CHAPTER 6: Risk and return

Intrinsic value: Present value of its expected future free cash flows (FCF) discounted at the
weighted average cost of capital (WACC).

Premise: Investors like returns and dislike risk; this is called risk aversion.

Return on investment: 2 problems: 1) size and 2) time. The rate standardizes

Risk: The chance that some unfavorable event will occur. For an investment is the unfavorable
event is ending up with a lower return than you expected.

Expected rate of return: If we multiply each possible outcome by its probability of occurrence
and then sum these products, the result is a weighted average of outcomes. The weights are
the probabilities, and the weighted average is the expected rate of return.

Payoff matrix: When the outcomes are cash flows or return

Portfolio: Collection of assets.

Correlation: Tendency of two variables to move together, and the correlation coefficient
measures this tendency.

For correlation of −1, the portfolio’s standard deviation can be as low as zero if the portfolio
weights are chosen appropriately. For correlation of +1, the portfolio’s standard deviation is
the weighted average of the stocks’ standard deviations. For correlation between −1 and +1,
the portfolio’s standard deviation is less than the weighted average of the stocks’ standard
deviations.

Market portfolio: Portfolio consisting of all stocks. The part of a stock’s risk that cannot be
eliminated is called market risk, while the part that can be eliminated is called diversifiable
risk.

Beta: a stock with a high standard deviation, σi, will tend to have a high beta, which means
that, other things held constant, the stock contributes a lot of risk to a well-diversified
portfolio. A stock with a high correlation with the market, ρiM, will also tend to have a large
beta and hence be risky. The standard deviation of a well-diversified portfolio, σp, is
approximately equal to the product of the portfolio’s beta and the market standard deviation

(1) Beta measures how much risk a stock contributes to a well-diversified portfolio. (2) The
average of all stocks’ betas is equal to 1; the beta of the market also is equal to 1. (3) A stock
with a beta greater than 1 contributes more risk to a portfolio than does the average stock,
and a stock with a beta less than 1 contributes less risk to a portfolio than does the average
stock. (4) Most stocks have betas that are between about 0.4 and 1.6.

Security market line: A stock’s risk premium is equal to the product of the stock’s beta and the
market risk premium. The higher a stock’s beta, the higher its required rate of return.

Market prices are based on investors’ selection and interpretation of information

Market equilibrium: Expected return = Required return ; Market price = Intrinsic value

Efficient Markets Hypothesis (EMH): (1) stocks are always in equilibrium and (2) it is
impossible for an investor to “beat the market” and consistently earn a higher rate of return
than is justified by the stock’s risk.

Weak-Form Efficiency: All information contained in past price movements is fully reflected in
current market prices. Weak-form efficiency implies that any information that comes from past
stock prices is too rapidly incorporated into the current stock price for a profit opportunity to
exist.

Semistrong-Form Efficiency: Current market prices reflect all publicly available information.
Whenever information is released to the public, stock prices will respond only if the
information is different from what had been expected.

Strong-Form Efficiency: Current market prices reflect all pertinent information, whether
publicly available or privately held.

Market bubbles: (1) prices climb rapidly to heights that would have been considered
extremely unlikely before the run-up; (2) the volume of trading is much higher than past
volume; (3) many new investors (or speculators?) eagerly enter the market; and (4) prices
suddenly fall precipitously, leaving many of the new investors with huge losses. These
instances are called market bubbles.
 CHAPTER 5: Bond, bond valuation, and Interest Rates

Bond: Long-term contract under which a borrower agrees to make payments of interest and
principal, on specific dates, to the holders of the bond. Can be classified in four types: treasury
bonds, corporate bonds, municipal bonds and foreign bonds.

Treasury bonds: Issued by the U.S. federal government. Treasury bond prices decline when
interest rates rise, so they are not free of all risks. Agency debt and GSE debt are not officially
backed by the full faith and credit of the U.S. government, but investors assume that the
government implicitly guarantees this debt, so these bonds carry interest rates only slightly
higher than Treasury bonds.

Corporate bonds: Issued by corporations. Are exposed to default risk.

Municipal bonds: Are issued by state and local governments. The interest earned on most
municipal bonds is exempt from federal taxes and also from state taxes if the holder is a
resident of the issuing state.

