Finance midterm 10,11,12
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What is beta?
–Beta is slope of characteristic line
DEFINITION of 'Beta'A measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. Beta is used in the capital asset pricing model (CAPM), a model that calculates the expected return of an asset based on its beta and expected market return
- –Historical relationship between share's return and return on a market index, such as the
- S&P/TSX Composite Index
Beta > 1.0: share moves
more than the market
Beta 0 -1.0 share moves
less than the market
Beta < 0
share moves against the market
Capital budgeting involves
planning and justifying large expenditures on long-term projects (investments)
What are project cashflows?
The first step in capital budgeting is reducing projects to a series of cash flows. Business projects involve early cash outflows and later inflows.
Cost of Capital
–Average rate the firm pays its investors for use of their money
- •Can raise money from two sources: debt and equity
- •If potential project is expected to generate
- return greater than cost of money to finance it, it is a good investment
Returns on equity investments (common shares)
–Historically much higher than return on debt investments
–Much more volatile (risky) than returns on debt instruments in short-run
DEFINITION of 'Required Rate Of Return - RRR' The minimum annual percentage earned by an investment that will induce individuals or companies to put money into a particular security or project. Therequired rate of return (RRR) is used in both equity valuation and in corporate finance.
If the asset values do not move up and down in perfect synchrony, adiversified portfolio will have less risk than the weighted average risk of its constituent assets, and often less risk than the least risky of its constituents. Diversification is one of two general techniques for reducing investment risk.
Return on investment
Return on investment (ROI) is the benefit to the investor resulting from an investment of some resource. A high ROI means the investment gains compare favorably to investment cost.
Risk aversion is the reluctance of a person to accept a bargain with an uncertain payoff rather than another bargain with a more certain, but possibly lower, expected payoff.
The Mean is
the weighted average of all possible outcomes
For symmetrical probability distributions, the mean is the centre of the distribution
–Measure of variability —how far from mean a typical observation is likely to fall
In portfolio theory risk is
variability in return (measured by variance)
High-risk share has high probability of
earning return that differs significantly from expected return
Low-risk (small-variance) share more likely to earn return similar to expected return
Political news, inflation, interest rates, war, etc
earnings, reports, unexpected death of key executive, labour disputes, shortage of raw material
Capital Asset Pricing Model (CAPM) helps determine
how share prices are set in the market.
–People won't invest unless share's expected return is at least equal to their required return
–The CAPM attempts to explain how investors' required returns are determined
–Share value (price) can be estimated based on its required return
DEFINITION of 'Risk-Free Rate Of Return'The theoretical rate of return of an investment with zero risk. The risk-free rate represents the interest an investor would expect from an absolutely risk-free investment over a specified period of time.
Required rate of return
is risk-free rate plus risk premium
The security market line
DEFINITION of 'Security Market Line - SML'A line that graphs the systematic, or market, risk versus return of the whole market at a certain time and shows all risky marketable securities.
how many years to recover project’s initial cost
Net Present Value (NPV)
how much present value of project’s inflows exceeds present value of its outflows
DEFINITION of 'Net Present Value - NPV'The difference between the present value of cash inflows and the present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of an investment or project.
Internal Rate of Return (IRR)
return on investment in project
Internal Rate Of Return - IRRAAA | DEFINITION OF 'INTERNAL RATE OF RETURN - IRR'The discount rate often used in capital budgeting that makes the net present value of all cash flows from a particular project equal to zero. Generally speaking, the higher a project's internal rate of return, the more desirable it is to undertake the project. As such, IRR can be used to rank several prospective projects a firm is considering. Assuming all other factors are equal among the various projects, the project with the highest IRR would probably be considered the best and undertaken first.
Payback periods - are shorter paybacks better?
What is the weaknesses of the Payback Method?
–Ignores time value of money
–Ignores cash flows after payback period
Why use payback method?
–Quick and easy to apply
–Serves as rough screening device
NPV Decision Rules
- NPV> 0 = accept
- NPV < 0 = reject
IRR method assumes
cash inflows will be reinvested at project’s IRR
NPV method assumes
- cash inflows will be reinvested at project’s cost
- of capital
Do NPV and IRR always provide the same decision for a projects acceptance?
