CFA V1 R6 DCF Flashcards
NPV and IRR are used in 3 key areas of financial decision making
1) capital budgeting- allocation of funds to relatively long-range projects or investments.also used to rate fund performance
2) capital structure- the choice of long-term financing for the investments the company wishes to make
3) working capital management- short term assets/liab
Inches to make
NPV and the NPV rule
NPV- PVC of inflows minuet pv of outflows
NPV Rule- accept is NPV is positive, reject if negative, choose higher nov if mutually exclusive
Steps 1 find all inflows and outflows 2 determine discount rate, often WACC of project. 3 find pv of all cf's 4 find sum of pv inflows - pv outflows 5 apply NPV rule
Positive npv means that shareholder wealth is increasing because the discount rate is an estimate of opportunity cost
IRR and IRR rule
IRR- the discount rate that causes NPV to be 0
Relies on the cf’s of the investment. Can be applied to any investment that is represented by a series of cf’s
Problems with IRR- realized compound return will only equal IRR if the cf’s can be reinvested at the exact same rate as IRR
Multiple negative cf’s causes multiple IRR’s
IRR and NPV lead to different conclusions if projects are independent, but can lead to different conclusions if mutually exclusive for 2 reasons
1) size or scale of project differs 2) timing of cf's of project differ
Always use NPV rule, b/c it will add the most shareholder value
Portfolio return measures
Holding period return
Money weighted rate of return
time weighted rate of return
Holding period return (HPR)
return an investor receives over a specific holding period
limitations, especially if there are additions/withdrawals
=(p1-p0 + d1)/p0
Money weighted rate of return (IRR)
Same as IRR, called money weighted rate of return in investment management applications
Accounts for the timing and amount of all dollars flows into and out of the portfolio
Rate at which pv of cash inflows minus pv of cash outflows = 0
Drawback- when evaluating portfolio return/ manager, the manager has no control over cash withdrawals and new money additions
Time weighted rate of return
Preferred performance measure in IM industry
Not sensitive to additions/ withdrawals
Measure the compound growth rate of $1 invested in the portfolio over a stated measurement period
3 steps
1) price the portfolio immediately before any major additions/withdrawals. Break the evaluation period into sub periods based dates of additions/withdrawals
2) calculate the HPR on the portfolio for each subperiod
3) link or compound the HPR’s to obtain an annual rate of return. If the investment is for more than 1 year, take the geometric mean of the Annual returns.
Valuing a series of HPR’s can be costly, so portfolios are often valued at regular intervals instead; more intervals=more accuracy
Daily valuation is commonplace
Money market
Market for short term debt instruments( 1 year or less maturity)
Pure discount instrument
Interest = difference between face value and price paid
Ex zero coupon bond
Several different quoting conventions for MM instruments
Bank discount basis- t bills
HPR holding period return, also called HPY in fixed income markets
Effective annual yield EAY
Money Market of CD equivalent yield
Bond equivalent yield
Bank discount basis
Bank discount yield( or just discount yield)
Annualizes the discount as a percentage of face values, based on a 360 day year
Rbd= D/F * 360/t D = dollar discount F= face value T= days left until maturity
Assumes a 360 day year, and no compounding
Not a meaningful measure of investors return: 3 reasons
1) yield is based on face value of bond, not on purchase price–not relative to amount invested
2) yield is annualized on a 360 day year instead of 365
3) ignores compound interest
2)
