Introductory Finance/trading Simulation Flashcards
Capital project
One whose lifetime (cash flows) extend beyond one year
Stages involved in the capital budgeting process
- find suitable investment projects
- estimate the cash flows
- evaluate and select the projects using various criteria
- implement and monitor the project
Methods of choosing between projects
1- rank proposals from best to worst
2- select a cut-off. If projects are independent, those above the cut-off are accepted, those below are rejected. If projects are mutually exclusive, accept only the best project and reject the rest
Interest rates compounding
Once a year; Future value= present value(1+r)^T
Twice a year; future value= present value(1+r/2)^2t
Paid month;future value=present value(1+r/12)^12t
Discounting
Present value= discount factor x future value
Discount factor = 1/(1+r)^t
Annuity
Pays a fixed sum of money for a specified number of years
PV= C(1/r - 1/r(1+r)^t)
Perpetuity
Pays a fixed sum every year to perpetuity e.g. irredeemable bonds
PV= C/r
Net present value
Takes into account the fact that we usually have to make an initial cash outlay
NPV= -C0+ C1/(1+r)^1 + C2/(1+r)^2 + C3/(1+r)^3 +…
Accept a project if NPV >0
Converting real to nominal
Real CF+ nominal CF/ (1 + expected inflation rate)^t
(1+ nominal IR)= (1+ Real IR)*(1+ Expected inflation rate)
Advantages of payback method
Quick & simple
No need to forecast cash flows over the whole of a project’s life
Sometimes used as a rough proxy for the riskiness of a project
Can be an efficient screening device to remove projects with very long lives
Disadvantages of payback method
Equal weights to all payments before cut off
No account taken of cash flows after cut off
Hence it tends to accept too many short lived projects
Accounting rate of return/return on capital employed
Average annual income of project/ average annual value of investment or average profits/ average assets
Must meet or exceed the specific hurdle rate
Easy and logical to use
Ignore time value of money
Internal rate of return (IRR)
The rate of return which makes NPV=0
Accept project if IRR>OCC
If projects mutually exclusive, select project with highest IRR
Future value=present value(1+r)^t
R=(future value/present value)^1/t -1
NPV vs IRR
Both allow for time value of money
NPV measures in units of change in wealth whereas IRR is unit free
Problems with using IRR
Cash outflows versus inflows
Multiple IRRs
IRR tends to overstate the benefits of a project since it assumes that all cash flows from interim payments can be invested at the IRR
Equities
Claim that entitles the holder to a share of firm’s profits
- ownership claim and voting rights
- high returns
- high risk
- residual claim in case of bankruptcy (last to receive any pay off)
Valuing shares
Firms balance sheet-> firm value= net assets
Share price= book value/ no. of shares
Problems; intangible assets e.g. goodwill, backward looking but investors buy stocks for future returns
When is it best to use accounting based valuation methods?
When firms;
- are in financial distress
-have no current earnings
- do not pay dividends
- are first quoted
-derive most of their values directly from their assets
Dividend valuation model
Method of calculating cost of equity
P0= current price
P1= end of period price
DIV1 = dividend payment during the period
Expected return=E(DIV1+P1-P0/P0)
Rearrange P0=E(DIV1)/(1+r) + E(P1)/(1+r) this is the fair price to pay for a share today
Problems with DDM
Assumes the market determined discount rate is constant for all future periods
The concept isn’t operational as it stands because we have expected dividends
The model based on growth rates is very sensitive indeed to the choice of g and the model will not work at all if g>r
Price earning (P/E) ratio
Often used qualitatively as a method of assessing stocks compared with a typical value for the industry
P/E= price per share/ earnings per share= market capitalisation/ total earnings
P/E ratios are higher for firms that have strong growth prospects, are well run and are less risky
Equation for P0
P0= D0(1+g)/(r-g)
D0= current period dividend per share
G= growth rate of dividend payments
Problems with P/E ratios as a value measure
The denominator is an accounting value, so firms engage in earnings management
Other valuation ratios
MTB- market to book
PCF- price to cash flow
PSR- price to sales ratio
Other techniques for mis-prices stocks
Technical analysis
Fundamental analysis
Technical analysis
One of the tools that investors might use to select assets or markets
Technical tools include charts, Dow theory, moving averages, support and resistance, patterns, momentum, smart money
Dow theory
Charles Dow though the market was subject to 3 trends; primary trend, secondary trend, minor trends.
A bullish primary trend will be initiated by investors thinking that a recession is coming to an end
The second phase of this trend arises when economic conditions indeed improve
The third phase is when the general public join the stock market bandwagon
Moving averages
Technical tool
Use 2 moving averages; short and long
When the short average rises through the long average, a new upward trend is established
When the short average falls a behind the long average, a new downward trend is established
Support and resistance
Technical tool
Psychological barrier levels of prices that markets seem to find hard to break. Once a support (resistance) level has broken, the fall (rise) that follows could be substantial
Momentum
Technical tool
Involves buying recent winders and short selling the losers
Calendar anomalies
Indicate to the existence of consistent patterns in stock returns depending on specific calendar days/months
Fundamental analysis
An alternative method for selecting stocks or sectors or markets
Trying to determine the underlying worth of a company
2 types; economic and accounting
Economic fundamentals
Use of leading indicators, surveys, or econometric models. Leading indicators (of the economy) include new housing starts, CBI optimism, the yield curve
Easy to understand but prone to people short term thinking
Accounting fundamentals
Looking at financial statement
Assets and liabilities, profit and loss, cash flows
Ratio analysis; debt to equity, liquidity
Need to beware of creative accounting
Need to think about a firms products markets, quality of its management
Bonds
A fixed income security is a claim on a specified periodic stream of income
Capital markets
Where long term bonds are issued/traded
Money markets
Where treasury bills are issued/traded
Rationale for investment
-low risk; payments of coupons and par-value are both scheduled and specified contractor
- the payments are independent of a firms earnings
- senior claim in case of bankruptcy
-higher return than cash
Features of bonds
- bonds have a nominal value which is the amount to be paid to the bond holder at maturity
- coupon payment; periodic payments of interest
- coupon rate; coupon payment expressed as a % of the face or par value
- can be issues at a price above their face value or below
Types of bonds
Straight bond-> pays regular coupon until maturity when it is redeemed at par
Zero coupon bonds-> sell at deep discount
Variable rate bonds
Callable bonds-> redemption date chosen by issuer
Convertible bonds-> holder has option to exchange for equity
Gilts-> issued by UK gov to finance the national debt
Corporate bonds-> issued by companies
Sovereign bonds-> issued by governments
