Teori Flashcards
Profitability index (PI)
PI is used to evalutate a projects profitability.
Criteria:
* The PI must be over 1 for the project to be accepted.
Ranking:
* The bigger the PI, the better.
Pros:
- Easy to understand and communicate
- Good tool when evalutaing multiple independent projects.
- Useful when availbale investment funds are limited
Cons:
- Problems with mutually exclusive investments
EXTRA:
- With capital rationing PI is a useful method for adjusting NPV
- When choosing mutually exclusive projects and using the profitability index on the incremental cash flows with PI > 1, we get the same result as using NPV
Price earnings (PE) ratio
Relates earnings per share to price.
Interpreting the PE-ratio:
Historically a company has a fair price if the P/E ratio is between 10 – 17.
Below 10:
- The company’s earnings are thought to be in decline, and the company’s future might be in question.
- Or, current earnings are substantially above historical earnings (e.g. through asset sales).
Over 17:
- The stock is overvalued or the earnings have increased since the last earnings figure was published.
- Or, the stock is a growth company where earnings are expected to increase in the future.
Over 25:
- High expected future growth in earnings (e.g. Facebook).
- May be a speculative bubble.
Pros and cons?
The PI is a function of:
* The risk of the stock
* The per share amount of the firms valuable growth opportunities
* The type of accounting method used by the company
NPV method (project selection)
Minimum acceptance:
NPV > 0
Ranking criteria:
Highest NPV
Must estimate:
- cash flows
- discount rate
- initial investment
Reinvestment assumption:
The NPV rule assumes that all cash flows can be reinvested at the discount rate.
Why use NPV?
- Accepting positive NPV projects benefits shareholders.
- NPV uses cash flows
- NPV uses all relevant cash flows of the project
- NPV discounts the cash flows properly
Payback Period Method
Payback period method = number of years to recover initial cost
Minimum acceptance:
Set by management; a predetermined time period.
Ranking criteria:
Set by management; often the shortest payback period is preferred.
Disadvantages:
- Ignores time value of money
- Ignores cash flows after the payback period
- Biased against long term projects
- Requires an arbitrary accpetance criteria
- A project accepted based on the payback criteria may not have a positive NPV
Advantages:
- Easy to understand
- Biased towards liquidity
Discounted Payback Period Method
How long does it take the project to pay back its initial investment, taking into account time value of money.
Minimum acceptance:
Set by management; a predetermined time period
Ranking criteria:
Set by management; often shortest payback is preferred.
By the time you have discounted the cash flow, you might as well calculate the NPV.
Internal Rate of Return (IRR)
IRR= the discount rate that sets the NPV to zero.
Minimum acceptance:
Accept the project if the IRR > discount rate,
Ranking criteria:
Select alternative with the highest IRR
Disadvantages:
- Does not distinguish between investing and borrowing
- IRR may not exist, or there may be multiple IRR’s, given that NPV and discount rate is declining
- Problems with mutually exclusive investments
- Timing
Advantages:
- Easy to understand and communicate
Extra:
- When a project has cash inflow followsed by two or more cash outflows (borrowing) One should accpet when the IRR is below the discount rate.
- When considering mutually exclusive investments. One can always reach a correct decision by accpeting the larger project if the incremental IRR is greater than the discount rate.
Are we borrowing or lending?
When borrowing money the NPV of the project increases as the discount are increases, since money today becomes increasingly and relatively more valuable. The is contrary to the normal relationship between NPV and discount rates
Mulitple IRRs
Certain cash flows can generate NPV = 0 at two different discount rates. You can guarantee against multiple IRRs by having only positive cash flows after the first initial investment.
No internal rate of return
It is possible to have no IRR and a positive NPV. Although it should be evident that IRR in this case is not important.
The scale problem
IRR sometimes ignores the magnitude of the project. Would you rather make 100% return on a 1% investment or 50% on 1000$ investment.
The timing problem
We have usually assumed independent projects: accepting or rejecting one project does not affect the decsion of the other projects. Our concern has been if the project has exceeded a MINIMUM acceptance criteria. There might be scenarios where we have mutually exclusive project: only ONE of several projects can be chosen. Then we need to RANK all alternatives, and select the best one. When using IRR the timing may provide a problem when comparing two or more projects.
When analyzing a balance sheet, one should be aware of three concerns
1. Accounting liquidity
Refers to the ease and quickness with which assets can be converted to cash — without a significant loss in value.
2. Debt versus equity
Creditors generally receive the first claim on the firm’s cash flow, while shareholders only have a residual claim.
Debt and equity have different costs; the relationship between them has impact on the firm’s profitability.
3. Value versus cost
Financial statements (in the U.S. and Norway) carry assets at historical cost. Market value may differ from the historical cost, as it is the price at which the assets, liabilities, and equity could actually be bought or sold.
MM Propositions I & II (with taxes)
1. M&M Theorem 1 (with taxes) says that a levered company has a higher value than an unlevered company, due to the tax shield.
The value of a company increases with debt (due to the tax shield).
