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Capital Budgeting & Valuation


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Optimal Financing Choices
Maximizing value=minimizing cost of capital
Unlevered Cash Flows
Accrue to shareholders if firm only uses equity
Levered Cash Flows
Accrue to shareholders under current capital structure (with some debt)
NPV
Net present value of a project calculated assuming no debt
NPVF
New present value of the financing side effects from financing the project
Errors with WACC and FTE
When debt ratios are expected to change over a project's life, Re and Rwacc will change over time
Errors with APV
When debt levels in the future are uncertain, value of tax shields is hard to predict
Valuing Ongoing Businesses
Value future cash flows as of time 0
APV
NPV +NPVF
tcB
value tax subsidy
cost of issuing new securities
investment banks' floatation fees associated with firms' issuance of debt and equity
cost of financial distress
increased probability of bankruptcy associated with increase debt which lowers firm's value
subsidies to debt financing
interest on debt issued by state and local govs not federally taxable to investor
Vu+Vtaxshield = B + S
relationship in firm between debt and equity
rSL
rSU + (B/s)*(rSU-Rb)-(Vtaxshield/s)*(rSU-rtaxshield)
FTE
Flow to equity approach
calculate levered CF
find after tax cost of interest and deduct from future CF
Calculate rSL
start with B/V to find B/S
value levered CF at rSL
discount CF to equity holders at rSL
WACC method
to find value of project, discount unlevered CF at WACC
comparison of APV, FTE, and WACC approaches
all three attempt valuation in presence of debt financing
WACC
all initial investment
scale enhancing project
one where project is similar to those of the existing firm
capital budgeting when discount rate must be estimated
in real world, execs would make assumption that business risk of non-scale enhancing project would be = business risk of firms already in business
beta and leverage
Basset = cov(UCF, Market)/ SD^2 market
Capital Budgeting
the process of planning and managing a firm's long-term investments; evaluate the size, timing, and risk of future cash flows
Capital Budgeting deals with...
Asset purchases (i.e. - infrastructure);
Capital Budget Process
Constrains financial impact of acquiring capital assets (on the budget)
Age of infrastructure;
Capital asset inventory-existing situation
capital improvements
an increase in the value of an owner's assets accomplished by either increasing income or reducing expenses
budgeting capital
a means of setting aside reserves for major expenditures
capital assets
major expenditures such as property, plant, or equipment
REITs
real estate investment trust; a business entity that sells stock and invests proceeds in real estate as its primary business
compounding
the calculation of interest on a principal amount, plus interest on the interest accrued during a previous period
time value of money
the notion that a rate of return should be expected from capital invested over a period of time
discounting
bring amount to today's value; future monies brought back to today's value; dividing the future value by the sum and interest compounded each year
capitalization
used to determine the value of real estate or other property; transferring items purchased for use over an extended period of time from the cash basis income statement and recording them as assets on the balance sheet
expenses
need to subtract from NOI before using capitalization rate equation
annual cash flow
NOI subtract debt service
present value
comparison of the anticipated cash flow from an investment to the initial investment
positive NPV
reflects return on capital
negative NPV
not all capital has been returned
IRR
a % rate that equates the present value of the future benefits to the present value of the capital outlays by ownership; measure of investment performance frequently used for acquisition purposes
payback period
the time required for the money saved and/or the income generated by a project or product to equal its initial investment cost; determined as part of life-cycle cost analysis
life-cycle costing
life expectancy, inflation rate, real interest rate, discount rate
Bond
long term debt instrument
Stocks
Only equity in capital market
cash flow
A revenue or expense stream that changes a cash account over a given period. Cash inflows usually arise from one of three activities - financing, operations or investing - although this also occurs …
claim
an interest in or right to the benefits of assets owned by a firm, which belongs to a third party. The shareholder's have a residual claim to the assets of a business after the creditor's claim.
cost
resources sacrificed or forgone to achieve a specific objective.
Debt
Obligation to repay
firm
A business organization, such as a corporation, limited liability company or partnership. Firms are typically associated with business organizations that practice law, but the term can be used for a wide variety or business operation units.
investment
An asset or item that is purchased with the hope that it will generate income or appreciate in the future. In an economic sense, an investment is the purchase of goods that are not cons…
law of one price
A law that says that two identical products at the same venue should sell for the same price.
payoff
cash inflow
project
the most basic object in finance, which is a set of flows of money (cash flows). Most projects start with an initial cash outflow, and are followed by a series of later cas inflows.
return
interest or similar
revenue
The amount of money that a company actually receives during a specific period, including discounts and deductions for returned merchandise. It is the "top line" or "gross income" figure from which costs are subtracted to determine net income.
valuation
The process of determining the current worth of an asset or company. There are many techniques that can be used to determine value, some are subjective and others are objective.