Finance for managers


Chapter 7- Net Present Value and Other Investment

Question 1 : List the methods that a firm can use to evaluate a potential investment.

There are discounted and non-discounted cash-flow capital budgeting criteria to evaluate proposed investments. They are

1) Net present value: NPV is a discounted cash flow technique, which is the difference between an investment's market value and its cost.

NPV = Present value of cash inflow- Present value of cash outflow

The investment should be accepted if the net present value is positive and rejected if it is negative.

2) Profitability index: PI is a discounted cash flow technique in which present value of an investment's future cash inflows divided by its initial cash outflow. It is also called benefit/cost ratio.

PI = PV of cash inflows / PV of cash outflows

If PI is positive, it will be accepted otherwise reject.

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3) Internal rate of return: IRR is the discount rate that equates the present values of cash inflows with the initial investment associated with the project thereby causing NPV = 0

If IRR ≥ required rate of return the project is accepted. If IRR < required rate of return the project is rejected.

4) Payback period: Payback period is the exact amount of time required for a firm to recover its initial investment in a project as calculated from inflows. It is a non-discounted cash-flow technique.

5) Discounted payback period: The time required for the discounted future cash flow at the firm's required rate of return of a project to recoup the initial outlay is called discounted payback period. An investment is accepted if its discounted payback period is less than prescribed number of years.

6) Accounting rate of return: ARR is a non-discounted cash flow method in which accounting information's are used rather than cash flows.

ARR= (Average annual profit after tax/Average investment over the life of the project) * 100.

Question 2 : Why is the NPV a preferred method when evaluating a potential investment opportunity?

NPV is the process of valuing an investment by discounting its future cash flows minus the initial outlay. The investment should be accepted if the net present value is positive and rejected if it is negative.

Most of the companies use both NPV and IRR technique because the theoretical and practical strengths of the approach differ. On a purely theoretical basis, NPV is the better approach to capital budgeting as a result of several factors. Most important is that the use of NPV implicitly assumes that any intermediate cash inflows generated by an investment are reinvested at the firm's cost of capital. The cost of capital tends to be a reasonable estimate of the rate at which the firm could actually reinvest intermediate cash inflows, the use of NPV, with its more conservative and realistic reinvestment rate is in theory preferable. Use of NPV is not a time consuming because it enhances theoretical superiority.

Question 3 : What is the IRR? How is it related to the NPV? Is the IRR always an effective method when evaluating a potential investment opportunity, and why?

IRR is the discount rate that equates the present values of cash inflows with the initial investment associated with the project thereby causing NPV = 0. If IRR ≥ required rate of return the project is accepted. If IRR < required rate of return the project is rejected. For finding out the IRR, we set NPV equal to zero and solve to find out the discount rate. This discount rate is compared with required rate to find out whether the project to accept or reject. So NPV rule and IRR rule leads to same accept or reject decision.

IRR is always an effective method when evaluating a potential investment opportunity because it helps to calculate the returns on more complicated investments. IRR also have practical advantage because we can still estimate IRR, if we do not know the appropriate discount rate. It is also easy to understand and communicate. IRR is most common method because financial analysts prefer talking about rates of return rather than dollar value.

Question 4 : Using the article from the Sydney Morning Herald, discuss why John Whiteman, the senior portfolio manager at AMP Henderson, can be considered 'skilled' in respect of his stock pickings. Why would it benefit fund managers to use discounted cash flows when picking stocks?

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According to the article of Sydney morning herald, Mr. Whiteman the senior portfolio manager is considered 'skilled' because he used to achieve the targets of his designed portfolio, in which most of his assumptions were write. Mr. Whiteman used to forecast for at least 10 years in which becomes less accurate. After plotting, he discounts the value back to today's dollars in converting the future value into the present value. This in turn benefits the financial managers in knowing the value of the share today and can be easily know the price of the share is over or undervalued in the market today. If the shares are undervalued he can easily make his suggestion or a proposal in the purchase of the shares or vice versa. Mr. Whiteman's analysis also depends on the credibility of the industry focusing mainly on the different aspects of the company.

Question 5 : A firm that pays out 65% of its earnings as dividends has an accounting rate of return of 20%. Its P/E ratio is 10 and its earnings per share are 108 cents.

