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FNCE 2P91 (13)
Chapter 9

FNCE+2P91-Corporate+Finance-Notes-Chapter+9+and+Review+for+Midterm.docx

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Department
Finance
Course
FNCE 2P91
Professor
Clarke Melville
Semester
Winter

Description
FNCE 2P91 - Section 05 Winter 2011 - Duration 03 01.03.11 FNCE 2P91: Corporate Finance-Notes-Chapter 9 and Review for Midterm Notes MIDTERM th  Saturday, March 5 at 9:00 am until 12:00 pm o TH325  Exam covers o Chapters 1, 5, 6, 7, 8  Format o 20% Multiple Choice o 80% Problems  7-8 Problems worth 8-12% each  Mostly the math and calculations but there could be definitions  No midterm posted in the library  As much round as you need for the answer to make sense o Judgment call for the rounding o As much needed for the question  No formula supply  Can use a financial calculator o But remember to put down the steps/formulas  Check off professor’s name on the midterm: Melville TONIGHT’S CLASS  First half: Chapter 9  Second half: Review CHAPTER 9  Five Capital Investment Decision Criteria CHAPTER 9 AND 10  Capital Budget o Identify projects that produce cash flow (C/F) that exceed the cost of the project FIVE CAPITAL INVESTMENT DECISION CRITERIA 1. NET PRESENT VALUE (NPV) ∑ Question: Assume Canadian Tire considers a capita project with investment of $50 000 000 and it is going to be earning $16 000 000 per year for the next 4 years and $20 000 000 in year 5. Your required return is 10%. Answer: ( ) ( ) ( ) ( ) ( ) ( ) So increase shareholder wealth by $13.136 million if you accept the project. FNCE 2P91 - Section 05 Winter 2011 - Duration 03 Rule Applied: If NPV > 0 accept the project If MPV < 0 reject the project 2. INTERNAL RATE OF RETURN (IRR) ∑ ( ) Example From Above: ( ) ( ) ( ) ( ) ( ) Solve for IRR, Trial and Error or you would have to use a computer or a financial calculator Try 15%: Try 20%: Try 19%: Try 19.52%: So IRR = 19.52% Rule Applied If IRR > Required Return  Accept the Project If IRR < Required Return  Reject the Project NPV PROFILE NPV 34 13.136 5.62 0 10 15 19.52 Required Return FNCE 2P91 - Section 05 Winter 2011 - Duration 03 3. PROFITABILITY INDEX (PI) OR Rule Applied IF PI > 1  Accept IF PI <1  Reject 4. PAYBACK The number of years to payback the initial investment Example: YEAR CASH FLOWS ∑ 0 (10 000) (10 000) 1 2 500 (7 500) 2 2 500 (3 000) 3 3 000 (2 000) 4 3 000 1 000 5 3 000 4 0000 FNCE 2P91 - Section 05 Winter 2011 - Duration 03 5. DISCOUNTED PAYBACK The number of years to pay back the discounted cash flows Example: Required Return of 10% YEAR CASH FLOW DISCOUNT FACTOR DCF ∑ 0 (5 000) 1 (5 000) (5 000) 1 1 500 1.12 1 363.64 (3 636.36) 2 1 500 (1.1) 1 239.67 (2 399.69) 3 1 500 (1.1) 1 126.97 (1 269.72) 4 4 1 500 (1.15 1 024.52 (245.20) 5 1 500 (1.1) 931.38 686.18 ( ) ( ) [ ] ANALYSIS OF THE 5 MEASURES NPV  Preferred criteria o Takes into consideration time value of money o Gives you the net shareholder wealth  Only as good as the assumptions for cost, cash flow, required return going into it IRR  If you are doing it right it will give you the same answer as NPV  Cannot use to it to rank mutually exclusive projects  Can give multiple answers for non-conventional cash flows BUILD GAS BAR BUILD A STORE IRR 27% 14% NPV $ 1.5 million $ 20 million Payback  Easy  Intuitive  No time value of money  Ignores cash flow beyond payback window PI  Will give you the same answer and the NPV  Cannot use it to rank mutually exclusive projects Discounted Payback  Includes time value of money  Ignores cash flow beyond payback FNCE 2P91 - Section 05 Winter 2011 - Duration 03 CROSS OVER RATES At what discount rate are we indifferent between two mutually exclusive projects Question: Compare 2 projects Year Project A C/F Project B C/F Delta (Difference) 0 (50 000) (100 000) 50 000 1 20 000 0 20 000 2 20 000 0 20 000 3 20 000 140 000 (115 000) IRR 13.8% 11.9% NPV Project B 40 000 15 000 Project A 10.9% 11.9% 13.8% Discount Rates At what rates are we going to be indifferent? That is produce the same NPV? Crossover Rate?  Find IRR of the delta in C/F ( ) ( ) ( ) So when discount rate is 0%  10.9% pick B At 10.9%  Indifferent From 10.9% to 13.8%  Pick A Greater than 13.8%  Pick none! FNCE 2P91 - Section 05 Winter 2011 - Duration 03 MIDTERM REVIEW APR and EAR APR
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