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 invest €5 000 at a nominal rate of 6% per year, compounded quarterly. Find the value FV of the investment after 10 years.

PV = €5 0006% / 4n = 10

FV = €

2.Time value of moneyHard

A mortgage of €250 000 is repaid with equal monthly payments over 20 years at 2.4% per year, compounded monthly. How much is still owed just after the payment at the end of year 11? Find the outstanding balance B.

P = €250 0002.4% / 12N = 240k = 132

B = €

3.Bond pricing & yieldMedium

A bond with a face value of €1 000 pays a 2% annual coupon in two half-yearly payments and matures in 12 years. The yield to maturity is 6% per year. Find the price P of the bond.

F = €1 000coupon = 2%YTM = 6%n = 12

P = €

4.Bond pricing & yieldHard

A bond with a face value of €1 000 and an annual coupon of 5% matures in 9 years and sells for €1 115. Find its yield to maturity YTM in percent.

F = €1 000coupon = 5%n = 9P = €1 115

YTM = %

5.CAPM & WACCMedium

A company has equity worth €12 000 000 and debt worth €6 000 000. Its cost of equity is 9%, its pre-tax cost of debt is 5% and the tax rate is 20%. Find the WACC.

E = €12 000 000D = €6 000 000r_e = 9%r_d = 5%T = 20%

WACC = %

6.CAPM & WACCHard

A company has equity with a market value of €6 000 000 and a cost of equity of 13%. Its debt consists of 5 000 bonds (face value €1 000, annual coupon 7%, 5 years to maturity) that trade at €980 each. The tax rate is 20%. Find the WACC, using the yield to maturity of the bonds as the pre-tax cost of debt.

E = €6 000 000r_e = 13%bonds: 5 000 × €980coupon = 7%n = 5T = 20%

WACC = %

7.NPV & IRRMedium

A machine costs €50 000 today. It generates €8 000 at the end of each year for 7 years and can then be sold for €12 500. The cost of capital is 12%. Find the net present value NPV.

C₀ = €50 000CF = €8 000S = €12 500n = 7r = 12%

NPV = €

8.NPV & IRRHard

A project costs €40 000 and returns €14 500, €26 000, €19 500 at the end of years 1 to 3. Find its internal rate of return IRR in percent.

CF₀ = −40 000CF₁ = 14 500CF₂ = 26 000CF₃ = 19 500

IRR = %

3Solutions

1.Time value of money

Answer: FV = 9070 €

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 = r/m = 0.06/4 = 0.015

N = m·n = 4·10 = 40

Future value

FV = 5 000·(1 + 0.015)⁴⁰ = 5 000·1.814 = €9 070.09

Answer

FV = €9 070.09

2.Time value of money

Answer: B = 127383 €

Monthly payment

i = 0.002, N = 240

A = 250 000·0.002/(1 − (1 + 0.002)⁻²⁴⁰) = €1 312.61

Present value of the remaining payments

Whatever is still owed must be exactly paid off by the remaining payments.

N − k = 240 − 132 = 108

B = 1313·(1 − (1 + 0.002)⁻¹⁰⁸)/0.002 = €127 382.99

Answer

B = €127 382.99

3.Bond pricing & yield

Answer: P = 661.3 €

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.

Per period

C = €10.00, i = 0.03, N = 24

Present value of the coupons

€10.00·(1 − 0.4919)/0.03 = €169.36

Present value of the face value

€1 000·0.4919 = €491.93

Price

P = €661.29

Answer

P = €661.29

The yield is above the coupon rate, so the bond sells at a discount.

4.Bond pricing & yield

Answer: YTM = 3.489 %

Equation for the yield

€1 115 = €50·(1 − (1 + y)⁻⁹)/y + €1 000/(1 + y)⁹

Solve numerically

P(3%) = €1 155.72, P(4%) = €1 074.35

YTM = 3.489%

Answer

YTM = 3.489%

5.CAPM & WACC

Answer: WACC = 7.333 %

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 = €18 000 000, E/V = 0.6667, D/V = 0.3333

WACC

WACC = 0.6667·9% + 0.3333·5%·(1 − 0.2) = 7.333%

Answer

WACC = 7.333%

6.CAPM & WACC

Answer: WACC = 9.851 %

Cost of debt (YTM)

980 = 70·(1 − (1 + y)⁻⁵)/y + 1000/(1 + y)⁵

y = 7.494%

Market values

D = 5 000·€980 = €4 900 000

V = €10 900 000, E/V = 0.5505, D/V = 0.4495

WACC

WACC = 0.5505·13% + 0.4495·7.494%·(1 − 0.2) = 9.851%

Answer

WACC = 9.851%

7.NPV & IRR

Answer: NPV = −7836 €

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 the yearly cash flows

8 000·4.564 = 36 510.05

Present value of the salvage value

12 500/2.211 = 5 654.37

NPV

NPV = −50 000 + 36 510.05 + 5 654.37 = −€7 835.58

Answer

NPV = −€7 835.58

8.NPV & IRR

Answer: IRR = 22.14 %

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(20%) = 1 423.61

NPV(25%) = −1 776.00

Narrow down

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

IRR ≈ 20 + 5·1 423.61/(1 423.61 − (−1 776.00)) = 22.22%

exact: NPV(22.14%) = 0 → IRR = 22.14%

Answer

IRR = 22.14%

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