Question 1

What is return?

Accepted Answer

Return is a term used to describe income/funds received bc of an investment.

Question 2

What are the 2 basic categories of returns?

Accepted Answer

1). Income — dividends (stocks), interest (bonds). 2). Realized Capital Gains. Example: an investor sells a security for a gain.

Question 3

What is time value of money?

Accepted Answer

This concept states that the value of a dollar today will be higher than the value of that same dollar in the future.

Question 4

Why is the value of a dollar today higher than the value of that same dollar in the future?

Accepted Answer

Two reasons: inflation and the potential appreciation or income received from investing that dollar.

Question 5

What is future value (also known as compounding)?

Accepted Answer

Calculations are generally used to determine what the value of a fixed sum of money invested today at a specific interest rate will be worth at a future date, taking into consideration compounding (reinvesting and earning interest on interest).

Question 6

What is the compound interest (future value) formula?

Accepted Answer

Future Value = P(1+i)^t Where: P = principal investment i = annual interest rate t = term in years

Question 7

If current annual interest rates were 6% and in investor invested $10,000 today; then at the end of 5 years, how much would that investment would be worth?

Accepted Answer

Future Value = P(1+i)^t ``` P = 10,000 i = 6% or 0.06 t = 5 years ``` 10,000(1 + 0.06)^5 = 13,382.26

Question 8

What is another name for future value?

Accepted Answer

Compounding.

Question 9

What is present value (also known as discounting)?

Accepted Answer

Present Value can be called Discounting, and vice versa. Calculations are generally used to determine how much money would have to be invested today (lump sum) at a specific interest rate to EQUAL a fixed amount of money you’re going to need in the future. This is referred to as discounting since we would be REVERSING the compounding process to determine an amount needed in the future to its present value.

Question 10

What is the present value formula?

Accepted Answer

Present Value = A / [(1 + i)^t] ``` A = Amount needed in the future i = annual interest rate t = term in years ```

Question 11

If current interest rates were 5%, and an investor needed $10,000 in 5 years from now, what would they have to invest today?

Accepted Answer

Present Value = P / [(1 + i)^t] ``` P = $10,000 i = 0.05 t = 5 ``` 10,000 / [(1 + 0.05)^5] = $7,835.27 $7,835.27 now to have 10,000 at the end of 5 years.

Question 12

What is discounted cash flow methodology (DCF)?

Accepted Answer

Discounted Cash Flow Methodology, or DCF, is a means of evaluation of securities, portfolios, or projects, collectively known as “investments” using the concept of discounting (present value). Analysts use DCF to evaluate an investment’s inflows and outflows, as well as the expected cost of capital related to the investment to determine the present value of the project (NPV), and the expected rate of return on that project (IRR / internal rate of return).

Question 13

What are other names for DCF?

Accepted Answer

Discounted Cash Flow Methods, Discounted Cash Flow Analysis, or DCF

Question 14

Can DCF be used to evaluate ongoing investments with no expected maturity?

Accepted Answer

Yes. a). DCF can be used to evaluate: 1). Ongoing investments with no expected maturity.

Question 15

Can DCF be used to evaluate investments with an expected maturity?

Accepted Answer

Yes. a). DCF can be used to evaluate: 2). Investments with an expected maturity.

Question 16

Can DCF be used to evaluate portfolios?

Accepted Answer

Yes. a). DCF can be used to evaluate: 3). Portfolios.

Question 17

Can DCF be used to evaluate specific projects which have a completion date?

Accepted Answer

Yes. a). DCF can be used to evaluate: 4). Specific projects which have a completion date.

Question 18

Can DCF be used to evaluate business ventures with no specified completion date?

Accepted Answer

Yes. a). DCF can be used to evaluate: 5). Business ventures with no specified completion date.

Question 19

Can DCF be used to evaluate investment managers?

Accepted Answer

Yes. a). DCF can be used to evaluate: 6). Investment managers.

Question 20

Can DCF be used to evaluate bonds and bond portfolios?

Accepted Answer

Yes. Use DCF to evaluate bonds and bond portfolios.

Question 21

What does the discounted cash flow (DCF) approach estimate as the value of a security?

Accepted Answer

The DCF valuation approach estimates the value of a security as the present value of all future cash flows that the investor expects to receive from that security. ( — What’s the present value today of all future cash flows that the investor expects to receive today from that security? — )

Question 22

For debt securities, what are the future cash flows that are used in the calculation of DCF?

Accepted Answer

For debt securities, those cash flows are typically future coupon (or interest) payments and the final principal payment at maturity.

Question 23

What does DCF assert is the value of a bond?

Accepted Answer

Basically, the value of a bond is the present value of the future coupon payments AND the final principal payment expected from the bond at maturity.

Question 24

What is the DCF calculation of the value of a bond used for?

Accepted Answer

Once the value of a bond has been calculated, the investor can compare it with the current market price of the bond to determine whether the bond is overvalued, undervalued, or fairly valued.

Question 25

When are DCF figures most reliable?

Accepted Answer

DCF figures are most reliable when evaluating investments with KNOWN characteristics such as fixed-income securities.

