Week 4

Question 1

What are two of the main ways investments can be not independent?

Answer 1

Investments are often not independent in the real world. Taking an investment often means rejecting another investment or being locked in to taking another investment in the future. They may also have negative or positive effects on other investments.

Question 2

What are our two main overarching methods for choosing between investments with similar lifespans?

Answer 2

When comparing and choosing between investments with the same (or similar) lives, we can:
computer the accounting returns (ROC, ROE) of the investments and pick the one with the higher returns.
Or we can compute the NPV and pick the higher, or compute IRR and pick the higher IRR.

Question 3

When can we have problems with IRR? What do we typically do?

Answer 3

We can end up with multiple, or no IRR if a project has abnormal cash flows (more than one sign swap). When a project has multiple or no IRR we typically use NPV instead.

Question 4

What business factors will typically lead to using NPV or IRR?

Answer 4

If a business has limited access to capital, has a stream of surplus value projects and faces more uncertainty in its project cash flows it is more likely to use IRR.
This leads to small, high-growth companies and private businesses to typically use IRR more.

If a business has substantial funds on hand, access to capital, limited surplus value projects, and more uncertainty on its project cash flows it is much more likely to use NPV, meaning as firms go public and grow they are more likely to use NPV as their decision rule.

Question 5

What is one of the major problems with NPV? How can we improve this? How can this be better than IRR?

Answer 5

NPV is a dollar value, which means it measures value in absolute terms. We can make it a relative measure by transforming it into the profitability index: NPV/initial investment. This factors in the scale of the project unlike IRR.

Question 6

How can we find the discount rate where the net present value of two projects is the same? What does this mean for choosing between the projects?

Answer 6

There is a discount rate where our net present value from two projects is the same, we can find this by subtracting one project’s cash flows from the other (including investment) to create a new project (A-B), we then find the IRR of this project. If our discount rate is equal to this level we will be indifferent between the projects in terms of NPV. Past or before this level we will prefer one or the other.

Question 7

What is the main difference between IRR and NPV that leads to inconsistent investment rankings?
What does this suggest about long life projects with high IRR?
How can we fix this?

Answer 7

If two projects have similar investment size and only one IRR the NPV and IRR can still be inconsistent. This is because NPV assuming reinvestment at the hurdle rate while IRR assumes reinvestment at the IRR.
This relies on the assumption that the firm has an infinite stream of projects yielding similar IRR, leading to IRR overstating the true return on the project when project life is long and the IRR is high.

IRR will not make bad projects look good, but does make good projects look better than they are.
To fix this we should use a modified IRR.

Question 8

What is the modified IRR for FINC303?

Answer 8

The modified internal rate of return (FINC303) = nroot(future value of positive cash flows divided by the present value of negative cash flows).
The future value and present value discount rate can be different, but will commonly be the hurdle rate. This means it assumes reinvestment at the hurdle rate.

Question 9

Which bias do NPV and IRR have?

Answer 9

NPV is likely to be larger for large scale projects while IRR is likely to be higher for small scale projects.

Question 10

Why can projects with differing lifes be problematic for NPV and how do we fix this? Does IRR have this problem?

Answer 10

A project with a longer life will likely be higher than the NPV for a project with a short life. As such the net present values of mutually exclusive projects with different lives cannot be compared, as such we need to replicate the projects till they have the same life (with repeating cash flows, starting with investment in the final year), or convert the net present values into annuities (NPV = present value of an annuity with the same discount rate and lifespan, solving for the cash flow and picking the highest).

IRR is unaffected by project life, so we can just pick the project with the higher IRR even if they have different lifespans.

Question 11

What are the most and least common decision rules?

Answer 11

Normally decision rules like the return on investment or payback/discounted payback are not preferred due to not factoring in time value of money, the profitability index is common, but it could be NPV or IRR depending on capital rationing.

Question 12

What are side costs and benefits with relation to projects? Are they typically captures in traditional capital budgeting analysis?

