FIN 301 Exam 3 Study Guide Topics Covered on Exam 3 o Chapter 10 Discounted Cash Flow o Chapter 11 Capital Budgeting o Chapter 12 Risk Return and CAPM o Chapter 13 Efficient Capital Markets o Chapter 14 Bonds o Chapter 15 Stocks o Chapter 16 Management of Risk CHAPTER 10 DISCOUNTED CASH FLOW o Introduction DCF Valuation determines the value of an investment while markets determine the price of that investment Make buying selling decisions based on price vs value is the value greater or less than the cost The value of an investment is equal to the present value of its expected cash flows discounted for risk timing Expected cash flows are typically cash payments such as dividends capital gain or loss interest etc that one can expect to receive Discount multiply a number by less than 1 Discount Rate a function of time and risk Discount Factor a function of both time and the discount rate Present Value the PV of an investment is the sum of the expected cash flows multiplied by their discount factors o Definitions o Discounted Cash Flow Valuation Decision Rule Value Price BUY Value Price SELL o Valuing Uneven Cash Flows Projects an investment to produce a product or provide a service to generate money in the future Cash Inflows additional revenues as a result of a Cash Outflows additional expenses being spent as a project result of a project Bonds debt instruments issued by corporations the government and municipalities Payable from taxes from the government or general revenues from the corporation Cash Inflows bond interest payments usually every 6 months and repayment of principal Stocks represent ownership interest in a corporation No maturity with a stock its life is infinite Risk of a stock is hard to quantify thus making it hard to determine proper discounting rate Cash Inflows dividends and increase decrease in stock price CHAPTER 11 CAPITAL BUDGETING o What is Capital Budgeting Process of planning and managing a firm s long term investment in projects ventures Involves estimating the amount timing and risk of future cash flows Starts with the estimation of incremental cash flows from a project then create a time line of expected cash flows then compare the value of these cash flows to the cost of the project itself o What is Net Present Value NPV The difference between the value of an investment and its cost The value of a project investment is equal to the present value of its expected cash flows discounted for risk and timing RULE Invest in projects if the NPV is positive reject if NPV is negative o How do you solve a Net Present Value problem 1 Estimate cash flows from project 2 Calculate the discounted cash flows 3 Calculate NPV and make the decision based on the NPV rule o What is Internal Rate of Return IRR The rate of return expected to be earned on a project the discounting rate that makes the NPV of an investment equal to 0 RULE if the investment has an IRR that is greater than a predetermined required rate of return accept that investment If it is lower than the required rate reject that investment o How do you solve an IRR problem 1 Estimate NPV from the investment based on a discount rate 2 Assuming the NPV calculated is positive increase the discount rate because IRR is the rate at which NPV is 0 for that project Then apply your new discount rate per year 3 Continue this process until we reach the rate at which NPV 0 4 Compare the IRR calculated with the predetermined rate of return and apply the rule to make your decision o What is a Payback Period Length of time for the return on an investment to cover the cost of that investment o What is Profitability Index PI This calculation involves ONLY gross cash flows and not discounted cash flows Payback period of years Cost Cash flows per year RULE accept the investment if its payback period is less than a predetermined number of years reject if the payback period is greater than that predetermined number The NPV of an investment divided by its cost PI It is used to identify projects that will receive the best return associated with the amount of dollars invested by ranking the projects by Profitability Index RULE accept the project with the highest PI first then continue to accept projects with lower positive PI s just until the projects utilize capital budget Do NOT accept projects with negative PI CHAPTER 12 RISK RETURN AND THE CAPITAL ASSET PRICING MODEL o Definitions CAPM E Ri Rf Beta Rm Rf Beta Risk Market Risk Premium Rm Rf Average market return Average T Bill return Alpha Observed Return of an Asset Expected Return of an Asset Systematic Risk Market related Measured by Beta Can NOT be diversified away Unsystematic Risk Firm specific risk Can be diversified away o Risk Return The higher the risk the higher your potential returns Risk is measured by price or return volatility T Bills tend to have lower returns between 2 4 while stocks are higher with 6 10 o Rate of Return Cash payment Change in price Price paid o Simple Averages of Percentages If there is a negative percentage return then the calculation of a simple average is biased upwards Simple average returns can hide poor performance o Asset Diversification IMPORTANT in order to reduce risk Means you spread your money amongst different investments Goal to invest in a group of assets to provide you with the best possible returns at a given level of risk Diversification reduces unsystematic risk firm specific risk Total risk in the stock market systematic unsystematic Correlation Coefficients 1 0 correlation coefficient between 2 stocks means that when one of those stocks is up by 10 then the other one will also increase by 10 1 0 correlation coefficient means that when one of the stocks is up 5 the other stock is down 5 Highly correlated assets offer less risk reduction from diversification than do assets that are less correlated o Capital Asset Pricing Model Estimates the rate of return an investor should expect on a risky asset an asset Purpose is to determine the discount rate to use when valuing CAPM E Ri Rf Beta Rm Rf CAPM Expected return of a risky asset Return on the risk free asset Beta Average market return Average T Bill return o Standard Deviation of Return The greater the SD means greater risk and more fluctuation o Beta Is the measure of market related systematic risk of an asset Lower Beta means less volatility Determines an investment s risk premium A stock with a Beta of 2 will usually double market movements A stock with a beta of 0 5 will