Investments and Valuation: cram pack

Formula sheets, the key method steps for every topic and 8 practice problems, with full solutions at the back.

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1Formulas and methods

Time value of money

Future value: FV = PV·(1 + i)ⁿ
Present value: PV = FV/(1 + i)ⁿ
Several periods per year: i = r/m, N = m·n
Annuity, present value: PV = PMT·[1 − (1 + i)⁻ⁿ]/i
Annuity, future value: FV = PMT·[(1 + i)ⁿ − 1]/i

Method

Draw a timeline with every cash flow and its timing.
Match the rate to the period: a monthly rate for monthly payments.
Use FV = PV·(1 + i)ⁿ for single amounts and the annuity formulas for equal payments.
Check the sign and the order of magnitude of the answer.

Bond pricing & yield

Bond price: P = C·(1 − (1 + y)⁻ⁿ)/y + F/(1 + y)ⁿ
Semi-annual: C/2, y/2 and 2n periods
Current yield: C/P
Price and yield: yield up → price down

Method

Find the coupon per period and the yield per period.
Price = present value of the coupons (an annuity) + present value of the face value.
For semi-annual coupons use half the coupon, half the yield and twice the periods.
Check: if the yield is above the coupon rate, the price is below face value.

CAPM & WACC

CAPM: r_e = r_f + β·(r_m − r_f)
WACC: E/V·r_e + D/V·r_d·(1 − T)
Firm value: V = E + D

NPV & IRR

Net present value: NPV = −C₀ + Σ CF_t/(1 + r)^t
Equal cash flows: NPV = −C₀ + CF·[1 − (1 + r)⁻ⁿ]/r
Internal rate of return: the r at which NPV = 0
Decision: accept when NPV > 0 (or IRR > required return)

Method

List all cash flows with their year; the investment at year 0 is negative.
Discount each cash flow: CF_t/(1 + r)^t.
Add them up to get the NPV. Positive means the project earns more than r.
For the IRR, find the rate that makes NPV zero by trial or interpolation.

2Practice problems

1.Time value of moneyMedium

A credit card charges a nominal interest rate of 17.5% per year, compounded daily. Find the effective annual rate EAR in percent.

r = 17.5%m = 365

EAR = %

2.Time value of moneyHard

A loan of €200 000 is repaid with equal monthly payments over 25 years. The interest rate is 2.4% per year, compounded monthly. Find the monthly payment A.

P = €200 0002.4% / 12N = 300

A = €

3.Bond pricing & yieldMedium

You buy a bond with 5 years to maturity (face value €1 000, annual coupon 2%) when its yield to maturity is 5.5%. One year later, just after receiving the first coupon, you sell it when the yield to maturity is 4.5%. Find your holding period return HPR in percent.

F = €1 000coupon = 2%n = 5y₀ = 5.5%y₁ = 4.5%

HPR = %

4.Bond pricing & yieldHard

A bond with a face value of €1 000 pays a 5% annual coupon in two half-yearly payments and matures in 11 years. It sells for €1 186. Find its yield to maturity YTM as an annual rate (twice the half-yearly yield), in percent.

F = €1 000coupon = 5% (2×)n = 11P = €1 186

YTM = %

5.CAPM & WACCMedium

A company is financed with ordinary shares worth €8 000 000, preferred shares worth €1 000 000 and debt worth €4 000 000. The cost of equity is 11%, the cost of preferred stock 7% and the pre-tax cost of debt 6%. The tax rate is 30%. Find the WACC.

E = €8 000 000P_s = €1 000 000D = €4 000 000r_e = 11%r_p = 7%r_d = 6%T = 30%

WACC = %

6.CAPM & WACCHard

A company has 4 000 000 shares at €19.50 each and 10 000 bonds trading at €1 020 each. The pre-tax cost of debt is 3% and the tax rate is 25.8%. The share’s beta is 0.6, the risk-free rate 3% and the market return 9%. Find the WACC.

β = 0.6r_f = 3%r_m = 9%r_d = 3%T = 25.8%

WACC = %

7.NPV & IRRMedium

An investment of €60 000 gives these cash flows at the end of years 1 to 4: €27 000, €12 000, €16 000, €23 000. The cost of capital is 5%. Find the net present value NPV.

r = 5%CF₀ = −60 000CF₁ = 27 000CF₂ = 12 000CF₃ = 16 000CF₄ = 23 000

NPV = €

8.NPV & IRRHard

A project costs €40 000 and returns €26 000, €17 500, €27 000 at the end of years 1 to 3. Find its internal rate of return IRR in percent.

