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Tessa-Quantitative Finance > Investment & Financing > Flashcards

Investment & Financing Flashcards

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1
Q

1.1 Corporate Investment and Financing Decisions

A
  • Real Assets
    • Used to produce goods and services
  • Financial Assets/Securities
    • Financial claims on income generated by firm’s real assets
  • Capital Budgeting/Capital Expenditure (CAPEX)
    • Decision to invest in tangible or intangible assets
  • Investment Decision
    • Purchase of real assets
  • Financing Decision
    • Sale of financial assets
  • Capital Structure
    • Choice between debt and equity financing
  • Capital Budgeting Examples
    • Tangible Assets

• i.e. Expanding stores

* Intangible Assets

• i.e. Research and development for new drug

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2
Q

• What Is a Corporation?

A
  • Legal entity, owned by shareholders
  • Can make contracts, carry on business, borrow, lend, sue, and be sued
  • Shareholders have limited liability and cannot be held personally responsible for corporation’s debts
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3
Q

Cash Flow between Financial markets and Firm‘s Operations

A
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4
Q

Stockholders Want Three Things

A
  • To maximize current wealth
  • To transform wealth into most desirable time pattern of consumption
  • To manage risk characteristics of chosen consumption plan
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5
Q

Profit Maximization- Not a well-defined financial objective

A

• Which year’s profits?

  • Shareholders will not welcome higher short-term profits if long-term profits are damaged

• Company may increase future profits by cutting year’s dividend, investing freed-up cash in firm

  • Not in shareholders’ best interest if company earns less than opportunity cost of capital
  • Shareholders desire wealth maximization
  • Managers have many constituencies, “stakeholders”
  • “Agency Problems” represent the conflict of interest between management and owners
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6
Q

The Investment Trade-off权衡资本

A

• Hurdle Rate/Cost of Capital

  • Minimum acceptable rate of return on investment

• Opportunity Cost of Capital

  • Investing in a project eliminates other opportunities to use invested cash
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7
Q

Agency Problems – Owners vs. Managements

A
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8
Q

Agency costs are incurred when:

A
  • Managers do not attempt to maximize firm value
  • Shareholders incur costs to monitor managers and constrain their actions
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9
Q

Tools to Ensure Management Pays Attention to the Value of the Firm

A
  • Manager’s actions subject to the scrutiny of board of directors
  • Shirkers are likely to find they are ousted by more energetic managers
  • Financial incentives provided, such as stock options
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10
Q

Ch-2 Calculating Future Values

A

• Future Value

  • Amount to which investment will grow after earning interest
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11
Q

Present Value

• Value today of future cash flow

A
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12
Q

Valuing an Office Building

A
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13
Q

Net Present Value

A
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14
Q

Risk and Present Value

A
  • Higher risk projects require a higher rate of return
  • Higher required rates of return cause lower PVs
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15
Q

Three Rules of Time and Travel

Financial decisions often require combining cash flows or comparing values. Three rules govern these processes.

A
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16
Q

Net Present Value Rule

A
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17
Q

Rate of Return Rule

A
  • Accept investments that offer rates of return in excess of their opportunity cost of capital
  • In the project listed below, the opportunity cost of capital is 12%. Is the project a wise investment?
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18
Q

Multiple Cash Flows

A

• Discounted Cash Flow (DCF) formula:

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19
Q

Perpetuity

A
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20
Q

Example： Perpetuity

A
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21
Q

Annuity

• Asset that pays fixed sum each year for specified number of years

A
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22
Q

Example：PV of Annuity

Example: Tiburon Autos offers payments of $5,000 per year, at the end of each year for 5 years. If interest rates are 7%, per year, what is the cost of the car?

A
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23
Q

Example：PV of Annuity 2

Example: The state lottery advertises a jackpot prize of $365 million, paid in 30 yearly installments of $12.167 million, at the end of each year. Find the true value of the lottery prize if interest rates are 6%.

A
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24
Q

Example: Future Value of an Annuity

What is the future value of $20,000 paid at the end of each of the following 5 years, assuming investment returns of 8% per year?