Foreign bonds: Are issued by foreign governments or foreign corporations.

Par value: Is the stated face value of the bond. The par value generally represents the amount
of money the firm borrows and promises to repay on the maturity date.

Coupon interest rate: The division between the coupon payment and the par value.

Floating-rate bond: When a coupon’s payment vary over time.

Zero coupon bonds: Pay no coupons at all but are offered at a substantial discount below their
par values and hence provide capital appreciation rather than interest income.

Original issue discount bond: Any bond originally offered at a price significantly below its par
value.

Payment-in-kind bond: Pay coupons consisting of additional bonds (or a percentage of an

additional bond).

Maturity date: Date on which the par value must be repaid.

Call provision: The right of the issuing corporation to call the bonds for redemption.

Refunding operation: Sell the bonds when interest rates are high, then issue low interest
bonds and buy back the high-interest bonds.

Sinking fund provision: Facilitates the orderly retirement of the bond issue. The sinking fund is
used to buy back a certain percentage of the issue each year.

Convertible bonds: Have the option to convert the bonds into a fixed number of shares of
common stock.
Warrants: Options that permit the holder to buy stock at a fixed price, thereby providing a gain
if the price of the stock rises.

Income bond: Is required to pay interest only if earnings are high enough to cover the interest
expense. If earnings are not sufficient, then the company is not required to pay interest and
the bondholders do not have the right to force the company into bankruptcy.

Discount bond: Whenever the going rate of interest rises above the coupon rate, a fixed-rate
bond’s price will fall below its par value, and it is called a discount bond.

Premium bond: In general, whenever the going interest rate falls below the coupon rate, a
fixed-rate bond’s price will rise above its par value, and it is called a premium bond.

Outstanding bond: When a bond is in a market for a while.

1. Whenever the going rate of interest, rd, is equal to the coupon rate, a fixed-rate bond will
sell at its par value. Normally, the coupon rate is set equal to the going rate when a bond is
issued, causing it to sell at par initially.

2. Interest rates do change over time, but the coupon rate remains fixed after the bond has
been issued. Whenever the going rate of interest rises above the coupon rate, a fixed-rate
bond’s price will fall below its par value. Such a bond is called a discount bond.

3. Whenever the going rate of interest falls below the coupon rate, a fixed-rate bond’s price
will rise above its par value. Such a bond is called a premium bond.

4. Thus, an increase in interest rates will cause the prices of outstanding bonds to fall, whereas
a decrease in rates will cause bond prices to rise.

5. The market value of a bond will always approach its par value as its maturity date
approaches, provided the firm does not go bankrupt.

The yield can be calculated in three different ways, and three “answers” can be obtained.

Yield to maturity: The rate of interest you would earn on your investment if you bought the
bond and held it to maturity. The yield to maturity can be viewed as the bond’s promised rate
of return, which is the return that investors will receive if all the promised payments are made.
However, the yield to maturity equals the expected rate of return only if (1) the probability of
default is zero and (2) the bond cannot be called. If either happens, there is some probability
that the promised payments to maturity will not be received, in which case the calculated yield
to maturity will differ from the expected return.

Yield to call: Valuation at the call time.

Current yield: The current yield is the annual interest payment divided by the bond’s current
price. The current yield provides information regarding the amount of cash income that a bond
will generate in a given year, but it does not provide an accurate measure of the bond’s total
expected return, the yield to maturity.
Determinants of the market interest rates:

Real risk-free interest (r*): The interest rate that would exist on a riskless security if no
inflation were expected, and it may be thought of as the rate of interest on short-term U.S.
Treasury securities in an inflation-free world.

Inflation premium (IP): Equal to the average expected inflation rate over the life of the
security.

Nominal, or quoted, risk-free rate (rRF): Is the real risk-free rate plus a premium for expected
inflation.

Default risk premium:

Bond indentures: Legal document that spells out the rights of both bondholders and the
issuing corporation.

Mortgage bonds: Pledging assets as securities

Debenture: Is an unsecured bond, and as such it provides no lien against specific property as
security for the obligation.

