Term
| Weighted average cost of capital, WACC; after-tax cost of debt, rd(1 − T) |
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Definition
The weighted average cost of capital, WACC, is the weighted average of the after-tax component costs of capital—-debt, preferred stock, and common equity.
Each weighting factor is the proportion of that type of capital in the optimal, or target, capital structure. The after-tax cost of debt, rd(1 - T), is the relevant cost to the firm of new debt financing. Since interest is deductible from taxable income, the after-tax cost of debt to the firm is less than the before-tax cost. Thus, rd(1 - T) is the appropriate component cost of debt (in the weighted average cost of capital). |
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Term
| Cost of preferred stock, rps; cost of common equity (or cost of common stock), rs |
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Definition
| The cost of preferred stock, rps, is the cost to the firm of issuing new preferred stock. For perpetual preferred, it is the preferred dividend, Dps, divided by the net issuing price, Pn. Note that no tax adjustments are made when calculating the component cost of preferred stock because, unlike interest payments on debt, dividend payments on preferred stock are not tax deductible. The cost of new common equity, re, is the cost to the firm of equity obtained by selling new common stock. |
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Term
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Definition
| Flotation costs are the costs that the firm incurs when it issues new securities. The amount actually available to the firm for capital investment from the sale of new securities is the sales price of the securities less flotation costs. Note that flotation costs consist of (1) direct expenses such as printing costs and brokerage commissions, (2) any price reduction due to increasing the supply of stock, and (3) any drop in price due to informational asymmetries. |
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Term
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Definition
| The target capital structure is the relative amount of debt, preferred stock, and common equity that the firm desires. The WACC should be based on these target weights. |
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Term
| cost of new external common equity, re |
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Definition
| The cost of new common equity is higher than that of common equity raised internally by reinvesting earnings. Projects financed with external equity must earn a higher rate of return, since the project must cover the flotation costs. |
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Term
| How can the WACC be both an average cost and a marginal cost? |
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Definition
| The WACC is an average cost because it is a weighted average of the firm's component costs of capital. However, each component cost is a marginal cost; that is, the cost of new capital. Thus, the WACC is the weighted average marginal cost of capital. |
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Term
Distinguish between beta (or market) risk, within-firm (or corporate) risk, and standalone
risk for a potential project. Of the three measures, which is theoretically the most relevant, and why? |
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Definition
Stand-alone risk views a project’s risk in isolation, hence without regard to portfolio effects; within-firm risk, also called corporate risk, views project risk within the context of the firm’s portfolio of assets; and market risk (beta) recognizes that the firm’s stockholders hold diversified portfolios of stocks.
In theory, market risk should be most relevant because of its direct effect on stock prices. |
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Term
Suppose a firm estimates its overall cost of capital for the coming year to be 10%.What
might be reasonable costs of capital for average-risk, high-risk, and low-risk projects? |
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Definition
| If a company’s composite WACC estimate were 10%, its managers might use 10% to evaluate average-risk projects, 12% for high-risk projects, and 8% for low-risk projects. Unfortunately, given the data, there is no completely satisfactory way to specify exactly how much higher or lower we should go in setting risk-adjusted costs of capital. |
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Term
| Capital budgeting; regular payback period; discounted payback period |
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Definition
Capital budgeting is the whole process of analyzing projects and deciding whether they should be included in the capital budget. This process is of fundamental importance to the success or failure of the firm as the fixed asset investment decisions chart the course of a company for many years into the future
The payback, or payback period, is the number of years it takes a firm to recover its project investment. Payback may be calculated with either raw cash flows (regular payback) or discounted cash flows (discounted payback). In either case, payback does not capture a project’s entire cash flow stream and is thus not the preferred evaluation method. Note, however, that the payback does measure a project’s liquidity, and hence many firms use it as a risk measure. |
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Term
| Independent projects; mutually exclusive projects |
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Definition
| Mutually exclusive projects cannot be performed at the same time. We can choose either Project 1 or Project 2, or we can reject both, but we cannot accept both projects. Independent projects can be accepted or rejected individually. |
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Term
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Definition
| The net present value (NPV) and internal rate of return (IRR) techniques are discounted cash flow (DCF) evaluation techniques. These are called DCF methods because they explicitly recognize the time value of money. |
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Term
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Definition
| The modified internal rate of return (MIRR) assumes that cash flows from all projects are reinvested at the cost of capital as opposed to the project’s own IRR. This makes the modified internal rate of return a better indicator of a project’s true profitability. |
