FINC 3610 Exam 3 (Dismukes)

Net Present Value (NPV)

a measure of how much value is created or added today by undertaking an investment

- numeric ($) value

- best option/always choose

- accept inv. if mkt value is greater

- benefits > costs then "creating value" => invest

- has to be positive

The NPV is the difference between...

the investment's market value and its cost

NPV Rule

investment should be accepted if the net present value is positive and rejected if it is negative

*assumes CF's reinvested at cost of capital

How to solve for NPV:

Estimate future cash flows

- Calculate the PV of Future CF's - initial cost

Internal Rate of Return (IRR)

the discount rate that makes the NPV = 0

- the breakeven

*Beware of Nonconventional Cash Flows*

How to solve for IRR:

set NPV = 0 and solve for "r" (YTM on bonds)

IRR Rule

An investment is acceptable if the IRR exceeds the required rate of return. It should be rejected otherwise

*Assumes cash flows are reinvested at the IRR

What to beware for IRR:

may result in multiple answers (non-conventional CF's)

may result in incorrect decisions (mutually exclusive investments)

What does the Net Present Profile provide?

- range of rates where NPV is positive

- range of rates where NPV is negative

- point of which NPV = 0 (IRR)

- Sensitivity of NPV to r (slope)

Mutually Exclusive Projects can cause what?

problems

Crossover Rate

1. Calculate (incremental CF's)

2. Calculate IRR based on incremental CF's

Modified Internal Rate of Return (MIRR)

- calculation of IRR on modified cash flows

(cash outflows discounted to time zero and cash inflows to end of project)

- combination approach, it is the discount rate that equates the present value of all cash outflows to the future value of all cash inflows

How to solve for MIRR

For the combination approach, discount all cash outflows to time 0 and compound all cash inflows to the end of the project

cant get multiple answers under this approach

MIRR Rule

An investment is acceptable if the MIRR exceeds the required rate of return

- should be rejected otherwise

*Assumes cash flows are reinvested at the cost of capital

Profitability Index (PI)

PV of future CF's / initial cost (absolute value)

- result will be a number that you compare to 1

- Also called a benefit-cost ratio

How to solve for PI

Calculate the present value of the future cash flows (the PV not the NPV) and divide by the initial cost. If a project has a positive (negative) NPV, the PI will be greater (less) than 1

PI Rule

Only accept projects with a PI greater than 1, and invest in projects with the largest PI's first

The 4 Investment criteria related to NPV

NPV, IRR, MIRR, PI

The Payback Rule

the length of time it takes to recover our initial investment

- Assume uniform cash flows. Calculate the # of years it will take for the future cash flows to match the initial cash outflow

"The Payback Rule "Rule

An investment is acceptable if its calculated payback period is less than some pre-specified number of years

How to solve for Payback Rule

- Assume cash flows are received uniformly throughout the year

- Calculate the number of years it will take for the future cash flows to match the initial cash outflow

The Payback Rule may accept a __________ NPV project

negative

The Discounted Payback Rule

Length of time to recover initial investment based on discounted cash flows

- adjusts for the time value of money

How to solve for Discounted Payback rule

Assume cash flows are received uniformly throughout the year. Calculate the number of years it will take for the present

"The Discounted Payback Rule" Rule

An investment is acceptable if its discounted payback is less than some pre-specified number of years

The Average Accounting Return (AAR)

the ratio of the average net income of the project to the average book value of the investment

(Avg NI / Avg BV)

- worst of all criteria we revieweds

How to solve for AAR

average net income / average book value

AAR Rule

An investment is acceptable if its average accounting return is greater than some pre-specified benchmark

what is capital budgeting?

making capital investment decisions

- how to pay for major equipment

How do compute the value of a bond/stock/project?

PV of FUTURE CF's

do we include sunk costs?

NO, any costs I cant recover because its upfront; non-incremental

do we include opportunity costs?

YES, "what else could i do with my money"

do we include side effects?

YES, impact an existing project

do we include changes in net working capital?

YES, current assets-current liabilities

do we include taxes?

YES

do we include financing costs?

not directly, because financing costs already included in require return

Project Cash Flows

Sales (Revenue)

- Costs

- Depreciation (non-cash, tax-deductible)

= EBIT (earnings before int. & taxes)

- Taxes

= NOPAT (net operating profit after taxes)

+ Depreciation (non-cash)

= Operating Cashflows

(+/- 3 potential adjustments)

3 Adjustments to Project CF's

(-) capital expenditures

(+/-) Net Working Capital

Salvage Value and Taxes (only added back at the end)

Net Working Capital

net change in current assets & current liabilities

- CA inc, CF dec

- CL inc, CF inc

*recover NWC at end of project

As net working capital increases.....

AS net working capital decreases.....

CF's decrease

CF's increase

Projects have ____________ (ending) life

discreet

How to calculate Salvage Value and Taxes:

BV = Cost - Accumulated Depreciation

What if we sell an asset for more than book value?

we have a gain

Depreciation

wear down of assets reduced from cost

- basically a tax shield

- take deduction on taxes that i'm not paying for

- is a non-cash expense

Straight Line Depreciation

same amount every year

- (purchase price - ending BV) / # of years

MACRS Depreciation

it is ACCELERATED

- always depreciate to zero

- assumes asset is purchased halfway through first year

- property class assigned

- tables will add up to 100%

- earnings will be lower

- use for taxes

Company Valuation

PV of future CF's

- difference is the time arising

- project has discrete life

- assume the company goes on forever (non-constant stock growth)

Risk Analysis

will never be 100% accurate; they are best estimate

Sensitivity Analysis

take and modify 1 variable

- change 1 input (others the same)