Bond ratings are based on both quantitative and qualitative factors: 1) Financial ratios, 2) Bond
contract terms, and 3) Qualitative factors.

Bond spread: Is the difference between a bond’s yield and the yield on some other security of
the same maturity. Unless specified differently, the term “spread” generally means the
difference between a bond’s yield and the yield on a Treasury bond of similar maturity.

Liquidity premium (LP):

Interest rate risk: Interest rates go up and down over time, and an increase in interest rates
leads to a decline in the value of outstanding bonds. This risk of a decline in bond values due to
rising interest rates is called interest rate risk.

Reinvestment risk: The risk of an income decline due to a drop in interest rates is called
reinvestment rate risk. Reinvestment rate risk is obviously high on callable bonds. It is also high
on short-maturity bonds, because the shorter the maturity of a bond, the fewer the years
when the relatively high old interest rate will be earned and the sooner the funds will have to
be reinvested at the new low rate.
 CHAPTER 7: Valuation of stocks and corporations

Preemptive right: Right to purchase any additional shares sold by the firm. It enables current
stockholders to maintain control, and it also prevents a transfer of wealth from current
stockholders to new stockholders

Tracking or target stock: To separate the cash flows and to allow separate valuations,
occasionally a company will have classes of stock with dividends tied to a particular part of a
company.

Quote (stock market reporting): Gives the total market value of GE’s common stock (the
Market Cap), the dividend, the dividend yield, the most recent “ttm” (“trailing twelve months”)
EPS and P/E ratios, and a graph showing the stock’s performance during the day.

Definitions of terms used in stock valuation models:

Constant growth model or Gordon model: A necessary condition for the validity of Equation 7-
2 is that rs be greater than g. If g is greater than rs then the constant growth model cannot be
used, and the answer you would get from using Equation 7-2 would be wrong and misleading.

The concept underlying the valuation process for a constant growth stock is graphed in Figure
7-2. Thus, the expected dividends are growing, but the present value of each successive
dividend is declining, because the dividend growth rate (8%) is less than the rate used for
discounting the dividends to the present (13.4%).

Do Stock Prices Reflect Long-Term or Short-Term Events?: More than 80% of a typical
company’s stock price is due to cash flows expected farther than 5 years in the future. Short-
term quarterly earnings themselves might not contribute a large portion to a stock’s price, but
the information they convey about future prospects can be extremely important. Ready
availability of information causes stock prices to be volatile.

Expected Rate of Return on a Constant Growth Stock:

For a constant growth stock, the following conditions must hold:

 The dividend is expected to grow forever at a constant rate, g.

 The stock price will also grow at this same rate.
 The expected dividend yield is constant.
 The expected capital gains yield is also constant and is equal to g, the dividend (and stock
price) growth rate.
 The expected total rate of return, ^rs, is equal to the expected dividend yield plus the
expected growth rate: ^rs= dividend yield + g

Valuing nonconstant growth stocks:

A stock’s estimated value today, P0 ^ , is the present value of the dividends during the
nonconstant growth period plus the present value of the dividends after the horizon date.

The stock’s current estimated value is the present value of all dividends during the
nonconstant growth period plus the present value of the horizon value:

 Estimate the expected dividends for each year during the period of nonconstant growth.
 Find the expected price of the stock at the end of the nonconstant growth period, at
which point it has become a constant growth stock.
 Find the present values of the expected dividends during the nonconstant growth period
and the present value of the expected stock price at the end of the nonconstant growth
period. Their sum is the estimated value of the stock, P0 ^.

Sources of value:

 Primary source: Value of operations.

 Secondary source: Nonoperating assets (also called financial assets). There are two major
types of nonoperating assets: (1) marketable securities, which are short-term securities
(like T-bills) that are over and above the amount of cash needed to operate the business;
(2) other nonoperating assets, which often are investments in other businesses.

