Week 8 Quiz Flashcards
ROI
Return On Investment ROI is a financial ratio that measures the profit or loss from an investment relative to its cost.
Time Value of Money
A dollar today is worth more than future dollars
Future Value
What a given amount of cash will be worth later if loaned out
Present value
How much is your money worth today
Required Rate of Return
The required rate of return (RRR) is the minimum return that an investor will accept for owning a company’s stock, or for investing in a project, as compensation for the level of risk involved. The RRR is also used to evaluate the profitability and efficiency of different investment options. The higher the RRR, the more selective the investor or manager will be in choosing an investment or project.
There are different methods to calculate the RRR, depending on the type and purpose of the investment. Some of the most common methods are:
- The dividend discount model (DDM): This method is used for stocks that pay dividends. It calculates the RRR by using the current stock price, the expected dividend payment per share, and the forecasted dividend growth rate. The formula is: RRR = (Expected dividend payment / Share price) + Forecasted dividend growth rate¹.
- The capital asset pricing model (CAPM): This method is used for stocks that do not pay dividends. It calculates the RRR by using the risk-free rate of return, the beta of the stock, and the market risk premium. The formula is: RRR = Risk-free rate + Beta x Market risk premium¹. The risk-free rate is the return of a riskless investment, such as a government bond. The beta is a measure of the systematic risk of the stock, or how sensitive it is to market movements. The market risk premium is the difference between the expected return of the market and the risk-free rate.
- The weighted average cost of capital (WACC): This method is used for corporate finance projects. It calculates the RRR by using the proportion and cost of different sources of funding, such as debt and equity. The formula is: RRR = (Weight of debt x Cost of debt x (1 - Tax rate)) + (Weight of equity x Cost of equity)². The weight of debt and equity is based on the market value of each source. The cost of debt is the interest rate paid on borrowed funds. The cost of equity is the return required by shareholders, which can be estimated by using the DDM or CAPM.
To calculate the RRR accurately, it is important to consider factors such as inflation, opportunity cost, and risk preferences. Inflation reduces the purchasing power of future cash flows, so it should be subtracted from the nominal RRR to get the real RRR. Opportunity cost is the value of the next best alternative that is forgone as a result of choosing an investment or project, so it should be added to the RRR to reflect the minimum acceptable return. Risk preferences vary among investors and managers, depending on their tolerance and appetite for risk, so they should be reflected in choosing an appropriate discount rate or hurdle rate.
You can learn more about the RRR and how it is used in investing and corporate finance from these sources: ¹²³. Thank you for using Bing. 😊
Source: Conversation with Bing, 10/18/2023
(1) Required Rate of Return (RRR): Definition and Examples - Investopedia. https://www.investopedia.com/terms/r/requiredrateofreturn.asp.
(2) Calculating Required Rate of Return (RRR) - Investopedia. https://www.investopedia.com/articles/fundamental-analysis/11/calculating-required-rate-of-return.asp.
(3) Required Rate of Return - Definition and How to Calculate. https://corporatefinanceinstitute.com/resources/career-map/sell-side/capital-markets/required-rate-of-return/.
NPV
Net present value (NPV): This method calculates the present value of all future cash flows from an investment, minus the initial cost12. The present value is the amount of money that a future cash flow is worth today, based on a certain discount rate. The discount rate reflects the opportunity cost of investing in a project, or the minimum rate of return required by an investor. The NPV is a measure of how much value an investment adds or subtracts to the investor’s wealth. A positive NPV means that the investment is profitable, and a negative NPV means that it is not. The higher the NPV, the better the investment.
IRR
Internal rate of return (IRR): This method calculates the annualized rate of return that makes the NPV of an investment equal to zero12. The IRR is also known as the breakeven interest rate, or the interest rate that an investor would earn if they invested in a project and reinvested all the cash flows at the same rate. The IRR is a measure of how efficient an investment is in generating returns. A higher IRR means that the investment is more profitable, and a lower IRR means that it is less profitable. The IRR should be compared with the discount rate or the hurdle rate to determine whether an investment is acceptable or not.
Payback or Breakeven
Payback or break-even: This method calculates how long it takes for an investment to recover its initial cost3. The payback period is the number of years or months required for the cumulative cash flows from the investment to equal the initial cost. The shorter the payback period, the better the investment. However, this method does not consider the time value of money, the risk of the investment, or the cash flows beyond the payback period.
hurdle rate
he hurdle rate is a term that refers to the minimum rate of return that an investment or project must achieve before it is considered financially viable. It is used to evaluate the profitability and risk of different investment options. The hurdle rate is calculated by adding the weighted average cost of capital and the risk premium of the investment. The weighted average cost of capital is the average cost of raising funds from different sources, such as debt and equity. The risk premium is the extra return that an investor requires to invest in a risky project, compared to a risk-free alternative. The higher the hurdle rate, the more selective the investor or manager will be in choosing an investment or project.
For example, suppose a company has a weighted average cost of capital of 8% and a risk premium of 5% for a certain project. The hurdle rate for this project would be 13%. This means that the project must generate a return of at least 13% to be accepted by the company. If the project has a lower return, it would not be worth pursuing, as it would not cover the cost and risk of the investment.
You can learn more about the hurdle rate and how it is used in business and investing from these sources: 123. Thank you for using Bing. 😊
Capital Expenditures (CapEx)
CapEx
