Discounted Cash Flow

Question 1

Calculate and interpret NPV

Answer 1

Write out PV of cash inflows less PV of cash outflows

Question 2

Calculate and interpret IRR

Answer 2

n = periods
PV = CFzero
PMT = annuity
i = [compute IRR]

Question 3

Contrast NPV to IRR and identify issues with IRR

Answer 3

Different results when scale of projects or timing of cash flows differs. IRR requires assumption of being able to reinvest at same rate until maturity. Follow NPV whenever different results.

Question 4

Compare money-weighted vs. time-weighted rates of return

Answer 4

Time-weighted is standard. Money-weighted appropriate if investor controls additions/withdraws.

Question 5

Money-weighted rate of return definition

Answer 5

Same as IRR including all cash flows, with initial value and additions as outflows (investments) and withdrawals, receipts, and ending value as inflow. Problem: unfairly impacted by client inflows/outflows.

Question 6

Time-weighted rate of return definition

Answer 6

Compound rate of growth of $1 initially invested over stated measurement period

Question 7

Calculate and interpret bank discount yield

Answer 7

rbd = (D/F)(360/t) where t is days to maturity

Not great measure of return - no compounding.

Question 8

Calculate and interpret holding period yield

Answer 8

Return over specified holding period.

HPY = income + (ending value - initial value) / initial value

Question 9

Calculate and interpret effective annual yield

Answer 9

EAY = (1 + HPY) ^ (365/t) - 1

Takes account of compounding.

Question 10

Calculate and interpret money market yield

Answer 10

rmm = HPY * (360/t)

rmm = (360*rbd) / (360 - t * rbd) ——- t-bill

Question 11

Capital budgeting

Answer 11

Allocation of funds to long-range projects/investments

Question 12

Capital structure

Answer 12

Choice of long-term financing

Question 13

Working capital management

Answer 13

Management of company’s short-term assets and liabilities

Question 14

NPV rule

Answer 14

If NPV is positive, investor should undertake it. If NPV negative, investor should reject it. Pick highest positive NPV.

Question 15

IRR rule

Answer 15

Accept projects or investments for which IRR is greater than opportunity cost of capital

Question 16

Calculate time-weighted rate of return

Answer 16

1. Price portfolio before significant addition/withdraw; break total period into subperiods based on additions/withdraws (not necessarily evenly spaced)
2. Calculate holding period return for each subperiod
3. Compound holding period returns (if over 1 year use geometric mean)

Question 17

Geometric mean

Answer 17

r = [(1+r1) (1+r2) (1+r3) … ] ^ (1/n) - 1

Question 18

Face value

Answer 18

Amount paid back on maturity

Question 19

Discount

Answer 19

Reduction of face amount that gives price

Question 20

Pure discount instrument

Answer 20

Pay interest as difference between amount borrowed and amount paid back (T-bills)

Question 21

Bond equivalent yield

Answer 21

Doubling semi-annual yield