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Term
| NPV profile; crossover rate |
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Definition
| An NPV profile is the plot of a project’s NPV versus its cost of capital. The crossover rate is the cost of capital at which the NPV profiles for two projects intersect indicating that at that point their NPVs are equal. |
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Term
| Nonnormal cash flow projects; normal cash flow projects; multiple IRRs |
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Definition
| Capital projects with nonnormal cash flows have a large cash outflow either sometime during or at the end of their lives. A common problem encountered when evaluating projects with nonnormal cash flows is multiple IRRs. A project has normal cash flows if one or more cash outflows (costs) are followed by a series of cash inflows. |
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Term
| Reinvestment rate assumption |
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Definition
| The mathematics of the NPV method imply that project cash flows are reinvested at the cost of capital while the IRR method assumes reinvestment at the IRR. Since project cash flows can be replaced by new external capital that costs r, the proper reinvestment rate assumption is the cost of capital, and thus the best capital budget decision rule is NPV. |
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Term
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Definition
A replacement chain is a method of comparing mutually exclu¬sive projects that have unequal lives. Each project is replicated such that they will both terminate in a common year.
If projects with lives of 3 years and 5 years are being evaluated, the 3-year project would be replicated 5 times and the 5-year project replicated 3 times; thus, both projects would terminate in 15 years. Not all projects maximize their NPV if operated over their engineering lives and therefore it may be best to terminate a project prior to its potential life. |
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Term
| What types of projects require the least detailed and the most detailed analysis in the capital budgeting process? |
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Definition
| Projects requiring greater investments or that have greater risk should be given detailed analysis the capital budgeting process. |
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Term
Explain why the NPV of a relatively long-term project is more sensitive
to changes in the cost of capital than is the NPV of a short-term project |
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Definition
| The NPV is obtained by discounting future cash flows, and the discounting process actually compounds the interest rate over time. Thus, an increase in the discount rate has a much greater impact on a cash flow in Year 5 than on a cash flow in Year 1. |
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Term
In what sense is a reinvestment rate assumption embodied in the NPV, IRR, and
MIRR methods? What is the assumed reinvestment rate of each method? |
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Definition
The NPV and IRR methods both involve compound interest, and the mathematics of discounting requires an assumption about reinvestment rates.
The NPV method assumes reinvestment at the cost of capital, while the IRR method assumes reinvestment at the IRR. MIRR is a modified version of IRR which assumes reinvestment at the cost of capital. |
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Term
| Project cash flow; accounting income |
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Definition
project cash flow is the free cash flow generated by the project.
Accounting income, on the other hand, reports accounting data as defined by Generally Accepted Accounting Principles (GAAP). |
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Term
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Definition
| Incremental cash flows are those cash flows that arise solely from the asset that is being evaluated. For example, assume an existing machine generates revenues of $1,000 per year and expenses of $600 per year. A machine being considered as a replacement would generate revenues of $1,000 per year and expenses of $400 per year. On an incremental basis, the new machine would not increase revenues at all, but would decrease expenses by $200 per year. Thus, the annual incremental cash flow is a before-tax savings of $200. |
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Term
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Definition
| A sunk cost is one that has already occurred and is not affected by the capital project decision. Sunk costs are not relevant to capital budgeting decisions. |
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Term
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Definition
| Within the context of this chapter, an opportunity cost is a cash flow that a firm must forgo to accept a project. For example, if the project requires the use of a building that could otherwise be sold, the market value of the building is an opportunity cost of the project |
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Term
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Definition
| An externality is something that is external to the project but occurs because of the project. For example, cannibalization occurs when a project’s product reduces the company’s sales of similar products. |
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Term
| expansion project; replacement project |
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Definition
| An expansion project is one in which new sales are generated. A replacement project is one in which an existing machine is replaced with a more efficient one—new sales might not be created, but cash flows improve because of the more efficient machine. |
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Term
| Net operating working capital changes |
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Definition
Net operating working capital changes are the increases in current operating assets resulting from accepting a project less the resulting increases in current operating liabilities, or accruals and accounts payable.
