Final Exam Flashcards
Alternative Investments
- Real Estate
- Commodities
- Private Equities
- Hedge Funds
- Currencies
- Derivative Secerities
Derivative Securities
A security whose value derives from the value of some underlying asset.
Examples: futures, forwards, swaps, options
Underlying assets:
interest rate, foreign exchange rate, index value such as stock, commodity price, common stock
Uses of Derivatives
- Hedge risk
- speculate
- Arbitrage profit lock-in
- change nature of liability
- Change nature of investment
Forward Contract
an agreement to buy or sell an asset at a certain time in the future for a certain price
At delivery (end of contract) ownership is transferred
Futures Contract
A futures contract is an agreement to buy or sell an asset at a certain time in the future for a certain price (futures price)
- The party that is buying has a long position
- The party that is selling has a short position
Forward vs Future
Forwards are: private, non standard, 1 specified delivery date, settled at maturity, delivery or final cash usually occurs
Futures are: exchange traded, standard, range of delivery dates, settled daily, usually closed out prior to maturity
Swaps
A financial contract between two counterparties who exchange future cash flows according to a prearranged formula.
Example: Interest rate swaps
Purpose is to hedge interest rate cash flows on balance sheets
LIBOR
London Interbank Offer Rate
Call option
A call option on an asset is an option to buy the asset at a fixed price.
Buyer is betting on price increasing
Seller is betting on price decreasing
Put Option
AN asset that is an option to sell the asset at a fixed price.
Buyer is betting on price decreasing
Seller is betting on price increasing
Options vs Forward/Futures
A forward/future contract gives the holder the obligation to buy/sell at a certain price.
A option gives the holder the right to buy/sell at a certain price.
A successful option
In the Money
Naked Call
Means you write a call without owning the underlying asset.
Cover call
Means you write a call while owning the underlying asset to hedge downside risk
Option Premium
Premium = intrinsic value (@ any point in time) + time value (is premium when intrinsic value is 0)
Always better to sell vs buy because you capture the time value.
Intrinsic value = value if about to expire
Factors affecting option premium
Risk: an option is insurance. The greater the risk, the more the option is worth.
Interest rates: Call options are worth more if the interest rate is higher. Put options are less.
Time to maturity: A greater time to maturity implies a higher investment factor and generally implies greater risk.
Current stock price
Future stock price=strike price
Long Put
Is a good way to hedge stock project against downside
Options in corporate securities
- convertible debt and preferred stock
- callable debt and preferred stock
- callable convertible debt and preferred
- warrants (call options)
- put warrants
NPV Rule
Net Present Value of all cash flows
All projects with NPV>0 should be accepted.
IRR
Internal Rate of Return: the discount rate that makes the NPC of investment =0.
- Break even discount rate
- Measures annualized rate of return
- In general, take project for which IRR > cost of capital
IRR & YTM
The YTM on a bond is an example of an internal rate of return. They are equal
IRR Rule
A project is standard if there are negative cash flows in one or more years at the beginning and positive cash flows in the later years.
For standard projects, NPV > 0 if and only if IRR >cost of capital
A standard project should only be taking if and only if its IRR is greater than the opportunity cost of capital.
For nonstandard projects, don’t use IRR not NPV.
Mutually Exclusive Projects
You want the largest NPV, not necessarily the largest IRR.
-It is usually better to earn 30% on 10 million than investment than earn 100% on a $100 investment.
Profitability Index (PI)
THe profitability index of a project expresses the present value as a proportion of the initial outlay.
Decision rule: accept a project if PI>1 and reject a project if PI<1.
For every $1 I put into a project, I make $x.
PI=Present value of all cash inflow/present value of all cash outflows
Payback Period
If payback period < cutoff period internally.. invest
Rank in order of lowest to highest payback periods
Working Capital
- Cash that is tied up but not consumed. At end of project company gets paid.
- Cash employed to run the day-to-day
Net working capital
- inventories and accounts receivable are working capital (current assets).
- For most projects, inventories + accounts receivable - accounts payable
A growth in net working capital = negative cash flow
Example of NWC
Net cash from equipment sale = Market value - (Market value -Book value (price of purchase - depreciation) times tax rate.
Investing now or later?
These are mutually exclusive projects, so choose one with highest NPV
Sunk Costs
Costs that have already been incurred and cannot be removed should be ignored
Opportunity Costs
AN opportunity cost is the most attractive alternative that is given up if a particular investment is undertaken.
Typically at a minimum of current market resale value.
Stand Alone Principle
A project should be evaluated on a stand alone basis
In effect, the cash flows from the project should be sufficient to meet the requirements of its security holders
Incremental Cash Flows
Always consider increment cash flows from a project, not total cash flows. Example: company already makes 1M, with project makes 3M, Incremental value is 3-1=2M
Incremental Costs
- Forget sunk costs
- Allocate only incremental overhead
- Include opportunity costs
Cost of capital
Is the hurdle rate
- appropriate discount rate
- risk adjusted discount
Consequences of wrong discount rates
if discount rate is too high, NPV will be lower, so you are going to decline projects that could’ve been profitable
If discount rate is low, NPC will be higher, so you might take projects that you shouldn’t.
Capital Components
Debt (bonds), Equity (stocks), preferred stock
Sources of funding that come from investors
WACC (Weighted Avg Cost of Capital)
WACC is the average cost of funds from all sources
A firm’s WACC represents:
- individual costs of capital and
- financing mix
WACC Formula
Weight of debtcost of debt(1-tax rate) + weight of preferred stock* cost of PS + Weight of stock * cost of stock
Estimating Cost of Debt
Pre-tax cost of debt =yield to maturity on new bond issue
after tax cost = pretax cost * (1-tax rate)
Actual expected cost may be somewhat lower:
- possibility of default lowes expected returns to investors relative to calculated YTM
- Call provisions lower expected corp interest costs
CAPM
Expected return on equity=risk free rate + Beta*Market risk premium
Source of Risk
THe cost of capital for a project depends on the riskiness of the assets being financed, not on the source of financing.
WACC
Is the hurdle rate on graph…. Shows that you should use different hurdle rates for different levels of risk on projects.
The lower the risk, the lower the hurdle. The higher the risk, the higher the hurdle.
