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These are the project’s payback period, its book rate of return, and its internal rate of return. The project’s internal rate of return—if used correctly—should always identify projects that increase shareholder wealth. However, we shall see that the internal rate of return sets several traps for the unwary.. Second, determine the appropriate opportunity cost of capital. The sum of the...
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discount cash flows. Always estimate cash flows on an incremental basis.. The first and most important point: Net present value depends on future cash flows. Always estimate cash flows on an after-tax basis. They try to offset this mistake by discounting the cash flows before taxes at a rate higher than the opportunity cost of capital. Estimate Cash Flows on...
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For the most part, we take the view of the individual investor. A portfolio of the common stocks of small firms.. An investor who shifts from cor- porate bonds to common stocks has a direct share in the risks of the enterprise.. 2 Figure 7.2 is identical except that it depicts the growth in the real value of the portfolio....
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One is the av- erage or expected return. The expected return on this portfolio is 13.5 percent, which is simply a weighted average of the expected re- turns on the two holdings. In Figure 8.4 we have plotted the expected return and risk that you could achieve by different combinations of the two stocks. Standard deviation (σ), percent Expected return....
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Therefore, financial managers demanded a higher rate of return from risky projects, or they based their decisions on conservative estimates of the cash flows.. The company cost of capital is defined as the expected return on a portfolio of all the company’s existing securities. It is used to discount the cash flows on projects that have similar risk to that...
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Maybe further expenditure on market research would clear up those doubts about acceptance by con- sumers, maybe another drill hole would give you a better idea of the size of the ore body, and maybe some further work on the test bed would confirm the durability of those welds. Put yourself in the well-heeled shoes of the treasurer of the...
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Think, for example, of what would happen if you were to jot down your esti- mates of the cash flows from operating various lines of business. This may not be because you personally possess any superior skill in operating jumbo jets or running a chain of laundromats but because you have inadvertently introduced large errors into your estimates of the...
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Thus senior managers, including the chief financial of- ficer, are simultaneously agents vis-à-vis shareholders and principals vis-à-vis the rest of the firm. The last two sections of the chapter describe performance measures, including residual income and economic value added. 12.1 THE CAPITAL INVESTMENT PROCESS. Preparation of the capital budget is not a rigid, bureaucratic exercise. Strategic planning takes a top-down...
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UP TO THIS point we have concentrated almost exclusively on the left-hand side of the balance sheet—the firm’s capital expenditure decision. This means that the firm is liable for interest payments of $3,000 in each of the years 1 through 10 and that it is responsible for repaying the $100,000 in the final year. We can compute the NPV of...
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Much of the money for new investments comes from profits that companies retain and rein- vest. Our second task in the chapter is to review some of the essential features of debt and equity.. Stockholders, on the other hand, have complete control of the firm, providing that they keep their promises to lenders.. As owners of the business, stockholders have...
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IN CHAPTER 11 we encountered Marvin Enterprises, one of the most remarkable growth companies of the twenty-first century. Such venture capital may be provided by investment institutions or by wealthy individuals who are prepared to back an untried company in return for a piece of the action. The next section of the chapter describes what is involved in such an...
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IN THIS CHAPTER we explain how companies set their dividend payments and we discuss the contro- versial question of how dividend policy affects the market value of the firm.. In this case the dividend is a by-product of the firm’s capital budgeting decision. How do we separate the impact of the dividend increase from the impact of investors’ disappointment at...
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In Chapter 18 we will undertake a detailed analysis of the imperfections that are most likely to make a difference, including taxes, the costs of bankruptcy, and the costs of writing and enforcing complicated debt contracts. 17.1 THE EFFECT OF LEVERAGE IN A COMPETITIVE TAX-FREE ECONOMY. We have referred to the firm’s choice of capital structure as a marketing problem....
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The explanation of these patterns lies partly in the things we left out of the last chapter. In effect the government pays 35 percent of the interest expense of L. The risk of these flows is likely to be less than the risk of the operating assets of L. But what rate? One common assumption is that the risk of...
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In well-functioning capital mar- kets the market value of the firm is the sum of the present value of all the assets held by the firm 1 — the whole equals the sum of the parts.. It is usually implemented via the after-tax weighted-average cost of capital or “WACC.”. In other words, the weighted average of the ex- pected returns...
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1 In Chapter 11 we valued Kingsley Solomon’s gold mine by calculating the value of the gold in the ground and then subtracting the value of the extraction costs. Otherwise, the value of the mine is in- creased by the value of the option to leave the gold in the ground if its price is less than the extraction cost.....
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The lower the price that you must pay to exercise the call, the more valuable the option.. You do not need to pay the exercise price until the option expires. However, for every dollar that the stock price rises above the exercise price, the option holder gains an additional dollar. A distant maturity delays the point at which the holder...
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22.1 THE VALUE OF FOLLOW-ON INVESTMENT OPPORTUNITIES. You are helping the CFO evaluate the proposed introduction of the Blitzen Mark I Micro.. “The Mark I just can’t make it on financial grounds,” the CFO says. “Hard to say precisely, but I’ve done a back-of-the-envelope calculation which suggests that the value of the option to invest in the Mark II could...
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You can depict the relationship be- tween the value of the warrant and the value of the common stock with our stan- dard option shorthand, as in Figure 23.1. The lower limit on the value of the war- rant is the heavy line in the figure. if the price of the stock is greater than. Investors in warrants sometimes refer...
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Each period’s cash flow on a bond potentially needs to be discounted at a different interest rate, but bond investors often calculate the yield to maturity as a summary measure of the interest rate on the bond. Then I will part with $100 today if I am repaid $115 at the end of the year. Instead we have done the...