BCOR 2200 Chapter 10

# BCOR 2200 Chapter 10 - Chapter 10 Lessons From Capital...

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1 Chapter 10 Lessons From Capital Market History

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2 We know from Chapter 8: Capital budgeting requires calculating the NPV: Discounting future Cash Flows (Numerator) At the Require Rate of Return (Denominator) We know from Chapter 9: Which Cash Flows to use: Use the Stand-Alone Principle Use Incremental Cash Flows associated with: – Operations (OCF) Capital Spending (NCS) – Working Capital ( NWC) Test the CF forecasts used to calculate the NPV – Sensitivity and Scenario analysis Now we will start looking at the Required Rate of Return
3 The General Idea: The appropriate discount rate reflects the project’s risk – The riskier the project, the higher the required return. Why? Investors are RISK AVERSE . – So how do we measure the project’s risk? – And once we know the risk, what is the correct rate of return for that risk? Start with this Assumption: The new project has the SAME risk as the firm’s current projects – Then we can use the rate or return firm is currently paying But how do we calculate that? Later: What if the new project’s risk is different , – We can adjust the use the rate or return firm is currently paying to account for difference in risk So we will look at: 1. The general historic risk and return for all companies (the market) 2. The risk and return for different types of companies 3. The risk for the company we’re analyzing

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4 Chapter Outline: 1. The Mechanics of Calculating Returns Dollar Returns Percent Returns 2. The Historical Record 3. Calculating Average Returns 4. Return Variability (Risk) 5. More about Calculating Average Returns 6. Market Efficiency
5 10.1 Returns Dollar Returns: Bond Example: You bought a bond for \$950 1 year ago. You have received two coupons of \$30 each. You can sell the bond for \$975 today. Calculate your total dollar return: Income = \$30 + \$30 = \$60 Capital gain = \$975 – \$950 = \$25 Total dollar return = \$60 + \$25 = \$85 Stock Example: 1 year ago, you bought stock for \$50 per share. You received 4 dividends of \$1.25 each Today the price of the stock is \$48 Calculate your total dollar return: Income = 4(\$1.25) =\$5.00 Capital gain = \$48 – \$50 = -\$2.00 Total dollar return = \$5.00 – \$2.00 = \$3.00

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6 Percent Returns: Of course dollar returns aren’t very useful New Stock Example: – 1 year ago, you bought stock for \$100 per share. You received 4 dividends of \$1.25 each Today the price of the stock is \$98 Calculate your total dollar return: – Income = 4(\$1.25) =\$5.00 – Capital gain = \$98 – \$100 = -\$2.00 – Total dollar return = \$5.00 – \$2.00 = \$3.00 Dollar returns are the same for \$50 and \$100 stocks Make \$3.00 on \$100 vs. Make \$3 on \$50 We can see this is 3% vs. 6%
7 Percent Return Formula A little Algebra: % 3 % 5 % 2 Return Total % 5 05 . 0 \$100

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## This note was uploaded on 03/17/2009 for the course BCOR 2200 taught by Professor Tomnelson during the Fall '08 term at Colorado.

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BCOR 2200 Chapter 10 - Chapter 10 Lessons From Capital...

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