Final Flashcards
(33 cards)
What is the decision rule used to decide whether or not to do a project based on NPV (Net Present Value?)
If the NPV is a positive number, the firm should go forward with the project
What is used as the discount rate when figuring out the Net Present Value (NPV) of a project?
Use the weighted average cost of capital (WACC), assuming that the project has similar risk characteristics to the existing businesses at the company.
What is the decision making criterion to decide whether or not to do a project based on an Internal Rate of Return (IRR) calculation?
If the IRR exceeds the hurdle rate, then the firm should go ahead with the project.
Assuming a proposed project has similar risk characteristics to the existing activities of a business, what typically is used as:
• the hurdle rate for making a go/no go decision based on an Internal Rate of Return (IRR) calculation
• the discount rate for making an NPV calculation?
The weighted average cost of capital (WACC)
What is the Net Present Value (NPV) of a project if you use the internal rate of return (IRR) as the discount rate?
By definition the IRR is the discount rate that sets the NPV of a project equal to zero.
What is the key consideration in deciding whether or not to include a particular cash flow in an NPV or IRR calculation?
The with/without criterion. You only factor in cash flows that will change if you do the project. So your baseline is what would cash flows be if you don’t do the project (without). Then you can see the cash flows that will come about if you do the project (with).
Give an example of a sunk cost.
The idea of a sunk cost is that it is an expense that has already been incurred and so should not be considered when decided whether or not to do a project. An example from the book would be a marketing study completed before deciding whether or not to add a product line. The expense of the study is gone, regardless of whether or not the product line is added. So, having done the study, a model of the cash flows from the new product line should not include the cost of the study. (Of course, the results of the study should influence projections for sales, etc.; it is just the cost of the study that should be excluded)
By convention, in this class, in calculating the weightings for the Weighted Average Cost of Capital, what figure is used to calculate:
• The value of Debt
• The value of Equity
1) The book value (i.e. what appears on the balance sheet) is used for debt
2) The market value (i.e. the publicly-traded share price x the number of shares outstanding) is used for equity.
What is the key modification that is made to the average interest rate that appears on the balance sheet when calculating the cost of debt in weighted average cost of capital (WACC
The average interest rate is multiplied by (1-tax rate) to accurately estimate the real after-tax cost of debt.
If a company has a tax rate of 30% and an average cost of debt on the balance sheet of 7%, what is the after-tax cost of debt?
4.9%
Calculated: 0.07 *(1-0.30) = 0.049
In making a weighted average cost of capital calculation, how is the cost of equity typically calculated?
By using the Capital Asset Pricing Model:
Re = Rf+ Beta(Rm –Rf)
Where:
Re = the return equity investors expect from the firm
Rf = the risk-free rate of return
Beta = The stock’s sensitivity to market fluctuations
Rm = the return equity investors expect from the market as a whole
If you are running a company to be as efficient in its use of assets as possible, would you like to see Days Sales in Inventory (DSI) rising or falling?
Falling. Maintaining inventory requires capital, you want to employ as little capital as possible.
From the standpoint of assets required, what would be a perfect business?
A business that generates cash without requiring any assets. The example given in class was a wallet that just magically refilled itself, but even there, you have an asset in the form of the wallet. Perhaps the perfect business would be a magic spell, which, when uttered, causes cash to appear in your hand.
If you are running a company to be as efficient in its use of cash as possible, would you like to see Days Sales Outstanding (DSO) rising or falling?
Falling. DSO represents sales where you have not yet collected the cash. You are effectively making a loan to your customers. The loan appears as an asset on your balance sheet. To maximize your cash on hand, you want to collect the money from your customers as quickly as possible.
If you are running a company to be as efficient in its use of cash as possible, would you like to see Days Payable Outstanding (DPO) rising or falling?
Rising: Your payables are supplies that you have received but not yet paid for, they effectively represent a loan from your suppliers, so you want to take advantage of that free credit as much as possible.
What was the basic ratio that is used to analyze how comfortably the cash generating capacity of a business can meet the firm’s debt requirements?
“Times interest earned
What is the formula for ‘Times Interest Earned’?
TIE = EBIT/Interest expense
EBIT: Earnings Before Interest and Taxes
What is the formula for return on equity (ROE)?
ROE = Net Income/Equity
Note that this is the book value of equity. Do not use the market value of equity in this calculation
In a DuPont Analysis, what is the mnemonic for remembering the 3 components into which Return on Equity can be broken down?
ROE is your PAL
P = profit margin = Net Income/Sales
A = asset turns = Sales/Assets
L = Leverage = Assets/Equity
Does a well-run business wants to see each ratio within the DuPont analys as high as possible, or as low as possible?
As high as possible – the higher each element is, the better the return on equity.
Miller-Modigliani’s basic insight was that, in the absense of either taxes or bankruptcy, the value of a company could not be changed by changing the debt/equity structure of the company. And yet, if a company has a cost of equity of 10% and a cost of debt of 5%, it would appear you could lower the cost of capital by borrowing more. What happens when the company borrows more that causes its value to be unchanged?
As the company borrows more, the equity becomes riskier, so the cost of equity rises. The rise in the cost of equity exactly offsets the cheaper capital raised by debt.
When only taxes are added to the Miller-Modigliani model, what becomes the ideal capital structure?
For the firm to use debt as essentially its only source of funds. (Of course owners would need to retain a tiny sliver of equity in order to have a funnel through which to get paid).
In the real world where there are both taxes and the possibility of bankruptcy, what is the optimal capital structure for a company?
The firm will borrow up to the point where the costs of the bankruptcy risk exactly offset the tax-shield benefit they get from borrowing.
Bankruptcy has direct and indirect costs. Give an example of each:
Direct costs = when you actually go bankrupt, the result is generally enormous legal fees while the situation is sorted out.
Indirect costs = what a firm may do because it fears bankruptcy. For example, it may:
1) Neglect needed research and development to conserve cash
2) Anger its suppliers by slowing down its payments (raising the Days Payments Outstanding) to conserve cash
3) Try ‘long shot’ projects that don’t actually have good risk adjusted returns, because they are “Gambling for Redemption”.