Question 26

To calculate the DCF of a bond, the investor must know the:

Accepted Answer

a). Coupon payment amount b). final principal payment at maturity c). Discount rate

Question 27

When evaluating bonds held in a portfolio, would the maturity date be relevant to include?

Accepted Answer

Yes.

Question 28

When evaluating bonds held in a portfolio, would the coupon rate be relevant to include?

Accepted Answer

Yes.

Question 29

When evaluating bonds, would the par value be relevant to include?

Accepted Answer

Yes

Question 30

When evaluating bonds, would the current market price be relevant to include?

Accepted Answer

No. Fluctuations in the bond’s current market price would NOT be relevant when evaluating existing bond holdings.

Question 31

How does an increase in interest rates impact discounted cash flow on new bonds and bond funds buying new bonds?

Accepted Answer

Increase in rates = DCF on new bonds / bond funds increase. If interest rates are increasing in general (discount rate, federal funds rate, etc.), then it can be anticipated that discounted cash flow (returns) on new bonds and bond portfolios/funds buying new bonds will increase due to the increase in rates.

Question 32

What is Net Present Value (NPV) as a method?

Accepted Answer

A form of DCF methodology which uses discounting to find the present value of inflows (revenues) and outflows (expenses) for each year of a given investment.

Question 33

What is the goal of NPV?

Accepted Answer

The goal of NPV is to allow comparison of the present value of the investment, discounted to today’s dollars, and the cost of the investment today (price of security/portfolio, initial cost of project, etc.).

Question 34

Is NPV a form of discounted cash flow?

Accepted Answer

Yes.

Question 35

How is Net Present Value calculated?

Accepted Answer

Net Present Value is actually just the sum of a series of calculations of Present Value, as previously discussed in section. Using a 4-function calculator, you will have to calculate to each Present Value individually, then you will add the sum of these numbers together to arrive at NPV. Remember our example of Present Value: Present Value = A / [(1 + i)^t] 10,000 / [(1 + 0.05)^5] = $7,835.27 $7,835.27 now to have 10,000 at the end of 5 years.

Question 36

What is the formula for Net Present Value?

Accepted Answer

NPV = [Cash Flow for Y1 / ((1 + i)^1) ] + [Cash Flow for Y2 / ((1 + i)^2) ] + [Cash Flow for Yx / ((1 + i)^x) ] In the NPV formula, the present value calculation is used for each respective year. Once present values are found for years 1, 2, and any other remaining years (labelled as x), then we can add the present values together to find the “net” present value.

Question 37

Net Present Value Calculating (Example) -- An investor with a minimum required rate of return of 3%. That investor might be looking at buying a $1,000 bond with a 5% coupon rate that matures in 3 years. What is the NPV of this bond?

Accepted Answer

Present value of Years 1, 2, and 3 would need to be found: Year 1 Present Value $50 coupon / (1 + 0.03)^1 = $48.54 Year 2 Present Value $50 coupon / (1 + 0.03)^2 = $47.13 Year 3 Present Value ($50 coupon + 1,000 par) / (1 + 0.03)^3 $1,050 / (1.03)^3 = $960.90 NPV = PV of Y1 + PV of Y2 + PV of Y3 $48.54 + $47.13 + $960.90 = $1,056.57

Question 38

Net Present Value Calculating (Example) -- What does an NPV of $1,056.57 mean for the investor (regarding the current bond price)?

Accepted Answer

Price = $1,056.57, investor achieves minimum required rate of return of 3% Price < $1,056.57, investor achieves a rate of return that EXCEEDS 3%. (The lower the price, the higher the return will be.) Price > $1,056.57, investor will NOT meet the minimum required rate or return of 3% (cost exceeds . We’re determining whether or not this investor is going to be satisfying their minimum required rate of return.

Question 39

What are we essentially determining when we calculate NPV?

Accepted Answer

We’re determining whether or not this investor is going to be satisfying their minimum required rate of return.

Question 40

Is market price of an investment included in the NPV calculation?

Accepted Answer

No. Market price of an investment is NOT included in the NPV calculation.

Question 41

Why isn't market price included in the NPV calculation?

Accepted Answer

because NPV is attempting to ASSIGN a present value to the investment, which can then be compared to the market price to determine whether the investment will, or will not be profitable for the investor.

Question 42

Do we have to discount the current market value?

Accepted Answer

No. Current market value is a reference point and is not a cash flow item.

Question 43

Generally, what does a positive, negative, and equal to 0 NPV finding actually mean? Generally, meaning ongoing investments with no expected maturity. Note: Positive, negative, and equal to 0 NPV values is different for investments with an expected maturity.

Accepted Answer

Positive NPV (above zero), = profitable and will exceed the hurdle rate or required rate of return. Negative NPV (below zero) = investment will lose money and will not meet the hurdle rate or required rate of return. NPV equal to zero = investment will not have net gains or losses for the investing entity. Typically such projects are not pursued UNLESS there are other outside factors and values NOT included in the NPV calculations.

