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Payback Period

-Measures the amount of time it would take to earn back the initial investment in the project. Management then decides how long they are willing to wait to recover their investment and compares the calculated PP to the critical acceptance level. -Decision rule for independent projects is to accept all projects that have a PP < the critical acceptance level. -Mutually Exclusive projects, the project with the lowest PP would be chosen. Ex. PP period = 2.2 years. Critical acceptance level = 2. Reject! -If independt: accept all projects where PP < T -If M.E.: accept project with lowest PP < T

NPV

-Measures the value added by investing in the project. NPV is equal to the present value of all cash flows less the initial investment. -Decision rule for independent projects is to accept all projects with a +NPV. For M.E. projects, accept the project with the highest NPV. -The decision rule for NPV will always provide the correct decision. -When evaluating projects always use NPV as the decision maker. Even if PP and IRR conflict with your NPV analysis, go with the project with the highest NPV.

Mutual Fund Asset by Category

-Money market = 17% -Bond = 22% -Hybrid= 8% -Equity= 52%

Empirical Findings of the SML

-While market returns play a major role in explaining returns of individual stocks, Beta doesnt do a very good job of explaining future returns. -Small firms seem to earn higher returns that can be explained by beta. -Firms with a low market-to-book ratio tend to earn higher returns than can be explained by beta. -Firms that have been top performers in the past 6-12 months tend to earn higher returns in the following 6-12 months that can be explained by beta.

You can expect greater benefits for using an IRA when you have

-longer time horizons (starting in 20's vs. 40's) -higher tax rates -higher ROR

Choose the correct statement regarding ETFs

An ETF is a security that is structured like a mutual fund (each share represents a portfolio of securities), but trades like a stock (bought sold through a brokerage account on stock exchanges)

Internal Rate of Return Example

Cash flow= -2000, CF1= 900, CF2= 900, CF3= 900 irr(-2000,{900,900,900}SOLVE = 16.65%

Crossover (Multiple IRR) Problem

Cash flows go from - in one period to + in the next or vice versa. IRR cannot be used bc the projects are of different size and the timing of cash flows is vastly different. This is referred to as the Reinvestment Rate Problem.

Standard Deviation

Measures the variability of possible returns and it represented by the sigma. The smaller the SD, the more likely we are going to earn something "close" to our expected return. The greater the SD, the greater the chance that we may earn something far more (good) or far less (bad) than our expected return.

What is the Market?

Refers to a portfolio of all investment assets.

Size Problem

The issue with the size problem is related to IRR's focus on ROR instead of value generation in terms of dollars. If initial investments are vastly different, we need to be aware of the size problem and use NPV if dealing with M.E. projects.

Capital Budgeting

The process of deciding which long-term projects the firm should undertake.

Capital Budgeting Process

*The most important factor in maximizing shareholder wealth. -Generating Ideas; gathering information and making cash flow estimates; make decision; evaluate/review

A mutual fund may contain ___.

- Common stocks from a variety of industries. - Treasury Bonds - International Stocks

Choose the correct statement regarding standard deviation

- If the standard deviation is zero, the actual return will always equal the expected return - All else equal, the higher the standard deviation the riskier the investment is as a stand-alone investment

Which of the following would NOT be a legitimate investment to include in an IRA?

- Treasury Bonds - Mutual funds - Shares of common stock - Certificate of Deposit from a bank

A 401(k) Plan

- allows investments to compound tax-free while the money is in the 401(k) plan - generates an income stream during retirement that is based on the person's contributions and rate of return on those contributions.

Beta

-A tool to measure how sensitive a stock is to the overall market. -Measures the degree of the market (non-diversifiable) risk -Tell us how a particular stock moves in relation to the rest of the stock market as a whole.

Important Implications of the CAPM/SML

-According to the SML, high beta stocks should, on average, earn higher returns than low beta stocks. -According to the SML, the only factor that should cause consistent differences in returns across stocks is beta. -When interest rates rise, required returns should increase (all else equal) cause stock prices to decline. -When investors become more risk-averse, the risk premium (km-kRF) should increase which will increase required returns and (all else equal) cause stock prices to decline.

