FINANCIAL MARKETS REVIEWER FINALS
Cost of Capital
Cost of Capital - provides a way to link investment and
financing decisions of a firm.
Cost of Capital in Capital Budgeting - cost of capital is the
fundamental requirement of capital budgeting technique
especially based on discounted cash flows.
Cost of Capital in Determination of Capital Structure -
cost of debt is considered at lower rate in comparison to
equity.
Cost of Capital and Financial Performance of the Firm -
the average cost of capital of a firm represent risk and return
of the firm.
Cost of Capital and Financial Decisions - cost of capital has
more usages in financial decision making, involves business
risk policy as well as financial risk recognizing time value of
money in optimum manner.
Cost of Capital and External Users - cost of capital is useful
in decision making for internal as well as external users.
Before Tax or After Tax - corporate tax affects associated
with financing can be incorporated in determination of cost of
capital.
Historical Cost of Future Cost - decision-making process of
financial management.
Average Cost Capital - combined cost of capital of all
components of capital
Average Cost - weighted average cost of capital
Marginal Cost - is an additional cost to raise additional
funds.
Floating cost - relevant when a firm raises new financing.
Additional outflow that increases the initial cash outlay of an
investment.
Explicit cost - cost which is directly connected with the
subject matter.
Implicit Cost - refers to opportunity cost.
Depreciation - internally generated source of funds.
Redeemable Debt - debts are issued for predetermined period
and has to redeem on maturity.
Long-term Investment Decisions
Capital Budgeting - is the process a business undertakes to
evaluate potential major projects or investments.
Investment Appraisal - is also known as the capital
budgeting process
Replacement: needed to continue current operations -
should the operation be continued if so, should the firm
continue to use the same production process.
Replacement: cost reduction - to replace serviceable but
obsilete equipment and thereby to lower the cost
Expansion of existing products or markets - require an
explicit forecase growth in demand
Expansion into new products or markets - involve strategic
decisions that could change the fundamental nature of the
business.
Safety and/or environmental projects - are expenditures
necessary to comply with government regulations, labor
agreements, or insurance policy terms.
Other projects - includes office buildings, parking lots, and
executive aricrafts.
Mergers - one firm buys another one.
Net Present Value (NPV) - is the difference between the
present value of cash inflows and the present value of cash
outfloes over a period of time. The NPV of one project cannot
be directly compared to the NPV of another project unless the
investments are equal.
Positive NPV - indicates that the project earnings generated
by a project–discounted for their present value–exceed the
anticipated costs
Negative NPV - will result in a net loss. This concept is the
basis for the net present value rule.
Internal Rate of Return (IRR) - metric used in financial
analysis to estimate the profitablity of potential investments.
Is a discount rate. Rate of return promised by an investment
project over its useful life.
Modified Internal Rate of Return (MIRR) - assumes that
positive cash flows are reinvested at the firm’s cost of capital
and the initial outlays are financed at the firm’s financing cost.
Payback Period - measures the amount of time required to
recoup the cost of an initial investment via the cash flows
generated by the investment. (payback period = initial
investment/cash flow per yr)
Capital Budgeting Decisions
Screening Decisions - does a proposed project meet some
present standard of acceptance. Pertain to whether or not some
proposed investment is acceptable; thse decisions come first.
Preference Decisions - selecting from among several
competing courses of action. Attempt to rank acceptable
alternatives from the most to least appealing.
Time Value of Money - best to recognize are those that
involce discounted cash flows.
If the net present The the project is
value is
Positive Acceptable bcs it promises a return
greater than the required rate of return.
Zero Acceptable bcs it promises a return
equal to the required rate of return.
Negative Not Acceptable bcs it promises a
return less than the required rate of
return.
Net present value analysis - emphasizes cash flows and not
accounting net income.
Discounted csh flow analysis - finds the present value of
expected future cash flows using a discount rate.
2 Simplifying Assumptions (NPVA)
1. All cash flows other than the initial investment
occur at the end of periods.
2. All cash flows generated by an investment project
are immediately reinvested at a rate of return equal
to the discount rate.