(i) What is the price per share?

Price per share (P0) = PE ratio* Earnings per share

P/E ratio= 10

EPS= $1.08

P0= 10*1.08 = $10.8

(ii) What is the dividend yield?

Dividend yield= D1/P0

D1= 1.08*65/100= .702

P0= 10.8

Dividend yield= .702/10.8= 0.065

(iii) If shares were bought, what would be the payback period? Assume the only return is the dividend.

Payback period= Price of share / cash inflow

Price of share= 10.8

Cash inflow (dividend) = .702

Payback period= 10.8/.702= 15.3 years

(iv) What is the net book value per share of the asset investment of the company?

ARR= Average net profit / Average book value

ARR= 20%

Average net profit= 1.08

Average book value= 1.08 / .20= 5.4

(v) If the risk-adjusted required rate of return is 6%, what would be the NPV per share for buying shares?

NPV= Present Value of Cash inflow- initial Cost

Present value=.702/.06= 11.7

Initial Cost= 10.8

NPV= 11.7- 10.8 = 0.9

(vi) Would you buy shares using AROR or NPV?

I think for buying shares NPV is the best method because it calculate the future value into present value and can see that the investment proposal is profitable or not. We can compare the cash inflow and the cost of investment which can satisfy the investors.

Chapter 11-Return, Risk and the Security Market Line

Question 1 : Discuss how risk is associated with the variances on an asset's expected return. What are some of the factors that come into play with respect to changes in the price of a particular security in the market?

Risk is the potential variability in future cash flows of an asset. Investment in an asset depends on risk of the asset and expected returns from the asset. There is greater uncertainty with the return from an asset if the Investing asset is more risky. The return from an investment is directly related to the risk factor of the asset. The expected return of an asset will be higher if the asset is risky. The factors that affect the price of a security in the market are

  1. Demand and supply of the security
  2. Performance of the company
  3. Economic factors

Question 2 : What is risk with respect to investment? Identify the two types of risk and discuss each one. Which is the most important type of risk? Why can only one type of risk be mitigated or eliminated?

Risk is the potential variability in future cash flow of an investment. It is defined as the variability of anticipated returns as measured by the standard deviation. As the standard deviation goes higher, higher will be the risk. The two types of risk are

1) Systematic Risk: It is also called unavoidable and non diversifiable risk. Systematic risk is attributable to market factors that affect all firms; it cannot be eliminated through diversification. Factors such as war, inflation, international incidents, and political events accounts for non diversifiable risk.

2) Unsystematic Risk: It is also called avoidable and diversifiable risk. Unsystematic risk represents the portion of an asset's risk that is associated with random causes that can be eliminated through diversification. It is attributable to firm-specific events, such as strikes, lawsuits, regulatory actions, and loss of a key account.

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Most important risk is systematic risk because any investor can create a portfolio of assets that will eliminate virtually all diversifiable risk; the only relevant risk is non-diversifiable risk. The measurement of non-diversifiable risk is thus of primary importance in selecting assets with the most desired risk-return characteristics. As some risk affects almost all assets to some degree we cannot eliminate all the risks. As a result, no matter how many assets we put into a portfolio, the systematic risk does not go away.

Question 3 : What is beta? How does beta relate to systematic risk?

The beta coefficient is a relative measure of non-diversifiable risk. It is an index of the degree of movement of an asset's return in response to a change in the market return. An asset's historical returns are used in finding the asset's beta coefficient. The market return is the return on the market portfolio of all traded securities.

Beta and systematic risk is directly related, as the value of beta is higher systematic risk also increases, if the value of beta is smaller, the risk associated with that asset is smaller.

Question 4 : What is the SML? What is the CAPM, and how does the SML relate to the beta coefficient?

SML is one of the most important concepts in modern finance. When the capital asset pricing model is depicted graphically, it is called the security market line. The SML will be a straight line. It reflects the required return in the market place for each level of non diversifiable risk. In the graph, risk as measured by beta is plotted on x axis and required return are plotted on y axis. The risk-return tradeoff is clearly represented by the SML.

