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Cfa1 5 Corporate Finance Notes

Finance Notes > CFA Level 1 Notes

This is an extract of our Cfa1 5 Corporate Finance document, which we sell as part of our CFA Level 1 Notes collection written by the top tier of University Of London (examined By LSE) students.

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CFA Level 1

Corporate Finance

Capital Budgeting
Capital Budgeting Process
 Generate investment ideas
 Analyze individual proposals
 Plan the capital budget
 Monitor and post-audit the project
Categories of Capital Budgeting Process
 Replacement project
 Expansion project
 New products / services
 Regulatory / Safety / Environmental project
Basic Principles of Capital Budgeting
 Decisions are based on cash flows
 Timing of cash flows is crucial
 Cash flows are based on opportunity costs
 Cash flows are analyzed on an after-tax basis
 Financing costs are ignored (NPV based on the required rate of return)
 Capital Budgeting cash flows are not accounting net income (e.g. no depreciation)
Important Capital Budgeting Concepts
Sunk Cost
 Cost that has already incurred
Opportunity Cost
 Benefit foregone by selecting one alternative over another
Incremental Cash Flow
 Difference between cash flows with and without the project
Externality
 Effect of an investment on other things besides the investment itself
Cannibalization
 Occur when investment takes customers and sales away from another part of the firm
Conventional Cash Flow 1 CFA Level 1

Corporate Finance

 Patten of cash flow with an initial outflow followed by a series of inflows
Unconventional Cash Flow
 Patten of cash flow different from conventional cash flow
Projects Obscuring Incremental Cash Flow Analysis
 Independent Projects
 Mutually Exclusive Projects
 Project Sequencing
 Projects with Unlimited Funds
 Capital Rational Projects

Investment Decision Criteria
Net Present Value (NPV)
 Invest if NPV > 0
 Not invest if NPV < 0
 The project with a higher NPV should be chosen
 Initial Outlay (IO)
 NPV = CF0 + CF1 / (1 + R)1 + CF2 / (1 + R)2 + … + CFN / (1 + R)N - IO
Internal Rate of Return (IRR) (Set NPV = 0)
 Accept the project: IRR > Opportunity Cost of Capital (Hurdle Rate)
 Reject the project: IRR < Opportunity Cost of Capital (Hurdle Rate)
 The project with a higher IRR should be chosen
 0 = CF0 + CF1 / (1 + IRR)1 + CF2 / (1 + IRR)2 +… + CFN / (1 + IRR)N - IO
Undiscounted Payback Period
 No. of years required to recover the initial outlay
Discounted Payback Period
 No. of years needed for cumulative discounted CFs of a project to equal IO
Average Accounting Rate of Return (AAR)
 AAR = Average Net Income / Average Book Value
 Average Book Value = (Initial Outlay - Residual Value) / 2
Profitability Index (PI)
 Present value of a project's future cash flows divided by IO
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Corporate Finance

Invest if PI > 1
Not Invest if PI < 1
PI = PV of Future Cash Flows / IO
PI = 1 + NPV / IO

Cost of Capital
 Rate of return that the suppliers of capital (e.g. bondholders and owners) require as compensation for their contribution of capital
Marginal Cost of Capital (MCC)
 Amount that would be cost to raise additional funds for an investment project
Weighted Average Cost of Capital (WACC)
 Weight average of the proportions of the various sources of capital that the company uses to support its investment program
Marginal Tax Rate (T)
 Additional tax rate results from an increase in income
 Weight of Debt Financing (Long-term Debt) (D)
 Weight of Equity Financing (Ordinary Shares) (E)
 Weight of Preferred Equity Financing (Preferred Shares) (P)
 Marginal Cost of Debt (before Tax) (RD)
 Marginal Cost of Common Stock (RE)
 Marginal Cost of Preferred Stock (RP)
 WACC = D RD (1 - T) + E RE + P RP
Preferred Stock
 Can be viewed as long-term debt or equity depending on accounting principles
Converting D/E Ratio into Weights
 D = D / (D + E)
 E = E / (D + E)
MMC Schedule
 Represents the cost of capital faced by the firm
 Cost of Capital (Y-axis), Required Capital (X-axis)
Investment Opportunity Schedule (IOS)
 Represents the projects that are available to the firm
 Rate of Return (Y-axis), Required Capital (X-axis)
3 CFA Level 1

