NPV if deciding between 2 projects choose one with higher NPV Directly measures the increase in firm value so also shows the increase in shareholders wealth Most theoretically correct NPV Cf0 CF1 1 r CF2 1 r 2 CFn 1 r n Payback An investment is acceptable if its calculated payback period is less then a pre specified of years payback Y1 CF0 CF1 payback Y2 payback Y1 CF2 do this for each year until you get a negative number Finding payback for the rest of partial year n Payback Yn 1 CFn Discounted Payback payback Y1 CF0 CF1 1 r payback Y2 payback Y1 CF2 1 r 2 Finding discounted payback for partial year CFn 1 r n x payback Yn 1 x IRR is the return that makes NPV 0 IRR Y0 OCF CF1 CFn wil not always be a Y0 Accept is IRR r as r increases NPV decreases When deciding between 2 projects choose one with higher IRR IRR and NPVE with normally give the same decision Nonconventional Cash Flows cashflow signs change more then once more then 1 IRR use NPV for decsion Mutually Exclusive projects Solve for the NPV and IRR of both projects Choose project with higher NPV Pro Forma statements project future year operations Always get back NWC Sales unit x price VC ppu Gross Profit Fixed Costs Depreciation EBIT Taxes NI Dep OCF Then NPV for x years NPV r Yo OCF x NPV Profile Undiscounted CF initial cost Y intercept Bigger Y intercept steeper slope Steeper Slope more sensative Profitability Index PV inflows npv r 0 CF1 CFn PV outflows outflow in Y PV inflows PV outflows Profitability index MIRR Solve in for I PV PV outflows FV FV inflows CF1 1 r n CF2 1 r n 1 CFn N periods PMT 0 Crossover Rate Firm A Year Firm B 0 1 2 400 250 280 500 320 340 NPV B A 100 70 1 r 60 1 r 2 IRR 100 70 60 r 20 then plug in and solve for NPV CashFlows Increase in sales op cost Y1 YT Change is NWC Y0 YT Inflation rate Y2 YT Y0 CF s cost of asset opp cost may not always be Y0 increase in inventory increase in AP Y1 CF Increase in Rev increase in op Cost subtract depreciation OI 1 t add back depreciation YT CF Increase in Rev 1 i n Increase in op cost 1 i n subtract depreciation OI t add back depreciation Operating CF Salvage Value Decrease in inventory decrease in AP Additional tax from sale additional tax from sale MV BV t After Tax Salvage Value MV BV MV t if BV 0 MV 1 t MV pretax salvage value Tax Shield OCF OCF x 1 t t annual dep X amount investment will save firm annually Initial Investment Price shipping installation NWC MACRS Accumulated depreciation Acquisition Cost MY1 MY2 MYn BVn Aquistion cost Acquisition Cost MY1 MY2 MYn FCF model Free cashflows discounted by r NPV NPV debt equity MV PV of future cashflows with constant growth assuming growth starts in Yn TVn 1 Yn 1 g r g Total CF Yn 1 CF Yn 1 TVn 1 Solve NPV r Y0 CF1 Total CF Yn 1 P0 D1 Re G DCF Re D1 P0 g OR Re D0 r g P0 g CAPM Re Rf B Rm Rf Rp D Po Rd i 1 t V E D 100 E V D V WACC E V x Re D V x Rd x 1 T WACC E V x Re P V x Rp D V x Rd x 1 T PV Savings WACC growth when determining WACC you use market value of the firm s debt and equity securities Within 1 firm Rd Re Higher t more debt demanded more debt means more return you get on your taxes When deciding between projects if all projects are equally risky then choose projects who have returns WACC after adjusting projects for risk if return is risk adjusted wack Acccept Case 1 Assume no taxes no bankruptcy cost Pi Value of firm is NOT effected by capital structure P2 WACC is not effected by the capital structure RA E V RE D V RD RE RA RA RD D E as D E increase so does RE Assuming Debt is riskless so RD Rf RE Rf BA 1 D E Rm Rf BE Levered Beta BE BA1 D E Case 2 RD no longer Rf Assume tax is deductible but no bankruptcy cost P1 value of the firm increases by the PV of the annual tax shield P2 WACC decreases as he D E increases CFFAL CFFAu yearly tax shield Yearly tax shield t interest PV of annual interest tax shield yearly tax shield interest rate RA E V RE D V RD 1 t RE Ru Ru RD D E 1 t Case 3 Optimal Capital structure occurs where WACC is minimized and stock price is maximized AS D E increase WACC decrease additional value of the interest tax shield will be offset by the expected bankruptcy cost WACC E V RE D V RD 1 tC If D E x then x 1 V Unlevered cost of equity RU RE RU RU RD D E 1 tC Vu EBIT 1 t RU if there is no debt the Vu MVE for Vu Ru Re VL VU t D If 100 Debt VL Vu t Vu Break Even EBIT Ebit interest shares in debt plan Ebit shares in equity plan Ebit interest NI ROE NI equity Change in ROE normal different normal when deciding between a levered and unlevered plan select the unlevered option if expected EBIT is less than the break even level If D E increases then there is MORE debt in the capital structure which means RD is decreasing WACC is decreasing Firms value is increasing Trade off Theory Theory that capital structure is based on a trade off between tax savings and distress costs of debt Pecking Order Theory Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient
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