FIN544/ADVANCED CORPORATE FINANCE.

TUTORIAL and Formula

1. What is forecasting risk?

Forecasting risk is the possibility of errors occurs in projected cash flows which can lead to
incorrect decisions. It is based on the sensitivity of the NPV because the more sensitive the
NPV, the greater the risk.

2. In general, would the degree of forecasting risk be greater for a new product or a cost-
cutting proposal? Why?

Forecasting risk may be greater for a new product because a new product comes with
greater needs of attention to competition. The company should consider questions such as
the following: Are we certain that our new product is significantly better than that of the
competition? Can we truly manufacture at lower cost, or distribute more effectively, or
identify undeveloped market niches, or gain control of a market? The company will also
have to consider the potential competition. This is because success attracts imitators and
competitors.

3. What are sensitivity analysis, scenario analysis and simulation?

Sensitivity analysis

Sensitivity analysis examines the effect of NPV when a specific variables, for instance fixed
costs, changes. If there is greater variation in NPV related to the change in fixed costs, then
the greater is the estimation risk. For example, when considering purchasing a company, an
investor may look at the production cost of an item the company makes, and the cost of the
components needed to make that product. By adjusting these prices, either lower or higher,
an investor can partially determine a number of eventualities. This will help them make an
educated decision about their purchase in light of better knowing what could happen to the
value of the company if certain variables change.

Scenario analysis
 Scenario analysis is to determine the uncertainty of cash inflows and NPVs. It also identifies
several possible outcomes to determine the variability of NPVs if several variables change
simultaneously. For example, investors considering purchasing a company will want to
understand the cash flow of the business. This is more than just considering revenue and
expenses. Expenses can manifest themselves in a number of ways including wages,
pensions, benefits, costs associated with production, and so forth. By changing a
combination of these factors, investors can get a feel for a number of different scenarios.

Simulation analysis

Simulation analysis is another method use to forecast risk. It combines both sensitivity and
scenario analysis where it assigns a wide range of values to multiple variables
simultaneously and then analyzes the result. Due to the complexity of the analysis, a
computer software program such as the Monte Carlo simulation analysis due to its
complexity. Simulation is really just an expanded sensitivity and scenario analysis. It can be
done by just enter certain amount on certain variable randomly or systematically. The
simulation only works as well as the information that is entered and bad decisions will occur
if care is not taken to analyze the interaction between variables

4. Discuss why it is important to perform a sensitivity analysis.

In sensitivity analysis, only one variable is changed while the rest are held constant. The
greater the volatility in NPV in relation to a specific variable, the larger the forecasting risk
associated with that variable, and the more attention we want to pay to its estimation. This is
a subset of scenario analysis where we are looking at the effect of specific variables on
NPV. Sensitivity analysis helps the financial manager to identify which variable will lead to a
bigger change in the estimated NPV.

5. Why are these analyses important, and how should they be used?
 Both scenario and sensitivity analysis can be useful when evaluating the best possibly
investment eventuality. The results of a sensitivity analysis will give the investor an idea of
the uncertainty involved with the investment. In this type of analysis, the investor will make
their decision based on how reliable they feel the outcome is based on a certain variable.
Scenario analysis considers a number of uncertainties and the possible ways in which they
could play out. When conducting scenario analysis, the investor makes a decision based on
which of the outcomes they've looked at will be most likely to happen.

In some cases, both types of analysis are used together. By understanding the details
associated with sensitivity analysis vs. scenario analysis, investors can determine which one
carries more weight for evaluating their particular investment. In the end, it comes down to
the investor's level of comfort with a particular business venture, and this level will vary from
person to person. We perform sensitivity analysis to check how easy it is for our model to go
out of whack. A greater sensitivity usually follows as greater uncertainty.

6. What are the three types of break-even analysis, and how should each be used?

a) Accounting break-even sales volume at which net income = 0

Accounting break-even analysis or also known as cost-volume-profit analysis, is used to

determine the sales level at which the firm neither makes a loss nor a profit. In short, it is
break-even point where the net income is zero. Mathematically, the net income for this
break-even analysis can be expressed as:

Q = (FC + D) / (P v)
Net income= (Sales-Variable Costs-Fixed Costs-Depreciation) x (1-Tax Rate) = 0

b) Cash break-even sales volume at which operating cash flow = 0

For this analysis, the manager will examine the level of sales at which the operating cash
flow is equal to zero instead of the net income. In addition for cash break-even analysis, the
level of ales is much lower than the accounting break-even analysis method. The
mathematical expression for this analysis (ignoring the tax) is:
 Q = (FC)/ (P v)

c) Financial break-even sales volume at which net present value = 0

Financial break-even analysis determine the level of sales at which the net present value is
equal to zero which is the minimum level of operating cash flow needed for the project to be
acceptable. The calculation of the financial break-even analysis will start off with identifying
the operating cash flow. The mathematically expression of Financial break-even analysis is:

Q = (FC + OCF)/ (P v)

7. What is the degree of operating leverage?

The degree of operating leverage is when a company’s costs of operation are fixed as
opposed to variable. The larger the fixed costs compared to variable costs, the larger the
operating leverage. Operating leverage is the relationship between sales and operating cash
flow. The degree to which a firm or project relies on fixed costs.