The basic theory that links risk and return for all assets is the capital asset pricing model. We can use CAPM to understand the basic risk-return tradeoffs involved in all types of financial decisions. A CAPM show is that the expected return for a particular asset depends on three things:

  1. Time value of money
  2. Reward for bearing systematic risk
  3. Amount of systematic risk

The relationship between beta and expected return will make the graph of SML, so the value of beta will decide the slope of the SML. If the value of beta increases, slope of the beta shows an upward shift and vice versa.

Question 5 : Using the article from The Sydney Morning Herald, discuss how diversification is used to bring about a positive outcome for retail investors. Why do investment portfolios with different asset classes need to be continually monitored? What are some alternative asset classes that investors can diversify into?

Diversification works more effectively if assets movements in the portfolio are not correlated to each other more it is negatively correlated more it is better as it reduces the risk associated with the portfolio. When u spread your investment among different asset classes which are negatively correlated more will be the better of the overall portfolio return.

According to Bewley, today's market there has been a development of correlation between various assets it may be due to globalization, or capital flows due to which the asset term to be positively correlated in which there is a less diversification which leads to risk. So in order to reduce risk the assets have to be measured more frequently and over what period. If the timing gap is too big and the correlation is evolving then it would be very hard to make changes. But if you are continuously monitoring the correlations your asset allocation can be more appropriate.

Retailers investors are venturing from traditional mix of shares into different alternative investments like:-

  1. Listed investment companies
  2. Capital guaranteed products
  3. Infrastructure funds
  4. Private equity funds.

Question 6 :

Assume that you have the betas of all the companies listed on the ASX. Now you select 20 shares based on their betas and, by investing an equal amount in each share, you create a portfolio with a beta of 1.1. You make sure you select shares with betas ranging in value from 0.4 to 2.4.

i. Is this likely to be an efficient portfolio?

The portfolio with 1.1 is considered as an efficient portfolio because the beta 1 is considered as the standard portfolio. As this portfolio contains higher and lower value of beta's it will diversify the fund into high risk as well as into low risk securities.

ii. Is the portfolio likely to be well diversified?

This portfolio can be diversified because it consist of high and low values of beta which means low and high risk securities are there in the portfolio. It is better to select shares from every sector and invest it in globally.

iii. Is the portfolio likely to have much non-systematic risk?

Non-systematic risk involved in this portfolio is very less because the total risk is diversified into 20 shares. As the portfolio consist of higher and lower values of beta, non systematic risk associated with the portfolio will be reduced.

Question 7 :

Now your selection is based upon putting the company names into a hat and withdrawing 20. Revisit Question 6 with relation to this portfolio

In my portfolio the beta ranges from 0.6 to 2.5 and I got my average beta as 1.3 and a total of 27.9 of these 20 companies. This portfolio is considered as efficient because I got my average beta as 1.3, beta 1.0 is considered as idle. As 20 companies selected is from different sectors we can diversify the portfolio and reduce the risk. As wide range of beta is selected this reduce the non systematic risk and can diversify the fund.

Chapter 17-Cost of Capital

Question 1

What is the weighted average cost of capital (WACC), and why is it of such importance to a firm?

Weighted average cost of capital is the expected average future cost of funds over the long run. It is found by weighting the cost of each specific type of capital by its proportion in the firm's capital structure. WACC can be calculated by multiplying the specific cost of each form of financing by its proportion in the firm's capital structure and sum the weighted values.

WACC has its own importance because it determines the return a project must earn to cover the cost of the funds used in the investment. Generally, a firm will accept a project that produces a return greater than the cost of capital. The most important measure for a firm is the adjusted WACC as this gives a true costing of capital funds. It is the overall return that the firm must earn on its existing assets to maintain the value of its shares through WACC.

Question 2

How is the cost of equity determined? Discuss the methods that can be used.

The cost of equity is the return required on the stock by investors in the market place. There are two forms of common stock financing: (1) retained earnings and (2) new issue of common stock. As a first step in finding each of these costs, we must estimate the cost of common stock equity. The cost of common stock equity is the rate at which investors discount the expected dividends of the firms to determine its share value. Two techniques are used to measure the cost of common stock equity.

