Time Value and Investment Appraisal AND Debt and Equity

Question 1

What is simple interest

Answer 1

Interest is earned on principal only

Question 2

What is compound interest

Answer 2

Interest is earned on both principal and interest

Question 3

What is the time value of money

Answer 3

interest earned

Question 4

The cost of replacing a fleet of company trucks with more energy efficient vehicles is £1 million in 2018. The cost is estimated to rise by 8.5% in 2019. If the interest rate is 4%, what is the cost of a delay in terms of GBP in 2018?

Answer 4

2018 £1m
2019 £1m*(1+8.5%)
2018 PV of £1.085m
PV = 1.085m/1.04= £1.0433m

The cost of a delay of one year = £0.0433m

Question 5

What is the nominal interest rate NIR

Answer 5

quoted as an annual rate and interest is compounded more frequently than annually

Question 6

What is effective interest rate EIR

Answer 6

the interest rate that produces the same yield as the nominal interest rate when compounded annually

Question 7

What is the EIR formula

Answer 7

EIR = (1+ NIR/X)^X - 1

Question 8

When the EIR is used

Answer 8

S = P (1+EIR)

Question 9

What is perpetuity

Answer 9

cashflow that will occur at regular intervals forever

Question 10

What is annuity

Answer 10

constant cashflow will occur at regular intervals for a finite number of periods

Question 11

What is the NPV formula

Answer 11

PV(benefits) - PV(costs)

Cashflow/r - Costs

Question 12

what happens to NPV if the cost of capital goes up while n remains constant

Answer 12

NPV drops as R rises

Question 13

What is the IRR

Answer 13

the interest rate that sets the net present value of the cashflows to zero

Question 14

What is the IRR investment rule

Answer 14

1. Take any investments where the IRR exceeds the cost of capital
2. Turn down any investment whose IRR is less than the cost of capital

Question 15

How do you calculate IRR

Answer 15

CF/r - Costs = NPV

Calculate what r is when NPV = 0

Question 16

Whats the difference between NPV rule and IRR rule

Answer 16

NPV rule = Accept the project with a positive NPV

IRR rule = Take any investment where the IRR exceeds the cost of capital

Question 17

Which situations are there where the NPV method is preferred over IRR

Answer 17

1. Cashflows of a project are not conventional
2. There are multiple IRRs or no IRR exists
3. Mutually exclusive projects are being considered

Question 18

What should you do when the IRR rule conflicts with the NPV rule

Answer 18

Take the NPV

Question 19

What is the formula for payback period

Answer 19

Initial Investment/ Annual Cashflow

Question 20

What is a pro of the payback period

Answer 20

simple and easy to use

Question 21

What is two cons of payback period

Answer 21

1. Ignores the cashflows outside the payback period and does the consider the project as a whole
2. Ignores the time value of money

Question 22

When the bond price is greater than the face value. What do we say it trades at and when does this occur

Answer 22

Above par or at premium

Coupon rate > Yield to maturity

Question 23

When the bond price is equal to the face value. What do we say it trades at and when does this occur

Answer 23

At par

Coupon rate = yield to maturity

Question 24

When the bond price is less than face value. What do we say it trades at and when does this occur

Answer 24

below par or at a discount

Coupon rate< yield to maturity

Question 25

What is yield to maturity

Answer 25

The yield to maturity of a bond is the discount rate that sets the value of the bond equal to the current market price of the bond

Question 26

Suppose a zero-coupon bond has a face value of £100 and a maturity in 2 years with a price of £92.45. Calculate the YTM

Answer 26

(100/92.45)^1/2 - 1 = 4%

Question 27

Bond value changes over time as a result of the change in r

Answer 27

r is subject to the change of the market interest rates which are affected by economic conditions such as inflation rates

Question 28

bond value changes over time as a result of the change in n

Answer 28

n decreases as the bond gets closer to its maturity date

Question 29

What happens to C and FV when a bond is issued

Answer 29

nothing they are fixed and do NOT change during the life of the bond

Question 30

What happens to the bond value of a zero coupon bond when the YTM increases

Answer 30

as interest rate YTM rises, the bond value falls and vice versa

Question 31

what is the macaulay duration

Answer 31

the macaulay duration is the weighted average maturity (measured in years) of the cashflows of a bond

Question 32

What do one year common stock (equity with one year horizon) have in common with a 1 year coupon bond

Answer 32

1. The format of the equation is the same | 2. Both equations are the result of the application of the PV formula

Question 33

What do one year common stock (equity with one year horizon) NOT have in common with a 1 year coupon bond

Answer 33

1. Div1 and P1 are expected values (UNCERTAINTY) C and FV are both fixed when a bond is issued (CERTAINTY) 2. Re cost of equity capital represents the return expected by shareholders (HARD TO DETERMINE) YTM cost of debt capital represents risk free interest rate (government bonds EASY TO DETERMINE)

Question 34

In Dividend Discount model what is the assumption

Answer 34

If a company exists forever its terminal value disappears

Question 35

In DDM if a company exists forever its terminal value disappears, Is this reasonable

Answer 35

Yes the assumption is reasonable 1. Terminal value tends to be negligible as N, the number of years increases 2. A common practice such as going concern

Question 36

What two challenges does DDM face

Answer 36

1. Re represents the rate of return required by shareholders, which is non observable and therefore impossible to calculate with provision 2. Dividends are difficult to forecast with accuracy because dividend payout is an internal issue of the company

Question 37

How do we overcome the two challenges face by DDM

Answer 37

1. To estimate Re by CAPM | 2. To simplify the forecast by making some assumptions

Question 38

What are 2 assumptions of DDM (intro to dividend growth model)

Answer 38

1. Dividend is a Constant in perpetuity (value of company equity equals dividend divided by the cost of equity capital) 2. Dividend grow at a constant rate ( cost of equity capital is the sum of dividend yield and dividend growth rate)

Question 39

DC pay an annual dividend of 26p per share. analysts expect dividend to grow 6% per year in perpetuity. What is the value of the share if firm cost of equity capital is 10%

Answer 39

``` Div0 = 26p Div1 = 26*1.06=27.56 ``` P0 = 27.56/(0.1-0.06) = 689p