BasicReview_521_2011

BasicReview_521_2011 - Basic Review 1 Goals: You should be...

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1 Basic Review
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2 Goals: You should be familiar with . . . 1. M&M 2. Metrics to Evaluate Projects 3. NPV and WACC 4. Stock Valuation 5. CAPM and other asset-pricing models 6. Financial Statements
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3 1. Modigliani & Miller Irrelevance of dividend policy and capital structure Key assumptions: No taxes No transaction cost No signaling Investors and firms can borrow at same rate
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4 2. Metrics to Evaluate Projects Payback period Book rate of return Internal rate of return Why NPV rule leads to best investment decisions Why NPV>0? What do CFOs Use?
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5 Payback Period Rule The payback period of a project is the number of years it takes before the cumulative forecasted cash flow equals/exceeds the initial investment. Only projects that recover their initial investment within a specified cutoff date are undertaken.
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6 Project A Project B Project C Time 0 -100 -100 -100 Time 1 60 40 0 Time 2 40 60 0 Time 3 10 50 80 Time 4 -10 -40 100 P. P. NPV (r=.10) -11.7 -3.8 28.4
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7 Book Rate of Return NPV rule just depends on cash flows of project and opportunity cost of capital Shareholders pay attention to book measures of profitability, so managers may care how project will affect book return. Book rate of return = book income / book assets on prospective assets firm is considering acquiring
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8 Internal Rate of Return internal rate of return (IRR): discount rate that makes NPV = 0 To solve for IRR for a project lasting T years, solve for IRR in the following equation: NPV = 0 = C 0 + C 1 /(1+IRR) + C 2 /(1+IRR) 2 + . . . + C T /(1+IRR) T
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9 Positive NPV & Economic Rents How can we tell the difference between forecasting error and actual positive NPV opportunities?
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BasicReview_521_2011 - Basic Review 1 Goals: You should be...

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