What are the three most common securities issued?
- Common stock (shares/equity)
- Preferred stock (sometimes convertible)
- Bonds
What is the valuation principle?
The value of an asset to the firm or its investors is determined by its competitive market price.
What are the three important rules that allow us to compare or combine values?
- Only possible at the same point in time
- Moving cash forward in time
- Moving cash flows back in time
What happens if g > r in a growing perpetuity?
The sum is infinite
What is the EAR?
The rate indicates the actual amount of interest that will be earned at the end of one year
What is the APR?
Indicates the amount of simple interest earned in one year; interest earned without the effect of compounding
What are nominal interest rates?
Indicate the rate at which your money will grow if invested for a certain period.
What is the real interest rate?
The rate of growth of purchasing power, after adjusting nominal interest rate for inflation
What is the opportunity cost of capital?
The best available expected return offered in the market on an investment of comparable risk and term to the cash flow being discounted
What can be said about the difference between the cost of capital and the IRR?
It is the maximum estimation error in the cost of capital that can exist without altering the original decision
What does the IRR rule state?
Take any investment opportunity where the IRR exceeds the opportunity cost of capital.
What is the only condition that guarantees that the IRR rule is correct for stand-aloe projects?
If all of the project’s negative cash flows precede its positive cash flows
What are pitfalls of the IRR rule?
- Delayed investments (borrow to invest later = prefer low rate)
- Multiple IRRs; generally as many as the number of sign changes
- Non-existent IRR
What are some pitfalls of the Payback rule?
- ignores the project’s cost of capital and the time value of money
- ignores cash flows after the payback period
- relies on an ad hoc decision criterion about the number of years to require for the payback period
What are factors that affect that IRRs of mutually exclusive investments can’t be compared?
- Differences in scale
- Differences in timing of cash flows
- Differences in risk
What are incremental earnings?
The amount by which the firm’s earnings are expected to change as a result of the investment decision
Are interest expenses a part of incremental earnings?
No, since we want to evaluate the project on its own, separate from the financing decision
How are taxes calculated?
Income tax = EBIT x t
What is the unlevered net income?
= EBIT * (1-t)
= (Revenues - Costs - Depreciation) * (1-t)
What are indirect effect on incremental earnings?
- Opportunity costs
- project externalities (cannibalization)
What are sunk costs that should not be taken into account in capital budgeting?
- Fixed overhead expenses
- Past R&D expenditures
- Unavoidable competitive effects
What are free cash flows?
The incremental effect of a project on the firm’s available cash, separate from any financing decisions
What is Net Working Capital?
Cash + Inventory + Receivables - Payables
= Current assets - current liabilities
How do we calculate the free cash flows?
FCF = Unlevered net income + depreciation - CapEx - change in NWC
