Finance Final Exam

Holding Period Return

The total return. Includes the return from reinvesting the dividends every year.

Why does traditional NPV analysis tend to underestimate the true value of a capital budgeting project?

Traditional NPV analysis is too conservative because it ignores profitable options such as the ability to expand if it is profitable or the ability to abandon if it is not profitable. The option to alter a project when it has already been accepted has a value, which increase the net present value.

R (t)

(1+R1) X (1+R2) X (1+R3) ...

Cov (RA,RB)

(RA - E(RA)) x (RB - E(RB)) = ADD UP ALL

Monte Carlo Simulation

1. Specify the basic model 2. Specify a distribution for each variable in the model 3. The computer draws one outcome 4. Repeat the procedure 5. Calculate NPV

Variance

1/T-1 [(R1-R)SQ + (R2-R)SQ + (R3-R)SQ]

Marginal Revenue and Costs

Accepting a project with marginal revenue in excess of its marginal costs clearly acts to increase operating cash flow.

Real Options

Adjustments to expand or abandon. NPV underestimates the true value of a project.

How does sensitivity analysis interact with break-even analysis

Sensitivity analysis can determine how the financial break-even point changes when some factors change

Corr(RA,RB)

Cov (RA,RB)/ (St DevA X St DevB)

Beta

Cov (Ri, Rm) / var Rm

Dividend Yield

Div (t+1) / P (t)

Total Dollar Return

Dividend Income + Capital Gain/Loss

R (t+1)

Dividend Yield + Capital Gain/Loss

Forms of return of Stock

Dividends to shareholders is the income component of your return. Capital gain or capital loss is the second component of your return.

Total Return

Expected Return + Unexpected Return

Total Cash if stock is sold

Initial Investment + Total dollar Return

Blume's Formula

R(T) = (T-1)/(N-1) X Geometric Average + (N-T)/(N-1) X Arithmetic Average

E(R)

Risk Free Rate + Beta of Security X Difference between expected return on market and risk free rate. <or risk premium

Sharpe Ratio

Risk Premium of the Asset / Standard Deviation

Standard Error

SD/sq(the number of observations) Helps with the issue of how much confidence we can have in our historical average.

Unexpected Return

Systematic and Unsystematic

Arithmetic Average Return

Tells you what you earned in a typical year.

What is the sensitivity of NPV to changes in the sales figure?

The change in NPV sold will always be the same for any number of sales we choose.

Risk Premium

The difference between risky returns and risk-free returns is called the excess return on the risky asset.

Order of Break-Even Analysis

The project will reach the cash break-even first, accounting break-even second, and financial break-even last if the project has an initial investment and sales after.

Ex-post Return

The return we actually end up getting from a project.

Ex-ante Return

The return we expect to get from a project, and on which we base our decisions.

What is the sensitivity of OCF to changes in the variable cost figure?

We will get the same ratio of OCF to a one dollar change in variable cost no matter what variable cost we choose.

Disadvantages of Sensitivity Analysis

increase the false sense of security among manages; treats each variable in isolation when the different variables are likely to be related

Why is Accounting Break-Even point different from the Financial Break-Even point?

When we use accounting profit as the basis for the break-even calculation, we subtract depreciation. This will not cover the economic opportunity costs laid out for the investment. Depreciation understates the true costs of recovering the initial investment. Companies that break even on an accounting basis are really losing money. They are losing the opportunity cost of the initial investment.

Difference between Sensitivity Analysis and Scenarios Analysis

With a sensitivity analysis, one variable is examined over a broad range of values. With a scenario analysis, all variables are examined for a limited range of values

Should you still consider the capital gain as part of your return if you don't sell it at year end?

Yes, you can sell the stock at year-end and immediately buy it back. You would not lose your return when you buy it back. You would be in exactly the same position as if you had not sold the stock.

Geometric Average Return

[(1+R1) x (1+R2) x (1+R3]^[1/t] - 1 Geometric average will always be smaller as long as the returns are not all identical; The geometric average returns tells you what you actually earned per year on average, compounded annually.

Present Value Break-Even Point

[(EAC+(Fixed Costs)(1-t)-(Depreciation)(t)] / [(Sales Price - Variable Costs)(1-t)]

Accounting Break-Even Point

[(Fixed Costs + Depreciation)(1-t)] / [(Sales Price - Variable Costs)(1-t)]

Capital Gain/Loss

[P (t+1) - P (t)] / P (t)

Scenario Analysis

a variant of sensitivity analysis; examines a number of different likely scenarios, where each scenario involves a confluence of factors

Variable Costs

change as the output changes

Break-Even Analysis

determines the sales needed to break even; complement to sensitivity analysis because it sheds light on the severity of incorrect forecasts

Sensitivity Analysis

examines how sensitive a particular NPV calculation is to changes in underlying assumptions

Frequency Distribution

histogram of numbers

Fixed Costs

not dependent on the amount of goods or services produced during the period

Advantages of Sensitivity Analysis

reduces the false sense of security; shows where more information is needed

Forecasting Risk

risk that a poor decision is made because of errors in projected cash flow; danger is greatest with a new product because the cash flows are harder to predict