FIN 301 Exam 3 Study Guide- Topics Covered on Exam 3:o Chapter 10 Discounted Cash Flowo Chapter 11 Capital Budgetingo Chapter 12 Risk & Return and CAPMo Chapter 13 Efficient Capital Marketso Chapter 14 Bondso Chapter 15 Stockso Chapter 16 Management of Risk- CHAPTER 10: DISCOUNTED CASH FLOWo 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 receiveo Definitions 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 factorso 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 project- Cash Outflows = additional expenses being spent as a 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 todetermine proper discounting rate- Cash Inflows = dividends and increase/decrease in stock price- CHAPTER 11 CAPITAL BUDGETINGo 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 itselfo 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 negativeo 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 ruleo 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 thatproject). 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 decisiono What is a Payback Period? Length of time for the return on an investment to cover the cost of that investment 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 apredetermined number of years, reject if the payback period is greater than that predetermined numbero What is Profitability Index (PI)? 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 withnegative PI.- CHAPTER 12 RISK & RETURN AND THE CAPITAL ASSET PRICING MODELo 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 awayo 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 paido 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 performanceo 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 bestpossible 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 correlatedo Capital Asset Pricing Model Estimates the rate of return an investor should expect on a risky asset Purpose is to determine the discount rate to use when valuing an asset CAPM = E(Ri) = Rf + Beta * (Rm - Rf)- CAPM = Expected return of a risky asset = Return on therisk-free asset + Beta