Expected Return

-Based on the probability distribution of returns. -The probability of a specific state of nature occurring times the return under that state of nature summed across all possible states of nature.

How to interpret Beta:

-Betas > 1.0 implies higher than average risk -Betas = 1.0 implies average risk -Betas < 1.0 implies less than average risk -Most Betas range btw .35 and 1.8

Internal Rate of Return

-Calculates the ROR that we can earn on our project. -Acceptance rule is if projects are independent, choose all projects where the IRR is above the required return for those projects. If projects are mutually exclusive, choose the one with the highest IRR. -If Independent: Accept all projects where IRR > k (Required return) -If M.E.: accept project with highest IRR> k

SD of a Portfolio

-Depends not only on the SD and weightings of each stock, but also on the correlation btw. pairs of stocks. -The CORRELATION btw. a pair of stocks measures how closely the returns of each stock are related. A (-) correlation means that the price of 1 stock tends to fall while the other rises (prices/returns are inversely related). A (+) correlation means that the price of 1 stock tends to rise while the other rises (prices/returns are positively related) -Correlations can range from -1.0 to 1.0 -52 of 66 of correlations btw. pairs of stocks are +

Roth IRA

-Each individual can contribute up to $5500 per person per year into a Roth IRA. -Not tax break for your contribution -Contributions to a Roth IRA are NOT tax-deductible in the year of the contribution. -Eligible withdraws in retirement are tax-free income -Higher income restrictions -All interest, capital gains, and dividend income are allowed to compound tax-free during the investment period. -Withdrawals taken after age 59.5 (and minimum 5 years) and NOT taxed. This is a benefit.

Traditional IRA

-Each individual can contribute up to $5500 per person per year into an IRA. -Contributions to IRA are tax-deductible in the contribution year. -No taxes on investment income while in IRA -Eligible withdraws in retirement taxed as ordinary income. -Lower income restraints -Any withdrawals taken prior to age 59.5 are subject to a 10% tax penalty. -Withdrawals must be initiated by the time your 70.5

Adding a Security to a Well-Diversified Portfolio

-If your portfolio is well diversified, adding a single security is not very relevant because its one of many. What matters is how the stock movers with the overall market. Use BETA.

Non-diversifiable Risk

-Leftover risk -examples include political events, energy price shocks, changes in interest rates, recessions, etc.

Single Security and/or Poorly Diversified Portfolio

-Placing entire investment into this, then SD is the appropriate risk measurement.

Security Market Line (SML)

-States that the required RROR for a stock is dependent on the beta of that stock. kA= kRF + BA(km - kRF) kA= required return for Stock A kRF= the risk-free rate of interest BA= beta for stock A km= expected return on the market

2 situations when PP can help

-When the distance cash flows are highly uncertain. -When our firm is facing significant financial problems

Capital Budgeting Decision Criteria

-the decision rule should consider all relevant cash flows. -the " " should acknowledge the time value of money concept. -the " " should consider the riskiness of cash flows. -the " " should always rank projects so that those projects that add the most to the value of the firm are ranked highest.

Tips for Mutual Fund Investing

1. Consider your goals first 2. Bad performance persist 3. Dont chase hot funds 4. Focus on cost 5. Think long-term 6. Consider some International Expense

If you leave the company prior to retirement, you have several options:

1. Leave your $ with the company. 2. Move your $ to your new employer's 401k plan 3. Use a Rollover IRA 4. Cash Out- significant tax penalties.

Major Mutual Fund Categories

1. Money Market Mutual Funds- extremely low risk investments, but also offer low rates of return. Extremely rare to lose money. Yielding < 1% of annual ROR. 2. Bond Funds- Vary in risk. Low would be treasury high would be junk bonds. Can lose money when interest rates increase and/or the bonds suffer from defaults. Average returns of 4-9%. 3. Stock Funds- Most common type. Riskiest type of fund bc its investing in common stocks. Earns rate of 7-13%. 4. Hybrid Funds- requires little management. But, more expensive, less control, cant pick specific stock based funds

You are evaluating a capital budgeting project that will cost $25,000 •Year 1 ==> $12,000 •Year 2 ==> $20,000 •Year 3 ==> $9,000 The required return is 13% and the critical acceptance level is 1.9 years. Calculate the Payback Period and determine whether or not the project should be accepted based solely on the Payback Period.

