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# The bottom-up approach to computing the OCF applies only when: the interest expense is equal to zero

The top-down approach to computing the operating cash flow: ignores all noncash items

Tax shield refers to a reduction in taxes created by: noncash expenses

Tonis Tools is comparing machines to determine which one to purchase. The machines sell for differing prices, have
differing operating costs, differing machine lives, and will be replaced when worn out. These machines should be
compared using: their equivalent annual costs

The equivalent annual cost method is useful in determining: which one of two machines to purchase when the machines
are mutually exclusive, have different machine lives, and will be replaced once they are worn out

Incremental cash flows are the changes in a firms future cash flows that are a direct consequence of accepting a project

Erosion: cash-flow amount transferred to a new project from customers and sales of other products of the firm

Equivalent annual costs are the annual stream of payments with the same present value as a projects costs

Depreciation tax shield is the cash flow tax savings generated as a result of a firms tax-deductible depreciation expense

The cash flow from projects for a company is computed as the sum of the incremental operating cash flows, capital
spending, and net working capital expenses incurred by the project

The increase you realize in buying power as a result of owning a bond is referred to as the: real rate of return

The market price of a bond is equal to the present value of the: face value plus the present value of the annuity payments

The yield to maturity is: the rate that equates the price of the bond with the discounted cash flows, the expected rate to be
earned if held to maturity, the rate that is used to determine the market price of the bond, equal to the current yield for bonds
priced at par

BOND VALUATION
N=number of periods
I=YTM (if semi-annual, divide by two)
PMT= based on coupon
FV= 1000
PV= market price

**DDM NOTE: if the company just paid a dividend, use the next dividend in the formula (past dividend * growth)

Exponential growth: y=A*B^x A= current, B= (1+growth), x= number of periods

Discounting: Price/(1+growth)^years

DDM Example: Next 4 dividends, \$3, \$5, \$7.50, \$10 and then \$2.50 after, 15% req return
Discount each of the 4, calculate P4=2.50/.15=16.67
Discount 16.67 with period of 4 and add all discounts together

Arithmetic Returns: 10%, 20%, -30% = (.1+.2-.3)/3

Geometric Returns: (1.1*1.2*.7)^(1/3)-1

Risk premium (stock)= Beta*market risk premium

Systematic risk: measured by beta

Total risk: systematic and unsystematic

Beta measures: how an asset covaries with the market

**Beta of US Treasury bills = 0

WACC: the weighted average of the firms equity, preferred stock, and after tax debt

Excess market return: difference between the return on the market and the risk-free rate

WACC: the overall rate which the firm must earn on its existing assets to maintain the value of its stock

Companies that have highly cyclical sales will have a: high beta if sales are highly dependent on the market cycle

For a multi-product firm, if a projects beta is different form that of the overall firm, then: the project should be
discounted at a rate commensurate with its own beta

Beta(asset)= (%equity)(equity beta) + (%debt)(debt beta)

Beta dependent on: cycles in revenues, operating leverage, financial leverage

Cost of debt: post-tax cost of debt since interest is tax deductible

MM Propositions
With Taxes: MM1)Value of levered firm = value of unlevered firm (through homemade leverage individuals can
either duplicate or undo the effects of corporate taxes)
MM2) Re = Ru + B/S(Ru-Rb) (the cost of equity rises with leverage because the risk to equity rises
with leverage)
**Rb= cost of debt, Re= cost of equity, req return on equity, expected return on stock, B= value debt, S= value of
equity, Tc= tax rate, Ru= unlevered cost of capital

Without Taxes: MM1) VL= VU+ Tc*B (because corporations can deduct interest payments but not dividend
payments, leverage lowers taxes)
MM2) Re= Ru+ B/S(1-Tc)(Ru-Rb) (the cost of equity rises with leverage because the risk to
equity rises with leverage)

Interest tax shield: the tax savings of the firm derived from the deductibility of interest expense

rWACC (zero tax): equal to the expected earnings divided by market value of unlevered firm, equal to the rate of return for
that business risk class, equal to the overall rate of return required on the levered firm, is constant regardless of the amount of
leverage

Value of firm: 500,000 shares outstanding, borrowing \$8million at 9% to buyback 200,000 shares
\$8million/200,000=\$40
500,000-200,000=300,000*\$40 + \$8million = 500,000 * \$40 = \$20 million

Value of levered firm= Vu + (Tc*D)

Ruths Chris Example (project WACC):
RC: Be= 1.25 60% debt, 40% equity
You finance with 45% debt, 55% equity
40% tax

Calculate unlevered beta with Ruths Chris, calculate new levered beta using this as beta, calculate cost of equity

MACRS vs. Straight line: MACRS produces less income and less taxes for the first few years, straight line produces more
income for the first few years

Net working capital: can affect cash flows for every year of the project, frequently affect by additional sales of another project

Cost of debt: YTM
-After tax: (1-tax rate)*borrowing rate

Bond yields and interest rates based on 6 factors:
-real interest rate
-inflation
-interest rate risk
-default risk
-taxability
-lack of liquidity