CFA 6: Discounted Cash Flow Applications

Question 1

net present value

Net Present Value and Internal Rate of Return

Answer 1

The present value of an investment’s cash inflows minus the present value of its cash outflows. The word “net” in net present value refers to subtracting the present value out of the investment’s outflows (costs) from the present value of its inflows (benefits) to arrive at the net benefit.

Question 2

NPV rule

Net Present Value and Internal Rate of Return

Answer 2

If the invesntment’s NPV is positive, an investor should undertake it; if the NPV is negative, the investor should not undertake it. If an investor has towo candidates for investment but can only invest in on, the investor should choose the candidate with the higher positive NPV.

Question 3

capital budgeting

Net Present Value and Internal Rate of Return

Answer 3

The allocation of funds to relatively long-range projects or investments.

Question 4

capital structure

Net Present Value and Internal Rate of Return

Answer 4

The choice of long-term financing for the investments the company wants to make.

Question 5

working capital management

Net Present Value and Internal Rate of Return

Answer 5

The management of the company’s short-term assets (such as inventory) and short-term liabilities (such as money owed to suppliers).

Question 6

internal rate of return (IRR)

Net Present Value and Internal Rate of Return

Answer 6

The discount rate that makes net present value equal to zero. It equates the present value of the investment’s costs (outflows) to the present value of the investment’s benefits (inflows). The rate is “internal” because it depends only on the cash flows of the investment; no external data are needed.

Financial managers often want a single number that represents the rate of return generated by an investment.

Question 7

IRR rule

Net Present Value and Internal Rate of Return

Answer 7

Accept projects or investments for which the IRR is greater than the opportunity cost of capital.

Question 8

hurdle rate

Net Present Value and Internal Rate of Return

Answer 8

The rate that a project’s IRR must exceed for the project to be accepted.

Note: if the opportunity cost of capital is equal to the IRR, then the NPV is equal to 0. If the project’s opportunity cost is less than the IRR

Question 9

performance measurement

Portfolio Return Measurement

Answer 9

The calculation of returns in a logical and consistent manner.

Question 10

performance appraisal

Portfolio Return Measurement

Answer 10

The evaluation of risk-adjusted performance; the evaluation of investment skill.

Question 11

holding period return (HPR)

Portfolio Return Measurement

Answer 11

The return that an investor earns over a specified holding period.

For an investment that makes one cash payment at the end of the holding period,

HPR = (P1-P0 +D1)/P0

Where:
P0 is initial investment
P1 is price received at the end of the holding period
D1 is the cash paid by the investment at the end of the holding period

Question 12

time-weighted rate of return

Portfolio Return Measurement

Answer 12

Measures the compound rate of growth of $1 initially invested in the portfolio over a stated measurement period. In contrast to the money weighted rate of return, the time-weighted rate of return is not affected by cash withdrawals or additions to the portfolio. The term “time-weighted” refers to the fact that returns are averaged over time.

To compute an exact time-weighted rate of return on a portfolio:

1) Price the portfolio immediately prior to any significant addition or withdrawal of funds. Break the overall evaluation period into subperiods based on the dates of cash inflows and outflows.
2) Calculate the holding period return on the portfolio for each subperiod.
3) Link or compound holding period retunes to obtain an annual rate of return for the year (the time-weighted rate of return for the year). If the investment is for more than one year, take the geometric mean of the annual returns to obtain the time -weighted rate of return over that measurement period.

Question 13

bank discount basis

Money Market Yields

Answer 13

A quoting convention that annualizes, on a 360-day year, the discount as a percentage of face value.

Question 14

pure discount instruments

Money Market Yields

Answer 14

Instruments that pay interest as the difference between the amount borrowed and the amount paid back.

Question 15

holding period yeld (HPY)

Money Market Yields

Answer 15

The return that an investor earns during a specified holding period; holding period return with reference to a fixed-income instrument.

Question 16

effective annual yield (EAY)

Money Market Yields

Answer 16

An annualized return that accounts for the effect of interest on interest; EAY is computed by compounding 1 plus the holding period yield forward to one year, then subtracting 1.

Question 17

money market yield

Money Market Yields

Answer 17

A yield on a basis comparable to the quoted yield on an interest-bearing money market instrument that pays interest on a 360-day basis; the annualized holding period yield, assuming a 360-day year.

Question 18

bond equivalent yield

Money Market Yields

Answer 18

A calculation of yield that is annualized using the ratio of 365 to the number of days to maturity. Bond equivalent yield allows for the restatement and comparison of securities with different compunding periods.