Term
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Definition
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Term
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Definition
| Ending Value – Beginning Value |
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Term
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Definition
| Dividends for Stock or Interest for Bonds |
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Term
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Definition
| {((End value – Beginning Value) + Income)/Beginning Value}*100% |
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Term
You bought a share of Coca-Cola stock for $40.00. You sold it for $50.00. Before you sold it, you received a dividend for $5.00.
A. What is your dollar return? |
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Definition
Dollar Return = Capital Gains + Income
Dollar Return = (Ending Value – Beginning Value) + Income
Dollar Return = ($50.00 – $40.00) + $5.00
Dollar Return = ($10.00) + $5.00
Dollar Return = $15.00 |
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Term
You bought a share of Coca-Cola stock for $40.00. You sold it for $50.00. Before you sold it, you received a dividend for $5.00.
B. What is your percentage return? |
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Definition
Percentage Return = {((End value – Beginning Value) + Income)/Beginning Value}*100%
Percentage Return = {(($50.00 – $40.00) + $5.00)/$40.00}*100%
Percentage Return = {($10.00 + $5.00)/$40.00}*100%
Percentage Return = {$15.00/$40.00}*100%
Percentage Return = {.375}*100%
Percentage Return = 37.5% |
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Term
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Definition
| sum of individual period returns divided by the number of periods |
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Term
Your stock has the following returns for the following years:
2004 6%
2005 8%
2006 10%
2007 12%
2008 14%
What is the average return on this stock? |
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Definition
(6% + 8% + 10% + 12% + 14%)/5
(50%)/5
10% is the average return |
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Term
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Definition
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Term
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Definition
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Term
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Definition
| Don’t put all of your eggs into one omelette |
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Term
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Definition
| Firm specific risk + Market risk |
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Term
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Definition
| diversification (aka unsystematic risk); it can be diversified away in a well-chosen portfolio. |
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Term
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Definition
| non-diversifiable (aka systematic risk); it cannot be diversified away |
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Term
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Definition
| Either the highest return for a given level of risk or the lowest risk for a given return |
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Term
| Correlation: how 2 stocks move compared to each other over time |
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Definition
A. Positively correlated: they move together
B. Negatively correlated: they move opposite each other |
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Term
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Definition
| calculate the portfolio return based on the weight or proportion of each asset in the portfolio |
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Term
Your portfolio is composed of the following stocks in the following percentages. The return of each stock is also given in the table.
Stock % of Portfolio % Return
Wal-Mart 50% 12%
Coca-Cola 30% 10%
Kellogg’s 20% 5%
What is the portfolio return? |
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Definition
Portfolio Return = (.50)(.12) + (.30)(.10) + (.20)(.05)
Portfolio Return = .06 + .03 + .01
Portfolio Return = .10
Portfolio Return = 10% |
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Term
| The expected return on a security is based on |
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Definition
| the probability of different outcomes occurring |
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Term
| You own a share of Kellogg’s stock. There is a 10% probability of a 12% return, a 40% probability of a 10% return, and a 50% probability of a 4% return. What is the expected return? |
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Definition
Expected return = (.10)(.12) + (.40)(.10) + (.50)(.04)
Expected return = 0.012 + .04 + .02
Expected return = 0.072
Expected return = 7.2% |
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Term
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Definition
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Term
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Definition
| Risk-free rate + Risk Premium |
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Term
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Definition
| the rate of return an investor can earn when there is no risk (Such as a short-term Treasury Bill) |
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Term
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Definition
| an extra amount of return an investor requires for taking on extra risk |
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Term
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Definition
| : a measure of the co-movement between a stock and the market as a whole. The Beta of the Market is 1 |
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Term
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Definition
| stock over-reacts. It moves to a greater degree than the market |
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Term
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Definition
| The stock reacts proportionally. It moves to the same degree than the market |
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Term
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Definition
| The stock under-reacts. It moves to a lesser degree than the market. |
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Term
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Definition
| The stock moves opposite the market |
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Term
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Definition
| Capital Asset Pricing Model |
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Term
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Definition
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Term
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Definition
| the Risk-free rate of return |
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Term
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Definition
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Term
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Definition
| the Return of the Market as a whole |
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Term
| You are looking at a stock whose Beta is 1.25. The risk-free rate of return is 5%. The return of the market is 13%. What is your required return for this stock? |
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Definition
Required Return = Rf + B(Rm – Rf)
Required Return = .05 + 1.25(.13 – .05)
Required Return = .05 + 1.25(.08)
Required Return = .05 + .10
Required Return = .15
Required Return = 15% |
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Term
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Definition
| to undertake and calculate the cost |
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Term
| Weighted Average Cost of Capital |
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Definition