A
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25
Q

Constant Growth Perpetuity

A
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26
Q

Example: Constant Growth Perpetuity

What is the present value of $1 billion paid at the end of every year in perpetuity, assuming a rate of return of 10% and constant growth rate of 4%?

A
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27
Q

Example: Growing Annuities

Golf club membership is $5,000 for 1 year, or $12,750 for three years. Find the better deal given payment due at the end of the year and 6% expected annual price increase, discount rate 10%.

A

不确定

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28
Q

Present Value of Growing Annuities

A
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29
Q

EAR and APR

A
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30
Q

Example:Using the present value formula to value bonds

Today is October 1, 2010; what is the value of the following bond? An IBM bond pays $115 every September 30 for five years. In September 2015 it pays an additional $1,000 and retires the bond. The bond is rated AAA (WSJ AAA YTM is 7.5%).

A
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31
Q

Example: Semiannual paid bond

In February 2012 you purchase a three-year U.S. government bond. The bond has an annual coupon rate of 11.25%, paid semiannually. If investors demand a 0.085% semiannual return, what is the price of the bond?

A
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32
Q

Duration & Bond Prices：continuous case

A
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33
Q

Duration ：discrete case

A
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34
Q

Ch-3：Convexity

A
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35
Q

Modified Duration

A
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36
Q

Duration：solution steps

A
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37
Q

3.3 Term structure of interest rates

A
  • Short- and long-term rates are not always parallel
  • Spot Rate: Actual interest rate today (t = 0)
  • Forward Rate: Interest rate, fixed today, on future loan at fixed time Future Rate: Spot rate expected in future
  • Yield To Maturity (YTM): IRR on interest-bearing instrument
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38
Q

Law of One Price

A
  • All interest-bearing instruments priced to fit term structure
  • Accomplished by modifying asset price
  • Modified price creates new yield, which fits term structure
  • New yield called yield to maturity (YTM)
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39
Q

Expectations Theory

A
  • Term Structure and Capital Budgeting
    • CF should be discounted using term structure info
    • When rate incorporates all forward rates, use spot rate that equalsproject term
    • Take advantage of arbitrage
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40
Q

Classical Theory of Interest Rates (Economics)

A
  • Developed by Irving Fisher:
    • Nominal Interest Rate = Actual rate paid when borrowing money
    • Real Interest Rate = Theoretical rate paid when borrowing money; determined by supply and demand
  • Nominal r = Real r + expected inflation (approximation)
  • Real r theoretically somewhat stable
  • Inflation is a large variable
    • • Term structure of interest rates shows cost of debt
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41
Q

Debt and Interest Formula:

A
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42
Q

3.6 The risk of default

A

Corporate Bonds and Default Risk

  • Payments promised to bondholders represent best-case scenario
  • Most bonds’ safety judged by bond ratings
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43
Q

Sovereign Bonds and Default Risk

A
  • Sovereign debt is generally less risky than corporate debt
  • Inflationary policies can reduce real value of debts
  • Foreign Currency Debt
    • Default occurs when foreign government borrows dollars
    • If crisis occurs, governments may run out of taxing capacity and default•
    • Affects bond prices, yield to maturity
  • Own Currency Debt
    • Less risky than foreign currency debt
    • Governments can print money to repay bonds
  • Eurozone Debt
    • Can’t print money to service domestic debts
    • Money supply controlled by European Central Bank
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44
Q

Example：Duration and Modified Duration 1

A
45
Q

Example：Duration and Modified Duration 2

A
46
Q

4.1 How common stocks are traded

A
  • Primary Market
    • New securities
  • Secondary Market
    • Previously-issued securities
  • Common Stock
    • Ownership shares in publicly-held corporation
  • Electronic Communication Networks (ECNs)
    • Computer networks that allow electronic trading
  • Exchange-Traded Funds (ETFs)
    • Stock portfolios bought/sold in single trade
  • SPDRs (Standard & Poor’s Depository Receipts or “spiders”)
    • ETFs tracking several S&P indexes
47
Q

How common stocks are valued 1

A
  • Book Value
    • Net worth of firm according to balance sheet
  • Dividend
    • Periodic cash distribution from firm to the shareholders
  • P/E Ratio
    • Price per share divided by earnings per share
  • Market Value Balance Sheet
    • Financial statement that uses market value of assets and liabilities
48
Q

How common stocks are valued 2

A
49
Q

Example: expected return

Fledgling Electronics sells for $100 per share today; they are expected to sell for $110 in one year. What is expected return if dividend in one year is forecasted to be $5.00?

