Finance Midterm 2

Risk Premium

Added return from bearing risk RP =% return - risk free rate

Beta

Beta highly varies over time. Firms that have cyclical revenues and operating leverage causes varied betas. More Leverage will increase the beta for the firm, but not the assets.

Real Options

Contracts to expand, abandon, and timing options.

CAPM

Determines cost of equity and debt.

Problems with IRR

Disadvantages: Does not distinguish between investing and borrowing IRR may not exist, or there may be multiple IRRs Problems with mutually exclusive investments Advantages: Easy to understand and communicate problems: Multiple IRRs Are We Borrowing or Lending The Scale Problem The Timing Problem

Payback Discount Rate

Discounted payback rate.

EAC

Equivalent Annual Cost (EAC)

Should flotation costs be calculated and what are they?

Flotation costs is the money spent to raise money. The "required return on an investment is determined by the risk of the investment, not the source of funds."

Return

Gain of price of invesment PLUS div all divided by beg market value

IRR

IRR: the discount rate that sets NPV to zero Minimum Acceptance Criteria: Accept if the IRR exceeds the required return Ranking Criteria: Select alternative with the highest IRR Reinvestment assumption: All future cash flows are assumed to be reinvested at the IRR

How do you price a real option?

M = NPV + Opt NPV is just NPV Opt is the same as NPV, but change in the payoff For Npv: a =(expected return x percent)+ (expected return x percent) Then = cost + ( a / discount rate)

Cost of Equity Capital

Risk free rate + beta ( market risk premium)

SD

Root of variance

What is the equity risk premium puzzle?

Small cap companies receive lots of money of the years. The return is higher than what the risk is

Different Types of Risk. How do you get rid of them?

Systematic ( market) and non-systematic ( div) risk. Div to get rid of non-systematic risk

Payback Rate

The amount of time it takes to payback the initial investment. Does not determine future cash flows after

What happens to the CAPM if the firm only uses equity financing?

The beta of the firm equals the beta of the equity

Holding Period Return

The holding period return is the return that an investor would get when holding an investment over a period of T years, when the return during year i is given as Ri:

What is the equity risk premium?

The price of risk. It is a market wide measure Why does it matter? It affects the discount rate for cash flows with average risk. In a risk neutral world there is no equity risk premium.

OCF

Top-down— (OCF =Sales- cash costs- taxes) Bottom-up— (OCF = Net Income (EBIT-taxes) + Depreciation) Tax shield— (OCF = OCF without Depreciation expense + Depreciation expense tax shield) Incremental cash flow is the additional operating cash flow that an organization receives from taking on a new project. A positive incremental cash flow means that the company's cash flow will increase with the acceptance of the project. There are several components that must be identified when looking at incremental cash flows: the initial outlay, cash flows from taking on the project, terminal cost (or value) and the scale and timing of the project. A positive incremental cash flow is a good indication that an organization should spend some time and money investing in the project. Incremental Cash Flow and Capital Budgeting When determining incremental cash flows from a new project, several problems arise: sunk costs, opportunity costs, externalities and cannibalization. Read more: Incremental Cash Flows - Complete Guide To Corporate Finance | Investopedia http://www.investopedia.com/walkthrough/corporate-finance/4/capital-investment-decisions/incremental-cash-flows.aspx#ixzz3rdaz4Flw Follow us: Investopedia on Facebook

NPV

Total PV of future CF's + Initial Investment Minimum Acceptance Criteria: Accept if NPV > 0 Ranking Criteria: Choose the highest NPV *Preferred decision criterion*

WACC

Weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is proportionately weighted. All sources of capital, including common stock, preferred stock, bonds and any other long-term debt, are included in a WACC calculation. A firm's WACC increases as the beta and rate of return on equity increase, as an increase in WACC denotes a decrease in valuation and an increase in risk. To calculate WACC, multiply the cost of each capital component by its proportional weight and take the sum of the results. The method for calculating WACC can be expressed in the following formula: Weighted Average Cost Of Capital (WACC) Read more: Weighted Average Cost Of Capital (WACC) Definition | Investopedia http://www.investopedia.com/terms/w/wacc.asp#ixzz3rdapEeCl Follow us: Investopedia on Facebook

Variance

_____ 1 Var = T − 1 [(R1 − R ) 2 + (R2 − R ) __ __ 2 + (R3 − R ) 2 + (R4 − __ R ) __ 2 ]