Chapter 10: Project Analysis Organizing the investment process Stage 1: Capital budget once a year, head office

e of firm requests a list of planned investment projects from each of its divisions. Stage 2: Project authorizations 4 types of projects: 1. Outlays required by law or company policy 2. Maintenance or cost reduction 3. Capacity expansion in existing business 4. Investment for new products Problems: ensuring the forecasts are consistent, eliminating conflicts of interest, reducing forecast bias, sorting the wheat from the chaff Solutions: 1. Sensitivity analysis analysis of the effects of changes in sales, costs, and so on, on project profitability. What else might happen and the implications of those possible events. Fixed costs stay the same as output changes. Variable costs change as output levels change. *variables are often inter-related and it may be difficult to identify all of the consquences associated with a change in one of them. 2. Scenario analysis Project analysis given a particular combination of assumptions. How the project would fare under different scenarios. Different but consistent combinations of variables. 3. Simulation analysis - computer generated estimation of the probabilities of different possible outcomes (ex. From an investment project) Probability distribution is assigned to each possible outcome. 4. ACCT Break even level of revenues = Fixed costs including depreciation Additional profit from each additional dollar of sales Cash flow from operations = profit after tax + depreciation Total cash flow from ops = initial investment NPV break-even point level of sales at which NPV is zero. Where NPV switches from negative to positive. PV (cash flows) = investment Operating Leverage degree to which costs are fixed. (High fixed costs = high operating leverage)

Degree of operating leverage (DOL) percentage change in profits given a 1% change in sales. DOL = % change in profits / % change in sales Decision Tree diagram of sequential decisions and possible outcomes. Used for projects that involve future decisions. Real Options options to invest, modify, or dispose of a capital investment project. Paying out money today to give you the option to invest in a real asset in the future. 1. Option to expand 2. Option to abandon 3. Option of timing 4. Flexible production facilities

Chapter 11: Intro to Risk Return, and the Opportunity Cost of Capital Total return of an investment is made up of: Income (dividend and interest payments) and Capital Gains (or losses) Percentage return = capital gain + dividend / initial share price Dividend yield = dividend / initial share price Percentage capital gain = capital gain / initial share price 1+real return rate = 1+nominal return rate / 1+inflation rate Market indexes financial analysts use to measure the investment performance of the overall market. Summarizes return of different classes of security. S&P Standard and poor, USA top 500 stocks index TSX Composite index Toronto stock exchange (major) formerly called TSE 300 (primary stock market index in Canada. Dow Jones industrial average USA 30 blue chip stocks. Maturity Premium extra average return from investing in long term bonds versus shortterm treasury securities. Long-term bonds gave higher returns than treasury bills. Risk Premium expected return in excess of risk-free return as compensation for risk. Compensation for taking on the risk of common stock ownership. ROR on common stocks = interest rate on treasury bills + market risk premium Expected market return (1981) = interest rate on treasury bill (1981) + normal risk premium Variance average value of squared deviations from mean (measures volatility)

Standard deviation square root of variance. (also measures volatility) *T-Bills have lowest average rate of return, and lowest level of volatility. **Bonds are in the middle. ***Stocks have highest. Diversification strategy designed to reduce risk by spreading the portfolio across many investments. The assets in the portfolio do not move in exact harmony with eachother. (When one is doing poorly, the other is doing well) Correlation coefficient is always between -1 and +1 Portfolio rate of return = (fraction of portfolio in first asset X ror on first asset) + (fraction of portfolio in second asset X ror on second asset) Covariance = probability-weighted avg of the products of each deviation for each scenario Correlation (x,y) = covariance / (standard deviation of x X standard deviation of y) Unique risk risk factors affecting only the particular firm (specific risk or diversifiable risk) Market risk economy-wide (macro) sources of risk that affect the overall stock market. (Systematic) Cannot be diversified.

Chapter 12: Risk, Return, and Capital Budgeting Market portfolio portfolio of all assets in the economy. Beta sensitivity of a stocks return to the return on the market portfolio. *Diversification can eliminate risk unique to individual stocks.