chapter 9 s66
An example of future value and com pounding is if current annual interest rates are 6% an investor invested $10,000, at the end of five years that investment would be worth how much ?:
$10,000/ ( 1 + .05 )^5= $10000/1.27628=$7835.27
The calculation to find Alpha first talk when we are provided with a beta figure is as follows:
Alpha =realize return -( risk free return +( market return -risk free return) x beta)
To calculate the DCF of a bond the investor must know leave:
1. Coupon payment amounts 2. final principle payment at maturity 3. discount rate
Would not provide it with the risk free return we can simplify the equation too:
Alpha =realize return minus (market return x beta)
Alpha :
Alpha gives the investor an idea of how investment performs relative to the amount of risk taken Alpha uses fundamentals of a specific company
when evaluating bonds held in a portfolio, we should include the bonds
1. Maturity rate 2. coupon rate 3. par value
DCF can be used to evaluate:
1. Ongoing investments with no expected maturity 2. investments with an expected maturity 3. portfolios 4. specific projects which have a completion date 5. business ventures with no specified completion date 6. investment managers
the four steps/considerations of modern portfolio theory are:
1. Security evaluation : evaluated from a risks /reward relationship 2. asset allocation: diversification of various investments by class 3. portfolio optimization 4. performance measurement 5. efficient frontier
Capital structure considerations the order of asset distribute atian under liquidation of a Corporation is listed as:
1. Taxes 2. secured that 3. unsecured debt 4. preferred stock holders 5. common stockholders
is important to know what kind of information the market prices are reflecting. EMH stipulates that there are three types of information:
1. the weak version of EMH says that market price reflects past prices and trading volumes. All investors have access to the same information. Is historical data therefore it is highly unlikely that investors will be able to outperform the market. 2. The semi strong version of Merck says that publicly available information is reflected in the market prices. 3. The strong version of EMH states that all information, public or private, is reflected in the market prices
a stock with a beta of 2.0 would be:
200% more volatile or twice as well tile as a benchmark (the S&P 500 in this case)
a stock with a beta of .5 would be only:
50% is volatile as a benchmark (less than S&P500 in this case).
finding the amount of time to double one's investment:
72 divided by the interest rate =number of years to double your investment
An investor buys 100 XYZ shares at $74.00 and sells them three months later at 76 dollars what is the investor's annualized return:
76 dollars -74 dollars =$2.00 $200 /$7400 =2.7% to annualize the return multiply by four quarters in a year 2.7% x 4 =10.8%
Risk/reward relationship:
A fundamental concept in finance is a correlation between risk and return the larger the potential return an investor desires and more risk would generally have to be assumed in order to achieve such a return
An example of risk or reward relationship is:
AUS Treasury bond is considered one of the safest investments Ann has a much lower rate of return than a corporate bond. This demonstrates the risk reward relationship in that Corporation is much more likely to default than the US government.
how is Alpha calculated :
Alpha is calculated using the stock's beta in order to account for the volatility that it is expected for this stock in relation to the benchmark
How is NPV expressed as?:
As a dollar figure
examples of investments with highly quality risk would be:
Finley traded stocks , limited partnerships, and real estate or land purchases
what does IRR take into consideration:
IRR consider the inflow and outflow of cash in a portfolio or for a prospective investment. IRR determinations are cash flow dependent
A client comes into your office. This client specifies that they'd like a minimum of 5% return on prospective investments in preferred stock. The client discuss several preferred stocks all of which have fixed evidence of $1.50 Per share per year. At what market price of the preferred stock would this customer be able to achieve the desired rate of return?
Price equals $1.50 annual dividend divided by zero point 5 requirement rate Overturn price equals $30 the client can be advised that any security that is: price below $30 will have a rate of return that exceeds $5 priced at $30 will have a rate of return that is 5% priced above $30 will have already returned less than 5%
Any reinvestment of revenues or proceeds from the project slash investment are expected to be reinvested at:
The IRR
What does the NPV dollar figure represent?
