Week 2

Question 1

What are three of the main ways we can work out a good estimate for a firms cost of debt?

Answer 1

If the firm has bonds outstanding, and the bonds are traded, the yield to maturity on a long-term, straight(no special features) bond can be used as the interest rate(cost of debt).
If the firm is rated, we can use the rating and a typical default spread on bonds with that rating to estimate the cost of debt.
If the firm is not rated, but has recently borrowed long term from a bank we can use that interest rate or we can estimate a synthetic rating for the company, and use the synthetic rating to arrive at a default spread and a cost of debt.

Question 2

What currency must the cost of debt be in?

Answer 2

The cost of debt has to be estimated in the same currency as the cost of equity and the cash flows in the valuation.

Question 3

What is the Weighted average cost of capital with relation to cost of equity and cost of debt?

Answer 3

WACC = cost of equity * weight of equity + cost of debt(1-marginal tax rate)weight of debt.

Question 4

What is one of the simplest ways to create a synthetic company rating?

Answer 4

The simplest synthetic rating can be done using the interest coverage ratio = earnings before interest rate and tex divided by the interest expenses. The higher the ratio the better the rating.

Question 5

What interest coverage ratio would we expect a AAA rated company to have? Is it the same for large and small caps? What does this suggest?

Answer 5

For large caps a AAA rates company would e expected to have an interest coverage ratio of above 8.5, a small cap or risky business would have above 12.5.
This suggests that higher cap companies should have a higher rating fo the same interest coverage ratio.

Question 6

What is the cost of debt pre and after tax typically given by with relation to the default spread?

Answer 6

The cost of debt pre-tax is the risk-free rate + the default spread. The cost of debt after-tax is the pre-tax cost of debt *(1-tax).

Question 7

Can we use book values in the cost of capital computation?

Answer 7

No, the weights used in the cost of capital computation should be market values, not book values.

Question 8

What is the general relative size of WACC, cost of debt, and cost of equity.

Answer 8

Generally cost of debt < WACC < Cost of equity.

Question 9

What are the two main measures used as the project hurdle rate?

Answer 9

Either the cost of equity or the cost of capital can be used as a hurdle rate, depending upon whether the returns are measured relative to shareholders or all claimants.

Question 10

Can we use the information from the income statement as is?

Answer 10

Typically, information from the income statement tells us earnings, not cash flows, we need to take steps to convert these earnings to cash flows.

Question 11

How do we typically get to net income from the income statement?

Answer 11

Revenues - operating expenses - other expenses (depreciation and amortization, and general and administrative expenses, and other non cash items) gives us operating income.
Operating income - tax gives us the net income.

Question 12

What do we do in accrual accounting?

Answer 12

In accrual accounting we show revenues when objects and services are sold or provided, not when they are paid for. We show expenses associated with these revenues rather than cash expenses.

Question 13

How do we get from accounting earnings to cash flows?

Answer 13

Take net income,

1. add back non-cash expenses like depreciation and tax benefits.
2. Then subtract out cash outflows which are not expensed (such as capital expenditures).
3. subtract out the change in non-cash working capital.

Question 14

What are the basic principals of measuring returns right?

Answer 14

The basic principals of measuring returns right:

1. Use cash flows rather than earnings.
2. Use “incremental” cash flows relating to the investment decision, i.e., cashflows that occur as a consequence of the decision, rather than total cash flows.
3. Use “time weighted” returns, i.e., value cash flows that occur earlier more than cash flows that occur later.

Question 15

Should we factor our risk aversion and the risk of the business into our cash flow estimates by underestimating?

Answer 15

When we estimate cash flows we should not factor in the risk of the business or our risk aversion, instead we should factor it into the hurdle rate, otherwise we would include our risk aversion twice.

Question 16

What is the general progression of capital maintenance expenditures? How are they typically estimated?

Answer 16

Capital maintenance expenditures tend to start low in early years while things are new, and increase as they age. They are typically estimated as the maintenance rate * the depreciation for that year.

Question 17

How is depreciation of fixed assets typically calculated for a single year.

Answer 17

The depreciation of fixed assets is typically the depreciation rate * the book value at the end of the prior year.

Question 18

What is return on capital given by?

Answer 18

Our return on capital is given by the after tax operating income divided by the book value.

Question 19

What does depreciation do for a business with relation to income and cash flows?

Answer 19

Depreciation reduces taxable income and taxes, but does not reduce the cash flows, therefore the benefit of depreciation is the tax benefit.

Question 20

How do we calculate the tax benefit? Does amortization and good-will help?

Answer 20

The tax benefit is generally depreciation * tax rate.
This means the tax benefit is higher with a higher tax rate, any non-cash charges that are not tax deductable (like amortization and good-will) provide no tax benefits and have no effect on cash flow.

Question 21

What are the two main methods for calculating depreciation?

Answer 21

Depreciation can be straight line, or accelerated methods.
In straight line depreciation, the capital expense is spread evenly over time. In accelerated depreciation, the capital expense is depreciated more in earlier years and less in later years.

Question 22

Which leads to higher income and cash flows out of straight line and accelerated depreciation?

