Brainscape's Knowledge GenomeTM

Browse over 1 million classes created by top students, professors, publishers, and experts.


See full index

Prelims - Financial Analysis > 1.4 Valuation > Flashcards

1.4 Valuation Flashcards

1
Q

What is compounded interest?

A

Where we add the interest from each period to the principal so that it also accrues interest in the next period.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
2
Q

If one has value P today, invested at rate r for n years, what is the final value?

A
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
3
Q

What is the difference between compounding and discounting?

A

Compounding: we take present value and calculate the future value.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
4
Q

If one receives value F for n years, discounted at rate r, what is the present value?

A

PV=F÷(1+r)^n

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
5
Q

What do we normally do in discounting?

A

As it is usually regular inflows of payments, we sum the values of each individual year.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
6
Q

Baseline case: Certain cash flows, flat (time-invariant) discount rate.

What is the formula for calculating present value?

A
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
7
Q

What are considered to be risk-free securities?

Why?

A

US

  1. Fiscal instruments - the power to tax the wealthiest population in the world.
  2. Ability to print money - will always be able to fulfil debts (although this isn’t great for obvious reasons).
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
8
Q

Non-flat discount rate term structure

What is the formula for calculating present value?

A
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
9
Q

What discount rate do we use for non-flat discount rate term structures?

A

Use zero-coupon bond rates (spot rates) of same riskiness as cash flows.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
10
Q

Uncertain cashflows

What is the formula for calculating present value?

A
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
11
Q

What discount rate do we use for uncertain cash flows?

A
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
12
Q

Show the cashflow diagram and the total present value for the whole strategy

A
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
13
Q

Show the cashflow diagram and total present value for strategy B

A
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
14
Q

Formula for rate of return in terms of profit and investment

A
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
15
Q

Discounted cash flow formula

A
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
16
Q

What is the value of $200/year for eternity?

Discount rate = 5%

A
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
17
Q

What is the formula for perpetuties?

A
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
18
Q

Perpetuities formula proof

A
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
19
Q

Rate of return formula in terms of cash flow and present value

A
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
20
Q

How do we derive the perpetuities formula?

A

From the rate of return rate formula (r = C/PV), we rearrange so that PV is the subject.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
21
Q

What is an annuity?

A

A regular payment (it suggests annual payment but it can be any regular payment).

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
22
Q

What is the value of $200/year for 5 years?

Discount rate is 5%.

A
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
23
Q

What is the formula for annuities?

A
24
Q

Annuity formula explained

A

Two perpetuities. One starts now (t=0), with the first payment in t=1. The second starts at the end of the annuity, at t=T.

25
Q

What is the annuity factor?

A
26
Q

What is the equivalent annual anuity/cost formula?

A
27
Q

Two warnings about the perpetuity formula

A
  1. Looks very similar to present value formula but remember PV=CF/(1+r) where as for perputities it is just PV=CF/r
  2. Regular stream of payments.
28
Q

How are interest rates usually quoted?

A

As APRs (rapr) which is associated with k periods.

29
Q

Formula for EAR

A

(accounting for compounding frequency k)

30
Q

Example: One-year investment account. 5% APR, semi annual compounding (k=2). $10,000 investment.

How much money after one-year?

A
31
Q

Example: One-year investment account. 5% APR, semi annual compounding (k=2). $10,000 investment.

What is the actual annual rate of interest earnt?

A
32
Q

How does compounding frequency impact the Effective Annual Rate?

A
33
Q

How do mortgages work in the UK?

A

Pay 20% down payment

Borrow the rest from the bank using property as collateral

Pay a fixed monthly payment for the life of the mortgage

The option to prepay the mortgage value before the maturity date of the mortgage

34
Q

Example: house for $500,000 with $100,000 down payment. 30 year fixed rate mortgage at 8.5% APR compounded monthly.

Calculate the monthly payment.

A
35
Q

Example: house for $500,000 with $100,000 down payment. 30 year fixed rate mortgage at 8.5% APR compounded monthly.

Calculate the effective annual rate.

A
36
Q

Amortisation schedule of mortgages

A

Same monthly payment, but each month the principal increases and the amount paid to interest decreases, until by the end it is balanced.

37
Q

How do you calculate the interest and principal paid in mortage payments?

A

As you have regular monthly payments, once you have calculated the annuity you can calculate interest by multiplying the previous month’s balance by the EAR (APR/12).

Once you have the interest, you can subtract it from the monthly payment to get the principal.

38
Q

What is NPV?

A

Net Present Value

the net value of all present values of future cashflows plus the (usually negative) cashflow in period t=0

39
Q

NPV formulae

A
40
Q

Basic rules for NPV

A

Single project, undertake if and only if NPV > 0

Several independent projects, undertake all with NPV > 0

Mutually exclusive project, take one with highest positive NPV

41
Q

What does a positive NPV mean? (Even if it just 1 dollar)

A

r rate represents risk. So a positive NPV means that all risk has been eliminated and all debts have been repaid.

42
Q

What is IRR?

A

Internal Rate of Return. The discount rate for which NPV = 0.

43
Q

How is IRR calculated?

A
44
Q

Basic rules for IRR

A

Independent projects, undertake if IRR > hurdle rate

Mutually exclusive projects, undertake the one with the highest IRR greater than hurdle rate

45
Q

When do the IRR and NPV methods arrive at the same conclusions?

A

If and only if:

  • Cash flow stream exhibits only one change of sign
  • Consideration of only a single project (yes/no decision)
  • Hurdle rate is the opportunity cost of capital, also flat
46
Q

Possible problems with IRR method

A

More than one change of sign, solving for the IRR might yield multiple solutions.

There may be no solution at all (neither analytical nor numerical).

Multiple mutually exclusive projects → wrong one might be selected.

IRR ignores scale of the project.

Different time patterns of the cash flows.

47
Q

What do we mean by payback period and discounted payback period?

A

The minimum length of time s such that the sum of cash flows from a project is positive.

Discounted, when we use present values of cash flows.

48
Q

Paybath period formula

A
49
Q

Discounted payback period formula

A
50
Q

Decision rule with payback periods

A

Accept projects if their payback period is less than or equal to a specified payback period.

51
Q

Advantages and drawbacks of payback periods

A

Advantage:

  • Simple to communicate

Drawbacks:

  • Cutoff period arbitrary
  • Rule ignores all cash flows after the cutoff date
  • Ignores time-value-of-money effect, equal weight to all cashflows (non-discounted method only)
  • It may accept bad short-live projects and reject good long-lived ones.
52
Q

What is the profitability index?

A

The ratio of the present value of cash flows and initial investment I0 of a project.

53
Q

Profitability index formula

A
54
Q

PI decision rules

A

Independent projects: accept all projects with PI > 1 (like NPV)

Mutually exclusive projects: accept the one with the highest PI greater than 1

55
Q

When do NPV and PI arrive at the same conclusions?

A

If and only if:

  • There is only one cash flow which is at time 0
  • Only one project is under consideration
56
Q

Possible problem with PI

A

PI scales projects by initial investments. Scaling can lead to wrong answers in comparing mutually exclusive projects.

57
Q

Of all measurements, which is dominant? Why?

A

NPV rule dominates - focus on shareholder value maximisation. Others can be misleading:

  • IRR ignores the scale of projects
  • PI can be an aid when capital is rationed
  • Payback rules is the worst

Prelims - Financial Analysis (14 decks)

Brainscape helps you reach your goals faster, through stronger study habits.
© 2024 Bold Learning Solutions. Terms and Conditions