The top-down approach to computing the operating cash flow: ignores all noncash items
Tax shield refers to a reduction in taxes created by: noncash expenses
Tonis Tools is comparing machines to determine which one to purchase. The machines sell for differing prices, have
differing operating costs, differing machine lives, and will be replaced when worn out. These machines should be
compared using: their equivalent annual costs
The equivalent annual cost method is useful in determining: which one of two machines to purchase when the machines
are mutually exclusive, have different machine lives, and will be replaced once they are worn out
Incremental cash flows are the changes in a firms future cash flows that are a direct consequence of accepting a project
Erosion: cash-flow amount transferred to a new project from customers and sales of other products of the firm
Equivalent annual costs are the annual stream of payments with the same present value as a projects costs
Depreciation tax shield is the cash flow tax savings generated as a result of a firms tax-deductible depreciation expense
The cash flow from projects for a company is computed as the sum of the incremental operating cash flows, capital
spending, and net working capital expenses incurred by the project
The increase you realize in buying power as a result of owning a bond is referred to as the: real rate of return
The market price of a bond is equal to the present value of the: face value plus the present value of the annuity payments
The yield to maturity is: the rate that equates the price of the bond with the discounted cash flows, the expected rate to be
earned if held to maturity, the rate that is used to determine the market price of the bond, equal to the current yield for bonds
priced at par
BOND VALUATION
N=number of periods
I=YTM (if semi-annual, divide by two)
PMT= based on coupon
FV= 1000
PV= market price
**DDM NOTE: if the company just paid a dividend, use the next dividend in the formula (past dividend * growth)
Exponential growth: y=A*B^x A= current, B= (1+growth), x= number of periods
Discounting: Price/(1+growth)^years
DDM Example: Next 4 dividends, $3, $5, $7.50, $10 and then $2.50 after, 15% req return
Discount each of the 4, calculate P4=2.50/.15=16.67
Discount 16.67 with period of 4 and add all discounts together
Arithmetic Returns: 10%, 20%, -30% = (.1+.2-.3)/3
Geometric Returns: (1.1*1.2*.7)^(1/3)-1
Risk premium (stock)= Beta*market risk premium
Systematic risk: measured by beta
Total risk: systematic and unsystematic
Beta measures: how an asset covaries with the market
**Beta of US Treasury bills = 0
WACC: the weighted average of the firms equity, preferred stock, and after tax debt
Excess market return: difference between the return on the market and the risk-free rate
WACC: the overall rate which the firm must earn on its existing assets to maintain the value of its stock
Companies that have highly cyclical sales will have a: high beta if sales are highly dependent on the market cycle
For a multi-product firm, if a projects beta is different form that of the overall firm, then: the project should be
discounted at a rate commensurate with its own beta
Beta(asset)= (%equity)(equity beta) + (%debt)(debt beta)
Beta dependent on: cycles in revenues, operating leverage, financial leverage
Cost of debt: post-tax cost of debt since interest is tax deductible
MM Propositions
With Taxes: MM1)Value of levered firm = value of unlevered firm (through homemade leverage individuals can
either duplicate or undo the effects of corporate taxes)
MM2) Re = Ru + B/S(Ru-Rb) (the cost of equity rises with leverage because the risk to equity rises
with leverage)
**Rb= cost of debt, Re= cost of equity, req return on equity, expected return on stock, B= value debt, S= value of
equity, Tc= tax rate, Ru= unlevered cost of capital
Without Taxes: MM1) VL= VU+ Tc*B (because corporations can deduct interest payments but not dividend
payments, leverage lowers taxes)
MM2) Re= Ru+ B/S(1-Tc)(Ru-Rb) (the cost of equity rises with leverage because the risk to
equity rises with leverage)
Interest tax shield: the tax savings of the firm derived from the deductibility of interest expense
rWACC (zero tax): equal to the expected earnings divided by market value of unlevered firm, equal to the rate of return for
that business risk class, equal to the overall rate of return required on the levered firm, is constant regardless of the amount of
leverage
Value of firm: 500,000 shares outstanding, borrowing $8million at 9% to buyback 200,000 shares
$8million/200,000=$40
500,000-200,000=300,000*$40 + $8million = 500,000 * $40 = $20 million
Value of levered firm= Vu + (Tc*D)
Ruths Chris Example (project WACC):
RC: Be= 1.25 60% debt, 40% equity
You finance with 45% debt, 55% equity
40% tax
Calculate unlevered beta with Ruths Chris, calculate new levered beta using this as beta, calculate cost of equity
MACRS vs. Straight line: MACRS produces less income and less taxes for the first few years, straight line produces more
income for the first few years
Net working capital: can affect cash flows for every year of the project, frequently affect by additional sales of another project
Cost of debt: YTM
-After tax: (1-tax rate)*borrowing rate
Bond yields and interest rates based on 6 factors:
-real interest rate
-inflation
-interest rate risk
-default risk
-taxability
-lack of liquidity