Cost of Capital - average rate of retun the company must pay
to its long-term creditors and stockholders. Usually regarded
as the minimum required rate of return.
Incremental-Cost Approach - only thos cash flows that
differ between the 2 alternatives are considered.
Least Cost Decisions - revenues are not directly involved,
managers should choose the alternative that has the least total
cost from a present value perspective.
Payback and uneven cash flows - when the cash flows
associated with an investment project change from yr to yr.
Simple Rate of Return Method - does not focus on cash
flows. It focuses on accounting net operating income.
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FINANCIAL MARKETS REVIEWER FINALS
Postaudit - is a follow-up after the project has been Effect of trade cycle - during the period of inflation, funds
completed to see whether or not expected results were actually generated from depreciation may not be adequate to replace
realized. the assets.
Attiture of the interested group - a concern may have
Dividend Policy certain group of interested and powerful shareholders. Certain
attitude towards payment of dividend and have a definite say
Dividend Policy - dictates the amount of dividends paid out in policy formulation regading dividend payments.
by the company to its shareholders and the frequency with Stable Dividend Policy - easiest and most commonly used.
which the dividends are paid out. Steady and predictable dividend payout each year.
Regular Dividend Policy - the company pays out dividends Constant Dividend Policy - company pays a percantage od
to its shareholders every year. (steady cash flow & low stable its earnings as dividends every year.
earnings, low-risk) Residual Dividend Policy - highly volatile, but some investors
Stable Dividend Policy - the percentage of profits paid out as see it as the only acceptable dividend policy.
dividends is fixed. (risky for investors) Cash Dividend - most common form. The shareholders
Irregular Dividend Policy - the company is under no receive cash for each share.
obligation to pay its shareholders and the board of directors Bonus Share - also called stock dividends. When a company
can decide what to do with the profits. (lack liquidity , very has low operating cash, it can distribute dividends in the form
high risk) of bonus shares.
No Dividend Policy - the company doesn’t distribute Share Repurchase - occurs when a company buys back its
dividends to shareholders. own shares from the market and reduces the number of shares
Optimal Dividend Policy - only distributes dividends when outstanding.
cash holdings exceed threshold, depends on the state of the Property Dividend - makes the payment in the form of assets
economy. under the property dividend.
Clientele Effect - investors needing current income will be Scrip Dividend - promissory note to pay the shareholders
drawn to firms with hight payout ratios. Suppose a dividend- later.
paying company is unable to pay returns to shareholders for a Liquidating Dividend - returns the original capital
certain period of time. contributed by the equity shareholders as a dividend.
Information Content - signals concerning the firm’s Dividend - distribution of part of the earnings of the company
financial condition. to its equity shareholders.
Residual Dividend Theory - retain and reinvest earnings as Bird-in-Hand Fallacy - shareholders prefers the certainty of
long as returns on the investments exceed the returns dividends in comparison to the possibility of higher capital
stickholders could obtain on the other investments of gains in the future.
comparable risk.
Stability of earnings - important factors influencing the
dividend policy.
Financing policy of the company - influences the dividend
policy of the business firm.
Liquidity of funds - important consideration in dividend
decisions.
Dividend, policy of competitive concers - if the other
competing concerns, are paying higher rate of dividend that
this concern, the shareholders may preger to invest their
money in those concerns rather than in this concern.
Past dividend rates - dividend rate may be decided on the
basis of dividends declared in the previous years.
Debt obligations - incurred heavy indebtedness, is not in a
position to pay higher dividends to shareholders.
Ability to borrow - requires bothe expansion programmes as
well as for meeting unanticipated expenses.
Growth needs of the company - influences the rate of
dividend is the growth of the company.
Policy of control - another important factor influences
dividend policy. (no new shareholders should be added, pay
less dividends)
Corporate taxation policy - affect the rate of dividends of
the concern.
Tax position of shareholders - large number of shareholders
hace high income from other sources and backeted in high
income structure, they are not interested in high dividends.
Tax position of shareholders cont - instead of receiving the
dividends in a form of cash, shareholders would like to get
shares and increase their holding in the form of shares.