The higher the DOL, the greater the variability in operating cash flow
The higher the fixed costs, the higher the DOL
DOL depends on the sales level you are starting from
DOL = 1 + (FC / OCF)
Percentage change in OCF = DOL*Percentage change in Q

8. Discuss the implications of the operating leverage.

The operating leverage effect is a phenomenon whereby a small change in sales triggers a
relatively large change in operating income. It is caused by the presence of fixed operating
costs. The potential benefits are that if sales are rising operating income will rise more
quickly. The negative consequences are that falling sales will cause operating income to fall
more quickly, including negative values. In order to run a business, firms are required to
incur some costs, which do not depend upon the volume of production. Such costs are
termed as fixed costs. For making a profit, firms are to recover such fixed costs. The ability
of a firm to make a profit after recovering the fixed costs are analysed through the operating
leverage. The risk of manufacturing firms for having fixed operating costs in the cost
schedule is termed as Degree of Operating Leverage.
9. What is the difference between hard rationing and soft rationing? What are the implications
if a firm is experiencing soft rationing? Hard rationing?

Soft rationing

A soft capital rationing arises when a firm puts a budget ceiling or constraints on the amount
of funds that could be invested during a specific time period. This constraint is usually
imposed during economic downturn or when a firm faces financial difficulties. The situation
occurs when units in a business are allocated a certain amount of financing for capital
budgeting. Profitability index is a useful tool in determine the projects to be choose when a
manager is faced with soft rationing.

The organization can browse a few different ways to force speculation confinements on it.
For instance, it might incidentally necessitate that undertaking offers high rate of return.
Which is normally fundamental for the organization to consider pushing ahead? Or on the
other hand the organization can set a breaking point on the quantity of new ventures
throughout the following a year. This sort of rationing comes because of the interior
approaches of an organization. For instance, moderate preservationist organization may
have high fundamental profit for cash-flow to acknowledge task to execute claim capital-
rationing itself.

Hard rationing

Hard rationing is when the capital will never be available for this project. A firm is confronted
with hard capital rationing when it has difficulty in sourcing for funds to finance its
investments. This could happen when the firm is in financial distress or is on the brink of
bankruptcy meaning that bankruptcy is a possibility or, strict debt covenant which restraints
the company from raising any funds.

This happens when an organization has issues of raising extra assets through value or
obligation. Apportioning originates from an outer need to decrease use and can prompt an
absence of cash-flow to fund future ventures. Ordinarily, the adolescent start-up firm can't
raise assets from the value showcase. It can exceedingly foresee or despite the captivating
eventual fate of the organization. For instance, an organization can be prohibited from
obtaining cash to back new ventures since it has confronted a decrease in its FICO score. In
this manner, verifying financing for an organization can be troublesome or effectively
incomprehensible, or it might just have the option to do this at high-loan costs.
10. List down all formulas for Chapter 1-8. ALL RELATED FORMULA.

Chapter 3

1. Break even EBIT=

EPS before = EPS proposed

EBIT EBIT −INTEREST

=
Number of shares Number of shares

EBIT EBIT−$ 400 k

=
400 000 200 000

EBIT = 2EBIT - $800 K

EBIT = $800 k

2. WACC (RA) = (E/V)RE + (D/V)RD

Rearrange the formula will get:-

RE = RA + (RA – RD) (D/E)

EBIT x (1−Tc)
3. Vu=
Ru
4. Vl=Vu+Tc xD
5. RE = Ru + (Ru – RD) (D/E) (1-Tc)
6. E/Equity= Total VL- Total debt value
7. WACC (RA) = (E/V) RE + (D/V) (RD) (1-Tc)

Chapter 5

1. Operating Cash Flow (OCF) = EBIT + depreciation – taxes

2. OCF = Net income + depreciation when there is no interest expense
3. Cash Flow From Assets (CFFA) = OCF – net capital spending (NCS) – changes in NWC
4. payback period=Years ¿ covered−1 ¿
5. Straight-line depreciation

D = (Initial cost – salvage) / number of years

6. Declining-balance method (or Reducing balance method)

Residual value
Use formula to find depreciation rate de preciation rate=1−
√
n

cost of ¿
assets ¿

7. Book value = initial cost – accumulated depreciation

8. After-tax salvage CF= salvage – T(salvage – book value)
9. If the book value= 0, After-tax salvage= Salvage(1-Tax)
10. The bottom-up approach: OCF = NI + depreciation
11. The top-down approach: OCF = Sales-Cash costs-Taxes
12. The tax shield approach: OCF = (Sales – Costs)(1 – T) + Depreciation*T

Chapter 6
1. Operating Cash Flow (OCF) = EBIT + depreciation – taxes
2. If using Tax Shield approach: OCF = (Sales – Costs)(1 – T) + Depreciation*T
3. OCF = NI + Depreciation
4. Net Income = Sales – Costs - depreciation - Taxes
5. OCF = (Q (P-V) – FC) (1-t) + Depreciation (t),
1
1−
6. Annuity Factor = (1+r )n
r
PV of cost
7. EAC =
Annuity Factor
Chapter 7

1. OCF = NI + Depreciation
2. Using Tax shield formula to find OCF
OCF= ((SP – VC) Q – FC) (1-T) + Depreciation*T
OCF NEW −OCF OLD/ BASE
3. Sensitivity of cash flow =
Item X new −Item x old /base
NPV NEW −NPV OLD/ BASE
4. Sensitivity of NPV =
Item X new −Item x old/ base

Chapter 8

1. Accounting break-even – sales volume at which net income = 0

Q = (FC + D) / (P – v)

2. Cash break-even – sales volume at which operating cash flow = 0

Q = (FC)/ (P – v)

3. Financial break-even – sales volume at which net present value = 0

Q = (FC + OCF)/ (P – v)
4. Total variable costs = quantity * cost per unit
5. Total costs = fixed + variable = FC + (Vperunit x Q)
6. Degree of operating leverage(DOL) DOL = 1 + (FC / OCF)
7. Percentage change in OCF = DOL*Percentage change in Q