Estimating the value of operations: The free cash flow (FCF) model is analogous to the
dividend growth model, except the FCF valuation model (1) discounts free cash flows instead
of dividends and (2) the discount rate is the weighted average cost of capital (WACC) instead
of the required return on stock.
 Recognize that growth after Year N will be constant, so we can use a constant growth
formula to find the firm’s value at Year N. The value at Year N is the sum of the PVs of FCF
for year N + 1 and all subsequent years, discounted back to Year N.
 Find the PV of the free cash flows for each of the N nonconstant growth years. Also, find
the PV of the firm’s value at Year N.
 Now sum all the PVs, those of the annual free cash flows during the nonconstant period
plus the PV of the Year-N value, to find the firm’s value of operations.

 If you are estimating the value of a mature company whose dividends are expected to
grow steadily in the future, you would need to use the dividend growth model. You only
would need to estimate the growth rate in dividends, not the entire set of forecasted
financial statements.
 If a company is paying a dividend but is still in the high-growth stage of its life cycle, you
would need to project the future financial statements before you could make a
reasonable estimate of future dividends. After you have estimated future financial
statements, it would be a toss-up as to whether the corporate valuation model or the
dividend growth model would be easier to apply. If you were trying to estimate the value
of a company that has never paid a dividend, a private company (including companies
nearing an IPO), or a division of a company, then there would be no choice: You would
have to estimate future financial statements and use the corporate valuation model.

Market multiple analysis: The analyst chooses a metric for the firm—say, its EPS—and then
multiplies the company’s EPS by a market-determined multiple such as the average P/E ratio
for a sample of similar companies. This would give an estimate of the stock’s intrinsic value.
Market multiples can also be applied to total net income, to sales, to book value, or to number
of subscribers for businesses such as cable TV or cellular telephone systems. Whereas the
discounted dividend method applies valuation concepts by focusing on expected cash flows,
market multiple analysis is more judgmental.

Preferred stock: The dividends on preferred stock are fixed, and if they are scheduled to go on
forever, the issue is a perpetuity whose value is found as follows:

Vps is the value of the preferred stock, Dps is the preferred dividend, and rps is the required
rate of return.
 CHAPTER 9: Cost of capital

The weighted average cost of capital:

The Before-Tax Cost of Short-Term Debt (rstd): Short-term debt should be included in the
capital structure only if it is a permanent source of financing in the sense that the company
plans to continually repay and refinance the short-term debt.

The Before-Tax Cost of Long-Term Debt (rd): The relevant cost is the marginal cost of new
debt to be raised during the planning period. For bonds with a relatively low expected default
rate, we recommend using the yield to maturity. But for bonds with high expected default
rates, it would be necessary to do a scenario analysis to estimate the bond’s expected return.

The After-Tax Cost of Debt: rd(1 − T) and rstd(1 − T):

Flotation Costs and the Cost of Debt: Here M is the bond’s maturity (or par) value, F is the
percentage flotation cost (i.e., the percentage of proceeds paid to the investment bankers), N
is the number of payments, T is the firm’s tax rate, INT is the dollars of interest per period, and
rd(1 − T) is the after-tax cost of debt adjusted for flotation costs.
Cost of Preferred Stock, (rps): For preferred stock with a stated maturity date, we use the
same approach as in the previous section for the cost of debt, keeping in mind that a firm has
no tax savings with preferred stock. For preferred stock without a stated maturity date, rps is:

Cost of Common Stock: The Market Risk Premium (RPM): Three approaches may be used to
estimate the market risk premium: (1) calculate historical premiums and use them to estimate
the current premium; (2) survey experts; and (3) use the current value of the market to
estimate forward-looking premiums

Using the CAPM to Estimate the Cost of Common Stock (rs): The firm should earn on its
reinvested earnings at least as much as its stockholders could earn on alternative investments
of equivalent risk.

Dividend-Yield-Plus-Growth-Rate, or Discounted Cash Flow (DCF), Approach: If an investor

expects dividends to grow at a constant rate and if the company makes all payouts in the form
of dividends (the company does not repurchase stock), then the price of a stock is as follows:

Investors expect to receive a dividend yield, D1/P0, plus a capital gain, g, for a total expected
return of r^ s. In equilibrium this expected return is also equal to the required return, rs. This
method of estimating the cost of equity is called the discounted cash flow, or DCF, method.
Henceforth, we will assume that markets are at equilibrium (which means that rs = r^s), and
this permits us to use the terms rs and r^ s interchangeably.

