Finance Final

PI equation

(NPV + ABS(IO)) / ABS(IO)

Expected Returns

-based on the probabilities of possible outcomes -"expected" means average if the process is repeated many times

How to get IRR

=IRR(all cash flow values, including IO)

How does the timing and the size of cash flows affect the payback method?

An increase in the size of the first cash inflow will decrease the payback period, all else held constant

Required Return

Appropriate discount rate and is based on the risk of cash flows

Beta < 1

Asset has less systematic risk than the overall market

Beta > 1

Asset has more systematic risk than the overall market

How do we measure systematic risk?

Beta coefficient

Perpetuity -> PV

C / r

If we know an asset's systematic risk, we can use the _______ to determine its expected return

CAPM

CAPM

Capital asset pricing model defines the relationship between risk and return E(Ra) = Rf + Ba(E(Rm) - Rf)

Portfolio

Collection of assets asset's risk and return are important in how they affect the risk and return of the portfolio

How to determine cost of equity

Dividend Growth Model SML or CAPM

WACC notation

E = market value of equity = # of outstanding shares times price per share D = market value of debt = # of outstanding bonds times bond price V = market value of the firm = D + E

When cash flows are conventional, NPV is ____.

Equal to zero when the discount rate equals the IRR Positive for discount rates below the IRR Negative for discount rates above the IRR

Drawbacks of Payback Period

Firm cutoffs are subjective Does not consider time value of money Does not consider any required rate of return Does not consider all of the project's cash flows

Accept PI if

Greater or equal to 1

How do we decide if a capital investment should be accepted or rejected?

Includes all cash flows that occur during the life of the project Consider the time value of money Incorporate the required rate of return on the project

Diversification

Investment in several different asset classes or sectors Holding assets which are not perfectly positively correlated Reduce the variability of returns without an equivalent reduction in expected returns Minimum level of risk that cannot be diversified away -> systematic portion

Size Disparity Problem

Mutually exclusive projects of unequal size -> select project with largest NPV

Time Disparity Problem

NPV and PI assume cash flows are reinvested at the required rate of return for the project -> IRR assumes cash flows are reinvested at the IRR Select largest NPV

Dividends are ____ tax deductible

Not, so there is no tax impact on the cost of equity

Dividend Growth Model

Po = D1 / (Re - g) Re = D1 / Po + g

Use perpetuity Formula when

Preferred stock, cash flows from a product whose sales are expected to remain constant forever, a consol

After tax cost of debt

Rd(1-Tc)

SML Approach

Re = Rf + Be (E(Rm) - Rf) Rf = risk-free rate E(Rm) - Rf -> Market Risk Premium B -> systematic risk of asset

If IRR less than the R

Reject IRR

Cost of Equity

Return required by equity investors given the risk of the cash flows from the firm Business risk & financial risk

Systematic Risk

Risk factors that affect a large number of assets Non-diversifiable risk / market risk Changes in GDP, inflation, interest rates

Unsystematic Risk

Risk factors that affect a limited number of assets Unique risk / asset-specific risk Labor strikes, part shortages, etc.

Diversifiable Risk

Risk that can be eliminated by combining assets into a portfolio Unsystematic, unique, or asset-specific risk

Systematic Risk Principle

There is a reward for bearing risk -> no reward for bearing risk unnecessarily Expected return on a risky assets depends only on that asset's systematic risk since unsystematic risk can be diversified away

Weighted Average Cost of Capital (WACC)

Use individual costs of capital to get our average cost of capital for the firm Average -> required return on the firm's assets, based on the market's perception of the risk of those assets Weights are determined by how much of each type of financing is used

WACC weights

We = E/V = percent financed with equity Wd = D/V = percent financed with debt

WACC equation

WeRe + WdRd(1-Tc)

If IRR greater than or equal to R

accept IRR

Beta = 1

asset has the same systematic risk as the overall market

NPV positive

discount rate < IRR

NPV = 0

discount rate = IRR

NPV negative

discount rate > IRR

Annuity

finite series of equal payments that occur at regular intervals

The higher the beta, the ________ the risk premium should be

greater

perpetuity

infinite series of equal payments

APR

interest rate per period multiplied by the number of periods in a year

EAR

interest rate stated as though it were compounded once per year

For positive stated annual interest rate and multiple compounding periods per year, EAR is always ___________ the APR

larger than

Reject PI if

less than 1

Amount of systematic risk

measured by beta

Reward for bearing systematic risk

measured by the market risk premium

Risk-return trade-off

measured by the portfolio expected return and standard deviation

Pure time value of money

measured by the risk-free rate

By ignoring time value, the payback period rule may accept projects with a ________ NPV.

negative

Interest expense _______ our tax liability

reduces reduction in taxes reduces our cost of debt

Cost of Debt

required return on our company's debt computing the YTM on existing debt

IRR

return on the firm's invested capital the rate of return that the firm earns on its capital budgeting projects rate of return that makes PV of the cash flows equal to the initial outlay

Expected Return

risk free rate + risk premium

Total Risk

systematic risk + unsystematic risk Standard Deviation of returns For well diversified portfolios, ____ is very small

Capital Budgeting

the process of planning and managing a firm's long-term investments

IRR is a good decision making tool as long as cash flows are conventional, meaning

there is only one negative value -> if there are multiple sign changes, we could get multiple IRRs

Which is greater, the APY or the EAR?

they are the same

Net Present Value (NPV)

total PV of the annual net cash flows - initial outlay NPV is positive -> accept NPV is negative -> reject

Variance & standard Dev measure

volatility of returns

Expected Return of a portfolio

weighted average of the expected returns of the respective assets in the portfolio