FIN 312- Exam 1 Flashcards
other things remaining equal, the value of cash flows in future time periods will decrease as:
- the preference for current consumption increases
- expected inflation increases
- the uncertainty in the cash flow increases
a rate at which present & future cash flows are traded off.
discount rate
what does the discount rate (DR) incorporate incorporates
- preference for current consumption ( greater.. higher DR)
- expected inflation ( higher inflation.. higher DR)
- uncertainty in the future cash flows (higher risk.. higher DR)
a higher discount rate will lead to a ____ value for cash flows in the future
lower
five types of cash flows
- simple cash flows
- annuities
- growing annuities
- perpetuities
- growing perpetuities
a combination of an annuity (coupons) and a simple cash flow (face value at maturity)
conventional bond
A single cash flow in a specified future time period
simple cash flows
PV of simple cash flow =
CFt / (1+r)^t
FV of simple cash flow =
CF0 (1+r)^t
As the holding period lengthens, the end-of-the-period value differences get _____
larger
The cost of not investing in stocks increases as your time horizon _____ . Presumably, this should lead to younger individuals investing more in _____ and older individuals in ____
increases; equity; bonds
frequency of compounding: annual
rate= 10%
time= 1
formula= r
effective annual rate= 10.00%
(1+r/2)^2 -1
rate= 10%
t= 2
effective annual rate= 10.25%
frequency of compounding: semi-annual
frequency of compounding: monthly
(1+r/12)^12 -1
rate= 10%
t= 12
effective annual rate= 10.47%
frequency of compounding: continuous
exp^r -1
effective annual rate= 10.5171%
For a cashflow to be an annuity, it has to be:
- The same amount in each period
- The periods have to remain fixed (monthly, annual)
A constant cash flow that occurs at regular intervals for a fixed period of time
annuity
A ______ is a combination of an annuity and a simple cash flow
straight bond
This asymmetric response to interest rate changes is called
convexity
The longer the ______ of a bond, the more sensitive it is to changes in interest rates.
maturity
The lower the _____ ____ on the bond, the more sensitive it is to changes in interest rates.
coupon rate
a cash flow growing at a constant rate for a specified period of time
growing annuity
is a constant cash flow at regular intervals forever
perpetuity
A ____ ____ is a bond that has no maturity and pays a fixed coupon
console bond
Assume that you have a 6% coupon console bond. The value of this bond, if the interest rate is 9%
Value of Console Bond = $60 / .09 = $667
the basic interest rate, assuming no inflation and no uncertainty about future flows
real risk-free rate (RRFR)
(This RRFR of interest is the price charged for the risk-free exchange between current goods and future goods)
refers to the yield on a risk-free asset without the effect of inflation
nominal risk-free rate (NRFR)
is the uncertainty of income flows caused by the nature of a firm’s business
business risk
is the uncertainty introduced by the method by which the firm finances its investments
financial risk
is the uncertainty introduced by the secondary market for an investment
liquidity risk
is the uncertainty of returns to an investor who acquires securities denominated in a currency different from his or her own
exchange rate risk
also called political risk, is the uncertainty of returns caused by the possibility of a major change in the political or economic environment of a country
country risk
- Issued by a public limited company and are traded on recognized stock markets
- become a shareholder when you invest
equities
- When you purchase, you are lending money to the issuer
- Issuer could be a corporation, a government, or another entity
- perceived as lower risk
bonds
- Typically invest in cash, money markets, and other short-term securities, and aim to achieve better rates of return than are typically available from bank deposit accounts.
- investment tends to be seen as a LOWER RISK, lower return option than bonds or equities
cash
Invest across a number of different asset types, including equities, bonds, cash, and alternative investments such as property and infrastructure.
multi-asset
use investment techniques that can profit from both the ups and downs in share prices and other capital markets
absolute return
__________ = f (business risk, financial risk, liquidity risk, exchange rate risk, country risk)
Risk premium
_________________ = RRFR + ease or tightness in capit. mkts and exp. infl. + risk premium on investment
Required rate of return
the minimum amount of profit (return) an investor will seek or receive for assuming the risk of investing in a stock or another type of security
The required rate of return (RRR)
the higher rate of return you can expect to earn from riskier assets like stocks
risk premium (RP)
The line that reflects the combination of risk and return available on alternative investments is referred to as the
security market line (SML)
The overall opportunity cost of the firm’s capital is a weighted average of the opportunity costs of capital from debt, preferred equity, and common equity.