1.65 years and accept the project To calculate the Payback Period, we count how long it takes us to recover our initial investment. In this problem, we spend $25,000 initially and get $13,000 back in year one. This gets our count to one. Then, we look at year two and realize that we will have MORE than paid back the initial investment by the end of year two. Therefore, our count will not reach two and our PP will be between one and two years. After year one, we have $13,000 yet to recover and we will get $20,000 in year 2, so we take the 1 year plus 13,000/20,000 and get a Payback Period of 1.65 years. Since this is LESS THAN the 1.9 year critical acceptance level we ACCEPT the project.

Consider the following probability distribution •Probability Return • 0.10 -20% • 0.20 5% • 0.40 12% • 0.30 30% Calculate the expected return for this security.

12.80% expected return = 0.1(-20%) + 0.2(5%) + 0.4(12%) + 0.3(30%) = -2% + 1% + 4.8% + 9% = 12.8%

Consider the following probability distribution •Probability Return • 0.25 -20% • 0.50 10% • 0.25 36% Calculate the standard deviation for this security.

19.82% Exp. Return = 0.25(-20%) + 0.5(10%) + 0.25(36%) = -5% + 5% + 9% = 9%. Once we have the Exp. Return, we can estimate the St. Deviation. St. Dev = [0.25(-20 - 9)^2 + 0.5(10 - 9)^2 + 0.25(36 - 9)^2]^0.5 = [210.25 + 0.5 + 182.25]^0.5 = [393]^0.5 = 19.82%

Consider two stocks. Stock A has a standard deviation of 29% and stock B has a standard deviation of 48%. The stocks have a correlation of -0.13. You plan to invest $6572 into stock A and $8818 into stock B. What is the standard deviation of your two stock portfolio?

28.66

Consider two stocks. Stock A has a standard deviation of 21% and stock B has a standard deviation of 50%. The stocks have a correlation of 0.28. You plan to invest $8919 into stock A and $8642 into stock B. What is the standard deviation of your two stock portfolio?

29.43 (Solve using the 2 stock portfolio standard deviation)

You are considering the purchase of a new stock. The stock is forecasted to pay a dividend next year (D1) of $4.24. In addition, you forecast that the firm will have a stable growth rate of 2.9% for the foreseeable future. The current risk-free rate of return is 3.1%. The expected return on the market is 12% and the standard deviation for the market is 18%. The stock has a correlation to the market of 0.57. Finally, the stock has a standard deviation of 45%. Given this information, what is the value of this stock?

32.91 The first step is to estimate beta by taking the standard deviation of the stock times the correlation then dividing by the standard deviation of the market. Once you have beta, plug it into the Security Market Line Formula to get required return. Finally, once you have required return, plug it into the stock valuation model.

You are considering the purchase of a new stock. The stock is forecasted to pay a dividend next year (D1) of $4.8. In addition, you forecast that the firm will have a stable growth rate of 2.1% for the foreseeable future. The current risk-free rate of return is 2.7%. The expected return on the market is 8.7% and the standard deviation for the market is 13%. The stock has a correlation to the market of 0.48. Finally, the stock has a standard deviation of 39%. Given this information, what is the value of this stock?

51.95

The expected rate of return on a Roth IRA is

A Roth IRA is a tax-shelter, not a type of investment. The expected rate of return depends on what invesment you put in your Roth IRA

Probability Distribution

A representation of possible outcomes (states of nature) that may occur and the likelihood (probability) of each outcome.

401k Plans

A retirement savings plan offered through an employer that allows employees to put away a portion of their paycheck each period on a pre-tax basis into an investment plan. The money in the 401k compounds tax-free during the employee's working life and withdraws are taxed as ordinary income. Max contribution for an employee is $18,000 ($24,000 for 50+ years of age) per year.