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Term
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Definition
= (Cost of Equity)*(% Equity is of Your Total)
+ (Cost of Preferred Stock)*(% Preferred Stock is of Your Total)
+ (Cost of Debt)*(% Debt is of Your Total) |
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Term
| You are going to finance a project with 60% common stock, 10% preferred stock, and 30% debt. The cost of equity is 12%, the cost of preferred stock is 10%, and the cost of debt is 8%. What is the WACC? |
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Definition
WACC = (60%)(12%) + (10%)(10%) + (30%)(8%)
WACC = (.60)(.12) + (.10)(.10) + (.30)(.08)
WACC = 0.072 + 0.01 + 0.024
WACC = 0.106
WACC = 10.6% |
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Term
| There are different tax treatments for different financing methods. |
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Definition
| 1. To pay for common stock and preferred stock, the corporation sends dividends to shareholders. For the corporation, dividends are paid AFTER taxes are paid. |
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Term
| There are different tax treatments for different financing methods. |
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Definition
| 2. To pay for debt (bonds), the corporation sends interest payments to shareholders. For the corporation, interest is paid BEFORE taxes are paid. This payment lowers taxable income for the corporation, so effectively this tax break lowers the cost |
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Term
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Definition
1. Project WACC
2. Division WACC
3. Company WACC |
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Term
| How much debt vs. how much equity? |
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Definition
DEBT
Good Bad
1. Do not have to have cash on hand 1. Scheduled interest payments increase risk
2. Tax benefits 2. Leverage works both ways
3. Bondholders do not vote
4. Leverage -- the use of borrowed money to magnify your gains |
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Term
| Buy a house for $100,000 and sell for $110,000 |
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Definition
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Term
| You pay $100,000 of your cash up front – all equity. Your profit as a percentage of your equity is |
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Definition
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Term
| You pay $10,000 of your cash up front and borrow the rest. Your profit as a percentage of your equity |
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Definition
| equity is $10,000/$10,000 = 100% |
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Term
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Definition
| magnifies your gains as a percentage of what you have invested. |
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Term
| Pro Forma Income Statement |
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Definition
| is a Projected (Before the Fact) Income Statement |
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Term
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Definition
| the value of the next best alternative |
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Term
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Definition
| costs already incurred or committed to that cannot be recouped. You must ignore sunk costs when deciding whether or not to proceed with a project. |
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Term
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Definition
| When you choose a project or a path, your choice is a substitute for other options |
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Term
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Definition
| When you choose a project or a path, your choice opens up related opportunities |
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Term
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Definition
| a plan of action expressed in dollars |
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Term
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Definition
| a plan of action expressed in dollars where decisions are made for choosing and/or rejecting capital projects |
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Term
| 4-Step Decision-Making Process |
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Definition
1. Search for and discovery of investment opportunities
2. Collection of data
3. Evaluation of projects and decision making
4. Reevaluation and adjustment |
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Term
| Investment opportunities can take on a number of forms |
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Definition
1. Creating a new business
2. Expanding an existing business
3. Replacing a capital asset
4. Creating a new product line or line of business |
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Term
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Definition
| If we find or create an investment opportunity, we need data regarding the opportunity. We collect existing data about many things: market for the good or service, competition, operating costs, potential sales volume, initial investment, lifespan of the project, cost of capita, and so forth |
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Term
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Definition
| We use the data we collect and create to evaluate the projects, so our evaluation and decision-making are only as good as the data we use. If our data is bad, our decision could be bad also |
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Term
| To evaluate our projects, we have 3 big methods to evaluate potential capital expenditures |
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Definition
1. Payback Method
2. Net Present Value
3. Internal Rate of Return |
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Term
. Payback Method.
We compute the time required to recoup our initial investment in a project. To do this, we total the annual incremental positive cash flows from the project and determine how long it takes to recover the money we initially invested. |
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Definition
| For example, suppose that we are looking at a project with an initial cost of $10,000. We forecast that the project will generate an additional $2,500 per year positive cash flows. To calculate the Payback Period, we divide $10,000 by $2,500 per year to get a 4-year payback period. We look at a second project with an initial cost of $10,000. We forecast that this project will generate an additional $2,000 per year positive cash flows. To calculate the Payback Period, we divide $10,000 by $2,000 per year to get a 5-year payback period. What do we do? Choose the first? The second? Both? Neither? It looks like the first option is better, but this Payback Method has some problems in addition to its positive aspects. |
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Term
| It looks like the first option is better, but this Payback Method has some problems in addition to its positive aspects. |
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Definition
Good Bad
1. Fast 1. No clear decision rule
2. Easy 2. No consideration of the time value of money
3. Rough estimate of risk 3. No consideration of cash flows after the payback period is over
4. Based upon estimates |
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Term
. Net Present Value
The Net Present Value is the present value of the Net Cash Flows. To calculate this, we calculate the present value of the cash flows the project will generate then subtract our initial investment. This method uses the formulas we had to calculate the present values of lump sums and annuities. |
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Definition
Assume we are considering a project which will generate Net Cash Flows of $10,000 per year for the next 5 years. Its initial cost is $40,000. The discount rate is 10%. Do we accept this project? Why or why not?