The Value of the project or investment to the investing party
Time weighted return:
This is an investment performance and measure in which the inflow and outflow money (distortion means of the capital flows of money) are eliminated . La time weighted return is often used to compare portfolios managers performance against a benchmark
Future value and compounding:
calculations are generally used to determine what the value of a fixed sum of money invested today at a specific interest rate will be worth at a future taking into consideration com pounding (reinvesting and earning interest on interest).
An investor purchases 100 ABC shares at $95 and sells them for years later at $90.00. During this time the investors see $25 in dividends annually what is the investors holding period rate of return (HP R )?
To calculate the total polling. Return the investor realized a loss on the shares $90.00 - 95 dollars equals negative $5 multiplied by 100 shares equals negative $500 however the investor receives $25 in dividends each year negative 500 + 100 dollars equals negative $400. Negative $400 / 9500 dollars equals negative 4.21%
net present value (NPV):
a form of DCF methodology which uses discontinuing to find the present value of inflows (revenues) and outflows (expenses) for each year of a given investment.
calculating stock price based on expected annual payouts in the client's required rate of return:
a. In some cases, you may have to use a client required rate of return an fixed payouts, such as interest or dividends, in order to figure out what in acceptable market price might be for a specific type of security. b. In these cases, the formula used is a variation of the same formula used to commute current yield (yield =annual payout /current market price). The current marketplace is the unknown variable, however so the formula can be adjusted to the place the current market price on its own: price for a given yield =annual payout /required rate of return
strong verison a
all information public or private is reflected in the market pries
Initial rate of return (IRR):
also known as dollar weighted return it's another form of DCF methodology the goal of IR is similar to that MPV but rather than comparing overall present value to cost, IR attempts to identify the rate of return and that gets a project tool a break-even point which then can be compared to the estimated cost of capital also known as discount rate hurdle rate or required rate of return for a project.
Interest rate risk:
arrest at a fixed income investments value will change due to a change in interest rates
for purpose of the equation the inflows of the investment are:
assume to be reinvested at the investments IRR
which type of bonds have the greatest interest rate risk:
bars with the longest maturities in the lowest coupons
In this example we will use the S&P 500 index as our benchmark if a stock has a beta of 1.0 then we would expect the stock to:
be as wall tile as the S&P 500 and to fluctuate at the same rate as the S&P 500
interest rate risk applies to:
bonds in that the price of a bond will move in the opposite direction of interest rates for example if interest rates move up bond prices will move down and vice versa
unsystematic risk include:
business risk, credit risk or financial risk regulatory risk liquidity risk political or country risk
using the formula is actually quite simple and the formula can be used for two purposes it can be used to find:
but number of years to double investment when the investment rate is provided, but the term is not. It can also be used to find the interest rate of an investment when the term is provided, but the interest rate is not
0 coupon bonds are the most sensitive to:
changes in interest rates because the interest payments accumulate in compound at the bond stated yield whereas bonds that pay interest semiannually will lose their price volatility as a bond gets closer to maturity and fewer interest payments remain that will be paid to the investor.
DCF figures are most reliable when evaluating investments with known:
characteristics such as fixed income securities
Equation for current yields on the bond :
current yield = annual interest /current market price
current yield ona bonds:
current yield is a measurement which takes the bonds current market value and the coupon into account. An investor who is interested in purchasing the bond would use current yield as a means to calculate what their actual return would be if they purchased the bond at the current market price (whether at a discount or a premium).
the current yield calculation does calculate what the yield is:
currently , but could be considered misleading since it does not measure the actual return earned if bond is held to maturity
0 coupon bonds are referred to as:
deferred interest bonds
performance measurement:
dividing each individual investment performance And to market, industry and security related classes
when diversification to lower or or reduce risk investment advisor would consider investments in both:
domestic and international stocks
IRR is a means of comparing multiple projects or investments against:
each other and against a required rate of return or hurdle rate
expected return/mean return/expecting annual return :
estimates return on investment based on certain scenarios (bull or bear market) and weighs these estimates based on the probability of the occurrence of each scenario. It is the weighted average of the expected annual returns for all components of the portfolio
portfolio optimization:
evaluation examining which portfolio has the highest return for a given level of risk. This is commonly referred to as the efficient frontier because it represents the best (or optimal) combination of assets that can produce the highest or maximum return of a given level of risk. The efficient frontier is the founding principle of the modern profolio theory . Expected return is Lee calculation generally used when making this determination.