Exchange Traded Fund (EFT's)

A stock/mutual fund hybrid. It trades like a stock in that you can buy/sell it at any time of the trading day (mutual fund contributions and withdraws are only done based on the end-of-the-day pricing), but each share you buy represents a portfolio of underlying stocks. Tend to have relatively low expense ratios and tend to use more passive stock selection.

Consider two projects: Project A Project B •PP 2.6 years 2.3 years •IRR 14.5% 17.3% •NPV $15,500 $6,900 Assume that the projects both have a required return of 12% and a critical acceptance level (T) of 2.5 years. If these are mutually exclusive projects we should

Accept Project A and reject Project B Mutually exclusive implies we can do one or the other, but not both (although we could reject both). Since we can only take one, we need to choose the best one. NPV is our best, most reliable decision tool so we want to rely on NPV when dealing with Mutually Exclusive projects. Despite Project B having a better IRR and PP, Project A has a higher NPV and will do more to help us maximize shareholder wealth...so choose A.

Probability Distributions

Allow us to calculate the E.R. of an investment and the SD of that investment based on the values of associated with our distribution of possible outcomes.

Diversification

Allows us to greatly reduce our risk by holding a portfolio.

Load Charge

An upfront fee that is taken from your investment. Usually used to help pay for the sales costs associated with marketing mutual funds.

Calculating Impact of Load Charges and Expense Ratios

Assume you are dealing with a mutual fund that has a 4% sales load and a 1.25% expense ratio. If you invest $10,000 today and $200 per month for 30 years, how much are these costing you if the fund earns 10% before any fees? Find FV N= 360 I= 10 PV= 10,000 PMT= 200 P/Y=12 FV=650,471.58 Calculate FV with fees -1.25% expense ratio and 4% load charge. N= 360 I= 8.75 PV= 9,600 PMT= 192 P/Y=12 FV=$464,984.97

Beta Equation

BA= {(oA)(corra,mkt) / omkt} BA= the Beta of Stock A oA= SD of Stock A coorA,mkt= correlation btw Stock A & overall market omkt= SD of overall market

Choosing btw 2 (or more) Well-Diversified Portfolios

Can use either SD or BETA bc the firm-specific risk is already diversified. Thus, whichever portfolio has the higher SD should also have the higher beta.

Stock C has an E.R. of 7% and a SD of 20%. Stock D has an E.R. of 9% and a SD of 28%. Which should you choose?

Could choose both. Stock D is more riskier but compensates with a higher E.R.

Interpreting Expected Return and SD

Expected Return gives us an idea oh how much we will make on the investment. It is NOT how much we WILL make, but how much we would make ON AVERAGE if we could repeat the holding period an infinite # of times.

Because of the flaws with the Payback Period, few firms (less than 25%) use the Payback Period when evaluating capital budgeting decisions

False

For an investor that plans to make regular contributions to a mutual fund over a long period of time (say $3000 per year for 30 years), the load charge is more important than the expense ratio in impacting net wealth at the end of the time period.

False

When using the Payback Period as a capital budgeting rule, we should increase the critical acceptance level (T) when evaluating projects with above average risk.

False

You are considering the purchase of a stock with a beta of 1.6. The current risk-free rate of interest is 5% and the expected return on the market is 11%. You have estimated that the expected return for this stock is 13%. Based on this information, you should purchase the stock.

False

ABC Shares

Funds sold with various expense packages. Used to pay the brokers/advisors who sell these shares. A shares have higher front-end load charges. B have higher annual expenses and back-end loads. C shares typically avoid load charges but have higher annual expenses. Shortterm holding use C, longterm holdings used A

Choose the correct statement regarding vesting

If you are vested, all of your contributions, the company's matching contributions and the returns from those contributions belong to you when you leave the firm.

E.R. for a Portfolio

Its the weighted average of each stock held in the portfolio.

SD

Measures total risk (diversifiable risk + market risk) for a security.

