Business Environment & Concepts 3

Part 1: Factors affecting financial modeling and decision making

1. A financial manager is often required to evaluate the business wisdom of different

alternatives.

2. STEPS NEEDED TO REACH A DECISION

a. Determine Strategic Issue – Identify problems to enhance shareholder/firm value.

b. Identify alternate courses of action

c. Perform analysis of relevant costs and strategic costs

d. Choose an alternative

e. Evaluate performance—Did we make the right decision?

3. Defining Relevant: Revenues and Costs

a. Future revenues and costs are only considered relevant if they change as a result
of selecting different alternatives.

b. Relevant costs can either be fixed or variable, but more often variable b/c they
change with production.

c. Other types of relevant costs:

i. Direct Costs – can be identified or traced to given cost object (generally

variable costs).

ii. Prime Costs– direct material and direct labor

iii. Discretionary Costs – costs arising from periodic (usually annual) budgeting
decisions to spend in areas not directly related to manufacturing.

iv. Incremental (differential) Costs – additional costs incurred to produce

additional unit over present output.

v. Avoidable Costs – results from choosing one alternative over the other

d. NOT RELEVANT

i. Sunk, historical, not avoidable, absorption, historical costs. They have no

effect on the decision.

4. Quantitative v. Qualitative Relevant Information

a. Quantitative

i. Financial – numerical measurements denominated in currency

ii. Non-Financial – numerical measurements denominated in other than currency

(i.e. time)
 b. Qualitative

i. Not numerical

ii. Examples: employee morale and customer satisfaction.

5. Probability

a. Definition: The chance that an event will occur; Assigned values between zero and
one.

b. Objective – based on past outcomes

c. Subjective – based on individual’s belief about a probability (or likelihood that an

outcome will occur)

6. Expected Value

a. Weighted-average of the probable outcomes of a variable

b. Calculation

i. Expected value is found by multiplying the probability of each outcome by its

payoff and summing the results.

Part 2: Financial Modeling for Capital Decisions

1. CAPITAL BUDGETING – Deciding which project to invest in

a. The goal: Present value of cash inflows > Cash outflow

b. Cash Flow Effects:

i. Direct—paying out cash or receiving cash that is directly related to the

capital investment

ii. Indirect—transactions indirectly associated or representing noncash

activities that produce cash benefits or obligations (i.e. depreciation on sale
of old equipment.

c. 3 Stages of cash flow

i. Inception of Project

1. Direct cash flow effects of acquisition

2. Indirect cash flow effects of working capital, anticipated salvage value

of replaced asset

ii. Operations
 1. Annuity – cash flow from operations of the asset that occur on a
regular basis.

2. Depreciation tax shields create ongoing indirect cash flow effects.

iii. Calculation of Pre-tax and After-tax cash flows

1. Pre-tax: larger cash outflows (excepted in the future) than inflows may
indicate that a project is unprofitable.

2. After-tax: Depreciation tax shield = Depreciation expense x

Marginal tax rate

iv. See page 13 for comprehensive example of the three stages.

2. METHODS of CAPITAL BUDGETING

a. DISCOUNTED CASH FLOW (DCF) - General

i. Capital Budgeting techniques that use time value of money concepts to

measure cash inflows and cash outflows of a project as they occur at a single
point in time.

ii. Rate for the project “Hurdle rate”

1. WACC – use if project similar in risk to ongoing projects in the company

2. Discount rate – used if specific project with new/different risk than

ongoing.

iii. Limitations

1. DCF uses simple constant growth; single interest rate assumption.

Unrealistic assumption b/c overtime actual interest rates may
fluctuate.

Types of Discounted Cash Flow Methods:

b. NET PRESENT VALUE METHOD (NPV)

i. Focus on the initial investment amount that is required to purchase (or

invest) in a capital asset that will yield return amounts in excess of a
management designated hurdle (discount) rate.

ii. Calculation steps:

1. Estimate Cash Flows

a. Ignore depreciation – unless adding back tax shield

b. Ignore method of funding – NPV uses hurdle rate, thus method of

funding is independent.

2. Discount the Cash Flows

a. Discount all cash inflow and outflow.

 b. The NPV method assumes that cash flows are reinvested at
same rate used in analysis.

c. Hurdle Rate Options

i. Opportunity cost – best alternative rate the firm could

have invested the same funds in with similar risk.

ii. Management selection – cost of capital, minimum rate of

return based on strategic plans, returns earned in
industry, etc.

d. Adjustments to Rate

i. Risk – discount rates may be increased to include

differences in risk analysis

ii. Inflation – rates may be raised to compensate for

expected inflation

iii. Interpreting Results

1. Positive Result (Result > or = Zero) = MAKE INVESTMENT

a. If result is positive, the rate of return for the project is greater

than hurdle rate

2. Negative Result (Result > Zero) = DO NOT MAKE INVESTMENT

a. If result is negative, the rate of return for the project is less than
hurdle rate

iv. Advantages

1. NPV is flexible and can be used when there is no constant rate

of return.

