Module 2: Intro to Financial Theories Flashcards
What is time value of money?
The time value of money: money received today can be reinvested to earn interest to increase its
value. Therefore $1 received today is worth more than $1 received in 1 year.
What is discounted cash flow (DCF)?
Discounted cash flow, (DCF), is an investment appraisal technique which takes into account both the
timings of cash flows and also total profitability over a project’s life.
Two important points about DCF are as follows:
DCF looks at the cash flows of a project, not the accounting profits.
DCF takes account of the time value of money.
The timing of cash flows is taken into account by discounting them.
The effect of discounting is to give a larger value per $1 for cash flows that occur earlier: $1 earned
after one year will be worth more than $1 earned after two years, which in turn will be worth more than $1 earned after five years, and so on.
What is compounding?
Suppose that a company has $10 000 to invest, and wants to earn a return of 10 per cent per annum
(compound interest) on its investments. This means that if the $10 000 could be invested at 10 per
cent, the value of the investment with interest would build up as follows:
After 1 year $10 000x(1.10) = $11 000
After 2 years $10 000x(1.10)2 = $12 100
After 3 years $10 000x(1.10)3 = $13 310 and so on.
This is compounding.
What is the compounding formula?
The formula for the future value of an investment plus accumulated interest after n time periods is:
FV = PV (1 + r)n
where: FV is the future value of the investment with interest.
PV is the initial or ‘present’ value of the investment.
r is the compound rate of return per time period, expressed as a proportion (so 10% =
0.10, 5% = 0.05 and so on).
n is the number of time periods.
What is the cost of capital?
The cost of capital as used in DCF is the cost of funds that a company raises and uses. It represents
the return that investors expect to be paid for putting funds into the company. It is therefore the
minimum return that a company should make from its own investments, to earn the cash flows out of which investors can be paid their return.
What is an annuity?
An annuity is a series of cash flows of equal amount, and equal frequency in time for a defined period.
The present value of an annuity is given by:
PV = Annual cash flow/r (1-/(1+r)n)
where r is the discount rate, expressed as a decimal.
What is a perpetuity?
A perpetuity is an annuity in which the cash flows continue at an equal amount forever. In other words
it has an infinite life.
The present value of a perpetuity is given by:
PV = Annual cash flow/r
where r is the discount rate, expressed as a decimal.
What is CAPM?
The Capital Asset Pricing Model (CAPM) is a formula for predicting the required rate of return for an investment, based upon its level of systematic risk relative to that of the market as a whole. It can be used to calculate a discount rate or cost of equity that incorporates risk.
What is relevant cost?
Relevant costs are future, incremental cash flows. Relevant costs are future costs. A decision is about the future; it cannot alter what has been done already. A cost that has been incurred in the past is totally irrelevant to any decision that is being made ‘now’. Costs that have been incurred include not only costs that have already been paid, but also costs that are the subject of legally binding contracts, even if payments due under the contract have not yet been made. (These are known as committed costs.)
Relevant costs are cash flows.
– Accounting profits and cash flow are not the same in any period for various reasons, such as the timing differences caused by giving credit and the accounting treatment of depreciation. In the long run, however, a profit that is earned will eventually produce a net inflow of an equal amount of cash. Hence when decision making we look at cash flow as a means of measuring
profits.
– Only cash flow information is required. This means that costs or charges which do not reflect additional cash spending should be ignored for the purpose of decision making. These include depreciation charges.
Relevant costs are incremental costs. A relevant cost is one which arises as a direct consequence of a decision. Therefore, only costs which will differ under some or all of the available opportunities should be considered; relevant costs are therefore sometimes referred to as incremental costs. For example, if an employee is expected to have no other work to do during the next week, but will be paid their basic wage of, say, $200 per week for attending work and doing nothing, the manager might decide to give them a job which earns only $140. The net gain is $140 and the $200 is irrelevant to the decision because although it is a future cash flow, it will be incurred anyway whether the employee is given work or not.
The net cash inflows from a project can be calculated as the incremental contribution earned minus any incremental fixed costs which are additional cash items of expenditure (that is, ignoring depreciation and so on).
Explain systematic and unsystematic risk
Systematic risk is risk that cannot be diversified away. E.g. Macroeconomic, inherent risks. Unsystematic risk is a risk that affects a small number of assets. It is a unique or an asset specific risk, and can be reduced or eliminated by diversification.
What is opportunity costs?
Opportunity costs. Opportunity costs are costs incurred or revenues lost from diverting existing resources from their best use.
Worked Example: Opportunity costs
If a salesperson, who is paid an annual salary of $30 000, is diverted to work on a new project and as a result existing sales of $50 000 are lost, the opportunity cost to the new project will be the $50 000 of
lost sales. The salesperson’s salary of $30 000 is not an opportunity cost since it will be incurred however their time is spent.
What is present value?
Present value can be defined as the cash equivalent ‘now’ of a future sum of money receivable or
payable at a future date, assuming that money ‘now’ can be invested at a given rate of return (known
as the ‘cost of capital’). A present value is calculated by discounting the future cash flow to its present
value equivalent amount.
What is discounted cash flow?
Discounted cash flow, (DCF), is an investment appraisal technique which takes into account both the timings of cash flows and also total profitability over a project’s life.
Two important points about DCF are as follows:
DCF looks at the cash flows of a project, not the accounting profits.
DCF takes account of the time value of money.
The timing of cash flows is taken into account by discounting them.
The effect of discounting is to give a larger value per $1 for cash flows that occur earlier: $1 earned after one year will be worth more than $1 earned after two years, which in turn will be worth more than
$1 earned after five years, and so on.
Systematic risk is measured using beta factors
Beta factor is the measure of the systematic risk of a security relative to the risk of the market
portfolio. The beta factor of the market as a whole is 1.0. A beta factor of 0 indicates a risk-free
investment.
What is a efficient market?
An efficient market is one where the prices of securities bought and sold reflect all the relevant
information available. The efficiency of a market refers to the extent to which share prices react to information about a
company and its profitability. Efficiency relates to how quickly and accurately prices adjust to new
information.