the cap and calculation questions are not expected is important that you know the components of cap M equation:
expected return =risk free rate of return +[beta x(market return -rest free rate of return) ]
if the IRR exceed the required rate of return slash hurdle rate, then the project is:
expected to be profitable
If an investment has an IRR that equals the required rate of return, that investments would be:
expected to have an NPV of 0
Fixed annuities are what too inflationary risk:
fixed annuities are succeptable to inflationary risk since your payout is a fixed amount and may not keep up with inflation
Calculating IRR assigns present values to:
future inflows and outflows (cash flows) and then sets these cash flows equal to the cost associated with the investment period when the result is equal to 0 the rate that has been found is the IR.
the project will lose money and have a negative NPV if the cost of capital was:
greater than 7.5%
Competitive risk:
he's arrested a company will fail to keep up with competing firms annu development in the industry or sector. It common example would be a technology company that expects to capture market share with a new product or a company which fails to stay on top of new developments in the industry or knew groundbreaking technology which may make the companies product's obsolete
the efficient frontier represents an investment portfolio with the:
highest returns given a limited amount of risk
Portfolios that measure above the frontier are:
ideal , and the returns are well balanced to the risk
using yield to maturity to compare investments:
if an investor is comparing multiple investments and the goal is to achieve the highest return (annualized or total), the investor should seek the investment with the highest yield to maturity.
dispersion:
illustrates a statistical range of potential returns foreign investment or portfolio returns. He is a tool to help measure the risk of an investment period types of dispersion include range, variance, standard deviation, and mean.
Efficient market hypothesis collyn is an investment theory that states it is
impossible to consistently beat the market because informationally efficient stock market, current share prices always reflect all relevant information. According to the EMH, this means that stock prices do not dip art for any length of time from the justified economic values that investors have Calculated for them.
efficient frontier:
in modern portfolio theory represents a set of or a group of portfolios that will provide the highest return to each level of risk in curd. The efficient frontier is a method of analyzing a portfolio to discover with combination of investments that will generate the best return for risk incurred.
if interest rates are increasing in general (discount rate, federal fund rate, etc.) then it can be anticipated that discontinued cash flow returns on you bonds and the bomb portfolio slash funds buying you bonds will :
increased due to increase in rates
Standard deviation:
is a measure volatility of a security or portfolio from expected return (mean) based on past performance. A range of returns are calculated with probabilities assigned to various returns. The greater the deviation range the greater the risk extended deviation of 20% is riskier than standard deviation of 5%
Holding period rate of return (HPR ) :
is a measurement of return on investment calculated over the time period during which the investment is held it is similar to a total return but calculated specifically for time period that investor held investment period HPR measures a specific period or HPR can also consider annualized returns or results
Capital asset pricing model (CAPM:
is a model that measures expected returns in relation to the amount of risk that investment carries. In cap M a security is evaluated in the context of its beta, anticipated market returns, and the risk free rate of return. With these factors included, cap M evaluates the expected return of an asset / investment by setting it equal to the risk free rate of return plus a risk premium (via the beta ) assuming the investors demand a higher return for greater risk
regulatory risk:
is a risk that changes in government activity including changes in laws rules , regulations and tax rates in the US will have an adverse effect on investments
liquidity risk:
is a risk that investment will not be able to be sold quickly enough to prevent loss
Return:
is a term used to describe incoming funds received because of an investment.
risk premium:
is a term used to describe the additional return an investor can expect for taking risk above and beyond risk investments
inflation adjusted /real return /real interest rate:
is a total or normal return on investment less the rate of inflation period this measurement attempts to give an adjusted return of an investment based on the current inflation rate. For example if the rate of return on investment is 6% and inflation is at 3% the real return would be 3%
market risk:
is also called systematic risk is a risk common to all securities or the same general asset class (stocks, bonds). It therefore cannot be minimized or illuminated with diversification with the same asset class period it would include general market forces and sentiment
treynor ratio:
is similar to the Sharpe ratio and that it measures a risk adjusted return of a fun or investment, but uses beta as the denominator rather than the standard deviation. A high treynor ratio generally means a fund will have high historical returns when compared to market related risk.
