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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