Corporate Finance

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WEEK 2 NPV, PBP, IRR, EAC( equivalent annual cash flow) NPV: If NPV>0, accept the project [which are expected to add value to the firm], otherwise don’t bother. Reminders Rule 1: Only cash flow is relevant Cash flow ≠ accounting income •In an income statement, profit is shown as it is earned rather than when the company and its customers get around to paying their bills. •Cash outflows are sorted into two categories: 1) current expenses, deducted when calculating income; and 2) capital expenses, depreciated over several years. •Always estimate cash flows on an after-tax basis; taxes should be discounted from their actual payment date Rule2: Estimate cash flows on an incremental basis Do not confuse average with…show more content…
EAC: Equivalent Annual Cash Flow The cash flow per period with the same present value as the actual cash flow as the project Markowitz Portfolio Theory Conditions: 1. If returns are normally distributed, expected return and standard deviation are the only two measures that an investor need consider. 2. Combining stocks into portfolios can reduce standard deviation, below the level obtained from a simple weighted average calculation. 3. Correlation coefficients make this possible. 4. The various weighted combinations of stocks that create this standard deviations constitute the set of efficient portfolios. •The expected return of the portfolio: E(Rp)=w1E(R1)+w2E(R2) •The standard deviation of the portfolio: σp=w12σ12+w22σ12+w1w2ρ12σ1σ2 •The key to diversification is ρ The gain from diversification depends on how highly the stocks are correlated. Unsystematic risk 1. Diversifiable risk; “Unique risk”; “Asset-specific risk” 2. Risk factors that affect a limited number of assets 3. Risk that can be eliminated by combining assets into portfolios Examples: labour strikes, part shortages, etc. Unsystematic risk 1. Diversifiable risk; “Unique risk”; “Asset-specific risk” 2. Risk factors that affect a limited number of assets 3. Risk that can be eliminated by combining assets into portfolios Examples: labour strikes, part shortages, etc. •If ρ = 1.0, there is no gain in diversification. •If ρ =−1.0, the portfolio would have no risk

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