1. Why is using the cost of equity to discount project cash flows inappropriate when a firm uses both debt and equity in its capital structure?
The cost of equity is inappropriate as it fails to correctly show the company’s cost of financing. The most appropriate discount rate should reveal the both the cost of debt and the equity financing of the company, given that capital as a resource, has a cost linked to it.
2. Why would a project that reaches the break-even point in terms of net income potentially be bad for shareholders?
For a project to be acceptable, it must cover the cost of capital. The analysis of the break-even point uses EPS, accounting numbers, and EBIT, which have no guarantee of indicating whether a project has positive Net Present Value.
3. Describe how the IRR and NPV approaches are related.
Both the IRR and NPV approaches use time value of the money and at the same time the risks into consideration. For NPV, the risk-adjusted discount rate is used, while for IRR, the risk-adjusted hurdle rate is used.
4. Why do we consider changes in net working capital associated with a project to be cash inflows or outflows?
For every project, a company must start with a given amount of working capital. This initial capital is irrelevant to the cash flows. However, if the company wishes to make changes to the working capital, then the change is relevant to the cash flows.
Exercises
1. Two firms in the same industry have very different equity betas. Offer two reasons why this can occur?
i. When the two firms chose differing capital structures.
ii. When the firms use different amounts of debt financing. The firm that uses less debt financing shall have a lower equity beta while that with more debt financing shall have higher equity beta.
2. Why must manager intuition be part of the investment decision process regardless of a project's NPV or IRR?
A manager must have the capability of explaining the NPV or IRR, based on the manager’s intuition. He/she must be able to give valid reasons for both positive NPV and negative NPV, which is a measure of the competitive advantage. The breaking down of a project into various real options depends on the manager’s intuition. This gives the manager the ability to forecast new possibilities that can result into sustainable competitive advantages.
3. What does it mean if a project has an NPV of $1 million? Explain.
In market capitalization, this is the value that is added to the firm, i.e. $1 million is added to the firm.
4. For what kinds of investments would terminal value account for a substantial fraction of the total project NPV; and for what kinds of investments would terminal value be relatively unimportant?
The terminal value of a project is directly proportional to the rate at which the cash flows grow. If the cash flows grow at a high rate, then the terminal value of the project is high. The terminal value accounts for a substantial fraction of the total project NPV in an investment with higher growth rate of cash flows.
Investments whose cash flows tends to zero in time -- i.e. the cash inflows tends to level off with the cash outflows -- have smaller terminal value. In such investments, the terminal value is relatively unimportant.
Reference
Graham, J., Smart, B. S., and Megginson, L. W. (2009). Corporate Finance: Linking Theory to What Companies Do. 3rd edition. Cengage Learning.
Smart, S., Megginson, W., Gitman, L. (2007). Corporate Finance, 2 edition. Thompson South-Western.
