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Final Review

Final Review. Preparation for the final exam. Review Topics. Capital Budgeting Cost of Capital Mergers & Acquisitions International Finance Cases. Capital Budgeting. Understand the role of capital budgeting techniques in the capital budgeting process.

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Final Review

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  1. Final Review Preparationfor the final exam

  2. Review Topics • Capital Budgeting • Cost of Capital • Mergers & Acquisitions • International Finance • Cases

  3. Capital Budgeting • Understand the role of capital budgeting techniques in the capital budgeting process. • Calculate, interpret, and evaluate the payback period. • Calculate, interpret, and evaluate the net present value (NPV). • Calculate, interpret, and evaluate the internal rate of return (IRR). • Use net present value profiles to compare NPV and IRR techniques. • Discuss NPV and IRR in terms of conflicting rankings and the theoretical and practical strengths of each approach.

  4. Capital Budgeting • Administrative Steps: • Identify Projects • Collect Data • Analyze Profit and Risk • Gain Regulatory Approvals • Arrange Financing • Implement • Control

  5. Capital Budgeting • NPV vs. IRR • Conflicting rankings between two or more projects using NPV and IRR sometimes occurs because of differences in the timing and magnitude of cash flows. • This underlying cause of conflicting rankings is the implicit assumption concerning the reinvestment of intermediate cash inflows—cash inflows received prior to the termination of the project. • NPV assumes intermediate cash flows are reinvested at the cost of capital, while IRR assumes that they are reinvested at the IRR.

  6. Capital Budgeting • On a purely theoretical basis, NPV is the better approach because: • NPV assumes that intermediate cash flows are reinvested at the cost of capital whereas IRR assumes they are reinvested at the IRR, • Certain mathematical properties may cause a project with non-conventional cash flows to have zero or more than one real IRR. • Despite its theoretical superiority, however, financial managers prefer to use the IRR because of the preference for rates of return.

  7. Capital Budgeting – Problem 1 Pound Industries is attempting to select the best of three mutually exclusive projects. The initial investment and after-tax cash inflows associated with these projects are shown in the following table: • Calculate the payback period for each project • Calculate the NPV of each project, assuming that the firm has a cost of capital equal to 13% • Calculate the IRR for each project • Summarize the preferences dictated by each measure and indicate which project you would recommend. Explain why

  8. Capital Budgeting – Solution 1 • Payback Period: • Project A: $60,000 / $20,000 = 3.0 years • Project B: $100,000 / $31,500 = 3.2 years • Project C: $110,000 / $32,500 = 3.4 years • NPV: • CF0 = -60,000 , C01 = 20,000, F01 = 5, I = 13%  NPVa = $10,345 • NPVb = 10,793 • NPVc = 4,310 • IRR: • IRRa = 20% • IRRb = 17% • IRRc = 15%

  9. Capital Budgeting – Problem 2 Russell Industries is considering replacing a fully depreciated machine that has a remaining useful life of 10 years with a newer, more sophisticated machine. The new machine will cost $200,000 and will require $30,000 in installation costs. It will be depreciated under MACRS using a 5-year recovery period. A $25,000 increase in net working capital will be required to support the new machine. The firm’s managers plan to evaluate the potential replacement over a 4-year period. They estimate that the old machine could be sold at the end of 4 years to net $15,000 before taxes; the new machine at the end of year 4 has a value of $75,000 that is relevant to the proposed purchase of the new machine. The firm is subject to a 40% tax rate.

  10. Capital Budgeting – Solution 2 After-tax proceeds from sale of new asset: Proceeds from sale of new machine 75,000 − Tax on sale of new machine l (14,360) Total after-tax proceeds-new asset 60,640 − After-tax proceeds from sale of old asset Proceeds from sale of old machine (15,000) + Tax on sale of old machine 2 6,000 Total after-tax proceeds-old asset (9,000) + Change in net working capital 25,000 Terminal cash flow 76,640 l Book value of new machine at end of year.4: [1 − (0.20 + 0.32+ 0.19 + 0.12) × ($230,000)] = $39,100 $75,000 − $39,100 = $35,900 recaptured depreciation $35,900 × (0.40) = $14,360 tax liability 2 Book value of old machine at end of year 4: $0 $15,000 − $0 = $15,000 recaptured depreciation $15,000 × (0.40) = $6,000 tax benefit

  11. Cost of Capital • Debt or Equity? • Optimal Capital Structure • Leverage • Cost of Capital • Cost of Debt • Cost of Equity • Cost of Preferred Stock

  12. Cost of Capital – Problem (part 1) Edna Reporting Studios Inc, reported earnings available to common stock of $4,200,000 last year. From those earnings, the company paid dividends of $1.26 on each of each $1,000,000 common shares outstanding. The capital structure of the company includes 40% debt, 10% preferred stock and 50% common stock. It’s taxed at a rate of 40%. • If the market price of the common stock is $40 and dividends are expected to grow at a rate of 6% per year for the foreseeable future, what is the cost of financing with retained earnings? • If under pricing and flotation costs on new shares of common stock amount to $7.00 per share, what is the company’s cost of new common stock financing? • The company can issue $2.00 dividend preferred stock for a market price of $25.00 per share. Flotation costs would amount to $3.00 per share. What is the cost of preferred stock financing?

  13. Cost of Capital – Solution (part 1)

  14. Cost of Capital – Problem (part 2) • The company can issue $1,000-par-value, 10% coupon, 5-year bonds that can be sold for $1,200 each. Flotation costs would amount to $25.00 per bond. Use the estimation formula to figure the approximate cost of new debt financing. • What is the maximum investment that Edna Recording Studios can make in new projects before it must issue new common stock? • What is the WACC for projects with a cost at or below the amount calculated in part e? • What is the WACC for projects with a cost above the amount calculated in part e, assuming that the debt across all ranges remains at the percentage calculated in part d?

  15. Cost of Capital – Solution (part 2)

  16. Mergers & Acquisitions – Problem 1 Toni’s Typesetters is analyzing a possible merger with Pete’s Print Shop. Toni’s has a tax loss carry forward of $200,000, which it could apply to Pete’s expected earnings before taxes of $100,000 per year for the next five years. Using a 34% tax rate, compare the earnings after taxes for Pete’s over the next 5 years both without and with the merger.

  17. Mergers & Acquisitions – Solution 1

  18. Mergers & Acquisitions – Problem 2

  19. Mergers & Acquisitions – Solution 2

  20. International Finance • Understand the major factors that influence the financial operations of multinational companies (MNCs). • Describe the key differences between purely domestic and international financial statements –consolidation, translation of individual accounts, and international profits. • Discuss exchange rate risk and political risk, and explain how MNCs manage them. • Describe foreign direct investment, investment cash flows and decisions, the MNCs’ capital structure, and the international debt and equity market instruments available to MNCs. • Discuss the role of the Eurocurrency market in short-term borrowing and investing (lending) and the basics of international cash, credit, and inventory management. • Review recent trends in international mergers and joint ventures.

  21. International Finance • Floating exchange rate key factors: • Relative Interest Rates • Relative Inflation Rates • Relative Economic Growth Rates • Exposure to Foreign Currency Risk: • Economic Exposure • Transactions Exposure • Translation Exposure

  22. Case Studies For the exam: • Netscape IPO • National Wind Power • Lockheed Martin & Loral • Massachusetts Carnegie Bank

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