A
50
Q

Price of share of stock

A
  • Price of share of stock is present value of future cash flows
  • For a stock, future cash flows are dividends and ultimate sales price
51
Q

Market Capitalization Rate

A
  • Estimated using perpetuity formula
  • Also called cost of equity capital
52
Q

Dividend Discount Model

A

Computation of today’s stock price: share value equals present value of all expected future dividends

53
Q

Example: Dividend discount

Fledgling Electronics forecasted to pay $5.00 dividend at end of year 1 and $5.50 dividend at end of year 2. End-of-second-year stock will be sold for $121. Discount rate is 15%. What is the price of stock?

A
54
Q

Dividend Yield:r-g

A
  • Expected return on stock investment plus expected dividend growth
  • Similar to capitalization rate
55
Q

Example:Dividend yield r with 0 g

Northwest Natural Gas shares sold for $47.30 at start of 2012. Dividend payments for 2013 were $1.86 a share with no growth. What is dividend yield?

A
56
Q

Example: divident yield r with g

Northwest Natural Gas shares sold for $47.30 at start of 2012. Dividend payments for 2013 were $1.86 a share with 4.6% growth. What is dividend yield?

A
57
Q

Return Measurements

A
58
Q

Dividend Growth Rate:g

A
  • Derived by applying return on equity to percentage of earnings
  • reinvested in operations
59
Q

Valuing Non-Constant Growth

A
60
Q

Example: valuing consecutive divident with g

Phoenix pays dividends in three consecutive years of 0, .31, and .65. Year-4 dividend is estimated at .67 with perpetuity growth at 4%. With 10% discount rate, what is stock price?

A
61
Q

Payout Ratio& Plowback Ratio

A
  • If firm pays lower dividend and reinvests funds, stock price may increase due to higher future dividends
  • Payout Ratio
    • Fraction of earnings paid out as dividends
  • Plowback Ratio
    • Fraction of earnings retained by firm
62
Q

Example:Stock price and earnings per share

Company plans $8.33 dividend next year (100% of earnings). Investors will get 15% expected return. Instead, company plows back 40% of earnings at firm’s current return on equity of 25%. What is the stock value before and after plowback decision?

A
63
Q

Present Value of Growth Opportunities (PVGO)

A

• Net present value of firm’s future investments

64
Q

Sustainable Growth Rate

A

• Steady rate at which firm can grow: plowback ratio x return on equity

65
Q

Valuing a Business or Project

A
66
Q

Example: valuing PV of cash fows

Given cash flows for Concatenator Manufacturing Division, calculate PV of near-term cash flows, PV (horizon value), and total value of firm; r = 10% and g = 6%

A
67
Q

CFO decision tools

A
68
Q

Book Rate of Return

A
  • Average income divided by average book value over project life
  • Also called accounting rate of return
  • Components reflect tax and accounting figures, not market values or cash flows
69
Q

5.2 Payback

A
  • Payback Period
    • Number of years before cumulative cash flow equals initial outlay
  • Payback Rule
    • Only accept projects that pay back within desired time frame
    • Ignores later year cash flows and present value of future cash flows
70
Q

Example: Find disadvantage of only taking projects with payback period of two years or less

A
71
Q

Example: IRR

Tool A costs $4,000. Investment will generate $2,000 and $4,000 in cash flows for two years. What is IRR?

A
72
Q

Pitfall 2: Multiple Rates of Return

A
73
Q

Pitfall 1: Lending or Borrowing?

