Exam #1 Class Notes I

Exam #1 Class Notes I - Chapters / Topics: (Order of topics...

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Chapters / Topics: (Order of topics is subject to change) 1-3,4-2, 4-4 Review / Goal of the Firm (please review Ch 5 on Capital Budgeting on your own) Risk & return 9 10 Project risk, Sensitivity analysis, variation of NPV 6 Determination and discounting of incremental cash flows & projects with unequal lives Intermediate Corporate Finance Spring Semester, 2011 REVIEW Goal of the Manager of the Firm: a) Maximize shareholder wealth b) Minimize risk c) Maximize profits (max dividends; max after-tax cash flows over time) d) Maximize his or her salary e) All of the above f) All of the above, except d Are these valid objectives? -Yes, you need to consider both risk and return Minimize Risk: - Low risk projects tend to be low earning. Maximize Profits: (Dividends, after-tax cash flows) -High profit projects to be high risk Need a performance measure that weighs the risk/return trade-offs. What is S/H wealth and why does it measure the risk/return trade-off ? - In the long run, managers can split the shares to affect the stock price and not share holder wealth. S-T: Can be measured by ___ Price __ x # shares L-T: Must consider _______ Dividend payments_____ in addition to above 1
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How does “stock price” weigh the risk/return tradeoff? To answer this, we need to examine stock price formulas. - Firms must pay dividends eventually. Positive NPV projects will be competed away. Today’s stick price appreciation= Present Value of tomorrow’s dividends -Firms that never pay dividends ever, they will run out of positive NPV projects. - If the firm is retaining all of its assets and continues to grow, by reinvesting its money back into the firm, the price of the stock will continue to go up and up. - Risk of stock (RRR) (also cost of equity for a firm excluding flotation costs.) reflects RISK. Stock Price = PV of future expected dividends. Why not include stock price appreciation when we value of stock price? (I.e., wouldn’t you be willing to pay more for a stock that is expected to appreciate, compared to one that is not?) STOCK PRICE FORMULAS : T P 0 = ∑[D t /(1+r) t ] + P T /(1+r) T (1) r=risk. Dividends=return t=1 P 0 = D 1 / (r –g) (2) r = required rate of return on stock (also cost of equity for a firm, excluding flotation cost). RISK of STOCK g = Dividend growth rate, assumed to be constant Dividends reflect return (in dollar metric) Discount rate of divs, r, reflects risk of what? Stock (equity) P 0 = EPS 1 / r + PVGO (3) . Used for stocks that doesn’t pay dividends . Used for non-publically traded firms . Can be used in a managerial setting to determine whether or not the firm has made a good investment decision 2
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EPS 1 /r = capitalized value of future earnings per share, with a no-growth policy (i.e., assuming 0 NPV investment opportunities) PVGO (Present Value of Future Growth Opportunities) = NPV of future growth opportunities (earnings not reflected in EPS) on a per-share basis Example: Prior stock price = $50
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Exam #1 Class Notes I - Chapters / Topics: (Order of topics...

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