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Flashcards in BEC-3 Deck (20):

Which projects to invest in?

Accept if the PvFCF* > Today's Cost

*Present value of Future Cash Flows


Working Capital Requirements

Additional Working Capital requirements - When you buy an item or piece of equipment these are the additional costs associated with the project and are treated as cash outflows

Reduced Working Capital requirements - When you buy an item, and additional costs you used to have associated with the same equipment are no longer there or lower. Treated as a cash inflow


Net Initial Outflow on new project

Invoice + Shipping + Installation = are all Outflows
+ Increase in Working Capital = which is an Outflow
- Any cash proceeds on the sale of old item(net of tax) = is an inflow


Net Proceeds of Sale of Old asset(net of tax)

Proceeds on sale = inflow
- Tax paid on Gain*(Gain x the tax rate) = outflow
+ Tax save on loss( Loss x tax rate)
= Net Proceeds of Sale of Old asset(net of tax)

*Selling price
- NBV(net book value after dep.) for tax
= Gain/Loss


Future annual cash inflow from operations

Cash flows that will be generated by that asset(since they occur every year it is an annuity):

pre-tax cash inflow x (1 - tax rate) = inflow
+ depreciation deduction that is taken which will be depreciation x the tax rate which is also an inflow


After-tax cash flows(important)

do NOT want to make decisions based on pre-tax cash inflows, want to take into tax effect before making any decisions about future cash flows


Discounted Cash Flow is the basis for net present value(NPV)(Memorize! - important)*

Step 1: Calculate after-tax cash flows = Annual net cash flows x (1- Tax Rate)

Step 2: Add depreciation benefit = Deprecation x tax rate

Step 3: Multiply result by appropriate present value of an annuity

Step 4: Subtract initial cash outflow

Result: Net present value


"Hurdle Rate"

Compensation for all risks assumed
- as long your return is above the "hurdle rate" you will take that project
- if you borrow money at 5% want to get a return on your investment of above 5%(the hurdle rate)


Advantage of NPV vs. IRR

NPV is considered to be superior to IRR because it is flexible enough to consistently handle either uneven cash flows or inconsistent rates of return for each year of return
- NPV can use different rates for example 12% for years 1,2,3 and 15% for years 4,5,6


Profitability index

Profitability Index = PV of net future cash flow / PV of net initial investment

if numerator is greater than denominator the deal you do will be profitable, if smaller than the deal will lose money



- works on percentages as opposed to NPV which uses dollar values


Payback Period

-how long it takes to get back initial investment
- focuses on liquidity and risk, quicker you can get money invested back less riskier

Payback period = Net initial investment / Increase in annual net after-tax cash flow

same thing = initial outflow / annual annuity


Discounted Payback

Same thing is as payback period just takes into account time value of money using the discount factor
-also can divide fraction of year where money comes back to know what % of that year + the previous years it takes to get back initial investment



- use of a fixed cost
- amplifies risk and potential return( if you have returns over the fixed costs you profit, under it and you have the risk of loss)
- if EBIT goes up good, if it goes down bad because fixed costs will stay the same
- higher degree of leverage greater amount of volatility and risk and return


Degree of operating leverage(DOL)

DOL = % change in EBIT / % change in Sales

shows when company has earnings how much they are profiting in respect to their variable operating costs


Degree of Financial Leverage(DFL)

DFL = % change in EPS / % Change in EBIT


Combined( total) leverage

Common mistake is to add them, do NOT, multiply the leverages to get total

DOL x DFL = combined leverage

- also can be computed as
DCL = % change in EPS / % change in sales

BIGGER number is always in the numerator, smaller number always in the denominator


Optimal Capital Structure

-Mixture of debt and equity financing that produces the lowest WACC(weighted-average cost of capital) which maximizes firm value
- same thing as a "hurdle rate"
- lower Cost of capital firm will have a higher value = better


WACC( weighted- average cost of capital)

WACC = Cost of equity multiplied by the percentage equity in capital structure + Weighted average cost of debt multiplied by the percentage debt in capital structure


Weighted average cost of debt

Weighted average interest rate = Effective annual interest payments / Debt cash available

- anytime you calculate the cost of any source of capital the numerator is the outflow and the denominator is the net inflow

Outflow / net inflow