F370 Final Exam

C1 (0-3 Concept., 0-7 Quant.)

Chief Financial Officer, CFO Overriding goal is to maximize the value of a firms stock shares Capital Investment Function The management of the investment potential of a firms combined portfolio of projects Capital Investment Strategy is to maximize NPV Financing Strategy is to minimize WACC Financing Policy, Capital Structure Policy, Cost-of-Capital Policy All the same thing Mergers & Acquisitions, Risk Management, ST Assets and ST Liabilities, and Corp. Governance All CFO duties Enterprise Value The fair market or competitive value of a total company EnV (external) the markets assessment of a firms value EnV (internal) the firms own internal assessment of its value Long-Term Financial Strategy versus Short-Term Deviations when ENV is Different EnV (external) the markets assessment of a firms value EnV (internal) the firms own internal assessment of its value Investment Project Investment Outlay o Business Projects use a graph with Implied Return on y-axis and Beta on x-axis NPV: Net Present Value The value created when the implied return is greater than the next-best investment IRR: Internal Rate of Return For corporate projects, the implied return is the IRR r: Project Cost of Capital (aka External Return) Return that the market would typically assign to stocks that have the same risk as our business project

r sub j is the opportunity cost, or cost of the next-best investment that is available to external investors

Excess Cash Flow vs. Competitive Cash Flow Excess Cash Flow means the IRR and Beta plotted above the SML line Competitive Cash Flow plots on the SML line Agency Issues and Costs The reality that managers may not make the best-available choices for the firms stockholders Agency Cost the missed value of the manager choosing the option that isnt the best available for the firm Principal, Agent Principal owner of a group of assets o in public company, principal are the public stockholders Agent person given the discretion over how the assets are used to produce cash flow o In public company, the agent is the manager with decision making authority Mis-Investment, Under-Investment, Over-Investment Mis-Investment when the managers choose a set of new projects that lead to less of an increase in stock price than is potentially available Under-Investment is more likely to happen than over Under-Investment when a manager passes up a positive NPV project Over-Investment when a manager accepts a negative NPV project Factors in mis-investment o Managers view distant cash flows as providing very little personal benefit o Managers see more risk in a project than shareholdersand will assign higher discount rates o Older managers tend to become more conservative and averse to taking risk as they gain stronger reputations o *(leads to over-investment) managers can be biased toward accepting negative NPV projects with substantial initial cash flow ICF 3 ways to control these conflicts o External monitoring o Internal monitoring o Performance incentives

Conceptual Questions
What is the very specific goal that a CFO is given? Maximize the share price of the firms current shareholders What is the capital investment function and what is the financing function for a CFO? How are these functions alike and how are they different? Financing Function o How and when a firm strategically chooses to raise capital from financial markets (whether to choose equity or debt) o CFO needs to think of things from the investors perspective o Strategy is the minimize WACC Capital Investment Function o Use the same knowledge to make investments into projects, ventures, and even mergers and acquisitions o Strategy is to maximize NPV CFO uses DCF in both approaches Describe the overall topic of corporate finance and relate it to the figures on pages 4 and 5 in the July 14 class handout. Firms top managers are competing in two different games o Internal Cash flow and risk are considered to raise EnV Try to maximize NPV and minimize WACC o External Outsiders are constantly assessing and valuing the CFOs firm CFO needs to be able to change strategy when internal and external values do not match In what ways is a project analysis similar to our treatment of finding a mispriced stock earlier in the semester? For both stocks and projects, Beta can be used as a measure of risk experienced by a diversified shareholder Both stocks and projects are future profit generators that carry risk In what ways are the NPV and IRR metrics alike? How are they different? Why does it make sense that a firm should only pursue projects when IRR>r? NPV and IRR are both variables that help make decisions related to value creation If IRR (implied return, what it is) is greater than (it beats) the r (competitive return), then the owner of the project gets some extra returns for their investment NPV is the present value of the extra cash flows What are agency costs and why do they exist?

Managers (agents)stockholders (principals) Managers view projects in their own NPV creation instead of the stock price NPV creation An agency cost is a cost that occurs when different interests (those of the manager and the stockholders) cause a firm to not realize some potential value creation

Concerning under-investment and over-investment, which is generally more prevalent in a firm and why does the use of executive stock options cure one but bring about the other? Managers have a bias towards projects with low-risk and short-term cash flows Under-investment is more prevalent Stock option values go up when risk goes up because the gains from an option are unlimited but the losses are capped at some point Stock options can lead to over-investing on high-risk, short-term projects