ECON 374

The three attributes of NPV are that it

measures profitability, accounts for time value of money, and incorporates all cash flows.

uses all the cash flows of a project

uses cash flows

discounts the cash flows properly

Capital Budgeting

is the decision-making process for accepting and rejecting projects. It involves analyzing potential investments to allocate capital most effectively.

Discounted Payback Rule

Cash Flow Analysis

- an investment is considered acceptable if its discounted payback period is less than a specified time frame. This rule incorporates time value, ensuring that cash flows are evaluated in their present value terms.

Basic NPV investment rule

Accept an investment if the NPV is greater than zero, indicating that it is expected to generate more cash than it costs.

Zero Growth

Constant dividend amount

Refers to a situation where a company pays a constant dividend amount over time, without growth in dividends.

- dividend/discounted rate

What is capital budgeting?

The process of evaluating and selecting long-term investment projects, ensuring that resources are allocated to projects that will enhance the firm's value.

What is the main goal of capital budgeting?

To determine whether a project adds value to the firm, helping guide investment decisions to maximize shareholder wealth.

What is NPV?

The difference between the present value of future cash flows and the initial cost. NPV indicates the profitability of an investment.

NPV decision rule?

• NPV > 0 → Accept

• NPV < 0 → Reject

This rule helps in making informed investment decisions.

Why is NPV the best method?

It considers time value of money and directly measures value added, providing a clear assessment of an investment’s potential success.

What does a positive NPV mean?

The project increases firm value, suggesting that it is likely to be a good investment.

What is payback period?

Time needed to recover the initial investment, providing a quick estimate of investment risk.

What is compounding?

The process where money grows over time by earning interest on both the initial amount and accumulated interest.

→ (Future value gets bigger)

What is discounting?

The process of finding the value today of future money, adjusting for the time value of money.

→ (Future value becomes smaller when brought to present)

Future Value (FV)?

The value of money at a future point in time after earning interest.

Present Value (PV)?

The value today of a future amount of money, calculated by discounting future cash flows.

How do you calculate PV with multiple cash flows?

Discount each cash flow separately and add them together to determine the total present value.

Two methods to find PV of multiple cash flows?

• Discount one period at a time

• Discount each individually and sum

What is a bond?

A loan from investors to a company or government, representing a promise to pay back the borrowed amount with interest.

Coupon?

The interest payment made on a bond, typically expressed as a percentage of the face value.

Face (Par) Value?

The amount repaid at maturity, which is the nominal value of the bond.

Coupon Rate?

Annual coupon ÷ face value, representing the percentage of the face value paid in interest each year.

Maturity?

Date when the bond is fully repaid, marking the end of the investment period.

Yield to Maturity (YTM)?

The required return on a bond, indicating the total return expected if the bond is held until maturity.

Relationship between bond price and interest rates?

Inverse relationship

→ Rates ↑ → Bond price ↓

This means that as interest rates rise, the prices of existing bonds typically fall.

Bond value formula?

Bond Value = PV of coupons + PV of face value, representing the total present value of all cash flows.

What is a discount bond?

Bond sells below face value (YTM > coupon rate), often issued when market rates are higher than the bond’s coupon.

What is a premium bond?

Bond sells above face value (YTM < coupon rate), typically occurring when market rates are lower than the bond’s coupon.

Semiannual coupons?

Interest paid twice a year (divide rate & periods by 2), affecting cash flow and yield calculations.

Interest rate risk?

Risk that bond prices change due to interest rate changes, impacting investment value.

What increases interest rate risk?

• Longer maturity

• Lower coupon

Sinking Fund?

A fund set aside to repay bond principal over time, ensuring that the issuer can meet its obligations.

Call Provision?

Allows issuer to repay bond early, typically advantageous if interest rates decline.

Call Premium?

Extra amount paid when bond is called early, compensating the bondholder for early redemption.

Deferred Call?

Bond cannot be called before a certain date, providing some level of protection to investors.

Call-protected bond?

Cannot be called for a period of time, offering assurance to investors against early redemption.

Government bonds?

Issued by governments (very low default risk), providing a secure investment option.

Municipal bonds?

Issued by local/state governments (often tax-free), attracting investors seeking tax advantages.

Corporate bonds?

Issued by companies (higher risk), often offering higher yields to compensate for the increased risk.

Zero-coupon bond?

No interest payments, sold at a discount, providing returns only at maturity.

Floating-rate bond?

Coupon adjusts with interest rates, providing investors with protection against rate changes.

TIPS?

Inflation-protected bonds, preserving purchasing power by adjusting principal with inflation.

What is a bond rating?

Measure of credit risk (likelihood of default), informing investors about the safety of the bond investment.

Investment-grade bonds?

BBB or higher, indicating lower risk and greater likelihood of repayment by the issuer.

Junk bonds?

Below investment grade (high risk), offering higher yields but with increased risk of default.

What determines stock value?

Present value of future dividends, reflecting the expected returns to equity investors.

Two ways to make money from stocks?

1. Dividends

2. Selling shares

Zero growth model?

Stock pays constant dividend forever

P₀ = D / R, used for valuing stocks with no expected growth.

Dividend growth model (Gordon)?

P₀ = D₁ / (R − g), a common model for valuing stocks with expected dividend growth.

What is g?

A: Growth rate of dividends, reflecting how much dividends are expected to increase.

Required return formula

R = Dividend yield + capital gain yield, helping investors determine the expected return from their investment.

Supernormal growth

High growth first, then normal growth later, applicable to companies with fluctuating growth rates.

Net Present Value (NPV)?

PV of cash inflows − cost, providing a measure to assess the profitability of an investment.

Accept/reject rule for NPV?

Accept if NPV > 0, guiding investment decisions based on expected value addition.

What is DCF?

Discounted cash flow valuation method, widely used in determining the value of investments by discounting future cash flows.

Payback period?

Time to recover initial investment, offering a simple measure of investment risk.

Payback disadvantages

• Ignores time value of money

• Ignores later cash flows

What is discounted payback?

Payback using discounted cash flows, providing a more accurate picture of investment timing.

Advantage?

Accounts for time value of money, improving the decision-making process.

Disadvantages

Still ignores long-term cash flows

• Requires cutoff

Problem with AAR?

Not based on cash flow or time value, leading to potential misjudgments in evaluating investments.

Average Accounting Return (AAR)?

Avg net income / avg book value, an accounting-based measure of investment return.

Internal Rate of Return (IRR)?

Discount rate that makes NPV = 0, helping to assess the profitability threshold of an investment.

Incremental cash flows?

Cash flows from a project vs without it, essential for project evaluation.

Stand-alone principle?

Evaluate project based only on its own cash flows, isolating its financial impact.

Sunk cost?

Cost already incurred (ignore it) when making future investment decisions.

Opportunity cost?

Value of next best alternative forgone when making a decision.

Erosion

New project reduces existing sales, an important consideration in project valuation.

Net working capital?

Current assets − current liabilities, reflecting the liquidity and operational efficiency of a business.

Timing matters?

Cash flow matters when it actually happens (not accounting), emphasizing the importance of cash flow timing in decision-making.