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· Capitalized expenditures are expenditures that may provide benefits into the future and therefore are treated as capital outlays and not as expenses of the period in which they were incurred.
· Shipping and installation
· In tax accounting, the fully installed cost of an asset. This is the amount that, by law, may be written off over time for tax purposes.
· Depreciable basis=cost of asset + capitalized expenditures
· To compute the payback period, estimate a project’s cost and its future net cash flows
· PB=Years before cost recovery + Remaining cost to recover/Cash flow during the year
· The Payback Period is the amount of time it takes for the sum of the net cash flows from a project to equal the project’s initial investment
· Says an acceptable project has a payback period shorter than a certain amount of time
· Can serve as a risk indicator—the quicker a project’s cost is recovered, the less risky the project
· Is one of the most widely used tools for evaluating capital projects
· Projects with shorter payback periods are more desirable. Cash flows occurring after the payback period are not considered.
· There is no economic rationale that makes the payback method consistent with shareholder wealth maximization.
· Is the best capital-budgeting technique. It is consistent with goal of maximizing shareholder wealth.
· The method compares the present value of expected benefits and cash flows from a project to the present value of the expected costs. If the benefits are larger, the project is feasible.
· The NPV calculation uses the discounted cash flow technique
v There is a discount rate at which the NPVs of two mutually exclusive projects will be equal. That rate is the crossover point. The IRR is where it crosses over the line and has an NPV of zero.
-Brokers earn a fee, a commission, for bringing buyers and sellers together
-Paying a commission may be less than the cost of direct search
-Has an advantage over a broker because a broker cannot guarantee prompt execution of an order while a dealer holds inventory of securities
-Eliminates time-consuming searches for a fair deal through immediate sales or purchases
securities are always correctly priced, it is easy to find a buyer or seller, transactions are completed quickly, no transaction costs
i = nominal interest rate
r = real rate of interest
∆Pe = expected annualized price-level change
r∆Pe = adjustment for expected price-level change
2.Cost Principle: assets values are recorded on the balance sheet at the cost they were acquired
Depreciation expense is on the income statements
Accumulated depreciation is on the balance sheet
Beginning Retained Earnings
+ Net Income
- Dividends Paid
Ending Retained Earnings
Big Lots Target Walmart
40.6% 30.5% 24.9%
Interest paid (earned) on the principal amount borrowed (lent).
Interest paid (earned) on any previous interest earned, as well as on the principal borrowed (lent).
Formula SI = P0(I)(n)
SI: Simple Interest
P0: Principal Amount today (t=0)
i: Interest Rate per period
n: Number of time periods
nper = number of periods
pmt = 0 because this isn’t an annuity
[pv] = -100
[type] = type of annuity; 0 for ordinary,
1 for annuity due.
· Include any additional investments in net work capital
· NWC=any increases in current assets minus any increases in current liabilities
· At time 0, NWC is a cost (outflow). In the terminal year, NWC is recovered (inflow).
· Notes Payable would not be considered because it includes interest.
Semiannual Compounding for Bonds
-A buyer and seller must find each other without assistance
-Transactions are infrequent
-Is the least efficient market
-Examples: Sale of small private company’s common stock; private placement of common stock
-Buyers and sellers interact with each other in a group and bargain over price
-The auctioneer, or specialist, is designated by the exchange to be a dealer for certain securities and fill orders by public customers
· Basic ownership claim in a corporation
· Right to vote on matters such as electing a board of directors, setting a capital budget, and proposed mergers or acquisitions
· Right to a firm’s residual assets after creditors, preferred stockholders, and others with higher priority claims have been satisfied
· Valuing common stock is more difficult than valuing bonds or preferred stock because…
v 1. Size and timing of dividends are less certain compared to coupon payments.
v 2. The rate of return on common stock cannot be observed directly from the market.3. Common stock is a true perpetuity because it has no maturity date.
· Are not “guaranteed” dividends; “promised”
· Are generally viewed as perpetuities—no maturity dates
· No voting rights
· Priority over common stock with respect to dividends and liquidation of assets
· Dividend must be paid before funds are distributed to common stockholders
· Frequently has a credit rating
· May be convertible into common stock
· Most preferred is not a “true perpetuity”—it may be called/retired by a firm
· Perpetual preferred stock has no maturity date, dividends are fixed (g=0), and dividend payments go on forever
· Same technique as regular payback, but future cash flows are first discounted at the firm’s cost of capitalThe major advantage of the discounted payback is that it tells management how long it takes a project to reach a positive NPV
· Is often called the book value rate-of-return
· Uses accounting numbers to compute the return on a capital project-the project’s net income and book value, rather than cash flow data
· AAR=Average NI/Average BV
· Has major flaws as a tool for making capital expenditure decisions
· The ARR is not a true rate of return. It is generated from numbers on the income statement and balance sheet.
· It ignores the time value of money.
· There is no economic rationale that makes it consistent with the goal of maximizing shareholders’ wealth.
· The IRR technique compares a firm’s cost of capital to the rate-of-return that makes the net cash flows from a project equal to the project’s cost
· A project is acceptable if its IRR is greater than the firm’s cost-of-capital
· The IRR is the discount rate that makes NPV=0
· When IRR and NPV methods agree…
v The methods will always agree when projects are independent and the cash flows are conventional. A conventional project has an initial outflow to begin and net inflows each year thereafter.
· When IRR and NPV methods disagree
v The IRR and NPV methods can produce different accept/reject decisions if a project has unconventional cash flows or projects are mutually exclusive.
· In the modified internal rate of return (MIRR) technique, cash flow is assumed to be reinvested at the firm’s cost of capital.
· The compounded values are summed to get a project’s terminal value at the end of its life
· The MIRR is the rate which equates a project’s cost to its terminal value
· A major weakness of the IRR compared to the NPV method is the reinvestment rate assumptionIRR assumes that cash flows from a project are reinvested to earn the IRR while NPV assumes that they are reinvested and earn the firm’s cost of
· Zero-growth dividend modelàthe dividend is constant; this cash-flow pattern describes a perpetuity with a constant cash flow
· Constant-growth dividend modelàthe current price of a share of stock is equal to next period’s dividend divided by the difference between the discount rate and the dividend growth rate
· The constant-growth dividend model yields invalid solutions when the dividend growth rate equals or exceeds the discount rate (g> or equal to R). If g=R, the denominator is zero and the value of the stock is infinite—which cannot occur. If g>R, the denominator of the fraction is negative and the stock price is negative—which cannot occur.
· Common stock and preferred stock
v Represent ownership interest in a corporation
v Dividend payments do not affect a firm’s taxes
· Preferred stock is equity but a strong case can be made that it is a special type of debt. The debt is listen in which the order you would be paid in case the company goes bankrupt. Sometimes preferred stock can be considered debt because it pays a fixed dividend.
Basic Principles to Adhere to in Estimating Cash Flows
· Only consider cash flows
· Assume annual, end of year cash flows
· Consider incremental after-tax cash flows
· Don’t ignore inflation
· Include any net working capital (NWC) requirements
· Ignore sunk costs
· Consider opportunity costs
· Consider externalities
· Depreciation is a non-cash expense that lowers taxable income
· The amount of taxes saved=depreciation expense * tax rate
· If the salvage value is more than its book value, the firm must pay taxes on the difference
· If the salvage value is less than its book value, the firm gets an offsetting tax deduction
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