, is often associated with market imperfections or financial distress
• not as common, market’s decision

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EBIT=

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all revenues or sales – all expenses except interest and taxes

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• E(Ri) =

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expected return of a security i = weighted average of its possible returns (Note: weights are the probabilities of each return.)

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• E(Ri) – Rf =

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Expected return – risk-free rate = projected risk premium of security i

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• Variance of return =

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measure of total risk

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o Total risk=

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systematic risk + unsystematic risk= market risk + unique risk
o If a security always gives you the same return, there is no risk by financial definition of risk

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• Portfolio

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a collection of securities, such as stocks and bonds, held by an investor; a portfolio diminishes unsystematic risk

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• Portfolio E(R) =

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expected return of portfolio = weighted average of its individual securities’ expected returns

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what # of stocks achieve the bulk of the benefits of diversification = lower risk

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25-30; about 40% of the average variances of the individual securities without any reduction in expected return

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• Lower covariance →

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lower portfolio total risk = lower portfolio variance, which in a well diversified portfolio approximates systematic risk since all or almost all non-systematic risk has been diversified away.

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• Investor attitude towards risk:

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o Risk aversion: assumes investors dislike risk
o Risk premium: the additional benefits to convince investors to take risks
o Risk aversion → risk premium

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• Total risk =

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systematic risk + non-systematic risk = measured by a stock’s variance; does not impact the expected return of a stock. Market does not pay/compensate for total risk, just systematic risk.

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• Systematic risk =

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market risk = non-diversifiable or undiversifiable risk. (This risk increases the covariances among most stocks.) – measured by beta; increases expected return of a stock (market compensates for systematic risk), due to its inability to be diversified away.

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systematic risk affects:

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Affects a very large number of assets

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• Unsystematic risk =

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• Unsystematic risk = unique risk = diversifiable risk (This risk does not increase the covariances among most stocks.) – does not impact the expected return of a stock; because it can be diversified away, market does not compensate for it.

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unsystematic risk affects:

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o Affects at most a small number of assets

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• Principle of diversification

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o Combining imperfectly related assets can produce a portfolio with less variability than the typical individual asset

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o Diversification and unsystematic risk-

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when securities are combined into portfolios, their unique risks tend to cancel out
• Thus: diversifiable risk=unsystematic risk

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• Large portfolios have _____ unsystematic risk

Back 47

little or no

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o Diversification and systematic risk-

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systematic risk cannot be eliminated by diversification
• Systematic risk = undiversifiable risk

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systematic risk is measured by what?

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• This risk is measured by ß
• High ß refers to anything that is highly affected by bad times or good times

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• Portfolio Beta =

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weighted sum of individual betas.

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• CAPM (Capital Asset Pricing Model):

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E(Ri) = Rf + b (E(Rm) – Rf) ;

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CAPM:

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o not very accurate but used because there is nothing better, it is used all the time
o expected return of a security is a function of the risk-free rate which adjusts for the time value of money, the measure of systematic risk (which is beta), and the reward for each unit of risk (which is the forecasted market risk premium or the difference between the market’s expected return and the risk-free rate).

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• Market’s beta =

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1

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Lower risk stocks have ____ betas

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lower

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Negative beta means

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the stock moves in the opposite direction of the market. Beta can be < or > 1.

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• SML (Security Market Line)

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o Graphic representation of CAPM; the line which gives the expected return/systematic risk combinations of assets in a well-functioning, active financial market

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• Uses of Cost of Capital (COC)

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o for capital budgeting (using NPV and IRR); [capital budgeting decisions]
o for financing to determine a firm’s optimal or target capital structure; [financing decisions]
o for rate setting for regulated companies (utilities, etc.) to determine a fair rate of return and thus the appropriate profit for the company. [operating decisions]

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• Required return vs. cost of capital

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o All denote the same opportunity cost:
o Required return- from an investor’s point of view
o Cost of capital- from the firm’s point of view
o Appropriate discount rate- same return as used in a PV calculation

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• 3 methods of calculating RE:

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o Dividend Growth (rarely used)
o CAPM and SML
o Own-Bond-Yield + Premium

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o Dividend Growth (rarely used)

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P0 = D1/ (RE – g)

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o CAPM and SML: RE = Rf + bE(RM - Rf)

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Beta is widely available for public but not private companies; Market risk premium = [E(RM - Rf) for which the historical average is often used; risk-free rate = T-bill rate]

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o Own-Bond-Yield + Premium

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RE = RD + RP

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• Why is the cost of retained earnings cheaper than the cost of issuing new common stock?

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o When a company issues new common stock they also have to pay flotation costs to the underwriter
o Issuing new common stock may send a negative signal to the capital markets which may depress the stock price

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• After tax cost of debt =

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cost of debt * (1 – marginal tax rate) = RD (1-TC) [YTM vs. EAR]

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o Preferred stock will have a___ before tax yield than the before tax yield on debt

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lower; • Corporations own most preferred stock because 70% of preferred dividends are excluded from corporate taxation
o The after tax yield to an investor and the after tax cost to the issuer are higher on preferred stock than on debt. (consistent with higher risk of preferred stock

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• ß ____ as debt increases →

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increases; increases RE due to increasing variability of return/risk.

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• What has higher flotation costs – debt or equity?

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o Flotation costs depend on the firms risk and the type of capital being raised
o Flotation costs are highest for common equity
• However since most firms issue equity infrequently, the per project cost is fairly small