Exam summary Topics in Corporate finance

Topics in corporate finance lecture notes
Week 1

Net present value and other investment criteria (assumed pre-knowledge)

 Annuity vs perpetuity
 Valuation of bonds
 Perpetuity/growing perpetuity/annuity formulas


NPV model

 Uses cash flows
o Better to use than earnings
 Uses all cash flows
o Other approaches ignore CFs beyond a certain date
 Discounts cash flows
o Fully incorporates the time value of money
 Weakness of NPV:
o One needs to determine the discount rate

Payback period

 Time taken for initial investment to be repaid out of project net cash inflows
 If PP is shorter than project duration, project should be accepted

Discounted payback

 The length of time required for an investment’s discounted cash flows to equal its initial
cost
 Accept if: discounted payback is less than benchmark

Internal rate of return (IRR)

 The discount rate, which, when applied to the future project cash flows, produces a zero NPV
 If IRR>discount rate, accept the project
 Problems with IRR:
o Ignores the scale of the investment
o Has difficulty with unconventional cash flows

Non-conventional cash flows

 Multiple rates of return
o The possibility that more than one discount rate will make the NPV of an investment
zero
 Rule of thumb
o The max number of IRRs there can be is equal to the number of times that the cash
flows change sign from positive to negative and/or negative to positive

The profitability index

 The present value of an investment’s future cash flows divided by its initial cost. Also called
the benefit‐cost ratio

,Making capital investment decisions

What is relevant for project evaluation?

 Always use cash flows
 Use only incremental cash flows

Operating cash flows

Three moments:

 CFs at the beginning of a project
o Investment cost of the project Io
 CFs during project
o Operating cash flows (OCF)
 CFs at the end of a project
o Salvage value

Calculation of OCFs

Revenues R
-Operating costs (C)
-Depreciation (Depr)
Operating profit before taxes X
‐Taxes on operating profit (T.X)
Net operating profit after taxes X(1-T)
+ Depreciation Depr
-Increase in NWC (NWC)
-Necessary capital expenditures (Capex)
Operating Cash Flows OCF



Why add depreciation?

 Depreciation is a non-cash cost?
 Deducted before taxed and re-added afterwards

Investments in working capital

 NWC = ST assets – ST liabilities
 Short‐term assets:
o Cash, accounts receivable, inventories
 Short‐term liabilities:
o Accounts payable, accruals
 Investments in working capital result in cash outflows

Interest costs?

 NOT included in cash flows, already reflected in discount rate

Relevant cash flow

 A relevant cash flow for a project is a change in the firm’s overall future cash flow that comes
about as a direct consequence of the decision to take that project

, Cost definitions

 Opportunity costs: Opportunity costs are lost revenues that you forego as a result of making
the proposed investment
o Rule :Incorporate Opportunity Costs into your analysis
 Sunk costs: sunk cost is a cash flow that has already occurred
o Rule: Ignore all sunk costs
 Side effects: A side effect is classified as either erosion or synergy
o Erosion is when a new product reduces the cash flows of existing products
o Synergy occurs when a new project increases the cash flows of existing projects
o Rule: Include side affects
 Salvage value:
o CF at the end, include any tax effects

Inflation – general rule

 Nominal CFs must be discounted at a nominal rate
 Real CFs must be discounted at a real rate

(1+Knom) = (1+Kreal)(1+h)

->Practice examples on all these topics in slides!

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Week 2

NPV Model



Principles of capital budgeting

1. Only look at cash flows
2. Only incremental cash flows matter
a. Expansion project
b. Replacement project
3. Ignore sunk costs
4. Take opportunity cost into account
5. Evaluate possible side effects (erosion)
6. Ignore interest costs
7. Treat inflation consistently
8. Do not forget working capital requirements
9. Watch out for tax implications
10. Pick the right risk‐adjusted discount factor

How to determine the discount rate?

1. Listed firms
a. All‐equity financed
b. Levered
2. Unlisted firms
3. Project