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Determine Strategic issue identify problems to enhance shareholder/firm value Identify alternate courses of action o short-term quantifiable criteria o non-quantifiable criteria Perform analysis of relevant costs and strategic costs o Obtain information o Make predictors about future costs o Consider strategic issues Select the best alternative (best course of action) Evaluate the effectiveness of the decision to meet the strategic objectives
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Sikhu Mtetwa
Chapter 3
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Probability
zero & one Objective probability - based on past outcomes (like returns on the stock market Subjective probability - based on an individuals belief about the likelihood of an event occurring (a lawsuit)
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Expected Value
the weighted average of the probable outcomes Expected value = (probability of each outcome * its payoff) then sum the results
Capital Budgeting
- Deciding which project to invest in. a. The goal :- Present Value of cash inflows > cash outflows b. Cash Flow Effects:a. Direct effect - a company pays out or receives cash b. Indirect effect - transactions either indirectly associated (sale of old assets) with a capital project or that represent non-cash activity (depreciation) that produce cash benefit (reduces taxable income) c. 3 Stages of cash flow a. Inception of Project - Direct cash flow effects of acquisition - Tme period = 0 - Indirect cash flow effects of working capital (WC), anticipated salvage value of replaced asset - Net cost of new PPE Invoice price + cost of shipping + cost of installation +/- Working capital [such as increase in payroll, supplies expenses or inventory requirements] - Cash proceeds on sale of old asset net of tax = net cash outflow for new PPE
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Chapter 3
Page 3 of 11 b. Operations - Annuity cash flow effects of acquisition - Depreciation tax shield creates ongoing indirect cash flow - Disposal of the investment at end of project = direct /indirect cash flow effects Tax depreciation on new PPE * Marginal tax rate = Depreciation tax shield
c. Calcualtion of pre-tax & after-tax cash flows i. Pre-tax cash flows - investment value = PV of cash flows that investors receive in future - cash outflows > cash inflows = UNPROFITABLE i. After-tax cash flows income taxes are deducted in estimating annual cash flows depreciation tax shield = depr expense x marginal tax rate After-tax cash flow on operations + Depreciation tax shield = Total after tax cash flow on operations * present value of annuity - initial cash outflow = Net Present Value (NPV See example on page B3-13!!!!
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Discounted Cash Flow (DCF) i. Capital Budgeting techniques that use time value of money concepts to measure cash inflows and outflows of a project as they occur at a single point in time ii. Best method to use for Long-term decisions iii. Steps :1. Initial investment (cash outflow) 2. Future cash inflows & outflows 3. Rate of return desired for the project hurdle rate Sikhu Mtetwa
Chapter 3
Page 4 of 11 iv. Rate for the project Hurdle rate 1. WACC use if project is similar in risk 2 ongoing projects 2. Discount rate risk specific to the proposed project v. Limitations 1. DCF only uses a single growth rate, which is unrealistic as interest rates change over time. Discounted Payback i. computes payback period using expected cash flows that are discounted by the projects cost of capital ii. evaluates how quickly new ideas are converted into profitable ideas iii. focuses on liquidity & profit iv. advantages & limitations are the same with payback except that this method takes into account the time value of money.. Payback Period i. Time period that is required 4 the net after tax cash inflows to recover the initial investment ii. Liquidity measures the time it will take to recover the initial investment iii. Risk the SOONER I recover the better!!!! iv. Net cash inflows assumed constant 4 each period v. Depreciation tax shield adds to after tax CFO vi. The larger the denominator the shorter the payback period
Advantage Disadvatnage
- is simple to understand and focuses on the time period for return - ignores the time value of money. - shows the return of investment not the return on investment - ignores cash flows occurring after initial investment is recovered
Net initial investment [cash outflow + change in WC - sale proceeds on old PPE] increase in annual net after-tax cash flow = payback period