Our initial reaction is to accept because it costs $40,000 and we get $50,000 back ($10,000 per year * 5 years = $50,000). Please note, calculating this way does not consider the time value of money with the 10% discount rate. We have to calculate the present value of the annuity of $10,000 per year for the 5 years discounted at the 10% rate and then subtract the initial cost of $40,000 to determine the Net Present Value. |
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Term
| Our initial reaction is to accept because it costs $40,000 and we get $50,000 back ($10,000 per year * 5 years = $50,000). Please note, calculating this way does not consider the time value of money with the 10% discount rate. We have to calculate the present value of the annuity of $10,000 per year for the 5 years discounted at the 10% rate and then subtract the initial cost of $40,000 to determine the Net Present Value. |
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Definition
NPV = PVNCF’s – Initial Cost
NPV = [PVAN = PMT * (Magic # Appendix D i%, n periods)] – Initial Cost
NPV = [PVAN = $10,000 * (Magic # Appendix D 10%, 5 periods)] – $40,000
NPV = [PVAN = $10,000 * (3.791)] – $40,000
NPV = $37,910 – $40,000
NPV = -$2,090 |
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Term
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Definition
IF NPV > or = 0, accept,
IF NPV < 0, reject |
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Term
IF NPV > or = 0, accept,
IF NPV < 0, reject |
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Definition
| So in this case we reject the project because the NPV < 0. In other words, the Net Present Value is a negative number |
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Term
| What if the discount rate changed to 7% instead of 10%? The calculations change to |
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Definition
NPV = PVNCF’s – Initial Cost
NPV = [PVAN = PMT * (Magic # Appendix D i%, n periods)] – Initial Cost
NPV = [PVAN = $10,000 * (Magic # Appendix D 7%, 5 periods)] – $40,000
NPV = [PVAN = $10,000 * (4.100)] – $40,000
NPV = $41,000 – $40,000
NPV = $1,000
In this case we accept the project because the NPV > 0. In other words, the Net Present Value is a positive number. |
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Term
Good Bad
1. Clear decision rule 1. More difficult to calculate with unequal cash flows
2. Consideration the time value of money 2. Based upon estimates
3. Considers all cash flows
4. Easy to understand the result |
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Definition
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Term
| Internal Rate of Return is |
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Definition
| is a variation on the NPV method. With the Internal Rate of Return, we are calculating the discount rate that makes the Present Value of the Net Cash Flows equal the Initial Investment. Put another way, we are calculating the discount rate that makes the NPV of the project equal 0. Once we have the IRR calculated, we compare it to the cost of capital and make a decision to accept or reject. |
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Term
| Suppose we are looking at a project that will generate net cash flows of $10,000 per year for 5 years. The initial cost of the project is $39,993. The cost of capital is 9%. Do we accept this project? Why or why not? |
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Definition
To solve this problem, we use the NPV formula, but we start by setting the NPV equal to 0 and solve for the i%.
NPV = PVNCF’s – Initial Cost
NPV = [PVAN = PMT * (Magic # Appendix D i%, n periods)] – Initial Cost
0 = [PVAN = $10,000 * (Magic # Appendix D i%, 5 periods)] – $39,993
$39,993 = [PVAN = $10,000 * (Magic # Appendix D i%, 5 periods)]
$39,993 = [$10,000 * (Magic # Appendix D i%, 5 periods)]
3.9993 = (Magic # Appendix D i%, 5 periods)
Go to the Appendix D. See that in the 5 period row, the number 3.9993 is associated with a discount rate of 8%. This tells us that the IRR is 8%. |
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Term
Decision Rule:
IF IRR > or = cost of capital |
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Definition
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Term
| Decision Rule:IF IRR < cost of capital |
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Definition
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Term
| In this case, the IRR is less than the cost of capital, so we reject the project. The return is not great enough |
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Definition
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Term
| What if the cost of capital decreased to 7% instead? With an IRR of 8%, |
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Definition
| we would accept the project because our return is greater than the cost of capital. |
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Term
Good Bad
1. Clear decision rule 1. Very difficult to calculate with unequal cash flows
2. Consideration the time value of money 2. Based upon estimates
3. Considers all cash flows 3. Can be difficult to calculate with the algebra involved
4. Easy to understand the result
5. Finance people like percentages |
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Definition
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Term
| Reevaluation and adjustment |
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Definition
| After the projects that are selected are actually implemented, we need to monitor the progress and evaluate whether or not our estimates and projections are developing the way we predicted them to |
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