Answer 12

Most projects created by businesses create side costs and benefits for that business. The side costs include the costs created by the use of resources that the business already owns (opportunity costs) and lost revenues for other projects the firm may have (product cannibalization).
The benefits that may not be captured in traditional capital budgeting analysis include project synergies (where cash flow benefits may accrue to other projects) and options embedded in projects (option to delay, expand, or abandon project).
It is important that returns on a project incorporate these costs and benefits.

Question 13

What is an opportunity cost in relation to projects?

Answer 13

An opportunity cost arises when a project uses a resource that may already have been paid for by the firm, when a resource that is already owned by a firm is being considered for use in a project this resource has to be priced on its next best alternative use, this could be:

• The sale of the asset, the opportunity cost being the expected proceeds, net any capital gains tax.
• Renting/leasing the asset out, the opporunity cost is the expected present value of the after-tax rental or lease revenues.
• Using it elsewhere in the business, the opportunity cost is the cost of replacing it.

Question 14

Is excess capacity a sunk cost or an opportunity cost? How do we assess this?

Answer 14

Excess capacity is not a sunk cost, even if it cannot be used currently for other purposes, the cost is that the firm will run out of capacity sooner.
To assess the cost of this we ask:
If I do not add the new product, when will I run out of capacity?
If I add the new product, when will I run our of capacity?
When we run out of capacity what will we do? (cut down on production, the cost is the present value of after tax cash flows from lost sales. Or buy new capacity, in which case the cost is the difference in present value between earlier and later investments).

Question 15

When do we include cannabilization costs?

Answer 15

When looking at cannibalization costs if the firm competitive advantage is high we must include it, if low we can ignore, there is a high barrier to entry we include it, if the barrier to entry is low we ignore the costs. Essentially, if the cannibalization costs are likely to occur anyways (due to easy competitor access) we ignore the cannibalization costs.

Question 16

Why are business synergies often treated wrongly in business analysis?

Answer 16

In investment analysis, synergies are often left unquantified and used to justify overriding the results of investment analysis, i.e used as justification for investing in negative NPV projects. However, this is bad, if synergies exist we must value the benefits and show them in the initial project analysis.

Question 17

What is the option to delay? When is it good? What must we be sure to factor in when acquiring these?

Answer 17

The option to delay taking a project (often when a firm has exclusive rights to it), until a later date. The rights to a currently bad project still have value today, with the value increasing with the volatility of the underlying business.
Although, the cost of acquiring these rights (through purchase or development costs) has to be weighed against these benefits.

Question 18

What is the option to expand? When is it good?

Answer 18

The option to expand/take other projects may allow for projects which have a negative NPV to be profitable by opening up to more projects which can compensate for the low NPV.

Question 19

When is the option to abandon good?

Answer 19

The option to abandon allows firms to abandon a project if the cash flows do not measure up to expectations, this allows the firm to save itself from further losses, hence making a project more valuable.

Question 20

What are the two main questions we should ask with existing and past investments?

Answer 20

With existing/past investments we can try to answer one of two questions:
Post mortem, we can look back at existing investments and see if they have created value for the firm (looking at actual cash flows relative to forecasts).
What next? We can use the tools of investment analysis to see whether we should keep, expand, or abandon existing investments.

Question 21

What are we looking for in a Post mortem analysis?

Answer 21

In a post mortem analysis the actual cash flows from an investment can be treated than or less than the original forecast for a number of reasons that can be categorized into two groups: chance, and bias(which gets worse with over-confident managers).

Question 22

How can we tell whether chance or bias was responsible for failures/success?

Answer 22

If change is the culprit, there should be symmetry in errors, meaning the actuals should be as likely to beat forecasts as to come under forecasts, if there is bias the errors will all be in one direction.

Question 23

When should we liquidate, terminate, or divestiture a project?

Answer 23

If the net present value of our future cash flows is less than 0 we should liquidate the project, if the net present value is less than the salvage value we should terminate the project, if the net present value is less than the divestiture value we should divest the project, if the net present value is greater than 0 and the divestiture value we should continue the project.

Question 24

What are the two large-scale ways for businesses to raise money?