1) Constant growth valuation model: The value of a share of stock to be equal to the present value of all future dividends, which in one model were assumed to grow at a constant annual rate over an infinite time horizon

2) Capital asset pricing model: The CAPM describes the relationship between the required return and the non-diversifiable risk of the firm as measured by the beta coefficient. Using CAPM indicates that the cost of common stock equity is the return required by investors as compensation for the firm's non diversifiable risk, measured by beta.

Question 3

How is the cost of debt determined?

The cost of debt is the return that the firm's creditors demand on new borrowing. We can determine the beta for the firm's debt and then use the SML to estimate the required return on debt. Firm's cost of debt can normally be observed either directly or indirectly, because the cost of debt is simply the interest rate the firm must pay on new borrowing, and we can observe interest rate in the financial markets. We can also use how firm's debts were rated then we could simply find out what the cost on newly issued debts.

Question 4

What is the difference between unadjusted WACC and adjusted WACC? Which measure is more accurate?

Unadjusted WACC only consider weighted average cost of debt and equity. It does not consider tax into account while estimating the cost of capital. If we are determining the discount rate appropriate to cash flows, then the discount rate also needs to be expressed on an after-tax basis. So the adjusted WACC is more accurate because it takes tax into consideration and gives true cost of capital.

Question 5

Using the article from Australian Banking and Finance, discuss how the Bank of Queensland has changed its financing strategies based on the capital costs of such financing.

I think bank of Queensland cannot reduce the cost of capital as the strategy followed by them is not efficient. Despite that high yield the income securities were said to be different as they used to underperform as interest rates and premiums demanded soared and didn't have liquidity. Then there was a strong move from the bank which started issuing Re-set preference share in which could be re-set every 5 years or convert to ordinary BOQ shares which was not possible with income securities. There was also a strategic alliances in traditional banking and e-commerce aimed at boosting its shares from 6 % to 15- 20 % in a short span of five years.

Question 6

Discuss why establishing the cost of capital is important when considering a firm's profitability.

A firm's cost of capital is the rate that must be earned in order to satisfy the firm's investors for a given level of risk. It can also be thought of as the rate of return required by the market suppliers of capital to attract their funds to the firm. The cost of capital is an extremely important financial concept because it acts as a major link between the firm's long term investment decision and the wealth of the owners as determined by investors in the market place. If the cost of capital is determined, it helps the firm to diversify the fund into equity and debt that can generate the return as required by the investors. So if firm borrows the money as debt it should pay interest or otherwise it should pay dividend if it borrows the money as equity. So the cost of capital must be ascertained for paying off such dividend and interest.

Question 7

We know the formula and the variables used in calculating WACC, so what are some of the practical problems in deriving the correct measure?

WACC has some practical problems with calculation of both cost of equity and debt capital. It can be calculated by multiplying the specific cost of each form of financing by its proportion in the firm's capital structure and sum the weighted values. In constant growth valuation model value of a share of stock to be equal to the present value of all future dividends, which in one model were assumed to grow at a constant annual rate over an infinite time horizon. As CAPM is a single period model and using it to generate a multi period NPV analysis may not be sensible. The dividend growth model also suffers from the impact of tax on dividends. Tax calculation is very difficult to estimate which will affect the calculation of debt.

References :

1. Gitman. L. J (2008), 'Managerial Finance', (1st E)Dorling Kindersley Pvt. Ltd. licensees of Pearson Education, South Asia

2. Hutchinson. P, Alison. S, Gregory. W, Lumby. S (1994), 'Financial Management Decisions', (1st E) Thomas Nelson Victoria, Australia.

3. Petty. J. W, Keown. A, Scott .D, Martin. J (2009), 'Financial Management', (1st E) Pearson Education, NSW 2086 Australia.

4. Ross. S, Thompson. S, Christensen. M, Westerfield. W, Jordan.B (2009), 'Fundamentals of Corporate Finance' (4th E) McGraw-Hill, North Ryde NSW 2113, Australia.

5. Ross. S, Trayler. R, Bird. R, Westerfield. R, Jordan. B (2008), 'Essentials of Corporate Finance', (1st E) McGraw-Hill, North Ryde NSW 2113, Australia.

6. William Petty. J, Peacock. R, Martin. P, Burrow. M,. Keown. J, Scott. D, Martin. J (2000), 'Financial Management', (3rd E) Pearson Education Australia.