Internal Rate of Return i. IRR is the expected rate of return of a project - NPV calculates amounts, while the IRR calculates percentages ii. Sometimes to referred to as the time-adjusted rate of return iii. Rate earned by an investment iv. Determines the present value factor that yields a NPV of zero Reject IRR if it is less than or equal to the hurdle rate NPV positive - IRR > required rate of return / hurdle rate = accept NPV negative - IRR < hurdle rate = reject IRR low = low tax credits high investment high PV factor . IRR high = low WC low investment low PV factor . = low payback period low PV factor Sikhu Mtetwa
Chapter 3
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How to calculate the IRR:1. Determine the life of the project e.g = 5yrs 2. Use the payback period (net increment investment net annual cash flows) as the present value factor e.g = 100/25 = 4.00(TVMF) 3. Locate PV factor using the tables then find approximate IRR NPV has a direct r/ship with IRR NPV NPV > 0 NPV = 0 NPV < 0 IRR IRR > discount rate IRR = discount rate IRR < discount rate
B3-27 example of how to calculate the IRR Limitations :IRR assumes cash flows from reinvestment are reinvested at the IRR % Less reliable when there are differing cash flows Does not consider the amount of profit
PV of an Annuity - the amount of cash needed 2day to yield a series of equal net cash flows at a fixed time intervals in the future e.g lease capitalization FV of an Annuity - amount available in n periods in future as a result of the deposit of an amount today e.g bond sinking fund Net Present Value (NPV) NPV focuses on the initial investment amount that is required to purchase (invest ) a capital asset that will yield a return amount in excess of hurdle/discount rate. Uses a hurdle rate to discount cash flows Calcuation steps:o Estimate Cash flows Ignore depreciation - unless adding back tax shield Ignore method of funding NPV uses a hurdle rate 2 discount cash flows o Discount the Cash Flows Discount all cash in & outflows using appropriate discount factor NPV is superior to IRR because it can still calculate when there are uneven cash flows or inconsistent rates of return. Assumes the cash flows are re-invested at the same rate Hurdle rate o NPV = or > than 0, make the investment because the rate of return is = or > than the hurdle rate/discount rate/required rate of return o Desired rate set by management ( cost of capital, minimum rate of return based on strategic plans , returns earned in industry etc) o Opportunity cost Interpreting Results :o Positive Results ( NPV > hurdle rate or = zero ) = make investment o Negative Result ( result > zero ) = dont invest
Sikhu Mtetwa
Chapter 3 Advantages:-
Page 6 of 11 1. NPV is flexible & can be used when there is no constatnt rate of return 2. best for LR decisions 3. NPV is considered superior to IRR method b/c it is flexible to handle uneven cash flows
Disadvantages:-
Use Present value of $1 when the cash inflows are different Use Present value of an Ordinary Annuity of $1 when the cash inflows are same across all years NPV is considered the best single technique for capital budgeting, however, NPV does not indicate the true rate of return on investment, just merely if it is less than or greater than our hurdle rate. Can be decreased by increasing the discount rate Can be increased by decreasing the income tax rate / decrease tax shield (depr) / increase cash inflow / increase life of project - increase salvage value / reduces NPV cash outflow / increases NPV
After-tax cash flow on operations (net cash flow x (1-tax rate)) + Depreciation tax shield depreciation x tax rate = Total after tax cash flow on operations x present value of annuity - initial cash outflow = Net Present Value (NPV see example on page B3-24-25
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Capital Rationing Ultimately the decision to invest or not is limited by the amount of capital
available to the fund the investment. Unlimited Capital = ALL investments with a positive NPV should be accepted Limited Capital = choose from 2 best choices o Managers should allocate capital to the combination of projects with the maximum NPV
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Profitability Index
measures the cash-flow return per dollar invested the higher the better NPV index ( excess present value) Want profitability index over 1.0 which means that the PV of inflows is greater than the PV of outflows PV of net future cash inflows PV of net initial investment = Profitability index
Sikhu Mtetwa
Chapter 3
