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

You need €10 000 in 8 years. An account pays 4% per year, compounded monthly. How much must you deposit today? Find the present value PV.

FV = €10 0004% / 12n = 8

PV = €

2.Time value of moneyHard

You save €100 at the end of every month for 26 years. The account pays 4.2% per year, compounded monthly. How much have you saved at the end? Find FV.

A = €1004.2% / 12N = 312

FV = €

3.Bond pricing & yieldMedium

You buy a bond with 10 years to maturity (face value €1 000, annual coupon 8%) when its yield to maturity is 7%. One year later, just after receiving the first coupon, you sell it when the yield to maturity is 7.5%. Find your holding period return HPR in percent.

F = €1 000coupon = 8%n = 10y₀ = 7%y₁ = 7.5%

HPR = %

4.Bond pricing & yieldHard

A bond with a face value of €1 000 and an annual coupon of 8% matures in 7 years and sells for €950. Find its yield to maturity YTM in percent.

F = €1 000coupon = 8%n = 7P = €950

YTM = %

5.CAPM & WACCMedium

A share with a beta of 0.9 has a required return of 8.8%. The risk-free rate is 2.5%. What expected market return r_m does CAPM imply?

β = 0.9r_e = 8.8%r_f = 2.5%

r_m = %

6.CAPM & WACCHard

A company has 2 000 000 shares trading at €48.00; the book value of its equity is €28 800 000. It just paid a dividend of €2.30 per share, and dividends grow by 4% per year. Its debt has a market value of €76 800 000 and a pre-tax cost of 4.5%. The tax rate is 30%. Find the WACC, using the dividend growth model for the cost of equity.

N = 2 000 000P₀ = €48.00book equity = €28 800 000D₀ = €2.30g = 4%D = €76 800 000r_d = 4.5%T = 30%

WACC = %

7.NPV & IRRMedium

An investment of €60 000 gives these cash flows at the end of years 1 to 4: €27 000, €18 000, €19 000, €24 000. The cost of capital is 5%. Find the net present value NPV.

r = 5%CF₀ = −60 000CF₁ = 27 000CF₂ = 18 000CF₃ = 19 000CF₄ = 24 000

NPV = €

8.NPV & IRRHard

A project costs €20 000 and returns €13 500, €10 000 at the end of years 1 to 2. Find its internal rate of return IRR in percent.

CF₀ = −20 000CF₁ = 13 500CF₂ = 10 000

IRR = %

3Solutions

1.Time value of money

Answer: PV = 7265 €

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 and number of periods

i = 0.04/12 = 0.003333

N = 12·8 = 96

Present value

PV = FV/(1 + i)^N = 10 000/1.376 = €7 265.36

Answer

PV = €7 265.36

2.Time value of money

Answer: FV = 56416 €

Monthly rate and number of deposits

i = 0.042/12 = 0.0035

N = 12·26 = 312

Future value of the deposits

FV = A·((1 + i)^N − 1)/i = 100·(2.975 − 1)/0.0035 = €56 415.77

Answer

FV = €56 415.77

You paid in €31 200 yourself; the rest is interest.

3.Bond pricing & yield

Answer: HPR = 3.892 %

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 = €80.00, i = 0.07, N = 10

€80.00·(1 − 0.5083)/0.07 + €1 000·0.5083 = €561.89 + €508.35 = €1 070.24

Selling price

C = €80.00, i = 0.075, N = 9

€80.00·(1 − 0.5216)/0.075 + €1 000·0.5216 = €510.31 + €521.58 = €1 031.89

Holding period return

HPR = (80 + 1 031.89 − 1 070.24)/1 070.24 = 3.892%

Answer

HPR = 3.892%

4.Bond pricing & yield

Answer: YTM = 8.993 %

Equation for the yield

€950 = €80·(1 − (1 + y)⁻⁷)/y + €1 000/(1 + y)⁷

Solve numerically

P(8%) = €1 000.00, P(9%) = €949.67

YTM = 8.993%

Answer

YTM = 8.993%

5.CAPM & WACC

Answer: r_m = 9.5 %

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).

Market risk premium

r_m − r_f = (8.8% − 2.5%)/0.9 = 7%

Market return

r_m = 2.5% + 7% = 9.5%

Answer

r_m = 9.5%

6.CAPM & WACC

Answer: WACC = 6.391 %

Cost of equity

D₁ = 2.3·1.04 = €2.39

r_e = 2.392/48 + 0.04 = 8.983%

Market values

E = 2 000 000·€48.00 = €96 000 000

V = €172 800 000, E/V = 0.5556, D/V = 0.4444

WACC

WACC = 0.5556·8.983% + 0.4444·4.5%·(1 − 0.3) = 6.391%

Answer

WACC = 6.391%

7.NPV & IRR

Answer: NPV = 18199 €

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 = 18 000/1.103 = 16 326.53

CF₃/(1 + 0.05)³ = 19 000/1.158 = 16 412.91

CF₄/(1 + 0.05)⁴ = 24 000/1.216 = 19 744.86

Add them up

NPV = €18 198.59

Answer

NPV = €18 198.59

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

8.NPV & IRR

Answer: IRR = 12.1 %

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(10%) = 537.19

NPV(15%) = −699.43

Narrow down

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

IRR ≈ 10 + 5·537.19/(537.19 − (−699.43)) = 12.17%

exact: NPV(12.1%) = 0 → IRR = 12.1%

Answer

IRR = 12.1%

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