Chapter 10
Making Capital Investment Decisions
Sunk Cost – cost that have incurred in the past
Opportunity cost – cost of lost options
Side effects –
Positive side effects - benefits to other projects
Negative side effects (erosion) – cost to other projects
Reading exam notes
Formulas:
Operating cash flow = EBIT+depreciation-taxes
Cash flow from assets = OCF – net capital spending(NCS)-changes in NCW
EBIT – Earning before interest and tax
EBIT cho tax aur interest minus kro tan piche bachdi ae net income
net capital spending is this year's fixed asset value minus last year's fixed asset value is your net capital spending.
calculate NPV and IRR
if NPV is +ve - accept
if calculated IRR is more –
accept
Marginal tax rate
depriciation tax shiled = *(depreciation)
cash inflows = sales – increase
in A/R
Cash outflows = costs –
increase in A/P + increase in
inventory
Net cash flow = cash inflow –
cash outflow
Straight line depreciation
depreciation = (initial cost-
salvage)/number of years
PV tax shield on CCA
=
Salvage value – after a certain
time how much u will make
Economic life = n (number of
years)
Tc = marginal tax rate
R = discount rate
D= cca tax rate
I = total investment
Bottom up approach
Works only when there is no
interest expense
OCF = NI(net income) +
depreciation
Top down approach
Not use depreciation
OCF= Sales-costs-taxes
Tax Shield Approach
OCF = (Sales-costs)(1-Tax
rate) + Depreciation*Tax rate
chapter 13
Return,
risk ..
expected” return =
E(R)=∑ p i R i
i=1
where p = probability, R= return
weighted average of squared deviations:
n
σ 2=∑ pi ¿¿
i=1
Standard deviation – ch square root hona ae
Expected return of portfolio m
E(R P )=∑ w j E(R j )
j=1
Variance of portfolio – not in syllabus
• Total Return = expected return + systematic return+ unsystematic return
What does beta tell us?
− A beta of 1 implies the asset has the same systematic risk as the overall market
− A beta < 1 implies the asset has less systematic risk than the overall market
− A beta > 1 implies the asset has more systematic risk than the overall market
Total risk measured by standard deviation
systematic risk is measured by beta.
Portfolio beta = beta*weight of each and then add all
When can a market equilibrium be achieved? – which is also called – The security market line
When beta=1
chapter 14
D1 Advantage (dividend growth model)
Cost of equity, Re = R E = + g (Dividend growth Easy to understand and use.
P0 Disadvantages:
model) Only applicable to companies currently paying dividends.
Not applicable if dividends aren’t growing at a reasonably constant rate.
Extremely sensitive to the estimated growth rate - an increase in g of 1%
D1 = Dividend to be paid increases the cost of equity by 1%.
D0 = Dividend already paid Does not explicitly consider risk.
P0= current share price
G = growth rate
D1= Do*(1+g)
1. Estimating dividend growth rate (growth estimation)
- Historical average method
Year Dividend Percent Change
2011 1.23
2012 1.30 (1.30-1.23)/1.23=0.057
2013 1.36 (0.36-1.30)/1.30= 0.046
2014 1.43 (1.43-1.36)/1.36= 0.051
2015 1.50 (1.50-1.43)/1.43= 0.049
Average = (0.057+0.046+0.051+0.049)/4 = 0.051
2. Alternative approach (growth estimation)
Growth Rate (g)=Retention Ratio×ROE
Profit = payout+retention
1=payout +retention
Retention= 1- payout
The SML approach Advantages
Explicitly adjusts for systematic risk.
Applicable to all companies, as long as we can compute beta.
Risk-free rate, Rf Disadvantages
Have to estimate the expected market risk premium, which does vary over
Market risk premium, E(RM) – Rf time.
Have to estimate beta, which also varies over time.We are relying on the past
to predict the future, which is not always reliable.
Systematic risk of asset,
cost of equity , R E =Rf + ¿ [E(RM) – Rf ]
Cost of Preferred Stock (loyal shareholders/fixed dividends)
RP = D/P0
The Weighted Average Cost of Capit
• WACC =W E R E +¿ W D R D(1 – Tc)
Or
• WACC = ( VE ) R +( DV ) R
E
D (1 – Tc)
E – market value of equity
D- market value of debt
V – market value of firm = V = D+E
We = E/V and Wd= D/V
After-tax cost of debt = RD(1 – TC)
Cost of Debt Rd
To calculate Rd(cost of debt) use excel rate formula
Pmt part calculate krn lai – (coupon rate*fv)/2
Nper – time hunda ae , agar semiannually likhea hove tan multiply by 2
FV
PV
Pmt
Eh sarian values rate de formule ch pake answer kdna ae
Chapter 18 (Short term finance planning)
Assets(A) = Liabilities(L) + Equity(E)
Current Assets(CA) + fixed assets(FA) = Current Liabilities(CL) + Long term debt (LTD) + Equity (E)
Cash + other CA + FA = CL+ LTD+ E
Cash = CL+ LTD+ E – other CA- FA
=> Cash = long-term debt + equity + current liabilities – current assets other than cash– fixed assets
NCW = (cash + other CA)- CL
Activities that increase/decrease cash – expect one question from this section
Average inventory = (beg +ending)/2
Inventory turnover = COGS(Cost of good sold)/Avg. inventory
Inventory period = 365/inventory turnover
Average receivable = (beg + end)/2
Rec turnover = Sales/Avg. Rec
Rec period = 365/Rec turnover
Operating cycle = Inventory period + receivable period (in days)
Avg. Payable = (beg+end)/2
Pay turnover = COGS/Avg. payable
Payable period = 365/ Payable turnover (in days)
Cash cycle = operating cycle – Payable period (in days)
cash budget
Expect one numerical
Pending to be done
Question 2 from the book
Question 9 and 10
chapter 20
1st step: calculate the incremental cash flow, that is price minus your variable cost multiplied by future units expected
minus current units that you're selling.
i.e. total price minus variable cost multiplied by future units expected minus current units produced.
2nd step: then you will find out the present value of the incremental cash flow that is calculated by taking incremental
cash flow divided by your required return in decimals.
i.e. incremental cash flow/rate
3rd step: finding cost of switching, price for 1000 units plus your variable cost and then multiply it with the difference
between the expected and the current units produced.
4th step: NPV of switching, NPV of switching would be your present value of incremental cash flow minus your cost of
switching.
# Economic Order Quantity (EOQ) Model
-total carrying cost, your total restocking cost and your total cost and from the total cost you get the formula for
economic order quantity.
-total carrying cost is average inventory that is total quantity divided by 2 multiplied by your carrying cost per unit.
-If restocking cost is asked, which is your shortage cost, it's also called as restocking cost for that the formula is fixed cost
per order multiplied by total number of orders. (number of orders is given by your total divided by the total number of
quantity.)
- Total cost = Total carrying cost+total restocking cost = (Q/2)(CC) + F(T/Q)
- in term of economic quantity , this is the formula
Units per year dite hone chahide
Q¿ =
√ 2 TF
CC
Je week dite ae tan 52 naal multiply krna ae
Je month dite ae tan 12 naal multiply.