Answer 24

Businesses can only raise money with debt or equity, with debt, they promise to make fxed payments in the future. If they fail to make these payments, they lose control of the business.

With equity, equityholders get whatever cash flows are left over after debt payments have been made.

Question 25

Why do businesses often prefer to use banks rather than bonds for debt?

Answer 25

When borrowing from the bank they only have to release their information to the bank, meaning the information won’t go public. Also companies may have relationships with banks that can lead to lower interest rates.

Also, smaller companies do not have as easy access to bonds/notes as larger companies.

Question 26

How does a company’s internal vs external funding change over its life?

Answer 26

Companies tend to need more funding at the beginning of their life, though this is restrained by infrastructure, as they grow their need for external funding will decrease as projects dry up.

Their internal financing starts low and increases as they grow in size, eventually becoming more than their funding needs as projects dry up.

External financing comes initially in the form of owners equity and bank debt, then moves to venture capital and common stock, then to common stock, warrants, and convertibles, then to debt, and then the debt is retired and stock is repurchased.

Question 27

What are the phases of company lifecycles? What are these transitions motivated by and how does it change the company?

Answer 27

Start-up > Rapid expansion > High growth > Mature growth > Decline.

These transitions from fully owned private businesses to venture capital, from private to public and subsequent seasoned offerings are all motivated primarily by the need for capital.
In each transition costs are incurred: venture capitalists will demand a fair share of more of the ownership to provide equity, when a firm decides to go public, it has to trade off the greater access to capital markets against the increased disclosure requirements, loss of control, and the transaction costs.

Question 28

Why might a firm raise debt if it still has cash and debts?

Answer 28

Sometimes firms may raise debt even if they have cash in order to retire more expensive debts.

Question 29

What is the debt to capital ratio? What does the debt include?

Answer 29

The debt to capital ratio is given by debt/(Debt + equity).
This debt should include all interest bearing liabilities, short term and long term, and any other commitments that meet the criteria for debt.

Question 30

How can equity be defined?

Answer 30

Equity can be defined either in accounting terms (book value) or in market value (based on current price, most common).

Question 31

What are the benefits and costs of debt?

Answer 31

Benefits of debt: Tax benefits, adds discipline to management
Costs of debt: Bankruptcy costs, agency costs, and loss of future financing flexibility.

Question 32

Why is interest useful for tax purposes and not equity? What does this mean for businesses with higher taxes and their debt to equity ratio?

Answer 32

Interest expenses can be deducted from income, hence reducing taxes. We can not deduct our payments to equity (dividends) to arrive at taxable income.
This tax benefit is given by the tax rate * the interest payment.
This means that the higher the marginal tax rate of a business the higher the benefit to using debt. Though even without this benefit debt can still be useful because it is often cheaper.

Question 33

How does the issuance of debt and equity change based on the price of the company stock?

Answer 33

If a firm is overvalued they will typically issue equity, if a firm is undervalued they will typically issue debt.

Question 34

How can debt help control management?

Answer 34

By forcing a firm to borrow money the managers have to ensure the investments will earn at least enough return to cover the interest expenses. This lowers the risk of complacency. It is particularly useful when the company is publicly traded with lots of investors which don’t hold a large percent of the stock.

Question 35

How can we get our expected bankruptcy costs? What does this mean for a company’s level of debt?

Answer 35

The expected bankruptcy cost is a function of the probability of bankruptcy, this will depend on how uncertain future cash flows are (more uncertain increases change), and the cost of going bankrupt, this has direct costs (like legal and other deadweight costs) and a much larger indirect costs (costs arising because people perceive you to be in financial trouble).
The greater the indirect bankruptcy cost, the less debt the firm can afford for any given level of debt.

Question 36

How do agency problems affect debt levels in firms?

Answer 36

Other things being equal, the greater the agency problems associated with lending to a firm, the less debt the firm can afford to use.

Question 37

How does a firms knowledge of its future financing needs affect its debt level?

Answer 37

When a firm borrows up to its capacity, it loses the flexibility of financing future projects with debt, hence, the more uncertain a firm is about its future financing requirements and projects, the less debt the firm will use for financing current projects.