Estimating Inputs for the DCF Approach: Three inputs are required to use the DCF approach:
the current stock price, the current dividend, and the marginal investor’s expected dividend
growth rate.

The payout ratio is the percent of net income that the firm pays out in dividends, and the
retention ratio is the complement of the payout ratio: Retention ratio = (1 − Payout ratio). The
earnings growth rate depends on the amount of income the firm retains and the rate of return
it earns on those retained earnings, so the retention growth equation is as follows:
Although easy to implement, this approach requires four major assumptions: (1) the payout
rate, and thus the retention rate, remain constant; (2) the ROE on new investments remains
constant and equal to the ROE on existing assets; (3) the firm is not expected to repurchase or
issue new common stock, or, if it does, this new stock will be sold at a price equal to its book
value; and (4) future projects are expected to have the same degree of risk as the firm’s
existing assets. Unfortunately, these assumptions apply in very few situations, limiting the
usefulness of the retention growth model.

The Weighted Average Cost of Capital (WACC): First, the WACC is the cost the company would
incur to raise each new, or marginal, dollar of capital—it is not the average cost of dollars
raised in the past. Second, the percentages of each capital component, called weights, should
be based on management’s target capital structure, not on the particular sources of financing
in any single year. Third, the target weights should be based on market values and not on book
values.

Adjusting the Cost of Equity for Flotation Costs: What rate of return must be earned on new
investments to make issuing stock worthwhile? The answer, for a constant growth firm, is
found by applying this formula:

Four factors the firm cannot control: Four factors are beyond managerial control: (1) interest
rates, (2) credit crises, (3) the market risk premium, and (4) tax rates.

Three factors the firm can control: A firm can affect its cost of capital through (1) its capital
structure policy, (2) its dividend policy, and (3) its investment (capital budgeting) policy.
 CHAPTER 15: Capital structure decisions

The value of a firm’s operations is the present value of its expected future free cash flows (FCF)
discounted at its weighted average cost of capital (WACC):

The WACC of a firm financed only by debt and common stock depends on the percentages of
debt and common stock (wd and ws), the cost of debt (rd), the cost of stock (rs), and the
corporate tax rate (T):

Business risk: The risk a firm’s common stockholders would face if the firm had no debt. It is
the risk inherent in the firm’s operations, which arises from uncertainty about future operating
profits and capital requirements. If a high percentage of a firm’s costs are fixed and hence do
not decline when demand falls, then the firm has high operating leverage, which increases its
business risk.

Operating leverage: A high degree of operating leverage implies that a relatively small change
in sales results in a relatively large change in EBIT, NOPAT, ROIC, ROA, and ROE. The higher a
firm’s fixed costs, the greater its operating leverage. Higher fixed costs are generally associated
with (1) highly automated, capital intensive firms; (2) businesses that employ highly skilled
workers who must be retained and paid even when sales are low; and (3) firms with high
product development costs that must be maintained to complete ongoing R&D projects.

Operating break-even point:

Modigliani and Miller – No taxes: MM’s study was based on assumptions: 1) There are no
brokerage costs, 2) There are no taxes, 3) There are no bankruptcy costs, 4) Investors can
borrow at the same rate as corporations, 5) All investors have the same information as
management about the firm’s future investment opportunities, and 6) EBIT is not affected by
the use of debt. Modigliani and Miller imagined two hypothetical portfolios. The first contains
all the equity of an unlevered firm, and the second is partially financed with debt. The cash
flow of each portfolio is equal to EBIT, so MM concluded that two portfolios producing the
same cash flows have the same value:

MM proved that a firm’s value is unaffected by its capital structure.

Modigliani and Miller – The effect of the corporate taxes: Interest payments reduce the taxes
a corporation pays, and if a corporation pays less to the government, then more of its cash
flow is available for investors: the tax deductibility of the interest payments shields the firm’s
pre-tax income. MM introduced a second important way of looking at the effect of capital
structure: The value of a levered firm is the value of an otherwise identical unlevered firm plus
the value of any “side effects.” MM focused on the tax shield:

The present value of the tax shield is equal to the corporate tax rate, T, multiplied by the
amount of debt, D:

The optimal capital structure is virtually 100% debt. MM also showed that the cost of equity,
rs, increases as leverage increases but that it doesn’t increase quite as fast as it would if there
were no taxes. As a result, under MM with corporate taxes the WACC falls as debt is added.

