DCF Applications

Question 1

Things to Remember about NPV and IRR Methods

Answer 1

• The NPV tells how much the value of the firm has increased if you accept the project.
• When evaluating independent projects, the IRR and NPV methods always yield the same accept/reject decisions.
• A project’s IRR can be positive even if the NPV is negative.
• A project with an IRR equal to the cost of capital will have an NPV of zero.
• The discount rate that gives an investment an NPV of zero is the investment’s IRR.
• The NPV method assumes that a project’s cash flows will be reinvested at the cost ofcapital, while the IRR method assumes theywill be reinvested at the IRR.

Question 2

holding period yield

Answer 2

Reflects the non-annualized return an investor will earn over a security’s life.

Question 3

Net Present Value

Answer 3

The NPV is the present value: of a project’s future: cash flows, discounted at the firm’s cost of capital, less the project’s cost.

Question 4

Internal Rate of Return

Answer 4

IRR is the discount rate that makes the NPV = 0 (equates the PV of the expected future cash flows to the project’s initial cost).

Question 5

NPV Rule

Answer 5

The NPV rule is to accept a project if NPV > 0

Question 6

IRR Rule

Answer 6

The IRR rule is to accept a project if IRR > required rate of return.

Question 7

Holding period return (or yield)

Answer 7

is the total return for holding an investment over a certain period of time and can be calculated as:

HPY = (Price@Maturity - Initial Price) / Initial Price

Question 8

Money-weighted rate of return

Answer 8

Is the IRR calculated using periodic cash flows into and out of an account and is the discount rate that makes the PV of cash inflows equal to the PV of cash outflows.

Question 9

Time-weighted Rate of Return

Answer 9

The time-weighted rate of return measures compound growth. It is the rate at which $ 1 compounds over a specified performance horizon.

Question 10

Money-Weighted Vs. Time-Weighted Rate of Return

Answer 10

If funds are added to a portfolio just before a period of poor performance, the money­ weighted return will be lower than the time-weighted return. If funds are added just prior to a period of high returns, the money-weighted return will be higher than the time-weighted return.
The time-weighted return is the preferred measure of a manager’s ability to select investments. If the manager controls the money flows into and out of an account, the money-weighted return is the more appropriate performance measure.

Question 11

Bank Discount Yield

Answer 11

((face value - price paid) / face value) X (360 / dtm)

Question 12

Holding Period Yield

Answer 12

(face value - price paid) / price paid

Question 13

Effective Annual Yield

Answer 13

= HPY ^ (365/dtm)

Question 14

Money Market Yield

Answer 14

HPY x (360/100)

Question 15

Money market security Holding Period Yield

Answer 15

(Bank discount Yield x (n/360)) / (1- bdy (n/360)

Question 16

Bond Equivalent Yield

Answer 16

= (((1 + EAY) ^1/2) - 1) x 2