2. NPV is considered superior to IRR method b/c it is flexible

enough to consistently handle either uneven cash flow or
inconsistent rate of return for each year of project.

v. Disadvantages

1. Do not actually know the rate of return on project.

See page 24/25 for comprehensive example of NPV

c. INTERNAL RATE OF RETURN

i. The IRR is the expected rate of return of a project and is sometimes called
the adjusted rate of return. The IRR method determines the present
value factor that yields an NPV equal to zero.

ii. Computing the IRR

 1. Determine the Life of the Project or Asset

2. Calculate the Payback Period (Present Value Factor

3. Find Proper Present Value Table to Use

4. Locate Present Value Interest Factor

a. Locate the section of the table that equals the life of the project
or asset determined in Step 1. Locate the factor on the table
that is closest to the payback period in step 2.

5. Find Approximate IRR

iii. Interpreting Results

1. ACCEPT when IRR> Hurdle rate

2. REJECT when IRR< Hurdle rate

iv. Advantages: Tells you the actual rate of return

v. Limitations: Unreasonable reinvestment assumption (assumes we can

reinvest at the same ROR – aggressive; whereas NPV assumes reinvest at
same hurdle rate – conservative). Does not consider amount of profit, and
timing of cash flows is misleading.

d. PAYBACK PERIOD METHOD

i. The time period required for the net after-tax cash inflows to recover initial
investment

ii. Objectives: Liquidity (measures time take for recovery of liquid assets) and
Risk (sooner I recover investment the better).

iii. Net Initial Investment = Payback

Increase in annual net after-tax cash flow period

iv. Advantages: Easy to use and understand, emphasis on liquidity

v. Limitations: time value of money ignored, cash flows after recovery not
considered (ROI ignored), total profitability is neglected.

e. DISCOUNTED PAYBACK (or BREAKEVEN TIME METHOD)

i. This variation computes the payback period using expected cash flows that
are discounted by the project’s cost of capital.
 ii. Advantages and limitations are same as w/payback EXCEPT that it
incorporates time value of money which was ignored by previous method.

3. CAPITAL RATIONING

a. Ultimately the decision to invest or not is limited by the amount of capital available
to fund the investment.

b. UNLIMITED CAPITAL

i. If a company has unlimited capital, ALL investment alternative with positive

NPV should be pursued.

c. LIMTED CAPITAL

i. Companies are often restricted by limited resources

ii. If company is down to two mutually exclusive choice, importance of clearly

defined calculations is much more critical

iii. Ranking and acceptance: managers will allocate capital to the combination of
projects with MAXIMUM net present value.

4. PROFITABILITY INDEX

a. If over 1, tells you that the PV of inflows is greater than PV of outflows.

b. PV of net future Cash Inflows = Profitability

PV of net initial investment Index

Part 3: Strategies for Short-Term and Long-Term Financing

I. Trade offs between risk and return

a. Risk Preferences

i. Risk-Indifferent—increase in risk would results in increase in

management’s ROR.

1. Certainty equivalent = expected value

ii. Risk-Averse – increase in risk results in increase in management’s ROR

1. Certainty equivalent < expected value

iii. Risk-Seeking – increase in risk results in decrease in management’s ROR.

1. Certainty equivalent > expected value

b. Diversification
 i. Risk is often reduced by diversification, the process of mixing investments of
different (or offsetting) risks. Not all risk however can be managed this way.

ii. Diversifiable Risk

1. Represents portion of a single asset’s risk that is associated with

random causes and can be eliminated through diversification.

2. Non-market, Unsystematic, or Firm-specific risk

iii. Nondiversifiable Risk

1. Market factors that affect all firms and cannot be eliminated through
diversification.

2. Market or Systematic Risk

II. COMPUTATION OF RETURN

a. Stated (Nominal) Interest Rate

i. Rate charged before any adjustments

ii. The rate shown in the agreement

b. Effective Interest Rate

i. The actual finance charge associated with a borrowing after reducing loan
proceeds for charges and fees.

ii. Compute: Interest Paid / Net proceeds = Effective Interest Rate

c. Annual Percentage Rate

i. Rate required for disclosure by federal regulations

ii. Compute:

1. Step 1 – Compute the effective interest rate

2. Step 2 – Multiply the effective rate by number of periods in a year

d. Effective Annual Percentage Rate

i. The stated interest rate adjusted for the number of compounding periods per
year

ii. Effective annual interest rate = (1+(1/p))p –1

Where i = stated interest rate

And p = compounding periods per year

e. Simple Interest
 i. Interest paid only on the original amount of principal without regard to
compounding

ii. SI = P0 (i)(n) where P0 = original principle, I – interest rate per time

period, n = # periods

f. Compound interest

i. Amount represented by interest earnings or expense that is based upon the

original principle plus any unpaid interest earnings or expense.