Realize return /realized profit or lossed:
is the amount profit or loss as a result of the sale of a security. It considers the original cost, sell price, interest and dividends but would not consider paper or unrealized gains or losses
opportunity cost:
is the economic term that describes a value of the next best choice that 1 four goes as a result of making a decision. For example if an investor is considering investments A&B the opportunity cost of choosing investments a would be la last opportunity of investing in B.
Risk free rate of return:
is the rate of return on a three month Treasury bill. A three month Treasury bill is considered to be risk free because the bills are short term and guaranteed by the government
Business risk, credit risk, or financial risk:
is the risk associated with the unique situation of an individual company some examples are the risk the company will fail this is an example of a non systematic risk which can be reduced by diversification with an asset class. to minimize risk in common stock portfolio invest Invest in the largest percentage of the portfolio insecurities that are affected directly by economic conditions and in leading companies in various industries
Reinvestment risk:
is the risk that interest and dividend income from existing investments may not be able to be reinvested in a way that will earn some rate of return
Political or country risk:
is the risk that investments returns could suffer as result of a political change or instability in a country. instability affecting investment returns could stem from a change in government, legislative bodies, other foreign policy makers or military control
inflation risk /purchasing power risk:
is the risk that the return from an investment will not cover the loss in purchasing power caused by inflation (in example dollars received in the future will buy less than in the present)
Sharpe ratio:
is used to distinguish how well the return of an asset compensates the investor for the amount of risk taken. It helps differentiate whether returns are due to intelligent investor decisions or excessive risk. It is a measureof the risk adjusted return relative to the portfolios
How is Alpha expressed numerically:
it is expressed in three ways as a percentage which is most common , numerically and numerically including the risk factor of the benchmark
random walk theory is similar to EMH in that both theories believe:
it is impossible to outperform the market. Random walk theory believes that stock market prices are random and not in fluctuated by past events whereas emh believes that the stock market is efficient and adapts to new information immediately.
Discounted cash flow methods /discounted cash flow analysis (DCF):
it's a means of evaluation of securities, portfolios, or projects , collectively investments using the concept of discounting (present value) analysis use related to the investment to determine the present value of the project (NPV) and the expected rate of return on that project (IR R ).
the stock has a beta below 1.0 we would expect this stock to be :
less volatile than the S&P 500 and fluctuate in prices than the S&P 500
if analyzing figures an allocations and looking at the volatility of those figures you are:
looking at the lowest standard deviation
Weak version
market price reflect past prices and trading vlume. it is historcal data
Systematic risk include:
market risk interest rate risk and inflation risk
income:
meaning dividends and interest pay to investors
Dollar weighted return:
measures a changes in the dollar value of a portfolio 2 total return . Dollar weighted return is sometimes used synonymously with internal rate of return (IR R )
the lower the standard deviation on a projection or figure, the:
more reliable the projection will be
If a stock has a beta above 1.0, we would expect this stock to be:
more volatile than the S&P 500 and fluctuate in price more than the S&P 500
how is NPV calculated:
net present value is actually just a sum of a series of calculations of present value, as previously discussed in the section. Using a four function Calculator, you will have to calculate each present value individually done you will add the sum of these numbers together to arrive to NPV
if Lee IRR is less than the required rate of return slash hurdle rate, then the project is:
not expected to be profitable
if the NPV found is equal to 0, the investment or project will:
not have net gains or losses for the investing entity. Typically such projects are not pursued unless there are other outside factors and values not included in the NPV calculations
Typically internal rate of return is expressed in the form of a:
percentage
tangible assets such as gold coins are sometimes included in a:
portfolio because these types of assets typically perform well in times of inflation
the higher the ratio the better the :
pro formance of the manager or safer the manager strategy
the HPR formula is:
profit or loss /the investment or cost
if a project has an IR of 7.5% then the project would be:
profitable and have a positive NPV if the cost of capital (discount or hurdle rate ) was less than 7.5
If the NPV found is positive (above 0 ), it is expected that the investment will be:
profitable and will exceed the hurdle rate or required rate of return
one would compare the IRR figure that is found to other :
prospective investments or a required rate of return to see whether the project in question meets minimum requirements or whether it exceeds the performance of another prospective Investment.