Choose the correct statement regarding expected return

None of the other answers is correct

Capital Budgeting Decision Techniques

Payback Period; Net Present Value; Internal Rate of Return

Advantages of Mutual Funds

Professional Management, low cost, diversification, low minimum investment, flexible & easily tailored to your needs.

Consider the following four capital budgeting projects. Based on this information, which project does management feel has the highest level of risk? (Note -- no calculations are necessary...this is a conceptual question) Project A Project B Project C Project D CF0 -25,000 -25,000 -50,000 -50,000 CF1 1,000 14,000 5,000 18,000 CF2 2,000 10,000 10,000 18,000 CF3 3,000 6,000 30,000 18,000 CF4 40,000 6,000 40,000 18,000 T 3 years 2.75 years 2.75 years 2.5 years k 10% 12% 12% 14%

Project D

Independent (stand-alone)

Projects are any set of projects in which choosing one has no impact on our decision to choose another project from that set. Taking one project does not influence the other, so they are independent. Decision rule should be based on if the project is good or bad.

Mutually Exclusive

Projects are any set of projects in which choosing one makes the other projects no longer possible. When we have M.E. projects, our decision rule needs to not only decide if a project is good or bad, but needs to be able to rank which project is the best.

Individual Retirement Accounts (IRA)

Provides a tax-incentive for personal retirement savings. Theoretically this should increase the savings rate and encourage more people to prepare for their financial future.

Diversifiable Risk

Refers to risk factors that are isolated towards one particular firm or industry.

Diversification

Refers to the concept that by holding a # of different securities from a spectrum of industries, we can negate the impact of company specific factors on our returns.

Vesting

Refers to the concept that your retirement benefits belong to you even if you leave the firm before retirement. Minimum vesting standards that require you to be fully vested in 3-6 years. If you are 60% vested, then 60% of your retirement benefits belong to you if you leave the firm early. It is only the matching contributions and the return on those contributions that need to be vested.

What is risk

Risk refers to the possibility of an unfavorable event occurring.

Rollover IRA

Rollover IRA's are designed to allow individuals to move their pension plan into a taxsheltered account when they switch jobs, essentially turning the old pension plan into a traditional IRA.

Stock A has an E.R. of 10% and a SD of 25%. Stock B has an E.R. of 10% and a SD of 30%. Which should you choose?

Stock A because Stock B offers no additional compensation.

Consider two projects: Project A Project B •PP 2.6 years 2.3 years •IRR 14.5% 17.3% •NPV $15,500 $6,900 Assume that the projects both have a required return of 12% and a critical acceptance level (T) of 2.5 years. If these are independent projects we should

Take both projects A and B Both A and B have a positive NPV (most important) and have IRR greater than the required return. While Project A exceeds the critical acceptance level, Payback Period is too flawed of a model to override the NPV analysis. If there is a conflict between NPV and PP, always side with NPV

Prospectus

Tells you all the important information you need to know. It discusses the investment style of the fund, the risk level of the fund, the various costs of the funds and much more.

You are evaluating a capital budgeting project that will cost $35,000 •Year 1 ==> $12,000 •Year 2 ==> $17,000 •Year 3 ==> $10,000 •Year 4 ==> $5,000 The required return is 15% and the critical acceptance level is 2.5 years. Calculate the Internal Rate of Return and determine whether or not the project should be accepted

The IRR is 11.32% and we should reject the project

You are evaluating a capital budgeting project that will cost $55,000 •Year 1 ==> $17,000 •Year 2 ==> $10,000 •Year 3 ==> $10,000 •Year 4 ==> $17,000 •Year 5 ==> $40,000 The required return is 12% and the critical acceptance level is 3.5 years. Calculate the Net Present Value and determine whether or not the project should be accepted based solely on NPV.

The NPV is $8,769.19 and we should accept the project

Expense Ratio

The amount of money taken out on an annual basis to cover the funds operating expenses. Ranges from .05% at the low end to over 2% at the high end.

Interdependent

The decision to take one project impacts our decision to take another, but they are not mutually exclusive. Some interdependent projects are compliments in which the cash flows from both projects takes together are greater than the cash flows from each project on a standalone basis. Other interdependent projects are substitutes in which the cash flows from both projects taken together are less than the cash flows from each project on a standalone basis.