Answer 22

Straight line depreciation will have higher net income in early years but less cash flows than the accelerated depreciation.

Question 23

What is the capital expenditures effect?

Answer 23

Capital expenditures are not treated as an accounting expense, but they do cause cash outflows. These capital expenditures can be new/growth capital expenditures, these are capital expenditures designed to create new assets and future growth, or they can be maintenance capital expenditures, these are capital expenditures designed to keep existing assets.

Both new and maintenance capital expenditures reduce cash flows, and the need for maintenance capital expenditures increases with the life of the project.

Question 24

Is it better to expense a cost or make it a capital expenditure?

Answer 24

Expensing a cost will have a more positive effect on cash flows in the short term, while making it a capital expenditure and depreciating it will have a more positive effect on income in the short term. This will flip in later periods as the depreciation expense will occur over several periods.

Question 25

What is net working capital given by?

Answer 25

Net working capital equals current assets - current liabilities.

Question 26

What is the working capital effect? What happens if we don’t consider this?

Answer 26

Money invested in inventory or accounts receivable can’t be used elsewhere and is as such a sdrain on cash flows.
If some of these investments can be financed using supplier credit (accounts payable), the cash flow drain is reduced.

As such, investments in working capital are cash outflows, any increase in working capital reduces cash flows in that year, and any decrease in working capital increases cash flows in that year.

To provide closure, working capital investments must be salvaged at the end of the project life.

Failure to consider working capital in a capital budgeting project will overstate cash flows on that project and make it look more attractive than it really is, also, other things held equal, a reduction in working capital requirements will increase the cash flows on all projects for a firm.

Question 27

What is a sunk cost? What do we do when analyzing projects with sunk costs?

Answer 27

A sunk cost is any expenditure which has already been incurred and cannot be recovered (even if the project is rejected).
When analyzing projects with sunk costs the sunk costs should not be considered since they are not incremental (the cost is earned regardless of acceptance or rejectance).

Question 28

Why must we only include incremental costs in project analysis?

Answer 28

Non incremental costs like sunk costs will exist and make the firm worse regardless. As such we should only consider the incremental components of allocated costs to a project.

Question 29

Can we add cash flows at different times up easily?

Answer 29

No, incremental cash flows in the earlier years are worth more than incremental cash flows in later years. in fact, cash flows across time cannot be added up, they must be brought back to the same time before aggregating.

Question 30

What is the present value of an annuity?

Answer 30

The present value of an annuity is (C/r)*(1-(1+r)^n)/r).

Question 31

Which cash flow is a growing perpetuity based on?

Answer 31

The cash flow of the next year.

Question 32

What is the net present value? When do we accept a project?>

Answer 32

The net present value is the sum of the present values of all cash flows from the project, including the initial investment, we accept the project if the net present value is greater than 0.

Question 33

What is the IRR?

Answer 33

The internal rate of return is the discount rate that sets the net present value equal to zero. It is the percentage rate of return, based upon incremental time-weighted cash flows, we accept the project if the internal rate of return is over the hurdle rate.

Question 34

What is the salvage value and why is it important?

Answer 34

In a project with a finite and short life we will need to compute a salvage value, this is the expected proceeds from selling all of the investment in the project at the end of the project life, this is usually equal to the book value of fixed assets and working capital.

Question 35

How do we compute the salvage value when a project has an infinite or very long life?

Answer 35

When a project has an infinite or very long life we compute cash flows for a reasonable period, and then compute a terminal value fo this project which is the present value of all cash flows that occur after the estimation period ends(e.g a growing perpetuity or annuity).

Question 36

Does taking a net present value increasing opportunity always increase the market value of a company?

Answer 36

Taking a net present value increasing opportunity does not necessarily increase the market value of the company, as that is up to investors and how they value the project.

Question 37

Do we include interest costs in cash flows? Why or why not?

Answer 37

Our cost of debt is included in our weighted cost of capital, as such it is important that interest payments are not included in the calculation of cash flows or it will be double counted.

Question 38

Is net present value more sensitive to changes in the discount rate when the discount rate is high or low?

Answer 38

The net present value is typically more sensitive to changes in the discount rate at low discount rate levels than at high discount rate levels.

Question 39

What are some of the reasons why NPV and IRR can yield different results?

Answer 39

NPV and IRR can have different results for the best projects because:
A project can only have one net present value but multiple internal rates of return (wherever NPV is 0). The NPV is a dollar surplus measure while IRR is a percentage, this means NPV will be likely larger for large scale projects while IRR is higher for small-scale projects. The net present value assumes that intermediate cash flows get reinvested at the hurdle rate, which is based upon what you can make on investments of comparable risk, while the IRR assumes that intermediate cash flows get reinvested at the IRR.

Question 40

Why do we often ignore uncertainties in project analysis? What is a useful measure we can use if we are worried about losing money due to this?

Answer 40

Generally, uncertainties in project analysis are ignored, as if we wait for uncertainty to clear up we will never invest in anything. One simple measure we can use though if we are worried is computing how many years it will take for us to get our money back from cash flows, this is known as the payback period. We could also use the discounted payback period, which uses discounted cash flows to see when the money will be repaid.