Questions and Answers
What is the purpose of break-even analysis?
Which of the following is a benefit of using MACRS depreciation?
What is the purpose of scenario analysis?
What is the benefit of considering liquidation or salvage value in a project's FCF?
Signup and view all the answers
What is the purpose of tax loss carry forwards or tax carry backwards?
Signup and view all the answers
What is terminal or conditional value used for?
Signup and view all the answers
What is sensitivity analysis used for?
Signup and view all the answers
What is the purpose of adjusting FCF for timing of cash flows?
Signup and view all the answers
What is the primary assumption about investors in the Capital Asset Pricing Model (CAPM)?
Signup and view all the answers
What type of risk is compensated for in the CAPM?
Signup and view all the answers
Why is the CAPM considered a good model?
Signup and view all the answers
What is the relationship between the cost of equity and the cost of capital in the CAPM?
Signup and view all the answers
What is the main advantage of the CAPM in capital budgeting and corporate finance?
Signup and view all the answers
What is the effect of holding only cash on a firm's beta?
Signup and view all the answers
What is the purpose of estimating the equity cost of capital using the CAPM?
Signup and view all the answers
What type of risk is diversified away in a portfolio?
Signup and view all the answers
What is the purpose of combining asset betas for firms in the same industry?
Signup and view all the answers
What is the relationship between beta and the expected return of an investment?
Signup and view all the answers
What is the effect of a higher proportion of fixed costs on project cash flows?
Signup and view all the answers
Why does the net cost to the firm of debt financing decrease?
Signup and view all the answers
What is the formula for the effective after-tax interest rate?
Signup and view all the answers
What is the weighted average cost of capital (WACC) used for?
Signup and view all the answers
What is the effect of taxes on the cost of capital in perfect capital markets?
Signup and view all the answers
What is the formula for the weighted average cost of capital (WACC)?
Signup and view all the answers
What does the abbreviation PPE stand for?
Signup and view all the answers
What is the investment ratio represented by in the given content?
Signup and view all the answers
What are the two main factors that make future interest payments uncertain?
Signup and view all the answers
What does the abbreviation ROE stand for?
Signup and view all the answers
What is the formula to calculate the present value of interest tax shield with constant growth?
Signup and view all the answers
What is the term for a solution designed for a specific problem or task, non-generalizable, and not intended to be adapted to other purposes?
Signup and view all the answers
What does the abbreviation WACC stand for?
Signup and view all the answers
What is the relationship between a firm's leverage and its WACC with taxes?
Signup and view all the answers
Why is it unlikely to precisely predict the optimal level of debt for a firm?
Signup and view all the answers
What does the abbreviation EBIT stand for?
Signup and view all the answers
What happens to tax savings when there is high uncertainty about EBIT?
Signup and view all the answers
What is the condition for interest payments to be equal to EBIT?
Signup and view all the answers
What is the purpose of recaptitalizing to capture the tax shield?
Signup and view all the answers
What is the relationship between the pre-tax WACC and the WACC with taxes?
Signup and view all the answers
Study Notes
Adjustments to FCF
- Other non-cash items include amortization
- Timing of cash flows may make a difference in real-life projects, potentially choosing a different level than yearly
- Accelerated depreciation using the Modified Acceleration Cost Recovery System (MACRS) increases the present value of the depreciation tax shield and raises the project NPV
- Liquidation of salvage value includes after-tax liquidation or salvage value of disposed assets
- Terminal or conditional value is the market value of the free cash flow from the project at all future dates
- Tax loss carry forwards or tax carry backwards allow corporations to take losses during the current year and offset them against gains in nearby years
Risk Analysis
- Break-even analysis computes the value of each parameter that makes the project's NPV equal to zero
- Sensitivity analysis shows how NPV varies with changes in one of the assumptions, holding other assumptions constant
- Scenario analysis considers the effect on NPV of simultaneously changing multiple assumptions
German Tax System
- Loan redemption by installment payment
- Yearly and intra-yearly annuity redemption with fixed payments
- Differing redemption and interest period
Cost of Capital
- Equity cost of capital for any investment is estimated using the Capital Asset Pricing Model (CAPM)
- CAPM assumes investors like high returns and low risk, and only compensates for systematic risk
- CAPM is practical, straightforward, and robust, and imposes a disciplined process on managers to identify the cost of capital
Industry Asset Beta
- Industry asset betas can be combined for multiple firms in the same industry to reduce estimation error
- Firms holding only cash have a beta of 0
Project Risk Characteristics and Financing
- Individual projects can be sensitive to market risk
- Operating leverage affects market risk of a project
- Higher proportion of fixed costs increase the sensitivity of project cash flows to market risks
Weighted Average Cost of Capital (WACC)
- WACC is a tool for evaluating levered projects and investments
- In perfect capital markets, the choice of financing does not affect the cost of capital or NPV
- Taxes create an imperfection, making interest payments on debt tax deductible
- Effective after-tax interest rate = r * (1-Tc)
- WACC formula: rWACC = (rEE + rDD*(1-Tc))
Optimal Capital Structure
- The optimal level of leverage is where interest = EBIT
- Limitations: uncertainty about EBIT and optimal level of debt, and risk that interest > EBIT reduces tax savings
Abbreviations
- NWC: Net working capital
- PPE: Property, plant, and equipment
- EV: Enterprise value
- TEV: Total enterprise value
- EPS: Earnings per share
- p: Dividend ratio
- (1-p): Investment ratio
- w: Growth ratio
- COGS: Costs of goods sold
- SGA: Selling, general, and administrative expenses
- D&A: Depreciation and amortization expenses
- EBIT: Earnings before taxes and interest
- P/E: Price-to-earnings
- ROE: Returns on equity
- ROA: Returns on assets
- ROIC: Return on invested capital
- Liquidity drain: How much capital is bonded in the project
- Ad hoc: A solution designed for a specific problem or task, non-generalizable, and not intended to be adapted to other purposes
Studying That Suits You
Use AI to generate personalized quizzes and flashcards to suit your learning preferences.
Description
Quiz on financial cash flow analysis, covering non-cash items, timing of cash flows, and potential project implications.