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65 Cards in this Set
- Front
- Back
- 3rd side (hint)
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What is the formula for WACC? |
WACC = Weighted cost of equity + Weighted cost of debt Interest on debt is taken from earnings before tax WACC = (E/V * Re) + [D/V * Rd * (1-T)] E = equity V = debt + equity Re = cost of equity (dividend/equity) D = debt Rd = cost of debt (interest payment on the P&L) T = tax rate (taxes/net profit) |
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Explain in words the Internal Rate of Return |
The discount rate required to get a 0 NPV from a cashflow |
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How do we calculate Internal Rate of Return? |
Calculate by "trial and error" of different discount rates in NPV calculation Solve for NPV = 0 (first cashflow must be negative, else reverse signs) |
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Explain in words how bond pricing works |
The Net Present Value of the future cashflows i.e. the Net Present Value of total coupon payments plus the Net Present Value of the redemption amount |
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What is running yield of a bond? |
Running Yield = annual coupon payments / par value |
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What is the current yield of an investment? |
Current Yield = annual interest payment / current price |
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Explain what the redemption yield of a bond is |
The IRR (single discount rate) for the bond cashflows |
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Give a formula for bond pricing using a single discount rate |
Bond price = Ct * [1-(1+r)^-t] / r + M / (1+r)^t Ct = annual coupons r = discount rate t = time (years) M = redemption value |
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How do we use spot rates in bond pricing when coupons are paid twice a year? |
Work in periods and divide the spot rate by two (t=6 months, r=spot rate/2) |
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What is yield curve and term structure? |
Term structure of interest rates:
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What determines the shape of a yield curve? |
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Why are longer term investments expected to pay higher rates? |
Longer period of uncertainty Great risk of change in inflation Greater effect of change in inflation (e.g. increase in inflation decreases value of coupons, longer period means more coupon payments affected) |
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What causes a yield curve to flatten? |
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What causes a yield curve to invert? |
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What can cause a yield curve to steepen? |
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What causes a parallel shift in a yield curve? |
The interest rate on all maturities changes by the same number of basis points |
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What are butterfly shifts? |
Positive - short and long term rates increase more than in the middle (smile) Negative - short and long term rates move down more than intermediate rates (frown) |
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What is Sharpe Ratio? (words and formula) |
Ratio indicating how well the asset compensates for volatility Sharpe Ratio = (Rp-Rf)/SD(Rp-Rf) Rp = expected rate of return Rf = risk free rate of return SD = standard deviation |
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What is a bond credit spread? |
Difference in yield between a "risk free" bond and one with the same maturity but of lesser quality The reward for holding a riskier bond |
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What's the formula for a credit spread? |
Credit spread = Bond yield - risk free bond yield |
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What are the total returns on equities made up of? |
Dividends AND Growth in capital value of the equities |
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Explain the present value of an equity? |
The IRR of the dividend payments |
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What discount rate should we use when pricing an equity (using present value)? |
R = Dividend yield + expected percentage change in capital (R = D1/P0 + g) |
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What does DDM stand for and explain what it is? |
DDM = Dividend Discount Model e.g. Gordon growth model A method for determining equity pricing |
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What is the formula for Gordon growth model? |
P0 = D1 / (R - g) P0 = price at time 0 D1 = price at time 1 R = investor return on equity (cost of equity capital) g = expected growth |
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What is "market risk"? |
The volatility of historic periodic returns of the market (eg FTSE all-share) |
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What is systemic risk? |
Market risk |
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How do we measure market risk? |
Market risk = volatility
Volatility = Standard deviation of returns (relative to risk free returns) |
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What is market risk premium? |
Market risk in excess of the risk free rate |
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What is individual risk premium? |
Risk of individual asset in excess of the risk free rate |
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What is the risk free rate? |
The rate of return on a "risk free" investment, typically a government bond |
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Explain what beta is |
The risk of an individual share compared to the market (effectively, ratio of individual volatility compared to market volatility, both in excess of the risk free volatility) |
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What determines beta? |
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What is the expected return of an asset using CAPM? |
Expected return = risk free rate + asset risk premium |
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What is the formula for asset risk premium? |
Asset risk premium = b (rm-rf) b = beta of the asset rm = return of market rf = risk free return |
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What is the security market line? |
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What is the capital market line? |
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What's the difference between security market line and capital market line? |
They are the same except: security is for a single asset capital is for the whole market (slightly different measures of risk) |
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Why would we expect longer term deposits to pay higher rates? |
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Obvious answer |
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What models to use to value projects |
NPV Payback and discounted chash== |
Can be viewed as an ordinary perpetuity |
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What is the Dividend Constant Growth Formula? |
Dt = Do x (1 + g)^t
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Compound growth formula |
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What is the Dividend Growth Model (definition) |
determines the current share price as its dividend next period divided by the discount rate less the dividend growth rate |
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What is the Dividend Growth Model Formula? |
Pt = Dt x (1 + g) = D (t+1) R - g R - g |
Remember can use either part of the formula to determine values to input into other part of the formla |
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How do you work out today's value of equity for non-constant growth |
Identify when long term/constant growth rate starts (e.g. year 3/4/5?) e.g if from yr 3: P3 = D3 x (1+g) / (R - g) to give long term growth rate. THEN, calculate the PV of all other rates (in this example, yrs 1, 2 and 3) and also the answer worked out for the constant growth Po = Div 1/ (1 +R) + Div 2 / (1 + R)^2 + Div 3 / (1 + R)^3 + Answer / (1 + R)^3 This will give you the present day value of equity. To determine share price, divide this answer by the number of shares. |
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Formula for Two Stage Growth (1/2) |
Once Po is determined, plug into the next formula |
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Formula for Two Stage Growth (2/2) |
To determine D1, increase Do by the dividend growth rate |
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Present Value Formula |
Vo = Today's value |
Discount future value by the rate |
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Future value of current amount |
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Discount cashflow model |
(multiple cashflows) Calculate the discount amount for each period individually and add together |
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Annuities |
Level stream of cashflows for a set period of time (work out PV/FV for each amount and add together) |
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Perpetuities |
Level stream of income forever |
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Net Present Value Formula |
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IRR |
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Trial and error... |
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What investment valuation models to use to value projects |
NPV Payback and discounted payback IRR |
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Strengths of NPV |
Pro:
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How to use NPV |
Accept if the NPV is positive and reject if the NPV is negative |
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Payback cons |
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Payback Pros |
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Payback Rule |
The length of time required for a projects cashflows to cover its initial cost |
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Discounted payback rule |
The length of time required for a project's discounted cashflows to cover its initial costs |
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Discounted payback advantages |
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Discounted payback cons |
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IRR Rules |
Accept projects where the IRR is greater than the discount rate Reject or short sell where IRR is less than the discount rate. |
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IRR Cons |
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IRR Cons |
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