A
74
Q

Pitfall 3: Mutually Exclusive Projects

A
75
Q

Pitfall 4: More than One Opportunity Cost of Capital

A
  • Term Structure Assumption
    • Assume discount rates stable during term of project
      • Implies all funds reinvested at IRR
      • False assumption
76
Q

Profitability Index (PI)

Choosing capital investments when resources are limited

A
  • Tool for selecting between project combinations and alternatives
  • Set of limited resources and projects can yield various combinations

• Highest weighted average PI indicates optimal project

77
Q

Example：weighted average Profitablity Index

Select best projects for $300,000

A
78
Q

Rationing

Choosing capital investments when resources are limited

A
  • Capital Rationing
    • Limit set on amount of funds available for investment
  • Soft Rationing
    • Imposed by management
  • Hard Rationing
    • Imposed by unavailability of funds in capital market
79
Q

Ch-6 Applying net present value rule

A
80
Q

Example: Inflation

Project produces real cash flows of -$100 in year zero and then $35, $50, and $30 in three following years. Nominal discount rate is 15% and inflation rate is 10%. What is NPV?

A
81
Q

Separate Investment and Financing Decisions

A
  • Regardless of financing, treat cash outflows required for project as coming from investors
  • Regardless of financing, treat cash inflows as going to investors

Net cash flow= cash inflow - cash outflow

82
Q

Problem 1: Investment Timing Decision

A
83
Q

Problem 2: Choice between Long- and Short-Term Equipment

Example: Given the following cash flows from operating two machines and a 6% cost of capital, which machine has the higher value using the equivalent annual annuity method?

A

Equivalent Annual Cash Flow, Inflation, and Technological Change

  • Inflation increases nominal costs of operating equipment, but real costs remain unchanged
  • Real cash flows are not always constant

Equivalent Annual Cash Flow and Taxes

  • Lifetime costs should be calculated after tax
  • Operating costs are tax-deductible
  • Capital investment generates depreciation tax shields
84
Q

Problem 3: When to Replace an Old Machine

A

Example: A machine is expected to produce a net inflow of $4,000 this year and $4,000 next year before breaking. You can replace it now with a machine that costs $15,000 and will produce an inflow of $8,000 per year for three years. Should you replace now or wait a year?

85
Q

Problem 4: Cost of Excess Capacity

A

Example: A computer system costs $500,000 to buy and operate at a discount rate of 6% and lasts five years

  • Equivalent annual cost of $118,700
  • Undertaking project in year 4 has a present value of 118,700/(1.06)4, or about $94,000
86
Q

• Variance

A

• Average value of squared deviations from mean; measures volatility

87
Q

• Standard Deviation

A

• Square root of variance; measures volatility

88
Q

Measuring portfolio risk

A
89
Q

• Diversification

A

• Strategy designed to reduce risk by spreading the portfolio across many investments

90
Q

• Unique Risk

A

• Risk factors affecting only that firm; also called “diversifiable risk”

91
Q

• Market Risk

A

• Economy-wide sources of risk that affect the overall stock market; also called “systematic risk”

92
Q

diversification eliminates specific risk

A
93
Q

variance of a two-stock portfolio

Variance of two-stock portfolio is sum of four boxes

A
94
Q

Calculating portfolio risk

Example: Invest 60% of portfolio in Heinz and 40% in ExxonMobil. Expected dollar return on Campbell Soup stock is 6% and 10% on Boeing. Expected return on portfolio is:

Standard deviation of annualized daily returns are 14.6% and 21.9%, respectively. Assume correlation coefficient of 1.0 and calculate portfolio variance.

A
95
Q

Portfolio calculation

A
96
Q

Example: Calculating portfolio risk

A
97
Q

• Market Portfolio

A
  • Portfolio of all assets in economy
  • Usually uses broad stock market index to represent market
98
Q

• Beta

A

• Sensitivity of stock’s return to return on market portfolio

99
Q

Harry Markowitz and the birth of portfolio theory

A

• Combining stocks into portfolios can reduce standard deviation below simple weighted-average calculation

  • Correlation coefficients made possible
  • Various weighted combinations of stocks that create specific standard deviation constitute set of efficient portfolios
100
Q

Expected return and standard deviation

A
101
Q

Efficient Frontier

A
102
Q

Sharpe Ratio

A

• Ratio of risk premium to standard deviation

103
Q

The relationship between risk and return

A
104
Q

Security market line

A
105
Q

Alternative to CAPM

A
106
Q

Three-Factor Model

A
107
Q

Example：Portfolio return

A
108
Q

Example：NPV

A

Tessa-Quantitative Finance (3 decks)

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