No. Occasionally they give conflicting results in mutually exclusive decisions.
Which is preferred, NPV or IRR?
- NPV method is the preferred over IRR
- method because reinvestment interest rate assumption is more practical
Cost of capital (k) plays key role
in NPV and IRR.
For NPV, k used as discount rate. A higher k leads to a lower NPV, reducing the chance of project accpetance.
For IRR, IRR is compared to k. A higher k leads to a lower chance of project acceptance.
The interest rate charged to commercial banks and other depository institutions for loans received from the Federal Reserve Bank’s discount window. The discount rate also refers to the interest rate used in discounted cash flow (DCF) analysis to determine the present value of future cash flows. The discount rate in DCF analysis takes into account not just the time value of money, but also the risk or uncertainty of future cash flows; the greater the uncertainty of future cash flows, the higher the discount rate. A third meaning of the term “discount rate” is the rate used by pension plans and insurance companies for discounting their liabilities.
- –Costs that have already occurred and
- cannot be recovered—should not be included in project’s cash flows
•Only future costs are relevant
DEFINITION of 'Sunk Cost'A cost that has already been incurred and thus cannot be recovered. A sunk cost differs from other, future costs that a business may face, such as inventory costs or R&D expenses, because it has already happened. Sunk costs are independent of any event that may occur in the future.
- - What's given up to undertake the new project?
- - Opportunity cost of resource is value in best alternative use.
- DEFINITION of 'Opportunity Cost'
- 1. The cost of an alternative that must be forgone in order to pursue a certain action. Put another way, the benefits you could have received by taking an alternative action.
- 2. The difference in return between a chosen investment and one that is necessarily passed up. Say you invest in a stock and it returns a paltry 2% over the year. In placing your money in the stock, you gave up the opportunity of another investment - say, a risk-free government bond yielding 6%. In this situation, your opportunity costs are 4% (6% - 2%).
Sales erosion (cannibalization)
- –when firm sells product that competes with
- other products within same firm (Diet
- Coke vs. Coke Zero)
Expansion projects tend to require
the same elements as new ventures, but generally have less new equipment and facility costs
Replacement projects generally
are expected to save costs without generating new revenue.
Relevant Project Cash Flows Are
- –New project often requires investment in
- working capital—inventory, for instance
- –Increasing net working capital means cash
Thoughts on Old Equipment in replacement projects?
–old equipment can be sold (thereby generating cash inflow)
Possible to assume that incremental cash flows
Therefore, they are compressed into terminal values using perpetuity formulas.
- –For instance, a repetitive cash flow starting at time 7 would be a perpetuity
- beginning at year 7
CRA requires that firms use
capital cost allowance (CCA) to calculate amortization for income tax purposes.
CCA divides capital assets into different classes (categories) and assigns CCA rate for each. Most classes call for declining balance CCA (accelerated amortization).
DEFINITION of 'Capital Cost Allowance - CCA'A yearly deduction or depreciation that can be claimed for income tax purposes on the cost of certain assets. The term capital cost allowance relates (CCA) mainly to taxation in Canada. CCA can be claimed on the assets of a business that are expected to last for several years, such as buildings, plant and equipment, or machinery, as well as on additions and improvements to such assets. CCA is generally calculated based on the declining balance method.
EFINITION of 'Amortization'
1. The paying off of debt with a fixed repayment schedule in regular installments over a period of time. Consumers are most likely to encounter amortization with a mortgage or car loan.
2. The spreading out of capital expenses for intangible assets over a specific period of time (usually over the asset's useful life) for accounting and tax purposes. Amortization is similar to depreciation, which is used for tangible assets, and to depletion, which is used with natural resources. Amortization roughly matches an asset’s expense with the revenue it generates.
CCA is calculated on the
undepreciated capital cost (UCC) of the pool of assets, rather than on individual assets
What is the CCA tax shield?
DEFINITION of 'Tax Shield'A reduction in taxable income for an individual or corporation achieved through claiming allowable deductions such as mortgage interest, medical expenses, charitable donations, amortization and depreciation. These deductions reduce taxpayers' taxable income for a given year or defer income taxes into future years.Tax shields vary from country to country, and their benefits will depend on the taxpayer's overall tax rate and cash flows for the given tax year.
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