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Final

# Final Review Final Review Notes

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Department
Economics
Course
ECON 371
Professor
Huang Hui
Semester
Winter

Description
Review for the ﬁnal exam Helen Huang ECON 371 Information for Final Time and Venue: ◮ Time: 4-6:30pm Dec.19 2009 ◮ Room allocation: ⋆ Section 001 (4:00pm class): PAC 4 ⋆ Section 002 (5:30pm class): PAC 5 Oﬃce hours: ◮ 4-5:30pm Dec.17, 2009 ◮ 4-5:30pm Dec.18, 2009 Information for Final Format: ◮ 20 multiple choice questions ◮ 4 short-answer questions Distribution: ◮ 30% from materials before Mid-term ◮ 70% from materials after Mid-term Only non-programmable calculators are allowed during the ﬁnal exam. In particular, ﬁnancial calculators are not allowed. Overview for Final The ﬁnal exam covers Chapters 4, 5, 6, 7, 8, 10 and 11. Chapter 4 (the time value of money, TVM) is the most important chapter Chapters 5 and 6 are just applications of the TVM to price bonds and stocks, respectively ◮ The fair price of any asset/security is the present value of all the cash ﬂows of the asset/security when discounted at an interest rate appropriate for the risk of the cash ﬂows Overview for Final NPV = PV (cash ﬂows) - investment Typically known 1) Forecasts of future cash ﬂow 2) Cost of capital (i.e. discount rate) depends on the risk of the project Overview for Final Chapter 7 NPV and other investment criteria Chapter 8 ◮ Which cash ﬂows are relevant? ◮ Calculating cash ﬂows Overview for Final Chapter 10 how to measure and quantify risk? ◮ Diversiﬁcation eliminates unique risk, so only the market risk counts in the end Chapter 11 the risk-return trade-oﬀ ◮ The expected rate of return on an asset/security given its market risk (β): CAPM and SML For materials before the mid-term, see Review for Mid-Term. Net present value (NPV) NPV is the only reliable criterion Alternative criteria: ◮ IRR ⋆ Compute IRR: By graph (NPV proﬁle) Excel spreadsheet ◮ Payback ◮ Discounted payback ◮ Each of the above alternative criteria has its own pitfalls Net present value (NPV) The NPV rule can be modiﬁed to handle: ◮ The Investment timing decision ◮ Machines of diﬀerent lives ⋆ the equivalent annual costs (EACs) ◮ Replacement decision ⋆ the equivalent annual costs (EACs) Capital rationing: combine NPV with proﬁtability index (PI) Discounted cash ﬂow analysis Discount incremental cash ﬂows: ◮ In particular, you need to be careful about: ⋆ Include both direct and indirect eﬀects of a project ⋆ Ignore sunk costs ⋆ Include opportunity costs (i.e. alternative uses of the investment in the project) ⋆ Include investment in working capital ⋆ Include allocated overhead costs if resulted directly from the project, ignored otherwise Discounted cash ﬂow analysis Total cash ﬂows from a project are the sum of the following 3 components: 1 Cash ﬂow from investments in plant and equipment ⋆ Most projects need initial capital investments 2 Cash ﬂow from investment in working capital ⋆ For example: cash, accounts receivable, and inventories etc. 3 Cash ﬂow f
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