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