Corporate Finance

Optimal Capital Budget
 Intersection of MMC Schedule with IOS
Cost of Debt
 Incurred when a firm issued bonds for debt financing
 Tax-deductible
Calculating the Cost of Debt
Yield-to-Maturity Approach
 Current Market Price of Bond (P0) (PV)
 Interest Payment per Period (PMT)
 Yield to Maturity (RD)
 No. of Periods (N)
 Maturity Value of Bond (FV)
 PV = PMT / (1 + RD) + PMT / (1 + RD)2 + … + (PMT + FV) / (1 + RD)N
 Before-tax Cost of Debt = RD
 After-tax Cost of Debt = RD (1 - T)
Debt-Rating Approach
 Used when PV is not available
 RD is based on the credit rating of the firm
 RD = Yield on debt of other firms with the same credit rating and similar maturity
 After-tax Cost of Debt = RD (1 - T)
Things Affecting the Cost of Debt
 Fixed-Rate Debt vs Floating-Rate Debt
 Debt with Optionlike Features
 Nonrated Debt
 Financing Lease (Long-term Borrowing)
Cost of Preferred Stock
 Incurred when a firm issues preferred stock and pay preferred dividends
 No maturity date and at a fixed rate (e.g. perpetuity)
 Not tax-deductible
 Current Preferred Stock Price per Share (PP)
 Preferred stock dividend per Share (DP)
 Cost of Preferred Stock (RP)
 P P = D P / RP
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Corporate Finance

 RP = DP / PP
Things Affecting Cost of Preferred Stock
 Convertibility
 Callability
 Cumulative Dividends
 Participating Dividends
 Adjustable-rate Dividends
Cost of Equity (Common Stock)
 Rate of return required by common shareholders
Capital Asset Pricing Model (Single-factor Model) (CAPM)
 RD = RF -  (RM - RF)
 Risk-free Rate of Return (RF)
 Sensitivity to Market Risk ()
 Expected Market Return (RM)
 Market Risk Premium or Equity Risk Premium (RM - RF)
Multifactor CAPM
 RD = RF - 1 (R1 - RF) + 1 (R2 - RF) + … + N (RN - RF)
 Expected Return of Bearing Factor Risk 1 (R1)
 Expected Return of Bearing Factor Risk 2 (R2)
 Expected Return of Bearing Factor Risk N (RJ)
 Sensitivity to Factor Risk 1 (1)
 Sensitivity to Factor Risk 2 (2)
 Sensitivity to Factor Risk N (N)
Dividend Discount Model Approach
 Current Market Price per Share of Common Equity (P0)
 Estimated Dividend in Next Period (D1)
 Current Dividend (D0)
 Expected Growth Rate of Dividend (G)
 P0 = D1 / (RE - G)
 RE = (D1 / P0) + G
 RE = [D0 (1 + G)] / P0) + G
Computing Growth Rate
 Dividend Payout Ratio (D / EPS)
 Historical Return on Equity (ROE) = Net Income / Common Equity 5 CFA Level 1

Corporate Finance

 Retention Rate = 1 - (D / EPS)
 G = (1 - D / EPS)  ROE
Bond Yield plus Risk Premium Approach
 RE = RD + Risk Premium
Things Affecting Cost of Equity
 Uncertain future cash flow
 Potential Share Dilution
 Uncertain Dividend Payout

Estimating Beta
Regression Model for Estimating Beta
 Expected Rate of Return of Stock (E(R))
 Estimated Intercept (a)
 Estimated Slope ()
 R = a +  (RM)
Factors Affecting Estimation
 Estimation Period
 Periodicity of the Return Interval
 Selection of an Appropriate Market Index
 Use of a Smoothing Technique
 Adjustments for Small-capitalization Stocks
Components of Beta
 Business Risk (Operating Risk, Sales Risk)
 Financial Risk
Pure-play Method for Estimation of Beta
 Use a comparable publicly traded company's beta and adjust it for financial leverage difference
(debt financing)
Steps in Using Pure-Play Method
 Select the comparable
 Estimate comparable's beta
 Unlever the comparable's beta
 Lever the beta for the project's financial risk 6

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