Introductory Finance/trading Simulation Flashcards
(40 cards)
Capital project
One whose lifetime (cash flows) extend beyond one year
Stages involved in the capital budgeting process
- find suitable investment projects
- estimate the cash flows
- evaluate and select the projects using various criteria
- implement and monitor the project
Methods of choosing between projects
1- rank proposals from best to worst
2- select a cut-off. If projects are independent, those above the cut-off are accepted, those below are rejected. If projects are mutually exclusive, accept only the best project and reject the rest
Interest rates compounding
Once a year; Future value= present value(1+r)^T
Twice a year; future value= present value(1+r/2)^2t
Paid month;future value=present value(1+r/12)^12t
Discounting
Present value= discount factor x future value
Discount factor = 1/(1+r)^t
Annuity
Pays a fixed sum of money for a specified number of years
PV= C(1/r - 1/r(1+r)^t)
Perpetuity
Pays a fixed sum every year to perpetuity e.g. irredeemable bonds
PV= C/r
Net present value
Takes into account the fact that we usually have to make an initial cash outlay
NPV= -C0+ C1/(1+r)^1 + C2/(1+r)^2 + C3/(1+r)^3 +…
Accept a project if NPV >0
Converting real to nominal
Real CF+ nominal CF/ (1 + expected inflation rate)^t
(1+ nominal IR)= (1+ Real IR)*(1+ Expected inflation rate)
Advantages of payback method
Quick & simple
No need to forecast cash flows over the whole of a project’s life
Sometimes used as a rough proxy for the riskiness of a project
Can be an efficient screening device to remove projects with very long lives
Disadvantages of payback method
Equal weights to all payments before cut off
No account taken of cash flows after cut off
Hence it tends to accept too many short lived projects
Accounting rate of return/return on capital employed
Average annual income of project/ average annual value of investment or average profits/ average assets
Must meet or exceed the specific hurdle rate
Easy and logical to use
Ignore time value of money
Internal rate of return (IRR)
The rate of return which makes NPV=0
Accept project if IRR>OCC
If projects mutually exclusive, select project with highest IRR
Future value=present value(1+r)^t
R=(future value/present value)^1/t -1
NPV vs IRR
Both allow for time value of money
NPV measures in units of change in wealth whereas IRR is unit free
Problems with using IRR
Cash outflows versus inflows
Multiple IRRs
IRR tends to overstate the benefits of a project since it assumes that all cash flows from interim payments can be invested at the IRR
Equities
Claim that entitles the holder to a share of firm’s profits
- ownership claim and voting rights
- high returns
- high risk
- residual claim in case of bankruptcy (last to receive any pay off)
Valuing shares
Firms balance sheet-> firm value= net assets
Share price= book value/ no. of shares
Problems; intangible assets e.g. goodwill, backward looking but investors buy stocks for future returns
When is it best to use accounting based valuation methods?
When firms;
- are in financial distress
-have no current earnings
- do not pay dividends
- are first quoted
-derive most of their values directly from their assets
Dividend valuation model
Method of calculating cost of equity
P0= current price
P1= end of period price
DIV1 = dividend payment during the period
Expected return=E(DIV1+P1-P0/P0)
Rearrange P0=E(DIV1)/(1+r) + E(P1)/(1+r) this is the fair price to pay for a share today
Problems with DDM
Assumes the market determined discount rate is constant for all future periods
The concept isn’t operational as it stands because we have expected dividends
The model based on growth rates is very sensitive indeed to the choice of g and the model will not work at all if g>r
Price earning (P/E) ratio
Often used qualitatively as a method of assessing stocks compared with a typical value for the industry
P/E= price per share/ earnings per share= market capitalisation/ total earnings
P/E ratios are higher for firms that have strong growth prospects, are well run and are less risky
Equation for P0
P0= D0(1+g)/(r-g)
D0= current period dividend per share
G= growth rate of dividend payments
Problems with P/E ratios as a value measure
The denominator is an accounting value, so firms engage in earnings management
Other valuation ratios
MTB- market to book
PCF- price to cash flow
PSR- price to sales ratio
