Consolidated Statement of Income
Y1
Sales
Less: cost of goods sold (60% of sales)
Operating profit
Less: other expenses
Salaries and administration expenses (5% of sales)
Royalty (5% of sales)
Utilities (4% of sales)
Marketing expenses (3% of sales)
Amort
C. CAPITAL RATIONING
(Suggestions by R. Bruner)
Exists whenever enterprises cannot, or choose not to, accept all value-creating investment
projects. Possible causes:
Banks and investors say NO
Managerial conservatism
Analysis is required. One must consi
Evaluating Equipment with Different Economic Lives
l
A firm is choosing between two pieces of equipment under the following
circumstances
1.
The pieces of equipment have different economic lives
2.
Whatever piece the firm buys, it needs it indefinitely. A
Note: NPV declines as k increases, and NPV
rises as k decreases.
If the projects are mutually exclusive, accept
Project S since IRRS > IRRL.
C. INTERNAL RATE OF RETURN
Note: IRR is independent of the cost of
capital.
IRR :
CFt
n
= $0 = NPV .
t
t = 0 (1 +
F. EQUIVALENT ANNUAL ANNUITY
What do you do when project lives vary significantly? An easy and intuitively
appealing approach is to compare the equivalent annual annuity among all the
projects. The equivalent annuity is the level annual payment across a p
The Internal Rate of Return (IRR) Rule
Internal rate of return: The discount rate that makes the present value of future
cash flows equal to the initial cost of the investment. Equivalently, the discount
rate that gives a project a zero NPV.
IRR Rule: An
Evaluating Cost Cutting Proposals
Consider the decision to upgrade existing facilities to make them more cost
effective. The financial manager has to determine whether these cost savings are
large enough to justify the necessary capital expenditure.
Con
Capital Budgeting Problem
Fairways Driving Range
l
Two friends are considering opening an indoor driving range for golfers.
Because of the popularity of golf in Dallas, they estimate that they could rent
20,000 buckets at $3 a bucket in the first year, an
Problems with the IRR Rule (continued)
Mutually Exclusive Projects
Mutually exclusive projects: If taking one project means another project is not
taken, the projects are mutually exclusive. The one with the highest IRR may not
be the one with the highest
F. EQUIVALENT ANNUAL ANNUITY
What do you do when project lives vary significantly? An easy and intuitively
appealing approach is to compare the equivalent annual annuity among all the
projects. The equivalent annuity is the level annual payment across a p
The Discounted Payback Rule
Discounted Payback period: The length of time until the accumulated discounted
cash flows from the investment equal or exceed the original cost. We will assume
that cash flows are generated continuously during a period.
The Dis
Note: NPV declines as k increases, and NPV
rises as k decreases.
If the projects are mutually exclusive, accept
Project S since IRRS > IRRL.
C. INTERNAL RATE OF RETURN
Note: IRR is independent of the cost of
capital.
IRR :
CFt
n
$0 NPV .
t
t 0 1 IRR
k
N
Normally the charge for invested capital is the book value of working capital plus fixed
capita times a discount rate, which reflects the entitys average nominal cost of capitol.
This approach contains three errors, which are assumed to be self-correcting
Depreciation
Economic and future market values are ignored.
Straight line: A fixed percentage of the asset base.
Since depreciation has cash flow consequences only because it affects the tax
bill, the way depreciation is computed for tax purposes is th
Summary of Net Present Value (NPV) Method
Decision Rule: NPV > 0: Accept the project.
NPV < 0: Reject the project.
Key Advantages
Key Disadvantages
1. Uses the discounted cash flow
1. Difficult to understand without an
valuation technique.
accounting and
It provides a simple measure of an investments liquidity risk.
The greatest advantage of the payback period is its simplicity.
It ignores the time value of money.
It does not adjust or account for differences in the overall, or total, risk for a
project,
D.
Basic Capital Budgeting Terms
The cost of capital is the minimum return that a capital budgeting project
must earn for it to be accepted.