Question 44

What is Internal Rate of Return (IRR)?

Accepted Answer

A form of DCF methodology that uses discounting to find present value of inflows and outflows for each year of a given investment, then sets the equation equal to zero ($0) in order to find the rate of return which gets the investment to a breakeven point.

Question 45

What is the goal of IRR?

Accepted Answer

to find the rate of return which gets the investment to a breakeven point (NPV of $0). the IRR can then be compared to the estimated cost of capital. The cost of capital is also known as the discount rate, hurdle rate, or required rate of return for a project.

Question 46

What does a higher IRR mean?

Accepted Answer

The higher the IRR, the better the investment (for example, an IRR of 10% is better than an IRR of 1%).

Question 47

Does IRR consider the inflow and outflow of cash in a portfolio or for a prospective investment?

Accepted Answer

Yes. IRR considers the inflow and outflow of cash in a portfolio or for a prospective investment.

Question 48

Are IRR determinations cash flow dependent?

Accepted Answer

Yes. IRR determinations are cash flow dependent. (we always look at inflows and outflows when we do IRR).

Question 49

For purposes of the equation, are the inflows of the investment assumed to be reinvested at the investment’s IRR?

Accepted Answer

Yes. For purposes of the equation, the inflows of the investment are assumed to be reinvested at the investment’s IRR.

Question 50

If a project has an IRR of 7.5%, then (meaning of positive NPV, negative):

Accepted Answer

The project would be profitable and have a positive NPV if the cost of capital (discount or hurdle rate) was less than 7.5%. The project would lose money and have a negative NPV if the cost of capital (discount or hurdle rate) was greater than 7.5%.

Question 51

What is the process of calculating IRR?

Accepted Answer

The process assigns present values to future inflows and outflows (cash flow) and then sets these cash flows equal to the costs associated with the investment. When the result is equal to zero, the rate that has been found is the IRR.

Question 52

What figure is any reinvestment of revenues or proceeds from the project/investment expected to be reinvested?

Accepted Answer

at the investment’s IRR.

Question 53

What do IRR findings mean?

Accepted Answer

IRR is a means of comparing multiple projects or investments against each other and against a required rate of return or hurdle rate.

Question 54

If the IRR exceeds the required rate of return/hurdle rate, what is the project expected to be?

Accepted Answer

profitable. If the IRR exceeds the required rate of return/hurdle rate, then the project is expected to be profitable.

Question 55

If the IRR is less than the required rate of return/hurdle rate, what is the project expected to be?

Accepted Answer

NOT profitable. If the IRR Is less than the required rate of return/hurdle rate, then the project is NOT expected to be profitable.

Question 56

Typically, Net Present Value is expressed as a

Accepted Answer

dollar figure.

Question 57

What does the NPV dollar value represent?

Accepted Answer

the value of the project or investment to the investing party.

Question 58

Typically, Internal Rate of Return is expressed in the form of a

Accepted Answer

percentage.

Question 59

What does the IRR percentage value represent?

Accepted Answer

where the inflows EQUAL the outflows for the investment that’s being analyzed.

Question 60

If an investment has an IRR that equals the required rate of return, what is the expected NPV of that investment?

Accepted Answer

If an investment has an IRR that equals the required rate of return, that investment would be expected to have an NPV of zero.

Question 61

A company is looking to maximize use of some free capital with a new project. The project in question has a hurdle rate of 7.5%. After analysis, it is found that the IRR on the project is 7.5%. What does this mean in terms of the project’s NPV?

Accepted Answer

1). In this case, the NPV on the project would be zero or $0.00. 2). Had the IRR exceeded, we would expect that the NPV would be positive (above $0.00). 3). Had the IRR been less than 7.5%, we would expect that the NPV would be negative (below $0.00).

Question 62

If an investment has a NPV that is equal to zero, what would be the expected IRR of that investment?

Accepted Answer

If an investment has a NPV that is equal to zero, that investment would be expected to have an IRR that equaled the required rate of return (or hurdle rate).

Question 63

A company is looking to maximize use of some free capital with a new project. The project in question has a required rate of return of 6%. After calculating the Net Present Value (NPV) of the project, it is found that the NPV is equal to zero ($0.00). What would the IRR be in this case?

Accepted Answer

1). In this case, the IRR would be 6%, because the project’s NPV is equal to zero. 2). Had the NPV been positive, we would expect the IRR to exceed 6%. 3). Had the NPV negative, we would expect the IRR to be less than 6%.

Question 64

What is Total Return (or Annualized Return)?

Accepted Answer

is the annual rate of return on an investment. It includes appreciation, capital gains or losses, dividends or interest, and other distributions. An investment’s performance is best measured by total return.

Ch 09(2) Inv Recs -- Risks & Returns | Returns and How to Measure Returns Flashcards

* Define returns. * Explain how to measure returns.

Brainscape's Knowledge GenomeTM

Ch 09(2) Inv Recs -- Risks & Returns | Returns and How to Measure Returns Flashcards

* Define returns. * Explain how to measure returns.

Brainscape's Knowledge Genome^TM