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# CORPORATION FINANCE FIN 306

Clemson

GPA 3.69

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This 2 page Class Notes was uploaded by Nayeli Wehner on Saturday September 26, 2015. The Class Notes belongs to FIN 306 at Clemson University taught by William Johnson in Fall. Since its upload, it has received 53 views. For similar materials see /class/214199/fin-306-clemson-university in Finance at Clemson University.

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Date Created: 09/26/15

Chapter 8 Net Present Value NPV The difference between an investments market value and its cost Discounted Cash Flow DCF Valuation The process of valuing an investment by discounting its future cash ows Payback Period The amount of time required for an investment to generate cash flows sufficient to recover its initial cost A e age Accounting Return AAR An investments average net income divided by its average book value AAR Average Net Income Average Book Value Book Value Initial CostZ Always STRAIGHTLINE METHOD Internal Rate ofReturn IRR The discount rate that makes the NPV of an investment zero Net Present Value Profile A graphical representation of the relationship between investments NPV and various discount rates Interest Rate INCREASES NPVDECREASES Multiple Rates of Return The possibility that more than one discount rate makes the NPV ofan investment zero Mutually Exclusive Investment Decisions A situation where taking one investment prevents the taking of another Profitability Index PI The present value ofan investments future cash flows divided by its initial cost Also benefitcost ratio PI PV ofCash Flows Initial Cost ofInvestment IVhen doing PI ALWAYS SETij 0 Chapter 9 Incremental Cash ows The difference between a firms future cash flows with a project and those without the project Standalone Principle The assumption that evaluation ofa project maybe based on the projects incremental cash ows Sunk Cost A cost that has already been incurred and cannot be recouped and therefore should not be considered in an investment decision Opportunity Cost The most valuable alternative that is given up ifa particular investment is undertaken Erosion The cash flows ofa new project that come at the expense ofa firms existingprojects Pro forma financial statements epreciation Tax Shield The tax saving that results from the depreciation deduction calculated as depreciation multiplied by the corporate tax rate Tax Shield Approach Sales Costs x1 TaxRate Dep x Tax Rate OCF Accelerated Cost Recovery System ACRS Depreciation method under U S tax law allowing for the accelerated writeoff of property under various classifications Forecasting Risk The possibility that errors in projected cash flows will lead to incorrect decisions Also Estimation Risk Scenario Analysis The determination of what happens to NPV estimates when we ask what if questions Sensitivity Analysis Investigation ofwhat happens to NPV when only one variable is chan ed Managerial Options Opportunities that managers can exploit if certain things happen in the future Also known as real opt1ons Contingency Planning Taking into account the managerial options implicit in a project Strategic Options Options for future related business products or strategies Capital Rationing The situation that exists ifa firm has positive NPV but cannot obtain the necessary financing Soft Rationing The situation that occurs when units in a business are allocated a certain amount of financing for capital budgeting Hard Rationing The situation that occurs when a business cannot raise financing for a project under any circumstances Operating Cash Flow Equation SALVAGE VALUE is NOTin OCF but is in NPV k k k Sales FC Depreciation EBIT Depreciation OCF Chapter 10 Risk Premium The excess return required from an investment in a risky asset over that required from a riskfree investment Variance The average squared difference between the actual return and the average return Standard Deviation The positive square root ofthe variance Normal Distribution A symmetric bellshaped frequency that is completely defined by its average and standard deviation Geometric Average Return The average compound return earned per year over a multiyear per1o ArithmeticAverage Return The return earned in an average year over a multiyear period Efficient Capital Market Market in which security prices reflect available information Efficient Markets Hypothesis EMH The hypothesis that actual capital markets such as NYSE are efficient VARIANCE Year Annual Return Average Return Actual Average ActualAveragequotZ 1 254 2 058 0254 0326 00106 3 079 0254 0536 00287 4 112 0254 1374 01888 5 024 0254 0494 00244 Sum Actual Average 2 Returns 1 03537 51 00884 Iftrying tojind the Standard Deviation SQRT 00884 RANGE OF RETURNS 90 Probability Range Average Return 1 x STD Deviations 95 Probability Range Average Return 2 x STD Deviations 99 Probability Range Average Return 3 x STD Deviations GEOMETRIC AVERAGE RETURN Year Annual Return Add 1 Multiply Together 263 X 1263 1 2 198 1 x 1198 3 046 1 x 954 4 079 1 x 1079 155751 RAISE T0 POWER 11 Y x 155751A14 111714 SUBTRACT1 111714 1 011714 11714 DISCOUNTED CASH FLOW CRITERIA Net Present Value NPV The NPV ofan investment is the difference between the market value and its cost The NPV rule is to take a project if it39sNPVis POSITIVE NPV is frequently estimated be calculating the present value ofthe future cash flows to estimate market value and then subtracting the cost NPV has no serious aws it is the PREFERRED DECISION CRITERION Internal Rate ofReturn IRR the IRR is the discount rate that makes the estimated NPV ofan investment equal to zero it is sometimes called the discounted cash ow DCF return The IRR rule is to take a project when its IRR EXCEEDS the required return IRR is closely related to NPV and itleads to exactly the same decisions as NPV for conventional independent projects When project cash ows are not conventional there maybe no IRR or there maybe more than one More seriously the IRR cannot be used to rank mutually exclusive projects the project with the HIGHEST 155 is not necessarily the preferred investment Profitability Index PI The PI also called the bene tcost ratio is the ratio of Present Value to Cost The PI rule is to take an investment ifthe indexEXCEEDS 1 The PI measures the present value ofan investment per dollar invested It is quite similar to NPV but like IRR it cannotbe used to rank mutually exclusive projects However it is sometimes used to rankprojects when a firm has more positive NPV investments than it can currently finance Payback Period The paybackperiod is the length oftime until the sum of an investments cash flow equals its cost The paybackperiod rule is to take a project if its payback is LESS THANsome cutoff The paybackperiod is a flawed criterion primarily because it ignores risk the time value of money and cash flows beyond the cutoffpoint Average Accounting Return AAR The AAR is a measure of accounting profit relative to book value It is NOT related to the IRR but it is similar to the accounting return on assets RDA measure in chapter 3 The AAR rule is to take an investment if it39s AAR EXCEEDS a benchmark AAR The AAR is seriously flawed for a variety of reasons and it has little to recommend it

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