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

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Chapter 10 Lessons From Capital Market History 1
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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 2
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The General Idea: The appropriate discount rate for a project (or a company) 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? 3
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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 4
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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
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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 6
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Dollar Returns: 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 7
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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% 8
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Percent Return Formula A little Algebra: 9 % 3 % 5 % 2 Return Total % 5 05 . 0
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