Financial Management Of The Firm Chapter 10 Sunk Cost are not included in the analysis consulting fees occurring before project Test marketing expenses incurred by a company for a new product prior to yes no decision Spillover or Side Effects should be included Proctor Gamble introduce new detergent already sells 2 3 of all detergents Outback Steakhouse considers 2nd restaurant 1st restaurant loses sales Opportunity Costs always use true market value as of today CFAT Estimation Procedure divides the project s CFAT into 3 categories 1 Initial Outlay purchase price increase in NWC 2 Operating CFATs 3 Terminal CFAT Depreciation Incremental CFAT refers to any CFATs that are a direct consequence of undertaking the project Straight line Depreciation divide the amount to be depreciated by the projected useful life of the asset MACRS asset falls into a particular property class with an assigned life Half year convention depreciated by the for each year over one more year than the class life Gain or loss on Sale selling price book value at time of sale Corporations must pay taxes on book gains and they realize tax savings on losses In other words if there is a book loss then tax x loss tax savings on sale Net CFAT from salvage selling price t selling price book value The Required Rate of Return on an Investment Proposal is the estimated cost of the funding for the project Capital Rationing refers to a situation where a firm puts a cap on the size of its total capital budget Treasury Bills has no negative nominal returns at all but many years the real rate of return was negative Order of best returns on investments small stocks large stocks long term bonds treasury bills Revenues Cost CFBT taxable income Depreciation EBT Tax Net Income Depreciation CFAT or CFAT CFBT 1 t t D There will be a 4 part problem 1 Initial Outflow Purchase price of building land equipment etc Installation shipping modification of existing facilities Increase in Net Working Capital required if project is undertaken Initial Training after yes no decision if not sunk CFAT disposal of old assets if a replacement problems 2 Operating CFATs year by year CFATs we expect to generate through operations Pro forma income project statement is constructed each year of the project s expected useful life and then depreciation expense associated with the project is added to the net income figure to obtain the estimated operating CFAT for each year 3 Terminal CFATs when business is terminated Recapture of Net Working Capital increases required by the project CFAT from disposal of equipment etc Cleanup expenses associated with the project CFATsalvage selling price tax rate selling price book value then recapture NWC Note Anything not included is interest expense incurred as a result of using debt financing to finance a portion of the assets acquired The costs of financing are accounted for in the project s discount rate required rate of return and therefore it would be double counting to include the interest expense when computing the CFATs of the project 4 Compute NPV IRR NOTE never depreciate land Chapter 12 13 Classes of Assets Common Stocks S P500 Small Stocks portfolio comprised of the smallest 20 of the companies on the NYSE Long Term U S Treasury Bonds 20 year maturity Treasury bond held for one year U S Treasury Bills T Bills three month maturity rolled over 4 times a year Top 500 stocks make up 80 of all stock equity Risk is associated with the uncertainty of the outcome from an investment Investments with greater risk are characterized by greater variability in returns over time We often measure the risk of a security or portfolio by calculating the dispersion in historical returns for the security or portfolio of concern Risk Premium difference between the expected return on a risky asset and a risk free asset or the difference between the actual return on a risky asset and the actual return on a risk free asset Geometric Mean Return GMR is the average periodic compound rate of return Arithmetic Mean Return AMR is the simple average GMR AMR whenever there is any variability in the period to period returns Efficient Capital Market a market where prices always fully reflect all available information and thus where prices are fair at any point in time It is not possible to develop trading strategies based on available information that are capable of producing excess or abnormal returns on a consistent basis in other words we could not develop strategies that produce greater than fair returns for the risk assumed consistently but that does not mean we can t make or lose a lot of money Returns on a portfolio are a weighted average of the returns on the securities that comprise the portfolio The weight on each security is the of the portfolio invested in that security security portfolio Real Returns are actual returns adjusted for inflation Average returns over long periods of time were higher for those classes of assets that had greater variability Greater risk is associated with higher average returns Variability is higher with one stock than 100 stocks Its easier for the individuals to diversify than it is for a corporation Individual stocks would have a higher standard deviation than a portfolio because the latter is Interest rate increasing causes a market wide stock decrease diversified A stock price depends on Projected EPS and DPS The current level of interest rates The level of risk aversion among investors Firm Specific Information Unsystematic Risk Diversifiable Ford Motor omits dividends CEO resigns Market Wide Information Systematic Risk Non diversifiable FED changes interests rates Inflation changes GDP statements released The total risk of a security is measured by the standard deviation of the returns of the security Diversification is used to curb risks and not to increase expected returns Through diversification the risk can be eliminated but the other half is the market risk Most of the risk reduction is achieved when the number of securities reaches 25 to 30 At first the average standard deviation of a portfolio declines rapidly as securities increases then it starts to level out The market s required rate of return on the stock and bonds of a firm is closely related to the firm s cost of raising equity and debt capital Fair Req d Rate of Return Risk Free Rate Risk Premium Finance Models aimed at explaining how to compute RRR s on financial securities have focused on systematic risk which is measured by
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