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Investment > Finance > Flashcards

Finance Flashcards

1
Q

general formula for future value (FV) due to compound effect, given rate of return (r)

A

FV = PV* (1+r/n)^nt
n= number of times compound per period (t)
t = period

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2
Q

Discount Cash Flow (DCF)

A

the process of computing present value from the future cash flows

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3
Q

what does discount rate reflect?

A

the cost of capital or the rate of return available on alternative investments of comparable risk.

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4
Q

What is the different way of saying: We calculate the present value (PV) from the future value (FV) given the rate of return (r)

A

We discount the FV to PV with the discount rate (r)

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5
Q

cost of capital

A

opportunity cost of capital or also called the rate of return of the alternative investment

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6
Q

formula to calculate net present value (NPV)

A

NPV = C(0) + C/ (1+r)^1 + C/(1+r)^2 + C/(1+r)^3 + ..+ C/(1+r)^n
r= discount rate
n= number of years
C (0) = the cash flow needed to pay today
C = the amount of cash flow for each year

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7
Q

perpetuity rate

A

a cash flow stream in which all the cash flows per period are the same and go on forever

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8
Q

what are the real life examples of perpetuity rate?

A

1) a bond with a coupon rate
2) annuity

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9
Q

what is the present value (PV) for perpetuity rate?

A

PV = C/ (1+r)^1 + C/(1+r)^2 + C/(1+r)^3 + ..+ C/(1+r)^n
r= discount rate
n= number of years
C= constant Cash flow

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10
Q

growing perpetuity rate

A

a cash flow stream in which cash flow grow at a constant rate and go on forever

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11
Q

what is the present value (PV) for growth perpetuity rate?

A

PV = C/(r-g)
g = growth rate
r= discount rate

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12
Q

Annuity

A

is cash flow stream in which all the cash flows per period are the same and last for a fix number of periods
i.e: the lottery pay-out each year (with a discount rate) instead of a lump sum right now

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13
Q

Future Value (FV) for constant cash flow (C), given discount rate (r)

A

FV = (C/r)*[ (1+r)^n - 1 ]

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14
Q

calculate for PV at time 0, given the known value of PV at a certain time (n)

A

PV (0) = PV (n) / (1+r)^n

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15
Q

How do you choose the most profitable project from looking at NPV values of all projects?

A

the most profitable project is the one that has the highest NPV value

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16
Q

internal rate of return (IRR)

A

the measure of profitability of a project for a certain period of time

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17
Q

T or F: To calculate the IRR, we have to set net present value (NPV) = 0

A

True

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18
Q

T or F: In the formula of NPV calculation, IRR is treated as discount rate

A

True

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19
Q

What is IRR rule?

A

That pick a project that gives a IRR value that is greater than the cost of capital/rate of returns on other alternative investment of comparable risk.

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20
Q

What is NPV rule?

A

positive NPV is always preferred to negative NPV

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21
Q

If the IRR and the NPV rule give contradictory recommendations, which rule is generally better to follow?

A

Always NPV rule because:
1) you want the sum of all cash flows at the end of period is positive
2) you want to have a project that give you the higher NPV value (concrete dollars), even though that project gives you lower IRR

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22
Q

Considering the IRR & NPV Rule, which project will you take, given cost of capital is 5%?
Project A C (0) = -10M & C(1)= 11M
Project B C(0)= 10M & C(1)= -11M

A

Same IRR = 10% from both projects but project A give you a positive NPV –> Project A

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23
Q

Considering the IRR & NPV Rule, which project will you take, given cost of capital is 25%?
Project A C (0) = -50M & C(1)= 80M
Project B C(0)= -120M & C(1)= 180M

A

Even though IRR of project A (60%) is greater than project B (50%), we choose project B
This is because project B has higher NPV value (24M) > 14M of project A’s NPV

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24
Q

T or F: IRR is a profitability measure that is informative about the scale of a project. NPV, however, is scale independent

A

F
IRR is a profitability measure that is not informative about the scale of a project. The NPV, however, captures the scale of the project.

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25
Q

how do you calculate the number of IRR?

A

the number of IRR corresponds to the number of switch sign (negative & positive) from cash flow
i.e: C(0,1,2)= 100, -230,132 has 2 IRR
C(0,1,2)= -100,-230, 132 has 1 IRR

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26
Q

T or F: in some cases of cash flows, there is no discount rate at which the NPV of a project is at zero

A

True

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27
Q

Probability Index (PI)

A

NPV/ Initial Investment or
PI= created value/ resources consumed

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28
Q

when do you use Probability Index (PI)?

A

To choose the best combination of multiple projects within the limit sum of initial investments to have the best value outcome

29
Q

How do you pick the best combination of multiple projects (within the total budget)?

A

1) Given the NPV of each project and its initial investment, we can calculate each Probability Index (PI)
2) Then, we add the highest values of PI from multiple projects whose initial investment sum is still below or equal to the required of total budget

30
Q

primary market

A

the market in which the investors buy the newly-issued securities

31
Q

what do the stocks represent?