Consider the following two projects: Project A Project B •CF0 -15,000 -15,000 •CF1 10,000 2,000 •CF2 8,000 3,000 •CF3 5,000 22,000 Assuming these projects are mutually exclusive, we could have problems when using IRR due to ___.

The reinvestment rate problem The size problem does not appear here as both projects have the same initial investment. The crossover (multiple IRR) problem does not appear here as both projects only have on crossover point (between year 0 and year 1) so there will only be a single, viable IRR solution for each. However, project A is frontloaded while project B is backloaded which could lead to a Reinvestment Rate Problem.

Reinvestment Rate Problem

This bias will be > for projects that are Frontloaded. Frontloaded refers to projects with higher cash flows early in the project life. This bias is > here bc the faulty reinvestment rate assumption has longer to impact our final answer. This bias is smaller for projects that are Backloaded. Bc of this difference in bias, Frontloaded projects are likely to have an artificially higher IRR than Backloaded projects causing us to make poor rankings. If we are evaluating M.E. projects with differnet timing, then we should be careful of the reinvestment rate problem and choose NPV as our decision tool.

All else equal, an increase in the beta of the stock will lower the stock price.

True

As long as the correlation is < 1.0 (which it will be for any 2 stocks), the risk of the portfolio is < the weighted average risk of the two securities which make up the portfolio.

True

Including a municipal bond in an IRA would generally be a bad idea.

True

Market risk impacts all stocks but not equally

True

When comparing two individual investments to be held as stand-alone investments (not as part of a well diversified portfolio), standard deviation is a better risk measurement than beta.

True

When dealing with independent projects, the size problem associated with the IRR is no longer relevant.

True

How well does the IRR meet criteria?

Very well if projects are independent. If they are M.E. not so well. If projects are independent (& there is no crossover problem) the IRR will always make the right decision.

Choose the correct statement regarding diversification.

We can eliminate most of our firm specific risk by holding a portfolio of 50 stocks from a variety of industries

Differences between Roth IRAs and Traditional IRAs include ___.

Withdraws from Traditional IRAs are treated as ordinary income while withdraws from Roth IRAs are tax-free

SD

a measure of volatility or total risk, which is appropriate when evaluation stand-alone risk.

Mutual Fund

a pooled investment portfolio managed by a professional portfolio manager.

What is the expected Rate of Return? State of Nature Probability Return Recession .20 -15% Normal .50 10% Boom .30 35%

k= (.20 * -15%) + (.50 * 10%) + (.30 * 35%) = 12.5%

Expected Return Formula

k=P1k1 + P2k2 + ..... + Pnkn k= the expected return on the stock Pi= the return probability of the ith possible outcome ki= the return under the ith outcome Pn= the probability of the nth possible outcome kn= the return under the nth outcome *Probabilities must sum to 1.0

E.R. for a Portfolio Equation

kp= W1k1 + W2k2 + .... Wnkn kp= the E.R. for the portfolio Wi= the weight (proportion) of stock 1 k1= expected return for stock 1 Wn= the weight (proportion) of stock n kn= E.R. for stock n

SD Equation

o= SQUARE ROOT OVER ALL! P1(k1 - k)squared + P2(k2 - k)squared + ....... Pn(kn - k)squared -Sigma (o)= SD -Pi= the probability of the ith outcome -ki= the return under of the ith outcome -k= the expected return for the stock -Pn= the probability of the nth outcome -kn= the return under the nth outcome

SD of a 2-stock Portfolio Equation

op= SQUARE ROOT ON ALL! W12o12 + W22o22 + 2W1W2o1o2corr1,2 op= the SD of portfolio Wi= weight (proportion) of stock 1 o1= the SD of stock 1 W2= weight (proportion) of stock 2 o2= the SD of stock 2 Corr1,2= correlation btw the returns of stocks 1 and 2

The information on the specifics of a particular mutual fund (costs, risks, objective, past performance, etc.) can be found in the

prospectus