Miller: The Effect of Corporate and Personal Taxes: On average, returns on stocks are taxed at
lower effective rates (Ts) than returns on debt. As Miller pointed out, (1) the deductibility of
interest favors the use of debt financing, but (2) the more favorable tax treatment of income
from stock lowers the required rate of return on stock and thus favors the use of equity
financing. Miller showed that the net impact of corporate and personal taxes is given by this
equation:

Here Tc is the corporate tax rate, Ts is the personal tax rate on income from stocks, and Td is
the tax rate on income from debt.

Trade-off theory: The results of Modigliani and Miller also depend on the assumption that
there are no bankruptcy costs. Bankruptcy-related costs have two components: (1) the
probability of financial distress and (2) the costs that would be incurred if financial distress
does occur. The trade-off theory says that the value of a levered firm is equal to the value of an
unlevered firm plus the value of any side effects, which include the tax shield and the expected
costs due to financial distress.
Signaling theory: The announcement of a stock offering is generally taken as a signal that the
firm’s prospects as seen by its own management are not good; conversely, a debt offering is
taken as a positive signal.

Reverse borrowing capacity: Firms should, in normal times, use more equity and less debt
than is suggested by the tax benefit–bankruptcy cost trade-off model.

Implications for managers: i) A firm whose sales are relatively stable can safely take on more
debt and incur higher fixed charges than a company with volatile sales. A firm with less
operating leverage is better able to employ financial leverage because it will have less business
risk and less volatile earnings. ii) Stable sales and lower operating leverage provide tax benefits
but also reduce the probability of financial distress

Estimating the optimal capital structure: There are several steps in the analysis of each
potential capital structure: (1) Estimate the interest rate the firm will pay. (2) Estimate the cost
of equity. (3) Estimate the weighted average cost of capital. (4) Estimate the value of
operations, which is the present value of free cash flows discounted by the new WACC.

An increase in the debt ratio also increases the risk faced by shareholders, and this has an
effect on the cost of equity, rs. Beta increases with financial leverage. The Hamada equation
specifies the effect of financial leverage on beta:

D is the market value of the debt and S is the market value of the equity. The Hamada
equation shows how increases in the market value debt/equity ratio increase beta. Here bU is
the firm’s unlevered beta coefficient—that is, the beta it would have if it had no debt. In that
case, beta would depend entirely on business risk and thus be a measure of the firm’s “basic
business risk.”

The ratio wd/ws is equal to the ratio D/S. Substituting these values gives us another form of
Hamada’s formula:

As the debt ratio increases, the costs of both debt and equity rise, at first slowly but then at an
accelerating rate. Eventually, the increasing costs of these two components offset the fact that
more debt (which is still less costly than equity) is being used. Also note that, even though the
component cost of equity is always higher than that of debt, only using debt would not
maximize value. If Strasburg were to issue more than 40% debt, then the costs of both debt
and equity would increase in such a way that the overall WACC would increase, because the
cost of debt would increase by more than the cost of equity.

Anatomy of a recapitalization: Means that a company should issue enough additional debt to
optimize its capital structure, and then use the debt proceeds to repurchase stock.
New issuance of debt: The issuance of debt and the resulting change in the optimal capital
structure caused (1) the WACC to decrease, (2) the value of operations to increase, (3)
shareholder wealth to increase, and (4) the stock price to increase.

Repurchase of stock: The total cash raised is equal to DNew − DOld. The number of shares
repurchased is equal to the cash raised by issuing debt divided by the repurchase price:

The number of remaining shares after the repurchase, nPost, is equal to the initial number of
shares minus the number that is repurchased:

The change in capital structure added wealth to the shareholders, increased the price per
share, and increased the cash (in the form of short-term investments) temporarily held by the
company. However, the repurchase itself did not affect shareholder wealth or the price per
share. The repurchase did reduce the cash held by the company and the number of shares
outstanding, but shareholder wealth stayed constant. The repurchase simply the funds out of
the company’s account and puts them into the shareholders’ personal accounts.