It is an opportunity cost since it reflects the rate of return investors can earn on
financial assets of similar r
Problems with the IRR Rule
l
Unconventional Cash Flows: Cash flows come first and investment cost is
paid later. In this case, the cash flows are like those of a loan and the IRR is
like a borrowing rate. Thus, in this case a lower IRR is better than a hi
II. Basic Steps of Capital Budgeting
Basic Data
1. Estimate the cash flows
2. Assess the riskiness of the cash flows.
3. Determine the appropriate discount rate.
4. Find the PV of the expected cash flows.
5. Accept the project if PV of inflows > costs.
IR
Two Ways to Do Capital Budgeting Problems
1.
Item by item discounting
l
Separately forecast revenues, costs and depreciation and discount each
item.
l
Can use different discount rates
2.
Whole project discounting
l
Determine project cash flows from financ
Aspects of Incremental Cash Flows
(Which costs should be included in incremental cash flows?)
Sunk Costs: A cash flow already paid or already promised to be paid.
Opportunity Costs: Any cash flow lost by taking one course of action rather
than another.
Review of Internal Rate of Return (IRR)
Decision Rule: IRR > Cost of capital Accept the project.
IRR < Cost of capital Reject the project.
Key Advantages
1. Intuitively easy to understand.
2. Based on the discounted cash flow
technique.
Key Disadvantages
The Payback Rule
Payback period: The length of time until the accumulated cash flows from the
investment equal or exceed the original cost. We will assume that cash flows are
generated continuously during a period.
The Payback Rule: An investment is accep
Both cash inflows (CIF) and cash outflows are likely in each year of the
project. Estimate the net cash flow (NCFt) = CIFt COFt for each year of the
project.
Remember to recognize any salvage value from the project in its terminal
year.
3. Determine the
Handout 5b
Financial Derivatives; 2016-17
Prof. Shashi Murthy
Topic 5b, Chapter 12, Some Trading Strategies with
Options
Covered Calls,
Protective Puts or Portfolio Insurance,
Bull Spreads,
Butterfly Spreads,
and Straddles
1
1
There are a multiplicity of
Handout 4
Financial Derivatives; 2016-17
Prof. Shashi Murthy
Topic 4, Chapter 10 Mechanics of Options Markets
Omitted: Warrants; ESOPs; Convertibles
1
1
Review of Option Types
A call is an option to buy
A put is an option to sell
A European option can
Handout 6b
Financial Derivatives; 2016-17
Prof. Shashi Murthy
Topic 6b, Chapter 13, The Binomial Model
This handout covers only part (b) of topic 6. It
covers:
More on (Hedge &) Replicating Portfolios, & Riskneutral valuation
American, or early-exercise
Handout 5c
Financial Derivatives; 2016-17
Prof. Shashi Murthy
This is a continuation of Handout 5a (Topic 5a,
Chapter 11, No-arbitrage Restrictions on Option
Prices, Chapter 11).
Here we examine the effect of dividends on (i)
Pricing Bounds, and (ii) Put-
Handout 3a
Financial Derivatives; 2016-17
Prof. Shashi Murthy
Topic 3, Chapter 5 Pricing Forwards &
Futures, Part 1. This handout covers a
subset of the issues listed in the Course
Outline under Topic 3:
Perfect Markets Assumptions; Short-Selling
Invest
Handout 3c
Financial Derivatives; 2016-17
Prof. Shashi Murthy
Topic 3, Chapter 5 Pricing Forwards & Futures, last part
To be read after Handout 3a, Handout 3b1, &
Handout 3b2 (the last 2 are Word files). This
handout covers the rest of Chp 5.
Currency fut
Handout 6a
Financial Derivatives; 2016-17
Prof. Shashi Murthy
Topic 6a, Chapter 13, The Binomial Model
This handout covers only part (a) of topic 6. It
covers:
Hedge & Replicating Portfolios
Risk-neutral valuation
It covers the above for the case of Singl