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

An annuity pays €5 000 at the end of each year for 4 years. The interest rate is 6% per year. Find the present value PV of the annuity.

A = €5 000i = 6%n = 4

PV = €

2.Time value of moneyHard

A loan of €150 000 is repaid with equal monthly payments over 30 years. The interest rate is 6% per year, compounded monthly. Find the monthly payment A.

P = €150 0006% / 12N = 360

A = €

3.Bond pricing & yieldMedium

A bond with a face value of €1 000 pays an annual coupon of 5% and matures in 5 years. Its yield to maturity changes from 4% to 2%. By how much ΔP does the bond price change?

F = €1 000coupon = 5%n = 5y₁ = 4%y₂ = 2%

ΔP = €

4.Bond pricing & yieldHard

A bond with a face value of €1 000 and an annual coupon of 7% matures in 3 years and sells for €1 025. Find its yield to maturity YTM in percent.

F = €1 000coupon = 7%n = 3P = €1 025

YTM = %

5.CAPM & WACCMedium

A company is financed with ordinary shares worth €4 000 000, preferred shares worth €1 000 000 and debt worth €5 000 000. The cost of equity is 13%, the cost of preferred stock 6% and the pre-tax cost of debt 5%. The tax rate is 21%. Find the WACC.

E = €4 000 000P_s = €1 000 000D = €5 000 000r_e = 13%r_p = 6%r_d = 5%T = 21%

WACC = %

6.CAPM & WACCHard

A company's shares have a beta of 1.5 at its current debt-to-equity ratio of 0.25. It plans to raise its debt-to-equity ratio to 1.25. The tax rate is 20%, the risk-free rate 2.5% and the market risk premium 5%. Find the cost of equity r_e after the change.

β_L = 1.5D/E₁ = 0.25D/E₂ = 1.25T = 20%r_f = 2.5%r_m − r_f = 5%

r_e = %

7.NPV & IRRMedium

A project costs €500 000 today. It generates €39 000 at the end of the first year, and the cash flow then grows by 3% per year forever. The cost of capital is 9%. Find the net present value NPV.

C₀ = €500 000CF₁ = €39 000g = 3%r = 9%

NPV = €

8.NPV & IRRHard

A project costs €40 000 and returns €16 500, €29 500, €17 500 at the end of years 1 to 3. Find its internal rate of return IRR in percent.

CF₀ = −40 000CF₁ = 16 500CF₂ = 29 500CF₃ = 17 500

IRR = %

3Solutions

1.Time value of money

Answer: PV = 17326 €

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.

Annuity factor

(1 − (1 + i)⁻ⁿ)/i = (1 − 0.7921)/0.06 = 3.465

Present value

PV = 5 000·3.465 = €17 325.53

Answer

PV = €17 325.53

2.Time value of money

Answer: A = 899.3 €

Monthly rate and number of payments

i = 0.06/12 = 0.005

N = 12·30 = 360

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 = 0.166

A = 150 000·0.005/(1 − 0.166) = €899.33

Answer

A = €899.33

3.Bond pricing & yield

Answer: ΔP = 96.89 €

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.

Price at the old yield

C = €50.00, i = 0.04, N = 5

€50.00·(1 − 0.8219)/0.04 + €1 000·0.8219 = €222.59 + €821.93 = €1 044.52

Price at the new yield

C = €50.00, i = 0.02, N = 5

€50.00·(1 − 0.9057)/0.02 + €1 000·0.9057 = €235.67 + €905.73 = €1 141.40

Change

ΔP = 1 141.40 − 1 044.52 = €96.89

Answer

ΔP = €96.89

4.Bond pricing & yield

Answer: YTM = 6.064 %

Equation for the yield

€1 025 = €70·(1 − (1 + y)⁻³)/y + €1 000/(1 + y)³

Solve numerically

P(6%) = €1 026.73, P(7%) = €1 000.00

YTM = 6.064%

Answer

YTM = 6.064%

5.CAPM & WACC

Answer: WACC = 7.775 %

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 = 4 000 000 + 1 000 000 + 5 000 000 = €10 000 000

E/V = 0.4, P_s/V = 0.1, D/V = 0.5

WACC

WACC = 0.4·13% + 0.1·6% + 0.5·5%·(1 − 0.21) = 7.775%

Answer

WACC = 7.775%

6.CAPM & WACC

Answer: r_e = 15 %

Levered beta (Hamada): debt makes equity riskier. β_L = β_U·(1 + (1 − T)·D/E), where β_U is the beta of the business without debt. To move a beta to another capital structure, unlever it first and then relever it at the new D/E.

Unlever the beta

β_U = 1.5/(1 + 0.8·0.25) = 1.25

Relever at the new D/E

β_L = 1.25·(1 + 0.8·1.25) = 2.5

Cost of equity (CAPM)

r_e = 2.5% + 2.5·5% = 15%

Answer

r_e = 15%

7.NPV & IRR

Answer: NPV = 150000 €

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.

Value of the cash flows

PV = 39 000/(0.09 − 0.03) = 650 000.00

NPV

NPV = 650 000.00 − 500 000 = €150 000.00

Answer

NPV = €150 000.00

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

8.NPV & IRR

Answer: IRR = 26.71 %

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(25%) = 1 040.00

NPV(30%) = −1 886.66

Narrow down

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

IRR ≈ 25 + 5·1 040.00/(1 040.00 − (−1 886.66)) = 26.78%

exact: NPV(26.71%) = 0 → IRR = 26.71%

Answer

IRR = 26.71%

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