- sensitivity of NPV to changes in 1 variable at a time

Scenario Analysis

changing a few variables

- few scenarios/stats of world (best/worse case)

Simulations

scenario on steroids

- monte carlo = a ton of them

- start with random variables

- repeat 1000's of times

Corporate bonds have ________ risk which is more risk

default

what determines the required return on an investment?

risk

Risk

- is a reward for bearing risk

- greater the risk, greater the potential reward

- risk adverse (label)

*always a risk

Returns

cash flows for shares of stock:

- dividends

- capital gains (or losses) + g (sales price-cost)

*both pay taxes

Percentage Return

(Cash flows over period + change in mkt value) / Beginning mkt value

Rates of Return (1926-2019)

- when down big, generally go up big

- large company stocks not nearly as volatile as small company

Risk Premium

excess return required from an investment in a risky asset over that required from a risk-free asset

- expected return - risk free premium

- risk free return = US Treasury Return

Nondiversifiable Risk

risk that influences a large number of assets

- systematic or market risk

- cant be eliminated

- applies to everybody

Diversifiable Risk

risk that affects at most a small number of assets

- unique risk or asset-specific risk

- can be essentially eliminated

Principle of Diversification

Spreading an investment across a number of assets will eliminate some, but not all, of the risk

- cant get rid of non-diversifiable

Unsystematic risk is essentially eliminated by _________________, so a portfolio with many assets has almost no unsystematic risk

diversification

The _______________________ on an asset depends only on that asset's systematic risk.

expected return

Beta Coefficient

how risky is an asset compared to an index fund whose beta is 1

- volatility/risks associated w/stocks

CAPM

An equilibrium asset pricing model showing that the expected return for a particular asset depends on the pure time value of money plus a reward for bearing systematic risk

CAPM formula

Return (asset) = Return (risk free) + Beta [Return(Market) - Return (risk free)]

Market Efficiency Hypothesis

- set up (lots of people, money, time)

- prices reflect information... Quickly

- no usual or excess profits from trading on information

the market is extremely...

efficient

Ultimately, everything is going to come back to the ____________

market

Weak Form Market Efficiency

all past information is reflected

Semi-Strong Form Market Efficiency

all publicly information + past info

Strong From Market Efficiency

all information (past, public, private)

- would be no need for insider trading law if we only had this

Why Technical Analysis Fails

Investor behavior tends to eliminate any profit opportunity associated with stock price patterns

- everyone would do it if you could find the "pattern"

Market Reaction

quick, accurate (public=semi-strong)

Reporting

- know the risk they are taking

- bias

- if its to good to be true, it is to good to be true

The Dow Jones Industrial Average (DJIA) represents _________ large-cap leading US companies

30

What are the sources of capital?

Debt

- loans & bonds (YTM)

Stock (Equity) (IPO)

- common (stock issue)

- preferred (similar to stocks and bonds)

What is the cost of capital?

It reflects the investment opportunities and alternatives in the financial market available to suppliers of the firm's capital => opportunity cost

Which cost of capital?

Marginal

How do we calculate WACC

Proportion of firm (weighted average) financed by the sources of capital above multiplied by the required return for that source of capital

How many different investment criteria did we review in the module, and thus you are responsible for understanding?

7

3 multiple choice options

An investment should be accepted if the _____________________ is positive and rejected if it is negative

NPV

3 multiple choice options

Which investment criteria create a % return as their calculated result?

IRR, MIRR, and AAR

3 multiple choice options

Which of the following incremental cash flows do we exclude when determining the cash flows associated with a project?

sunk costs

3 multiple choice options

Which of the following items are components of the cash flows associated with a project?

All of these items are included when determining a project's cash flows

3 multiple choice options

Which of the following is NOT a potential adjustment to a project's cash flows?

adjust for net working capital changes at the beginning of the project only

3 multiple choice options

Which of the following is true if I sell an asset for less than its book value at the end of the project

the after-tax salvage value will be greater than the sales price

3 multiple choice options

Which of the following incremental cash flows do we include when determining the cash flows associate with a project?

Changes in net working capital, taxes, opportunity costs

how is working capital calculated

current assets - current liabilities

3 multiple choice options

In which type of risk analysis do I change only one input while keeping all of the others the same?

sensitivity analysis

3 multiple choice options

Which of the following is NOT true regarding MACRS depreciation?

you will depreciate to the ending book value of the asset if its greater than zero

3 multiple choice options

which of the following is true if I sell an asset for more than its book value at the end of the project?

the after-tax salvage value will be less than the sales price

3 multiple choice options

which of the following statement(s) is/are true?

both statements are true

3 multiple choice options

Assume that last year T-bills (a risk-free investment) returned 2.2% while your investment in large company stocks earned an average of 8.1%. Which of the following refers to the difference in these two rates of return?

risk premium

3 multiple choice options

An investor who owns a well-diversified portfolio would be least concerned with which of the following types of risk?

unsystematic

3 multiple choice options

The amount of systematic risk present in a particular risky asset relative to the market portfolio is referred to as?

beta coefficient

3 multiple choice options

Which investment criteria is calculated as the present value of the future cash flows divided by the initial cost?

PI

3 multiple choice options

The payback rules uses ________________________ to match the initial cash outflow, while the _______________________ uses the present value of future cash flows to match the initial cash outflow

future cash flows; discounted payback rule

3 multiple choice options

Which term(s) below mean the same thing as required return, and thus could be terms we see related to rates in our capital budgeting problems?

all these terms mean the same thing as required return

3 multiple choice options

The principle of diversification eliminates what amount of risk?

some, but not all

3 multiple choice options