Financial Cash Flow Analysis

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Questions and Answers

What is the purpose of break-even analysis?

To analyze the sensitivity of NPV to changes in one assumption

To consider the effect on NPV of simultaneously changing multiple assumptions

To determine the value of each parameter that makes the project's NPV equal to zero (correct)

To compute the NPV of a project

Which of the following is a benefit of using MACRS depreciation?

It allows for larger depreciation deductions earlier in an asset's life (correct)

It is required by law for all businesses

It provides a more accurate estimate of an asset's useful life

It is simpler to calculate than straight-line depreciation

What is the purpose of scenario analysis?

To consider the effect on NPV of simultaneously changing multiple assumptions (correct)

To determine the value of each parameter that makes the project's NPV equal to zero

To compute the NPV of a project

To analyze the sensitivity of NPV to changes in one assumption

What is the benefit of considering liquidation or salvage value in a project's FCF?

It increases the project's NPV Signup and view all the answers

What is the purpose of tax loss carry forwards or tax carry backwards?

To offset gains in nearby years against current year losses Signup and view all the answers

What is terminal or conditional value used for?

To evaluate a company's performance Signup and view all the answers

What is sensitivity analysis used for?

To analyze how NPV varies with the change in one of the assumptions Signup and view all the answers

What is the purpose of adjusting FCF for timing of cash flows?

To account for the fact that cash flows may not always occur at the end of one year Signup and view all the answers

What is the primary assumption about investors in the Capital Asset Pricing Model (CAPM)?

They like high returns and dislike high risk Signup and view all the answers

What type of risk is compensated for in the CAPM?

Systematic risk Signup and view all the answers

Why is the CAPM considered a good model?

It is straightforward, robust, and imposes a disciplined process on managers Signup and view all the answers

What is the relationship between the cost of equity and the cost of capital in the CAPM?

The cost of equity is equal to the cost of capital Signup and view all the answers

What is the main advantage of the CAPM in capital budgeting and corporate finance?

It is not critical 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?

Beta decreases to 0 Signup and view all the answers

What is the purpose of estimating the equity cost of capital using the CAPM?

To determine the expected return of available investments with the same beta Signup and view all the answers

What type of risk is diversified away in a portfolio?

Unsystematic risk Signup and view all the answers

What is the purpose of combining asset betas for firms in the same industry?

To reduce estimation error in the estimated beta for the project Signup and view all the answers

What is the relationship between beta and the expected return of an investment?

Beta measures the sensitivity of an investment to market risk Signup and view all the answers

What is the effect of a higher proportion of fixed costs on project cash flows?

Increases the sensitivity to market risks Signup and view all the answers

Why does the net cost to the firm of debt financing decrease?

Due to tax deductible interest payments Signup and view all the answers

What is the formula for the effective after-tax interest rate?

r * (1-Tc) Signup and view all the answers

What is the weighted average cost of capital (WACC) used for?

Evaluating levered projects and investments Signup and view all the answers

What is the effect of taxes on the cost of capital in perfect capital markets?

Taxes have no effect on the cost of capital Signup and view all the answers

What is the formula for the weighted average cost of capital (WACC)?

rE + rD*(1-Tc) Signup and view all the answers

What does the abbreviation PPE stand for?

Property, Plant and Equipment Signup and view all the answers

What is the investment ratio represented by in the given content?

(1-p) Signup and view all the answers

What are the two main factors that make future interest payments uncertain?

Amount of debt outstanding and interest rate on the debt Signup and view all the answers

What does the abbreviation ROE stand for?

Return on Equity Signup and view all the answers

What is the formula to calculate the present value of interest tax shield with constant growth?

PV = CF / (r - g) 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?

Ad hoc Signup and view all the answers

What does the abbreviation WACC stand for?

Weighted Average Cost of Capital Signup and view all the answers

What is the relationship between a firm's leverage and its WACC with taxes?

The higher the firm's leverage, the lower the WACC with taxes Signup and view all the answers

Why is it unlikely to precisely predict the optimal level of debt for a firm?

Because it's hard to predict future EBIT of the firm Signup and view all the answers

What does the abbreviation EBIT stand for?

Earnings before Taxes and Interest Signup and view all the answers

What happens to tax savings when there is high uncertainty about EBIT?

Tax savings decrease Signup and view all the answers

What is the condition for interest payments to be equal to EBIT?

When the optimal level of debt is reached Signup and view all the answers

What is the purpose of recaptitalizing to capture the tax shield?

To state the tax shield as the firm's asset Signup and view all the answers

What is the relationship between the pre-tax WACC and the WACC with taxes?

WACC with taxes is always lower than pre-tax WACC 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

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Description

Quiz on financial cash flow analysis, covering non-cash items, timing of cash flows, and potential project implications.