Reading...
Play button
Play button
Use LEFT and RIGHT arrow keys to navigate between flashcards;
Use UP and DOWN arrow keys to flip the card;
H to show hint;
A reads text to speech;
25 Cards in this Set
- Front
- Back
|
capital budgeting process
|
1)Idea generation
2)analyze project proposals (npv, irr) 3)create the capital budget for the firm 4)onitor decisions and conduct a post audit |
|
|
Dividend Discount
|
K= (D(next year)/Price)growth rate
(growth rate= ROE*retention rate) ROE=net profit/equity |
|
|
two primary agency conflicts
|
Stockholders versus Managers
If the manager owns less than 100% of the firm’s common stock, a potential agency problem between mangers and stockholders exists. Managers, at times, may make decisions that have the potential to be in conflict with the best interests of the shareholders. For example, managers may grow their firm to escape a takeover attempt to increase their own job security. However, a takeover may be in the shareholders’ best interest. 2. Stockholders versus Creditors Creditors decide to loan money to a corporation based on the riskiness of the company, its capital structure and its potential capital structure. All of these factors will affect the company’s potential cash flow, which is the main concern of creditors. Stockholders, however, have control of such decisions through the managers. Since stockholders will make decisions based on their best interest, a potential agency problem exists between the stockholders and creditors. For example, managers could borrow money to repurchase shares to lower the corporation’s share base and increase shareholder return. Stockholders will benefit; however, creditors will be concerned given the increase in debt that would affect future cash flows. |
|
|
Four primary mechanisms are used to motivate managers to act in stockholders’ best interests:
|
Managerial compensation
Direct intervention by stockholders Threat of firing Threat of takeovers |
|
|
Mutually exclusive projects
|
Mutually Exclusive Projects are a set of projects from which at most one will be accepted. For example, a set of projects which are to accomplish the same task. Thus, when choosing between "Mutually Exclusive Projects" more than one project may satisfy the Capital Budgeting criterion. However, only one, i.e., the best project can be accepted.
|
|
|
Independent projects
|
An Independent Project is a project whose cash flows are not affected by the accept/reject decision for other projects. Thus, all Independent Projects which meet the Capital Budgeting critierion should be accepted.
|
|
|
CAPM
|
Rate= Risk free ROR+B(Market Return-RF ROR)
|
|
|
Bond YieldPlus Premium Approach
|
ks = long-term bond yield + risk premium
|
|
|
Discounted Cash Flow
|
ks = D1/P0+ g;
where: D1 = next year’s dividend g = firm’s constant growth rate P0 = price g = (retention rate)(ROE) = (1-payout rate)(ROE) |
|
|
Constant Growth Rate
|
g = (retention rate)(ROE) = (1-payout rate)(ROE)
|
|
|
Cost of newly issued stock (kc)
|
kc = D1__ + g
P0 (1-F) where: F = the percentage flotation cost, or (current stock price - funds going to company) / current stock price D1 = next year’s dividend g = firm’s constant growth rate P0 = price |
|
|
Net Cash Flow Formula
|
Net Cash Flow = Net Income + Depreciation
|
|
|
Advantages and Disadvantages of the NPV and IRR Methods
|
With the NPV method, the advantage is that it is a direct measure of the dollar contribution to the stockholders.
With the IRR method, the advantage is that it shows the return on the original money invested. With the NPV method, the disadvantage is that the project size is not measured. With the IRR method, the disadvantage is that, at times, it can give you conflicting answers when compared to NPV for mutually exclusive projects. The 'multiple IRR problem' can also be an issue, as discussed below. |
|
|
The Multiple IRR Problem
|
A multiple IRR problem occurs when cash flows during the project lifetime is negative (i.e. the project operates at a loss or the company needs to contribute more capital).
|
|
|
If a NPV and a IRR show different winners for what the best project to take on is, what should you do?
|
1)Replacement Chain Method-streach it so that both ime periods are the same and see which has the higher NPV
2)Equivilant annual annuity....solve for PMT. |
|
|
Stand-Alone Risk
|
This risk assumes the project a company intends to pursue is a single asset that is separate from the company's other assets. It is measured by the variability of the single project alone. Stand-alone risk does not take into account how the risk of a single asset will affect the overall corporate risk
|
|
|
Corporate Risk
|
This risk assumes the project a company intends to pursue is not a single asset but incorporated with a company's other assets. As such, the risk of a project could be diversified away by the company's other assets. It is measured by the potential impact a project may have on the company's earnings.
|
|
|
Market Risk
|
This looks at the risk of a project through the eyes of the stockholder. It looks at the project not only from a company's perspective, but from the stockholder's overall portfolio. It is measured by the effect the project may have on the company's beta.
|
|
|
The primary factors that influence a company's capital-structure decision are:
|
1.Business risk
2.Company's tax exposure 3.Financial flexibility 4. Management style 5.Growth rate 6.Market Conditions |
|
|
Break Even Equation
|
BEQ = fixed costs /
price – variable costs |
|
|
Modigliani and Miller's Capital-Structure Irrelevance Proposition
|
Essentially, they hypothesized that in perfect markets, it does not matter what capital structure a company uses to finance its operations.
No taxes No transaction costs No bankruptcy costs Equivalence in borrowing costs for both companies and investors Symmetry of market information, meaning companies and investors have the same information No effect of debt on a company's earnings before interest and taxes |
|
|
Bird-in-the-Hand Theory
|
Gordon and Lintner argued that investors value dividends more than capital gains when making decisions related to stocks. The bird-in-the-hand may sound familiar as it is taken from an old saying: "a bird in the hand is worth two in the bush."
|
|
|
ROE Dividend payout
|
ROE = g___ or, g = ROE * (1-p)
(1-p) |
|
|
residual-dividend model
|
The residual-dividend model is based on three key pieces:
1.An investment opportunity schedule (IOS), 2.Target capital structure 3.Cost of external capi |
|
|
Country Risk Premium
|
CRP = Sovereign yield spread (Ann. STD of index ÷ Ann. STD of sovereign bond market)
|