After the recap is completed, the percentage of equity in the capital structure, based on
market values, is equal to 1 − wd if the firm holds no other short-term investments. Therefore,
the value of equity after the repurchase is

The post-repurchase number of shares can be found using this equation:

Given the value of equity and the number of shares, it is straightforward to calculate the
intrinsic price per share as PPost = SPost/nPost. But we can also calculate the post repurchase
price using

The number of shares goes down as debt goes up because the debt proceeds are used to buy
back stock. The capital structure that maximizes stock price, wd = 40%, is the same capital
structure that optimizes the WACC and the value of operations. Maximizing EPS will not
maximize shareholder wealth.
 CHAPTER 10: The basics of capital budgeting: Evaluating CF’s

Capital budgeting: Whole process of analyzing projects and deciding which ones to accept and
thus include in the capital budget. The whole process of analyzing projects and deciding which
ones to accept and thus include in the capital budget: 1) Replacement needed to continue
profitable operations, 2) Replacement to reduce costs, 3) Expansion of existing products or
markets, 4) Expansion into new products or markets, 5) Contraction decisions, 6) Safety and/or
environmental projects, 7) Other, 8) Mergers.

The following measures have been established for screening projects and deciding which to
accept or reject: 1) Net Present Value (NPV), 2) Internal Rate of Return (IRR), 3) Modified
Internal Rate of Return (MIRR), 4) Profitability Index (PI), 5) Regular Payback, 6) Discounted
Payback.

Project analysis: 1) Estimate the project’s expected cash flow, 2) Calculate evaluation
measures.

Net Present Value (NPV): Is defined as the present value of a project’s expected cash flows
(including its initial cost) discounted at the appropriate risk-adjusted rate. It measures how
much wealth the project contributes to shareholders.

We can calculate NPV with the following steps. 1) Calculate the present value of each cash flow
discounted at the project’s risk-adjusted cost of capital, 2) The sum of the discounted cash
flows is defined as the project’s NPV.

The cash flows for independent projects are not affected by other projects. Mutually exclusive
projects, on the other hand, are two different ways of accomplishing the same result, so if one
project is accepted then the other must be rejected.

Internal Rate of Return (IRR): Is the discount rate that forces the PV of the expected future
cash flows to equal the initial cash flow. If a project’s cash flows have a nonnormal pattern
(i.e., the cash flows have more than one sign change), it is possible for the project to have
more than one positive real IRR. If the sign changes more than once, don’t even calculate the
IRR, because it is at best useless and at worst misleading.

If projects are mutually exclusive, managers should choose the project that provides the
greatest increase in wealth (as measured by the NPV) even though it may not have the highest
rate of return (as measured by the IRR).

The crossover rate is where to IRRs cross at each other. A crossover rate only can exist for
projects with positive NPVs if the cash flows have timing differences, size (or scale) differences,
or some combination.

Modified internal rate of return (MIRR): Is similar to the regular IRR, except it is based on the
assumption that cash flows are reinvested at the WACC (or some other explicit rate if that is a
more reasonable assumption).

The MIRR has two significant advantages over the regular IRR. First, the MIRR assumes that
cash flows are reinvested at the cost of capital (or some other explicit rate). Because
reinvestment at the IRR is generally not correct, the MIRR is usually a better indicator of the
rate of return on the project and its reinvested cash flows. Second, the MIRR eliminates the
multiple IRR problem—there can never be more than one MIRR, and it can be compared with
the cost of capital when deciding to accept or reject projects.

Our overall conclusions are that (1) the MIRR is superior to the regular IRR as an indicator of a
project’s “true” rate of return, but (2) NPV is better than either IRR or MIRR. If managers want
to know the expected rates of return on projects, it would be better to give them MIRRs than
IRRs because MIRRs are more likely to be the rates that are actually earned if the projects’ cash
flows are reinvested in future projects.

Profitability Index (PI): Shows the relative profitability of any project, or the present value per
dollar of initial cost. A project is acceptable if its PI is greater than 1.0, and the higher the PI,
the higher the project’s ranking.

