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FIN3403 Exam 3 Review 10 conceptual 15 computational Chapter 10 3 conceptual 5 computational Chapter 12 4 conceptual 4 computational Chapter 13 3 conceptual 6 computational Depreciation a non cash deduction that affects taxes which are a cash flow The relevant depreciation expense is the depreciation that will be claimed for tax purposes Depreciation Tax Shield Depreciation Expense Marginal Tax Rate Straight Line Depreciation D Initial Cost salvage number of years very few assets are depreciated straight line for tax purposes MACRS D initial cost IRS Percentage each asset is assigned a specific property class assets are depreciated to zero mid year convention causes depreciate expense to be taken in one more year than specified by the property class 3year MACRS has 4 years of depreciation expense Capital Budgeting Decision Making Tools 1 Does the decision rule adjust for the time value of money 2 Does the decision rule adjust for risk 3 Does the decision rule provide information on whether we are creating value for the firm Net Present Value cost the difference between the market value of a project and its Calculation 1 Expected future cash flows 2 Estimate R aka discount rate 3 PV of cash flows initial investment Goal increase owners wealth IF NPV is positive accept the project Account for time value of money Yes Account for risk of cash flow Yes Increase in value Yes NPV rule as primary decision rule Yes Internal Required Return NPV 0 the rate that makes the PV the initial cost of investment aka produce a percentage return indicating the value created unreliable with non conventional cash flows of mutually exclusive projects same decision as NPV with conventional cash flows if the cash flows are of loan type meaning money is received at the beginning and paid out over the life of the then IRR is really a borrowing rate and LOWER is project better Calculation 1 Enter cash flows as you would for NPV 2 Press IRR then CPT 3 Compare IRR to R ACCEPT IF IRR R Account for time value of money Yes Account for risk of cash flow Yes Increase in value Yes IRR rule as primary decision rule Yes NPV and IRR Comparison if a project s cash flows are 1 Conventional costs are paid early and benefits are received over the life and if the project is 2 Independent then NPV and IRR will give the same accept of reject decision NPV and IRR are the most commonly used primary investment criteria NPV directly measure the increase in value to the firm Whenever there is conflict between NPV and another decision rule always use NPV IRR is unreliable in the following situations non conventional cash flows multiple sign changes mutually exclusive events if you choose one you can t choose the other Choose the Project with the higher NPV Cash Flows in Capital Budgeting Decision Making Relevant Cash flows cash flows that occur or don t occur because a project is undertaken Incremental cash flows any and all changes in the firm s future cash flows that are a direct consequence of taking the project Sunk cost a cash flow already paid or accrued these costs should NOT be included in the incremental cash flows of a project Opportunity costs any cash flows lost or forgone by taking one course of action rather than another Applies to any asset or resource that has value if rather than used sold or leased Erosion or cannibalism new project revenues gained at the expense of existing products services Changes in NWC can adjust for the difference in cash flow that results from accounting conventions Most projects will require an increase in NWC initially as we build inventory and receivables Then we recover NWC at the end of the project NWC current assets current liabilities Change in NWC ending NWC beginning NWC Operating Cash Flow OCF Bottom Up approach works only when there is no interest expense OCF EBIT depreciation taxes OCF net income depreciation Top Down Approach don t subtract non cash deductions depreciation OCF sales costs taxes Tax Shield Approach OCF sales costs 1 t depreciation t After Tax Salvage After tax salvage value salvage tax rate salvage BV Book value initial cost accumulated depreciation If the Salvage value book value you don t pay taxes If the salvage value book value you owe taxes If the salvage value book value you get tax benefit Cash flow from assets CFFA OCF net capital spending NCS changes in NWC NPV with CFFA for each period 1 Initial cash flow set up costs NCS working capital 2 Operating cash flow 3 Final cash flow OCF working capital recovery after tax salvage value Risk and Return Total Dollar Return income from investment capital gain loss Dividend Yield income beginning price Capital Gains Yield ending price beginning price beginning price Total Percentage Return dividend yield capital gains yield Total Percentage Return Total Dollar Return beginning price Risk Premium reward for bearing risk the difference between a risky investment return and the risk free rate treasury bills risk free Efficient Markets Efficient Market Hypothesis modern US stock markets are in general efficient An important implication of the EMH is that the expected return on securities equals their risk adjusted required return Misconceptions market efficiency does not imply that it doesn t make a difference how you invest since the risk return trade off still applies but rather you can t expect to consistently earn excess returns using costless trading strategies the influences of previously unknown information causes randomness in price changes As a result price changes can t be predicted before they happen Efficient capital market market in which current market prices reflect available information In such a market it is not possible to devise trading rules that consistently beat the market after taking risk into account Strong Form Efficiency all information both public and private is already incorporated into the price Empirical evidence indicates that this form of efficiency does NOT hold Semi strong Form Efficiency All public information is already incorporated into the price It says that you cannot consistently earn returns using available information to do fundamental analysis Evidence is mixed but suggests it holds for widely held firms Weak Form Efficiency all market information including prices and volume is included in the price It says that you cannot consistently earn excess returns by looking for patterns in past prices and volume information such technical analysts Evidence suggests that markets

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