Weighted average cost of capital (WACC)
The slope of the SML indicates the ____ per unit of risk required by all investors.
return
demonstrates a change in the risk characteristics of a specific investment, such as a change in its business risk, its financial risk, or its systematic risk (its beta). This change affects only the individual investment.
movement along the SML
Occurs in response to a change in the attitudes of investors toward risk. Such a change demonstrates that investors want either higher or lower rates of return for the same intrinsic risk. This is also described as a change in the market risk premium (Rm − NRFR). A change in the market risk premium will affect all risky investments.
Change in the slope of the SML
Reflects a change in expected real growth, a change in market conditions (such as ease or tightness of money), or a change in the expected inflation rate.
- Such a change will affect all investments
Shift in the SML
determined by the cash flows you expect that asset to generate over its life and how uncertain you feel about these cash flows
- Assets with high and stable cash flows should be worth more than assets with low and volatile cash flows
The intrinsic value of an asset
Assets are valued by looking at how the market prices similar assets
Relative valuation
1) TIME HORIZON (GENERALLY SPLIT INTO TWO SUB- PERIODS: FROM PERIOD 1 TO PERIOD 5; THEN RESIDUAL LIFE)
2) DETERMINATION OF CASH FLOW: PERIOD «0»
3) CHOICE OF GROWTH RATES OF NOPAT, REINVESTMENT
4) FORECAST OF FIRST PERIOD CASH FLOWS (GENERALLY FOCUSING ON A PERIOD OF 5 OR 10 YEARS; THEN FORECAST OF FIRST YEAR CASH FLOW RELATED TO THE SECOND RESIDUAL, INFINITE, SUB-PERIOD
5) ESTIMATE OF WEIGHTED AVERAGE COST OF CAPITAL (WACC)
6) PRESENT VALUE OF FIRST SUB-PERIOD CASH FLOWS AND OF FIRST YEAR CASH FLOW OF SECOND PERIOD: BOTH OF THEM DISCOUNTED USING THE FIRST SUB-PERIOD WACC. BY DOING THIS,YOU GET THE VALUE OF THE ENTIRE COMPANY’S OPERATIONAL ACTIVITIES. THEN YOU DEDUCT, FROM THIS VALUE, THE NET FINANCIAL POSITION (DEBT …), AD FIND THE EQUITY VALUE OF THE FIRM (FCFE).
Discounted cash flow method
steps to estimate the intrinsic value of the firm and of its equity
DCF =
CFt = cash flow period t
r = discount rate
t = periods, ranging from 1 to infinity
Represents a company’s theoretical income from operations if it had no debt (no interest expense).
Net Operating Profit After Tax (NOPAT)
____ = operating income (1- tax rate)
NOPAT
_____ = after-tax operating income - (net capital expenditures + change in non-cash working capital)
Free cash flow to firm (FCFF)
_____ = net income - net capital expenditure - change in working capital + new debt issued
Free Cash flow to equity (FCFE)
Cash available after a firm meets its debt obligations and necessary capital expenditures
- reflects the firm’s capacity to pay dividends
FCFE
The overall opportunity cost of the firm’s capital is a weighted average of the opportunity costs of capital from debt, preferred equity, and common equity.
- A project should be undertaken only if the return on invested capital is greater than its opportunity cost
Weight average cost of capital (WACC)
The opportunity cost of all capital invested in an enterprise
cost of capital
what you give up as a consequence of your decision to use a scarce resource in a particular way.
opportunity cost
model says that equity shareholders demand a minimum rate of return equal to the return from a risk-free investment plus a return for bearing extra risk.
This extra risk is often called the “equity risk premium”, and is equivalent to the risk premium of the market as a whole x a multiplier–called “beta”–that measures how risky a specific security is relative to the total market.
Capital Asset Pricing Model (CAPM)
1) cost of capital components
- Debt Capital: The after-tax cost of debt-capital = The Yield-to-Maturity on long-term debt x (1 - marginal tax rate %)
- Equity Capital: CAPM –> cost of equity capital = Risk-Free Rate + (Beta * Market Risk Premium)
2) capital structure
3) weighting the components
3 steps to calculate WACC
____ = (wd)[kd(1 – t)] + (wps)(kps) + (wce)(kce)
kd = yield to maturity on existing/ new debt; this is the before-tax cost of debt
kd(1-t) = after-tax cost of debt, where t is the marginal tax rate- only interest on debt is paid pre-tax
kps = cost of preferred stock
kce = cost of common equity
WACC
____ = Risk-free rate + Beta * ERP
Cost of equity
ERP = equity risk premium
____ = average yield on debt * (1- tax rate)
cost of debt (after-tax)
