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FSU FIN 3403 - Exam 3 Review

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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 computationalDepreciation-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 DepreciationD= (Initial Cost-salvage) /number of years-very few assets are depreciated straight-line for tax purposesMACRSD=(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 expenseCapital Budgeting Decision Making Tools1. 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-the difference between the market value of a project and its costCalculation:1. Expected future cash flows2. Estimate R aka discount rate3. PV of cash flows – initial investmentGoal: increase owners wealth** IF NPV is positive, accept the projectAccount for time value of money? YesAccount for risk of cash flow? YesIncrease in value? YesNPV rule as primary decision rule? YesInternal Required Return-the rate that makes the PV = the initial cost of investment, aka NPV =$0-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 project, then IRR is really a borrowing rate, and LOWER is betterCalculation:1. Enter cash flows as you would for NPV2. Press IRR then CPT3. Compare IRR to R* ACCEPT IF IRR > RAccount for time value of money? YesAccount for risk of cash flow? YesIncrease in value? YesIRR rule as primary decision rule? YesNPV 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 MakingRelevant 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 flowsthat are a direct consequence of taking the projectSunk cost: a cash flow already paid or accrued; these costs should NOT be included in the incremental cash flows of a projectOpportunity 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 sold, or leased, rather than used. Erosion(or cannibalism): new project revenues gained at the expense of existing products/servicesChanges 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 liabilitiesChange in NWC= ending NWC- beginning NWCOperating Cash Flow (OCF)Bottom- Up approach-works only when there is no interest expenseOCF= EBIT + depreciation – taxesOCF= net income + depreciationTop-Down Approach-don’t subtract non-cash deductions (depreciation)OCF= sales – costs – taxesTax Shield ApproachOCF= [(sales-costs)(1-t)+(depreciation(t))]Cash flow from assets (CFFA)= OCF- net capital spending (NCS)- changes in NWCAfter-Tax SalvageAfter-tax salvage value= salvage – tax rate(salvage-BV)Book value= initial cost- accumulated depreciationIf the Salvage value= book value, you don’t pay taxesIf the salvage value > book value, you owe taxesIf the salvage value < book value, you get tax benefitNPV with CFFA for each period1. Initial cash flow: set up costs (NCS) + working capital2. Operating cash flow3. Final cash flow: OCF+ working capital recovery+ after tax salvage valueRisk and ReturnTotal Dollar Return= income from investment + capital gain(loss) Dividend Yield= income/beginning priceCapital Gains Yield= (ending price- beginning price)/beginning price Total Percentage Return=dividend yield + capital gains yieldTotal Percentage Return= Total Dollar Return/ beginning priceRisk Premium: reward for bearing risk; the difference between a risky investment return and the risk-free ratetreasury bills= risk freeEfficient 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 returnMisconceptions-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 accountStrong Form Efficiency: all information, both public and private, is already incorporated into the price. Empirical evidence indicates that this form of efficiency does NOT holdSemi-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


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