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Trade offs between risk & return borrowing money vs. adding partners How should we raise capital? Risk indifferent - increase in risk does not increase management's required rate of return Certainty equivalent = expected value Risk averse - increase in risk, increases management's required rate of return Certainty equivalent < expected value Risk-seeking - increase in risk, decreases managements required rate of return Certainty equivalent > expected value Diversification Risk is often reduced by diversification, the process of mixing investments of different (offsetting) risks, Not all risks can be managed this way though. Diversifiable risk Un-systematic risk, non-market risk - risk that is firm specific and can be diversified away Non-diversifiable risk Systematic risk, market risk - risks that can not be diversified away
****As any risk factor increases (interest rate risk, market risk, credit risk, default risk) the required rate of return increases, which causes the PV of an asset to decrease Projected cash flow required rate of return = PV of asset Computation of Return o Stated interest rate (nominal interest rate) is the interest rate charged before any adjustments for market factors rate shown in the debt agreement o Effective interest rate the actual interest rate charged with a borrowing after reducing loan proceeds for charges and fees related to a loan origination. Effective interest rate = Interest paid (coupon) net proceeds o Annual percentage rate effective periodic interest rate * number of periods in a year The annual % rate is the rate required for disclosure by federal regulators o Simple interest Interest paid only on the original amount of principal original principal * interest * number of periods o Compound interest Interest earnings or expense based on the original principal + any unpaid interest original principal * (1 + interest rate) number of periods Sikhu Mtetwa
Chapter 3
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Sikhu Mtetwa
Chapter 3
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Cost of debt must be after tax so, cost of debt = effective interest rate * (1 - tax rate) ***general rule- as a firm raises more capital either equity or debt, the WACC increases As the WACC or discount rate decreases, the PV increases Debt carries the lowest cost of capital and is tax deductible The higher the tax rate, the more incentive to use debt financing After tax cost of debt = pre-tax cost of debt * (1 - tax rate) Cost of preferred stock = dividends net proceeds B3 44-45-47 examples of how to calculate cost of debt, preferred stock, and equity (retained earnings) Cost of Equity (or Retained earnings) A firm should earn at least as much on any earnings retained and reinvested in the business as stockholders could have earned on alternative investments of equivalent risk, otherwise they should pay dividends 3 common methods of computing cost of equity - Capital Asset Pricing Model (CAPM) - DCF - Bond Yield plus Risk Premium CAPM = risk free rate + beta *(expected return on market - risk free rate) [market risk premium] B =1 as risky as market B> 1 more risky than market B< 1 less risky than market Short-term financing is classified as current and will mature within 1 year Short-term financing rates are lower than long term rates, which increases profitability However, increased interest rate risk (didnt lock in a rate), and increased credit risk Debentures are unsecured, while bonds are often secured ROI - ignores cash flows and uses GAAP income ROI = income investment capital [avg assets] [which is avg PPE + avg WC] or ROI = profit margin * investment turnover [NI sales] [sales investment] - invested capital = average assets = average PPE + average WACC ROA = NI assets Net Book value = historical cost - accumulated depreciation Net book value is affected by age and method of depreciation so it can be a misleading indicator Sikhu Mtetwa
Chapter 3 Gross book value - historical cost Ignores depreciation Replacement cost = cost to replace asset Ignores both age and method of depreciation
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The method used to value the investment affect the ROI. As the denominator increases the ROI decreases ROI focuses on short term results and my cause a disincentive to invest because the shortterm result of the new investment may reduce ROI Residual income measures the excess actual income earned by an investment over the required rate of return, while ROI provides a % return Required return = net book value * hurdle rate [Equity] [CAPM] Residual income = NI - Required return Debt to total capital ratio or assets = debt assets Debt to equity = debt equity
Sikhu Mtetwa
Chapter 3
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