Corporate Finance Equations Notes 5
Corporate Finance Equations Notes 5
to NPV
o It selects the project that adds the
most to shareholder wealth
- Therefore when there is a conflict in
ranking between net present value and
IRR when cost of capital is less than
crossover point, you should use net
present value.
Downfall of IRR: - A lower IRR can be better if a cash INflow is
- IRR is a return measure therefore you followed by cash outflows.
cannot tell how much value has actually - Investment decision: Choose IRR _>__ cost o
been created without knowing the basis capital
for the return. - Loan decision: Choose IRR _<__ cost of capi
- The IRR rule is unaffected by the scale of o Here IRR will be the cost of borrowin
the investment opportunity because IRR
measures average return of the
investment.
- Another shortcoming of IRR rule? – The
IRR rule cannot be used to compare
projects with different scales.
o Therefore use the same scale (the
investment amount)
4th method of evaluating investment opportunities: Calculating PI:
Profitability Index and Summary: - NPV/Resource consumed
- When funds are limited, we must pick the - Measures NPV per $1 of investment
project that offer the highest NPV per - PI=NPV/Resource consumed ("PI > 0"
dollar of initial investment; the ratio equivalent to "NPV > 0")
known as the Profitability Index o Therefore – when you have one
- Why - when your resources are constraint, independent project the rule will be a
when you evaluate the project, you want long PI > 0
to make sure that you can maximize the - RULE for multiple independent projects: Ran
net present value per every single dollar projects according to their profitability index
that you invest based on the constrained resource and move
- Meaning of PI - every single dollar that down the list accepting value-creating project
you invest your net present value per until the resource is exhausted.
dollar is $2.10 - Steps : calculate PI
o Rearrange most beneficial projects ba
on highest PI and choose them all unt
you run out of your budget limit
(investment limit)
Where does PI fail:
- Where there is more than one constraint
(example of constrain – you can only
spend 10 M in year 0 and 10 M in year 1):
- Sometimes it is best to choose investments
that have the highest sum of the NPV
Week 8 – Fundamental of Capital Budgeting (Chapter 9)
Objective - Evaluate the value of productive assets using a range of capital budgeting techniques.
Notations: We are learning how to estimate the use of free cash
COGS = Cost of goods sold: flows which is a common feature of each investment
- COGS = Production related expenses and decision tool learnt in week 7 of:
it includes the items such as the cost of - NPV
raw materials and the cost of direct Labor. - IRR
- Revenue – COGS = Gross Profit - Payback
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OR:
FCF = (Revenue – Costs – Depreciation) X (1- Tc) +
Depreciation – CapEx – Changes in NWC
Note – the red highlighted does not include interest
expenses associated with debt (this is the unlevered net
profit)
o When you calculate the free cash flows you d
deduct interest expenses.
o By definition, free cash flow is supposed to b
funds available for distribution to both
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Or
reflects a short-term investment that ties up cash associated with the future cash flows that's wh
flow that could be used elsewhere. For example, the company would like to keep some cash
when a firm holds a lot of unsold inventory or has balance as a safety cushion.
a lot of outstanding receivables, cash flow is tied - To get your project going it is necessary for th
up in the form of inventory or in the form of credit firms to make an investment in networking
extended to customers. It is costly for the firm to capital but,
tie up that cash flow because it delays the time - Those funds invested in networking capital
until the cash flow is available for reinvestment or they are recoverable so it will eventually be
distribution to shareholders. Since we know that recovered, because the money that you put
money has time value, we cannot ignore this delay into inventories, you will be able to recover
in our forecasts for the project. Thus, whenever you sell your inventories and accounts
net working capital increases, reflecting additional receivables will also be collected over time.
investment in working capital, it represents a - So to reflect that for our practical questions, w
reduction in cash flow that year. will assume that all networking capital will be
recovered in the terminal year (the last year),
we will just to make one-off adjustment in the
terminal year to recover any working capital
investment.
need for investment. In this section, we examine the role of financing sources in determining the firm’s
overall cost of capital. We begin by stepping back to assess these financing sources in the context of the
firm’s balance sheet. the firm’s capital structure. A firm’s sources of financing, which usually consist of de
and equity, represent its capital . The typical firm raises funds to invest by selling shares to shareholders (it
equity) and borrowing from lenders (its debt).
