Time Value and Investment Appraisal AND Debt and Equity Flashcards
What is simple interest
Interest is earned on principal only
What is compound interest
Interest is earned on both principal and interest
What is the time value of money
interest earned
The cost of replacing a fleet of company trucks with more energy efficient vehicles is £1 million in 2018. The cost is estimated to rise by 8.5% in 2019. If the interest rate is 4%, what is the cost of a delay in terms of GBP in 2018?
2018 £1m
2019 £1m*(1+8.5%)
2018 PV of £1.085m
PV = 1.085m/1.04= £1.0433m
The cost of a delay of one year = £0.0433m
What is the nominal interest rate NIR
quoted as an annual rate and interest is compounded more frequently than annually
What is effective interest rate EIR
the interest rate that produces the same yield as the nominal interest rate when compounded annually
What is the EIR formula
EIR = (1+ NIR/X)^X - 1
When the EIR is used
S = P (1+EIR)
What is perpetuity
cashflow that will occur at regular intervals forever
What is annuity
constant cashflow will occur at regular intervals for a finite number of periods
What is the NPV formula
PV(benefits) - PV(costs)
Cashflow/r - Costs
what happens to NPV if the cost of capital goes up while n remains constant
NPV drops as R rises
What is the IRR
the interest rate that sets the net present value of the cashflows to zero
What is the IRR investment rule
- Take any investments where the IRR exceeds the cost of capital
- Turn down any investment whose IRR is less than the cost of capital
How do you calculate IRR
CF/r - Costs = NPV
Calculate what r is when NPV = 0
Whats the difference between NPV rule and IRR rule
NPV rule = Accept the project with a positive NPV
IRR rule = Take any investment where the IRR exceeds the cost of capital
Which situations are there where the NPV method is preferred over IRR
- Cashflows of a project are not conventional
- There are multiple IRRs or no IRR exists
- Mutually exclusive projects are being considered
What should you do when the IRR rule conflicts with the NPV rule
Take the NPV
What is the formula for payback period
Initial Investment/ Annual Cashflow
What is a pro of the payback period
simple and easy to use
What is two cons of payback period
- Ignores the cashflows outside the payback period and does the consider the project as a whole
- Ignores the time value of money
When the bond price is greater than the face value. What do we say it trades at and when does this occur
Above par or at premium
Coupon rate > Yield to maturity
When the bond price is equal to the face value. What do we say it trades at and when does this occur
At par
Coupon rate = yield to maturity
When the bond price is less than face value. What do we say it trades at and when does this occur
below par or at a discount
Coupon rate< yield to maturity
What is yield to maturity
The yield to maturity of a bond is the discount rate that sets the value of the bond equal to the current market price of the bond
Suppose a zero-coupon bond has a face value of £100 and a maturity in 2 years with a price of £92.45. Calculate the YTM
(100/92.45)^1/2 - 1 = 4%
Bond value changes over time as a result of the change in r
r is subject to the change of the market interest rates which are affected by economic conditions such as inflation rates
bond value changes over time as a result of the change in n
n decreases as the bond gets closer to its maturity date
What happens to C and FV when a bond is issued
nothing they are fixed and do NOT change during the life of the bond
What happens to the bond value of a zero coupon bond when the YTM increases
as interest rate YTM rises, the bond value falls and vice versa
what is the macaulay duration
the macaulay duration is the weighted average maturity (measured in years) of the cashflows of a bond
What do one year common stock (equity with one year horizon) have in common with a 1 year coupon bond
- The format of the equation is the same
2. Both equations are the result of the application of the PV formula
What do one year common stock (equity with one year horizon) NOT have in common with a 1 year coupon bond
- Div1 and P1 are expected values (UNCERTAINTY)
C and FV are both fixed when a bond is issued (CERTAINTY) - Re cost of equity capital represents the return expected by shareholders (HARD TO DETERMINE)
YTM cost of debt capital represents risk free interest rate (government bonds EASY TO DETERMINE)
In Dividend Discount model what is the assumption
If a company exists forever its terminal value disappears
In DDM if a company exists forever its terminal value disappears, Is this reasonable
Yes the assumption is reasonable
- Terminal value tends to be negligible as N, the number of years increases
- A common practice such as going concern
What two challenges does DDM face
- Re represents the rate of return required by shareholders, which is non observable and therefore impossible to calculate with provision
- Dividends are difficult to forecast with accuracy because dividend payout is an internal issue of the company
How do we overcome the two challenges face by DDM
- To estimate Re by CAPM
2. To simplify the forecast by making some assumptions
What are 2 assumptions of DDM (intro to dividend growth model)
- Dividend is a Constant in perpetuity (value of company equity equals dividend divided by the cost of equity capital)
- Dividend grow at a constant rate ( cost of equity capital is the sum of dividend yield and dividend growth rate)
DC pay an annual dividend of 26p per share. analysts expect dividend to grow 6% per year in perpetuity. What is the value of the share if firm cost of equity capital is 10%
Div0 = 26p Div1 = 26*1.06=27.56
P0 = 27.56/(0.1-0.06) = 689p
