Flashcards in BEC-3 Deck (20):

1

## Which projects to invest in?

###
Accept if the PvFCF* > Today's Cost

*Present value of Future Cash Flows

2

## 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

3

## 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

4

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

###

Proceeds on sale = inflow

- Tax paid on Gain*(Gain x the tax rate) = outflow

or

+ 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

5

## Future annual cash inflow from operations

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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

6

## 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

7

## 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

8

## "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)

9

## 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

10

## 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

11

## IRR

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

12

## Payback Period

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-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

13

## 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

14

## Leverage

###
- 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

15

## 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

16

## Degree of Financial Leverage(DFL)

### DFL = % change in EPS / % Change in EBIT

17

## 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

18

## 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

19

## 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

20