CF₀ = −40 000CF₁ = 26 000CF₂ = 17 500CF₃ = 27 000

IRR = %

3Solutions

1.Time value of money

Answer: EAR = 19.12 %

Time value of money: money today is worth more than the same amount later, because it can earn interest. With interest rate i per period, an amount grows as FV = PV·(1 + i)ⁿ. A series of equal payments (an annuity) is valued by adding up each payment, which gives the annuity formulas.

Rate per period

r/m = 0.175/365 = 0.0004795

Compound over one year

EAR = (1 + 0.0004795)³⁶⁵ − 1 = 1.191 − 1 = 19.12%

Answer

EAR = 19.12%

The EAR is always above the nominal rate when interest compounds more than once a year.

2.Time value of money

Answer: A = 887.2 €

Monthly rate and number of payments

i = 0.024/12 = 0.002

N = 12·25 = 300

Payment

The present value of N equal payments A is A·(1 − (1 + i)⁻ᴺ)/i. Set it equal to the loan and solve for A.

(1 + i)^−N = 0.5491

A = 200 000·0.002/(1 − 0.5491) = €887.19

Answer

A = €887.19

3.Bond pricing & yield

Answer: HPR = 9.379 %

Bond pricing: a bond’s price is the present value of its cash flows, discounted at the yield to maturity (YTM): the coupons form an annuity and the face value is paid back at maturity. P = C·(1 − (1 + y)⁻ⁿ)/y + F/(1 + y)ⁿ. When the yield is above the coupon rate the bond trades below face value, and the other way round.

Purchase price

C = €20.00, i = 0.055, N = 5

€20.00·(1 − 0.7651)/0.055 + €1 000·0.7651 = €85.41 + €765.13 = €850.54

Selling price

C = €20.00, i = 0.045, N = 4

€20.00·(1 − 0.8386)/0.045 + €1 000·0.8386 = €71.75 + €838.56 = €910.31

Holding period return

HPR = (20 + 910.31 − 850.54)/850.54 = 9.379%

Answer

HPR = 9.379%

4.Bond pricing & yield

Answer: YTM = 3.002 %

Per period

C = €25.00, N = 22

Solve numerically

i = 1.501% per half-year

YTM

YTM = 2·1.501% = 3.002%

Answer

YTM = 3.002%

5.CAPM & WACC

Answer: WACC = 8.6 %

Cost of capital: CAPM gives the return shareholders require: r_e = r_f + β·(r_m − r_f). The weighted average cost of capital mixes equity and debt by their market values: WACC = E/V·r_e + D/V·r_d·(1 − T), with V = E + D. Interest is tax-deductible, hence the (1 − T).

Weights

V = 8 000 000 + 1 000 000 + 4 000 000 = €13 000 000

E/V = 0.6154, P_s/V = 0.07692, D/V = 0.3077

WACC

WACC = 0.6154·11% + 0.07692·7% + 0.3077·6%·(1 − 0.3) = 8.6%

Answer

WACC = 8.6%

6.CAPM & WACC

Answer: WACC = 6.094 %

Market values

E = 4 000 000·€19.50 = €78 000 000

D = 10 000·€1 020 = €10 200 000

Cost of equity (CAPM)

r_e = 3% + 0.6·6% = 6.6%

Weights

V = €88 200 000, E/V = 0.8844, D/V = 0.1156

WACC

WACC = 0.8844·6.6% + 0.1156·3%·(1 − 0.258) = 6.094%

Answer

WACC = 6.094%

7.NPV & IRR

Answer: NPV = 9342 €

Net present value: discount every cash flow back to today with the required rate of return r, then add them up: NPV = Σ CFₜ/(1 + r)ᵗ. A project with NPV > 0 earns more than r and adds value. The internal rate of return (IRR) is the rate at which NPV = 0.

Present value of each cash flow

CF₀ = −60 000

CF₁/(1 + 0.05)¹ = 27 000/1.05 = 25 714.29

CF₂/(1 + 0.05)² = 12 000/1.103 = 10 884.35

CF₃/(1 + 0.05)³ = 16 000/1.158 = 13 821.40

CF₄/(1 + 0.05)⁴ = 23 000/1.216 = 18 922.16

Add them up

NPV = €9 342.20

Answer

NPV = €9 342.20

NPV is positive, so the project earns more than the required return.

8.NPV & IRR

Answer: IRR = 34.69 %

Bracket the IRR

NPV falls as the rate rises, so the IRR lies between a rate with positive NPV and one with negative NPV.

NPV(30%) = 2 644.52

NPV(35%) = −164.61

Narrow down

Linear interpolation gives a first estimate; repeating it (or a calculator's IRR function) gives the exact rate.

IRR ≈ 30 + 5·2 644.52/(2 644.52 − (−164.61)) = 34.71%

exact: NPV(34.69%) = 0 → IRR = 34.69%

Answer

IRR = 34.69%

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