Growth stocks and income stocks
When a corporation generates a positive Net Income, it uses a portion of those earnings to pay
dividends to its shareholders and uses the remaining portion to reinvest back into the company
with the intent to expand its operations (grow). The percentage of earnings that are paid out as
dividends is referred to as the Payout Ratio, and the remaining percentage that is reinvested is
referred to as the Retention Ratio.
Estimating g
To estimate g, we need the retention ratio and Return on Equity (ROE) where;
Retention Ratio = (Net income – Dividend) / Net income
ROE= Net income/Owner’s equity
So, g can be calculated as follows:
g = (retention ratio)*ROE = (1-payout ratio)*ROE
Total value = value of assets in place + Present value of growth opportunities

NPV and Other Investment Criteria
The following are ways firms determine how to evaluate investment opportunities:
1. NPV
Formula: NPV = PV – Required Investment (C0)
Take into consideration the opportunity cost of capital, as it is the return you give up by
investing in the project.
2. IRR
IRR is the rate of return that makes the NPV equal to 0
Formula: NPV = PV of Anticipated Cash Flows – Cost of Asset = 0
•
You can determine IRR by trial and error followed by a graph.
•
You can determine IRR by using finance calculator.
3. Payback Period Rule
Payback period is the time needed to recover the initial investment.
4. Discounted Payback
Discounted payback is the time period it takes for the discounted cash flows generated by the
project to cover the initial investment in the project.
5. Book Rate of Return
Book rate of return equals the company’s accounting income divided by its assets.
Formula: Book rate of return = Book Income/Book Assets
6. Profitability Index
Pick the projects that generate the highest NPV per dollar of investment.
Formula: NPV/Initial Investment (C0)
Some points to note:
•
NPV has proven to be the only reliable measure of a project’s acceptability
•
The NPV rule can be adapted to deal with the following situations:
o Mutually exclusive projects
o The investment timing decision
o Long vs. short-lived equipment (unequal lives)
o Replacing an old machine
•
Rules for project selection: a firm maximizes its value by accepting all positive NPV projects.
With capital rationing, you need to select a group of projects which:
o Is within the company’s resources
o Gives the highest NPV
o When capital rationing is in place, NPV by itself cannot lead you to the correct decision - you
must combine NPV with the Profitability Index.

SOS: FINE 2000
Alac Kim & Yiran Li
February 6
th
& 7
th
, 2013

Structure
1.
Chapter Overview
2.
Q&A about Concepts
3.
Questions:
1.
Basic (few)
2.
Intermediate (more)
3.
Advanced (few)
4.
Sample Midterms

INTRO TO FINANCE
Chapter 1:

Chapter 1: Overview
Separation of
–
Investment decision: Risk vs. Reward
–
Financing decision: Capital Structure
In Canada, over 80% of corporations are privately held
Corp
Sole-Pro
Partner
Ownership
Shareholder
Individual
2+
Liability
Limited
Unlimited
Either
Tax
“Double”
Income
Individual
Legal Fee
High
Low
Medium
Advantage
Liquidity
Premium
Low set-up cost
Strategic Gains
Disadvantage
Agency Problem
Investor Attraction
Decision Making

FINANCIAL MARKET