Capital = A firm’s sources of financing, which usually consist of debt and equity
Homemade notations
DH = Debtholders
SH = (Ordinary) Shareholders
PSH = Preference Shareholders
Why WACC/cost of capital is important: Looking at definition of Free Cash Flows again:
- For IRR determination as: - They are distributable cash flows or ready to
o Accept if IRR > Cost of Capital distribute cash flows after a company has mad
o Reject if IRR < Cost of Capital an investment in new project via Capex and
- & for the calculation of profitability index NWC
you divide net present value by the - So after the company has made an investmen
resource consumed, which is $5 so your long term assets and networking capital and a
WACC is embedded in the calculation of leftover cash flow is now ready to be distribu
net present value so to all types of investors to either debtholders (
coupons), ordinary or preference shareholders
(as dividends)
- Therefore because of the different nature of c
flows involved to discount those cash flows, y
have to employ different types of discount rat
o For coupons you will need cost of de
and for ordinary shares you will need
cost of equity and for preference shar
you will need cost of preference share
- Therefore for Free Cash flows because they a
take into account the different cost of capital
rates we need to know how to calculate each o
these rD, rE & rP
Intuition behind rWACC: - The average of the company's equity and deb
- When investors buy the shares or bonds of cost of capital weighted by the fractions of th
a company they forgo the opportunity to company's market value that corresponds to
invest that money elsewhere, so there equity and debt respectively
exist opportunity costs and the expected o So your WACC will be the weighted
return from those alternative investment average of cost of equity and cost of d
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Calculating rWACC:
- WACC is what you need for the use of Prerequisite in calculating P% (must calculate the tota
investment decision making tools like net market value of the firms debt) = current share price x
present value IRR discounted payback shares outstanding
period and profitability index.
RWACC = rE E% + rp P% + rd (1− T)D% Prerequisite in calculating E% (must calculate the tota
Part of it is calculating the weighted market value of the firms debt) = current share price x
average of the costs of e.g. debt from the shares outstanding
three sources. E.g D%
Perquisite in calculating D% weighted Then input everything into RWACC formula (Reference
average of the costs of e.g. debt from the slides 24 -28 of week 9)
three sources. E.g D%:
For this you need the total value of the
firms debt: Therefore plus the value of
each source of debt to get the ‘total
market value of the firm’s debt” for e.g. rD
and then get the fraction of each source of
debt over the total market value and add
them together to get the total weight for
each component e.g. rD
Note for rD the weight, it is the pre-tax
cost of debt, therefore it will need to be
converted to after tax
There are three conditions that need to be met to 2. Assumption 2 - Constant debt-equity ratio
use a company’s WACC as a discount rate for a The company will maintain a constant debt to
new project: equity ratio remember in addition to the cost
1. Assumption 1 – Average risk: itself the WACC contains the weightings D%
The market risk or systematic risk of the % and P%, and you have to make sure that th
project, should be comparable to the debt to equity ratio will be maintained.
average market risk of the company's When the new project is employed.
existing investments. This policy determines the amount of debt
So you have to make sure that systematic company will take on when it accepts a new
risk, beta, is comparable, otherwise the project, so it doesn't mean that you can't incre
higher risk, it should be followed by a the debt.
higher discount rate. But for you to maintain debt to equity ratio w
Therefore, to start with, you have to make debt is raised the equity will have to be raised
sure that the systematic risk of the new as well, so that you can maintain the debt to
project is comparable to the average equity ratio.
market risk of the company's the existing It also implies that the risk of the company's
investment so that the level of WACC is equity and debt therefore its rWACC will not
appropriate to reflect the level of risk fluctuate as leverage changes, so having the
inherent in the new project. constant debt to equity ratio will make sure th
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