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Unformatted text preview: Chapter 3 Valuation Contents Two Approaches to Financial Decision- Making NPV Calculations Basic Valuation Model Choosing the Discount Rate Capital Allocation Decision Making in Practice Appendix 3A: Advanced Present Value Analysis Page 24 Chapter 3 - Page 25 Answers to Questions: 1. The process of short-term financial decision making is generally less complex than that of making long-term investment and financing decisions. Short-term projects' desirability is only slightly affected by the time value of money. In some cases the time value of money becomes vital--when a project would affect cash flows, and thus a firm's financial position, for a period of years. 2. The financial statement approach augments the traditional profitability analysis, with a balance sheet evaluation of what effect a proposed course of action would have on the company's liquidity and cash position. By contrast, the valuation approach to financial decision making dictates that the analyst incorporates the time value of money and the riskiness of projected cash flows. The principles of valuation are carried out in financial management choices by calculating the net present value of each alternative and selecting the alternative with the highest net present value. 3. Net income and EVA differ because EVA deducts from operating income an opportunity cost of all capital employed while net income deducts interest charged on debt capital only. 4. In situations where sales are stable or growing at a stable rate and occur at an approximately constant rate, one day's sales (average daily sales) can give us the net present value effect of a financial decision. For cases in which the decision alters the growth rate of cash revenues or expenses, or results in fixed cash costs subsequent to project implementation, this approach is only an approximation of the actual net present value. 5. Using a simple interest approximation formula to approximate the net present value effect of a financial decision ignores compounding. This formula assumes that interest is only added to the account at the end of the period, eliminating the possibility of earning "interest on interest." When a company "sweeps" excess cash balances into an overnight, interest-bearing account, the simple interest approach will only approximate financial effects. The longer the time period, the larger the cash flows, and the higher the discount rate, the greater the inaccuracy of the simple interest approximation. 6. Effective rates are annual rates linking beginning wealth to ending wealth. The greater the frequency of compounding, the higher the effective rate. More frequent compounding results in interest being added to the account more often, increasing the "interest on interest" buildup in the account. Whether the interest is compounded semiannually, as with consecutive six-month maturities, or monthly or daily, the effective annual rate will exceed the nominal rate....
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- Spring '12