Financial Modelling 2555A/B Study Guide  Midterm Guide: Sunk Costs, Standard Deviation, Accounts Payable
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7 Dec 2016
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Npv rule recognizes 3 things: $ today is worth more than $ tomorrow, only takes into account cash flows and the opportunity cost of capital, can add npv because all measured in todays $ Book rate of return = book income/book assets. Depends on which items accountants treat as capital investments + how fast they depreciate. Payback period: number of years it takes before cumulative cash flow = initial investment. Payback rule: accept investments if payback period < cutoff. Payback and misleading answers: ignores cash flows after cutoff, gives equal weight to cash flows before cutoff. Why use payback rule: simplest way to communicate profitability, if managers want quick profit, could look to pbr, if small businesses want rapid payback projects. Discounted payback measure: how many years a project has to last to make sense in terms of. Rate of return = payoff/investment 1 = r (c1 = payoff, c0 = investment)
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The discounted dividend model can be used to value divisions and firms that do not pay dividends. For the discounted dividend model, a firm's weighted average cost of capital is used as the discount rate. For the corporate valuation model, a firm's cost of equity is used as the discount rate. 
For the constant growth model to hold, a firm's cost of equity needs to be greater than its constant dividend growth rate (i.e., rs > g). From the constant growth model, if the constant dividend growth rate is equal to zero, a firm's share price is equal to the constant dividend divided by the cost of equity (i.e., g=0). If a company's constant dividend growth rate is negative, the formula for the constant growth model cannot be applied. 
The internal rate of return method (IRR) assumes that cash flows are reinvested at the internal rate of return. The modified internal rate of return method (MIRR) assumes that cash flows are reinvested at the weighted average cost of cpaital. For mutually exclusive projects, if there is a conflict between NPV and IRR, the project with the highest IRR is chosen. The IRR is independent of a firm's weighted average cost of capital. 
The WACC only represents the "hurdle rate" for a typical project with average risk. Therefore, the project's WACC should be adjusted to reflect the project's risk. Firms with riskier projects generally have a lower WACC. Holding all else constant, an increase in the target debt ratio tends to lower the WACC. 
Shortterm bond prices are less sensitive than longterm bond prices to interest rate changes. Companies are not likely to call bonds unless interest rates have declined significantly. Thus, the call provision is valuable to firms but detrimental to long term investors. On balance, bonds that have a sinking fund are regarded as being safer than those without such a provision. 
If beta < 1.0, the security is less risky than average. According to the Security Market Line (SML), in general, a companyâs expected return will double when its beta doubles. According to the Security Market Line (SML), if a portfolio of real world stocks has a beta of zero, the required rate of return for the portfolio is equal to the riskfree rate. 
7.37%. 11.05%. 8.32%. 
It ignores cash flows occurring after the payback period. It ignores the time value of money, that is, dollars received in different years are all given the same weight. 
1.82. 2.00. 1.94 
undervalued. overvalued. 
13.92%. 16.34%. 12.17%. 
$221.86. $195.23. $257.35. 
10.82%. 11.76%. 9.64%. 
10 years. 4.58 years. 6.12 years. 
12.04%. 14.93%. 9.15%. 
1.24 years. 1.62 years. 1.15 years.