A net operating working capital change must be financed just as a firm must finance its increases in fixed assets |
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Term
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Definition
| Salvage value is the market value of an asset after its useful life. Salvage values and their tax effects must be included in project cash flow estimation. |
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Term
Stand-alone risk
corporate (within-firm) risk
market (beta) risk |
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Definition
Stand-alone risk is the risk a project would have it it were held in isolation.
Corporate (within-firm) risk is the risk that a project contributes to a company after taking into consideration the cash flows of the company’s other projects; because projects are not perfectly correlated, corporate risk usually will be less than stand-alone risk.
Market (beta) risk is the risk that a company contributes to a well diversified portfolio. |
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Term
| Real options; managerial options; strategic options; embedded options |
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Definition
Real options occur when managers can influence the size and risk of a project’s cash flows by taking different actions during the project’s life.
They are referred to as real options because they deal with real as opposed to financial assets.
They are also called managerial options because they give opportunities to managers to respond to changing market conditions.
Sometimes they are called strategic options because they often deal with strategic issues.
Finally, they are also called embedded options because they are a part of another project. |
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Term
| Why is it true, in general, that a failure to adjust expected cash flows for expected inflation biases the calculated NPV downward? |
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Definition
| Since the cost of capital includes a premium for expected inflation, failure to adjust cash flows means that the denominator, but not the numerator, rises with inflation, and this lowers the calculated NPV. |
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Term
| Explain why sunk costs should not be included in a capital budgeting analysis but opportunity costs and externalities should be included. |
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Definition
Capital budgeting analysis should only include those cash flows which will be affected by the decision.
Sunk costs are unrecoverable and cannot be changed, so they have no bearing on the capital budgeting decision.
Opportunity costs represent the cash flows the firm gives up by investing in this project rather than its next best alternative, and externalities are the cash flows (both positive and negative) to other projects that result from the firm taking on this project. These cash flows occur only because the firm took on the capital budgeting project; therefore, they must be included in the analysis. |
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Term
| Define (a) simulation analysis, (b) scenario analysis, and (c) sensitivity analysis. |
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Definition
Simulation analysis involves working with continuous probability distributions, and the output of a simulation analysis is a distribution of net present values or rates of return. Scenario analysis involves picking several points on the various probability distributions and determining cash flows or rates of return for these points.
Sensitivity analysis involves determining the extent to which cash flows change, given a change in one particular input variable
Simulation analysis is expensive. Therefore, it would more than likely be employed in the decision for the $200 million investment in a satellite system than in the decision for the $12,000 truck. |
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Term
| Why are interest charges not deducted when a project’s cash flows are calculated for use in a capital budgeting analysis? |
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Definition
| The costs associated with financing are reflected in the weighted average cost of capital. To include interest expense in the capital budgeting analysis would “double count” the cost of debt financing. |
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Term
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Definition
| NPV is the present value of the project’s expected future cash flows (both inflows and outflows), discounted at the appropriate cost of capital. NPV is a direct measure of the value of the project to shareholders |
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Term
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Definition
| The profitability index is the ratio of the present value of future cash flows to the project’s initial cost. It shows the relative profitability of any project. A profitability index greater than 1 is equivalent to a positive NPV project. |
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Term
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Definition
| The internal rate of return (IRR) is the discount rate that equates the present value of the expected future cash inflows and outflows. IRR measures the rate of return on a project, but it assumes that all cash flows can be reinvested at the IRR rate. |
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