Cfa Level 1 2006 - Formula Sheet Page 10
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18CFA Level 1 2006 - Formula Sheet
period over which outstanding.
Conflicts Between IRR and NPV: Differences in
timing and scale of mutually exclusive projects.
Adjustment for Stock Dividends and Splits:
Always go with NPV.
Applied as of beginning of fiscal year, i.e., previous
Multiple IRR Problem: It occurs when cash flows
share actions, not to shares issued, exercised or
purchased after the split or dividend.
change signs more than once. Be careful for the
range of COC matters.
Convertible Bonds: Diluted EPS – include after-tax
NPV Profile: Graphical relationship between
interest savings in numerator.
project NPV and different discount rates. Its
CORPORATE FINANCE
intersection with the x-axis gives the IRR.
Incremental Cash Flow: Always use incremental
cash flow for project analysis.
COST OF CAPITAL (COC)
NWC = Current Assets – Current Liabilities.
After-tax Cost of Debt = k
x (1-T)
d
Operating CF for a Project = Net income +
Cost of Preferred Stock = k
= D
÷ P
ps
ps
net
Depreciation + Change in working capital
Cost of Retained Earnings:
Terminal Cash Flow from Salvage = Salvage
• CAPM/SML Approach
value – Tax rate x (Salvage value – Book value).
Recovery of NWC is usually not taxed.
k
= k
+
[k
– k
]
s
riskfree
s
m
riskfree
Unequal Lives: (1) Replacement chain – use the
• Bond yield plus risk premium Approach
lowest common multiple of project lives and
k
= Yield on company’s LT debt + Risk
s
estimate their NPVs over this period. (2) Equivalent
premium (between 3 and 5%)
Annuity Approach –after computing NPV of a
• DCF Approach
project find the equivalent annuity payment over
D
project’s life that has the same present value as
1
=
+
k
g
s
NPV.
P
0
Effect of Inflation: Use nominal cash flows and
Cost of New Equity:
discount them at nominal rates.
Types of Project Risk: (1) Standalone risk, (2)
D
1
=
+
k
g
Corporate risk, and (3) Market risk.
ne
−
P
(1
F
)
0
Sensitivity Analysis: Changes in project NPV to
Wtd. Average Cost of Capital (WACC):
changes in single inputs or variables.
=
−
+
+
Scenario Analysis: Project NPV under different
k
w k
(1
T
)
w k
w
k
a
d
d
ps
ps
c equity
.
c equity
.
scenarios
where
many
variables
change
Weights are based on market values.
simultaneously.
Monte-Carlo Simulation: Extension of scenario
Marginal Cost of Capital: It is computed with the
analysis where thousands of scenarios are randomly
help of WACC by plugging in marginal cost of each
generated with the help of computers.
component of capital.
CAPITAL STRUCTURE
CAPITAL BUDGETING
Optimal Capital Structure: Mix of debt and equity
Payback Period: Period over which the initial
that maximizes value of the firm.
investment is recouped. Discounted payback
discounts the cash flows for estimating the
Irrelevance Proposition: In the absence of taxes
recouping period.
and bankruptcy costs, financial leverage is
irrelevant to a firm.
NPV Rule: Discount and add all cash flows (future
and initial investment). Accept if NPV
0.
Tradeoff Theory: Under bankruptcy and taxes,
deductibility of interest shields taxes but higher debt
IRR Rule: Use the NPV equation and find the
levels increase cost of debt due to potential of
discount rate that sets NPV = 0. Accept if IRR
bankruptcy. At the optimal leverage, the marginal
Discount rate (cost of capital).
tax benefits equal marginal bankruptcy cost.
10
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