Driving the NPV of Free Cash Flow
- Incremental profit --> free cash flow represents the incremental profit of the project, as investors interested in how much new cash is coming into the firm in return.
- Export cannibalisation: losing profit from export sales to foreign market due to establishing new plant in foreign country.
- Forecast of revenue --> depend on the corporate future economic environment, demand: company's pricing and advertising policies. Also, future exchange rates.
- Forecast of costs --> measures as the cost of goods sold (COGS)
- Depreciation --> legal tax shield; subtracted out before taxes are calculated.
- Capital expenses --> money spent on property, plant and equipment (PPE).
- Net working capital --> inventory and cash on hand to run business.
Financial side effects:
- The cost of issuing securities: monetary fee (compensation to financial intermediaries in issuing securities), underwriting discount (the spread between what the firm receives from issuing securities and what the public pays for the securities).
- Tax shield for certain securities: interest tax shield (the value of the ability to deduct interest expense for tax purposes)
- The proper discount rate: rate should reflect the appropriate riskiness of the project's cash flows.
- Cost of financial distress: Direct costs (legal consulting and accounting fees -- 3%); indirect costs (loss of value due to the expectation of failure) -- creditors unwilling to extend more credit, inability to attract skilled labor.
Pros and Cons of alternative approach to capital budgeting
- WACC predict the project will perpetually provide the expected level of CFs.
- D/VL constant
- ANPV Pro: allows managers to make informed decisions about the economic profitability of a project versus other sources of value.
- ANPV Pro: works well for international projects and nicely with hedging foreign exchange risk.
- ANPV Con: problematic if D/E ratio os going to be held constant.
- WACC and FTE Con: problematic if D/E ratio is going to change.
Tax implication of borrowing in a foreign currency (FC):
- If the borrowed (foreign currency) strengthens against domestic currency, borrower owes more.
- If the foreign currency weakens against domestic currency, borrower owes less.
- Because high interest rate currencies are expected to depreciate relative to lower interest rate currencies, the borrower expects to have a capital gain on the repayment of the principal.
- Capital gain tax offsets the higher interest tax shield and prevents the existence of a tax incentive to borrow in high interest rate currencies.
Conflicts between bondholders and stockholders
- The incentives to take risks: stockholders have the incentives to take on risk.
- Bondholders want low variance projects.
- Equity holders want high variance projects.
- The underinvestment problems: no incentives to take +NPV project, because bondholders will get all of the value.
- Other managerial problems: cash distribution for shareholders and misrepresentation of earnings.
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