Payback Period: Defined as the number of years required to recover the funds invested in a
project from its operating cash flows. We start with the project’s cost, a negative number, and
then add the cash inflow for each year until the cumulative cash flow turns positive. The
payback year is the year prior to full recovery, plus a fraction equal to the shortfall at the end
of the prior year divided by the cash flow during the year when full recovery occurs:

The regular payback has three flaws: (1) Dollars received in different years are all given the
same weight—that is, the time value of money is ignored. (2) Cash flows beyond the payback
year are given no consideration whatsoever, regardless of how large they might be. (3) Unlike
the NPV or the IRR, which tell us how much wealth a project adds or how much a project’s rate
of return exceeds the cost of capital, the payback merely tells us how long it takes to recover
our investment. There is no necessary relationship between a given payback period and
investor wealth, so we don’t know how to specify an acceptable payback.

To counter the first criticism, financial analysts developed the discounted payback, where cash
flows are discounted at the WACC and then those discounted cash flows are used to find the
payback.

Issues in capital budgeting: Three other issues in capital budgeting are discussed in this
section: (1) how to deal with mutually exclusive projects whose lives differ; (2) the potential
advantage of terminating a project before the end of its physical life; and (3) the optimal
capital budget when the cost of capital rises as the size of the capital budget increases.

CHAPTER 11: Cash flow estimation and risk analysis

Incremental cash flows: The differences between the cash flows the firm will have if it
implements the project versus the cash flows it will have if it rejects the project.

Relevant costs:

Depreciation must be added back when estimating a project’s operating cash flow.

You should not subtract interest expenses when finding a project’s cash flows.

A sunk cost is an outlay related to the project that was incurred in the past and that cannot be
recovered in the future regardless of whether or not the project is accepted. Therefore, they
are not incremental costs and thus are not relevant in a capital budgeting analysis.

Another conceptual issue relates to opportunity costs related to assets the firm already owns.

Externalities are the effects of a project on other parts of the firm or on the environment and
should be considered: i) negative within-firm externalities (cannibalization), ii) positive within-
firm externalities (complimentary), and iii) environmental externalities.

Cash flow projections: Estimating the Net Operating Tax after Taxes (NOPAT): Negative taxes
should be considered because it can shelter income for the company if it has profit in other
projects.

Risk analysis in capital budgeting:

 Stand-alone risk is a project’s risk assuming (a) that it is the firm’s only asset and (b) that
each of the firm’s stockholders holds only that one stock in his portfolio. Stand-alone risk
ignores diversification by both the firm and its stockholders
 Within-firm risk (also called corporate risk) is a project’s risk to the corporation itself.
Within-firm risk recognizes that the project is only one asset in the firm’s portfolio of
projects; hence some of its risk is eliminated by diversification within the firm. However,
within-firm risk ignores diversification by the firm’s stockholders.
 Market risk (also called beta risk) is the risk of the project as seen by a welldiversified
stockholder who recognizes that (a) the project is only one of the firm’s projects and (b)
the firm’s stock is but one of her stocks.

Sensitivity analysis: Measures the percentage change in NPV that results from a given
percentage change in an input variable when other inputs are held at their expected values.

Scenario analysis: What would happen to the project’s NPV if several of the inputs turn out to
be better or worse than expected? Also, scenario analysis allows us to assign probabilities to
the base (or most likely) case, the best case, and the worst case; then we can find the expected
value and standard deviation of the project’s NPV to get a better idea of the project’s risk.

Monte carlo simulation: In a simulation analysis, a probability distribution is assigned to each

input variable—sales in units, the sales price, the variable cost per unit, and so on. The
computer begins by picking a random value for each variable from its probability distribution.
Those values are then entered into the model, the project’s NPV is calculated, and the NPV is
stored in the computer’s memory (trial). After completing the first trial, a second set of input
values is selected from the input variables’ probability distributions, and a second NPV is
calculated. This process is repeated many times. The NPVs from the trials can be charted on a
histogram, which shows an estimate of the project’s outcomes. The average of the trials’ NPVs
is interpreted as a measure of the project’s expected NPV, with the standard deviation (or the
coefficient of variation) of the trials’ NPV as a measure of the project’s risk.