VL = VU + (D x TC)
2. M&M Theorem 2 (with taxes) risk of the company increases with debt as the expected return for shareholders increases. The increased risk is reduced due to the tax shield.
MM Proposition I & II (No Taxes)
1. The company’s capital structure does not impact its value. Since the value of a company is calculated as the present value of future cash flows, the capital structure cannot affect it.
VL = VU
2. The company’s cost of equity is directly proportional to the company’s leverage level (amount of debt). An increase in leverage/debt induces a higher default probability to a company. Therefore, investors tend to demand a higher cost of equity (return) to be compensated for the additional risk.
Operational cash flow (OCF)
After the initial investment, the project/company is dependent on the operational cash flow (OCF) from its investment. Operating cash flow is generated by business activities, including sales of goods and services. It reflects payment, not financing, capital spending or changes in net working capital.
Monte Carlo simulation
Monte Carlo attempts to model real-world uncertainty and is seen as a step beyond sensitivty or scenario analysis.
Algorithm for Monte Carlo:
1. Specify the basic model
2. Specify a probability distribution for each variable in the model
3. The computer draws on outcome
4. Repeat the procedure
5. Calculate NPV
Advantages:
Possibility to define advanced/complex NPV-estimation, and include correlation.
Disadvantages:
* Complex - prob of every underlying value/correct prob. distr./interaction between variables/sensitive to assumptions/garbage in garbage out
* Time consuming
What is a sensitivity analysis?
With scenario analysis, one variable is examined for å broad range of values.
Algorithm for sensitivity analysis:
1. Specify the NPV equation, including cash flow equation
2. Specify base values for stochastic variables in the NPV equation (base assumptions)
3. Calculate NPV using base values
4. For each stochastic variable:
- Decide upon alternative outcomes for the variable (e.g. -20% drop, +20% rise etc.)
- Calculate the NPV under alternative outcomes
- Under sensitivity analysis, one input is varied at a time while all other inputs are assumed to meet their expectations (base assumption)
5. Analyze the effect of alternative outcomes on NPV
- Find which variables have the greatest effect, e.g. by using a ”spider” (also called “star”) diagram.
Advantages and disadvantages of sensitivity analysis
Advantages of sensitivity-analysis:
- Recognizes the uncertainty of variables
- Shows how significant any variable is in determining a project’s NPV
- Does not depend on probabilities associated with outcomes of variables
- Can be used when there is little information, resources and time for more sophisticated techniques
Disadvantages of sensitivity-analysis:
- Variables are often interrelated
- No explicit probabilistic measure for values (probability distr.) or risk exposure
- How likely is a pessimistic, optimistic or expected value and how likely is the corresponding outcome value?
Capital asset pricing model (CAPM)
CAPM tells us the relationship between the risk of one single asset compared to the risk in the market.
Expected return E(R) = RF + beta(RM-RF)
RF - risk free rate (10yr bond yield)
RM - avrg historical return
(RM-RF) - market risk premium (expected reward for taking extra risk)
CAPM can also be described as the cost of equity. I.e. what an investor expects to get in return for the investment in your company.
CAPM can be used to calculate discount rate or expected rate of return.
The Beta:
- The beta measures an asset’s sensitivity to market fluctuation.
- Beta= 1, will move just like the market.
- An asset with a beta = 2, will have twice as much risk compared to the market portfolio. If the market rises by 1%, the asset will rise by 2%. If the market falls by 2%, the asset will fall by 4%.
Dividend growth model (DGM)
A way of evalutaing a common stock. There are three valuations based on DGM (see picture).
Flaws:
1. Need to agree on r and g
▪ Can calculate implicit r and g using the DGM
2. What if r < g?
▪ DGM will give negative company value
3. What if the company don’t pay dividend?
▪ DGM will value company = 0
4. What if the company provide other cash flows than dividends?
▪ Total Payout model
5. How about extra opportunities?
▪ NPVGO
Bonds
A bond is a legally binding agreement between a borrower and a lender that specifies the:
* Par (face) value (F)
* Coupon rate (r)
* Coupon payment (C)
* Maturity Date (t)
With the current bond price, we can calculate the implied rate of return, called the Yield To Maturity (YTM).
- When coupon rate = YTM, price = par value
- When coupon rate > YTM, price > par value (premium bond)
- When coupon rate < YTM, price < par value (discount bond)
- Bonds can be traded like any other financial asset, and the price is set by comparing the bond interest rate with the market interest rate.
- Bond prices and market interest rates move in opposite directions.
Bond values vary because of:
1. Price risk
▪ Change in price due to changes in interest rates
2. Reinvestment risk
▪ Uncertainty concerning rates at which cash flows can be reinvested
3. Default risk
▪ Uncertainty concerning the repayment of the face value
What is total payout valuation?
Dividends may not be a firm’s only cash payout. Recently many
firms have repurchased shares, another form of payout
Using the Dividend Growth Model, the price of a share will be
higher if considering total payout rather than just dividends.