A

1) an ownership in a corporation
2) all the earnings for their owners after all the obligations are paid

32
Q

preferred stock

A

stock that entitles the holder to a fixed dividend, whose payment takes priority over that of common stock

33
Q

what is the characteristic of limited liability?

A

you can’t lose more than your initial investment
i.e: You are among the company owners. If at some point in the future the company does not have enough funds to pay all of its debts and goes bankrupt, the creditors cannot go after your personal asset for the amount the company stills owes them.

34
Q

T or F: Stockholders have unlimited liability

A

False

35
Q

definition of net present value (NPV)

A

the result of calculations that find the current value of a future stream of payments using the proper discount rate.
i.e: if an asset is bought below it’s NPV, you can make the profit from the market

36
Q

T or F: If the NPV of a project or investment is positive, it means its rate of return will be above the discount rate.

A

True

37
Q

T or F: A negative NPV shows that the expected rate of return will fall short of it, but means that the project will still create value.

A

False - a negative NPV will mean that the project will not create value, so you shouldn’t invest in the project

38
Q

time value of money (TVM)

A

The time value of money (TVM) is the concept that a sum of money is worth more now than the same sum will be at a future date due to its earnings potential in the interim (discount rate)

39
Q

according to TVM, $100 now worths how much in the next year (given interest rate is 5%)

A

$95.24
Hint: think of the interest rate is the inflation rate, which eats into your money.

40
Q

risk or volatility

A

a measure of dispersion of returns for a given security or market index

41
Q

T or F: Higher volatility signifies a riskier security

A

T

42
Q

what is efficient frontier?

A

its the curve of optimal portfolios given the ratio of risk and return

43
Q

How to calculate correlation between two stocks X & Y?

A

ρ (X,Y) = cov (X,Y) / σ(X)*σ(Y)
cov = covariance of x & y
σ = standard deviation

44
Q

When negative correlations between share A & B happen, what is the value of volatility?

A

Volatility or standard deviation of the portfolio is zero

45
Q

If the correlation between Securities A and B is -0.2, and their respective standard deviations are 8% and 18%, what is the standard deviation of a portfolio with one quarter invested in A and three quarters invested in B?

A

√ (0.08^2x0.25^2 + 0.18^2x0.75^2 - 2x0.2x0.25.0.08x0.75x0.18)

= 13.2%

46
Q

systematic risk

A

undiversifiable risk or market risk

47
Q

capital asset pricing model (CAPM)

A

an empirical model used to determine a theoretically required state of return of an asset (that will be added to a well-diversified portfolio)

48
Q

unsystematic risk

A

diversifiable risk or risk particular to an individual asset, which can be averaged out through an inclusion of a large number of other assets

49
Q

beta

A

a measure of risk of an asset that contributes to systematic risk and that can’t be reduced through diversification

50
Q

T or F: Expected returns are related to standard deviation or variance

A

F
its related to Beta

51
Q

how do you calculate beta?

A

beta = cov (Ri, Rm)/ var (Rm)
Ri = returns of a beta stock
Rm = returns of the corresponding market

52
Q

what other technique can be used to calculate beta?

A

Linear Regression
y = alpha (a) + beta (b)* X(i) + e(i)

53
Q

CAPM formula

A

E(Ri) = Rf + βi x [E(Rm)−Rf)]
E(Ri) is the expected returnn of the asset.
Rf is the risk-free asset
βi is beta
E(Rm)−Rf is the risk premium.

54
Q

non-terminal FCF

A

the estimated FCF of a firm for the next X-number of years

55
Q

terminal FCF

A

cash flow beyond the explicit forecasting period

56
Q

residual value

A

the present value of terminal-cash flows

57
Q

terminal growth rate

A

the growth rate that a term settles into in the future and then maintains over time-forever

58
Q

valuation with multiples

A

The use of multiples for valuation relies on comparison with a similar asset for which we already know the value.

59
Q

What does multiple tell us?
How do we construct multiples?

A

the price-per-unit of some important feature of the asset you want to value

By dividing the enterprise value by some income measures such as sales or EBIT

60
Q

trailing multiple

A

a multiple constructed by using prior income data

61
Q

forward multiple

A

a multiple constructed using estimates of future income.

62
Q

T or F: We can measure the enterprise value as of the non-current date at which the multiple is constructed

A

F- of the current date at which multiple is constructed

63
Q

above the line multiple

A

the multiples formed by dividing the enterprise value (equity+debt) by an income measure
Note: it’s the earning before interest (cz we have debt holders)

64
Q

Below the Line Multiple

A

the multiple formed by dividing equity holders value to the income measure
i.e: price to earnings ratio

65
Q

what is a critical assumption in perpetuity growth model?
where does this assumption draw from?

A

1) the growth rate
2) US economy, particularly GDP (3-4%)

66
Q

Why the growth rate can’t be higher than the average US GDP?

A

Due to the terminal assumption, a company can’t grow larger than the US economy itself

67
Q

what is a critical assumption in multiple valuation model?

A

that we do compare apples with apples in the sense that we find comparable firms and using the right “multiples” for valuation.

68
Q
A

Investment (6 decks)

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