semistrong
publicly available information is reflected in the market
sharpe's ratio is calculated as:
return a portfolio -risk free return/ standard deviation
risk adjusted return is the investments total:
return minus the risk free rate of return
portfolios that measure below the efficient frontier are considered:
sub ideal because the rate of return does not justify low risk
Overall return on a diversified portfolio:
you may be required to calculate the expected or overall return of a portfolio which is compromised of different types of security or products. in these instance, you can simply multiply the percentage of the portfolio compromised by each security or product by the expected return for that security or product, add these figures together and arrive at the expected overall return
Beta:
the beta of a stock provides us with a measure of the volatility of this particular stocks price in relation or comparison to a benchmark such as an index or the market as a whole
The higher the IR means:
the better the investment (for example an IRR of 10% is better than IRR of 1% )
What is the goal of NPV:
the goal of the NPV is to allow comparison of the net present value of the investment, discounted to today's dollar, and the cost of the investment today (price of security/portfolio, initial cost of project)
this percentage simply represents where:
the inflows equals outflows for the project or investment being analyzed
as a bond approaches maturity, the interest rate risk does what:
the interest rate risk declines since there are fewer remaining interest payments that will be paid to the investor the risk is greater in earlier years of a long term bond than in later years.
the higher the standard deviation on a projection or figure,the :
the less reliable the production or figure will be
A market risk example would be:
the price of ABC common stock declined as the entire stock market declined today. This is an example of systematic risk (marketwide risk) which cannot be reduced by diversification within the stock market
Use of DCF to evaluate bonds and bond portfolios:
the value of a debt security can be estimated using a discount cash flow DCF approach this valuation approach estimates the value of a security as a present value of all future cash flows that Lee investor expects to receive from the security.
Yield to maturity or basis:
the yield to maturity is a long term yield on the bond that is expressed as an annual rate. It takes into account the purchase price, redemption value, coupon rate, and time to maturity. Primary difference between current yield an you'll to maturity is that ytm considers time remaining until maturity (the time value of money) and current yield does not
random walk
theory sttates that stock prices are random and are not influenced by past events
types of investment risk:
there are generally 2 main risk categories systematic and unsystematic (or nonsystematic).
realized capital gains:
this concept applies on an investment when investor realizes a profit. For example an investor sells security for a gain
Time value of money:
this concept states that the value of dollar today will be higher than the value of that same dollar in the future two reasons are for inflation and the potential appreciation or income received from investing the dollar. For example due to the time value of money is usually better to take lottery winnings as a lump sum now that rather than in periodic payments.
modern portfolio theory:
this is an investment theory that attempts to optimize expected returns for portfolio for a given level of risk . Modern portfolio theory can also work in the opposite direction, attempting to minimize risk for a given amount of return . The theory places more value on overall portfolio rather than individual investments.
inflation risk /purchasing power risk is especially true with which type of securities:
this is especially true of long term bonds (longer maturity equals greater risk).
Dividend discount model :
this model provides a tool to determine the price at which the common stock should be trading considering the discounted value of potential future dividends. Some analysis uargue data DDM is an unrealistic model because it requires a forecast of dividends into the future. The basic model is used to determine common stock values
the rule of 72:
this rule is useful when attempting to give estimates of how long it will take for an investor to double their money given a specific rate of return on the investment
The benchmark index has returned 8% over the past year. ABC shares have risen 12.5% in the past year and has a beta of 1.4 what is ABC's Alpha:
to calculate the Alpha of ABC shares use the following formula Alpha =realize return -(market return times beta) 12.5% -( 8% x 1.4 ) =12.5% -11.2% =one point 3% so the return of ABC is 1.3% above or in excess of the risk level taken on owning ABC shares
if the NPV found is negative (below 0 ), it is expected that the investment:
will lose money and will not meet the hurdle rate or required rate of return
an example of a security with low liquidity risk:
would be a New York Stock exchange listed common stock