Review for the final exam - Amazon S3s3.amazonaws.com/prealliance_oneclass_sample/ZRz4GVdkZJ.pdfThe...

Review for the final exam

Helen Huang

ECON 371

Helen Huang (Fall 2009) Review for the final exam 1 / 19

Information for Final

Time and Venue:

◮ Time: 4-6:30pm Dec.19 2009

◮ Room allocation:

⋆ Section 001 (4:00pm class): PAC 4

⋆ Section 002 (5:30pm class): PAC 5

Office hours:

◮ 4-5:30pm Dec.17, 2009

◮ 4-5:30pm Dec.18, 2009


Information for Final

Format:

◮ 20 multiple choice questions

◮ 4 short-answer questions

Distribution:

◮ 30% from materials before Mid-term

◮ 70% from materials after Mid-term

Only non-programmable calculators are allowed during the final exam.In particular, financial calculators are not allowed.


Overview for Final

The final exam covers Chapters 4, 5, 6, 7, 8, 10 and 11.

Chapter 4 (the time value of money, TVM) is the most importantchapter

Chapters 5 and 6 are just applications of the TVM to price bonds andstocks, respectively

◮ The fair price of any asset/security is the present value of all the cashflows of the asset/security when discounted at an interest rateappropriate for the risk of the cash flows


Overview for Final

NPV = PV (cash flows) - investment

Typically known

1) Forecasts offuture cash flow

2) Cost of capital (i.e. discountrate) depends on the risk of theproject


Overview for Final

Chapter 7 NPV and other investment criteria

Chapter 8

◮ Which cash flows are relevant?

◮ Calculating cash flows


Overview for Final

Chapter 10 how to measure and quantify risk?

◮ Diversification eliminates unique risk, so only the market risk countsin the end

Chapter 11 the risk-return trade-off

◮ The expected rate of return on an asset/security given its market risk(β): CAPM and SML

For materials before the mid-term, see Review for Mid-Term.


Net present value (NPV)

NPV is the only reliable criterion

Alternative criteria:

◮ IRR

⋆ Compute IRR:

By graph (NPV profile)

Excel spreadsheet

◮ Payback

◮ Discounted payback

◮ Each of the above alternative criteria has its own pitfalls


Net present value (NPV)

The NPV rule can be modified to handle:

◮ The Investment timing decision

◮ Machines of different lives

⋆ the equivalent annual costs (EACs)

◮ Replacement decision

⋆ the equivalent annual costs (EACs)

Capital rationing: combine NPV with profitability index (PI)


Discounted cash flow analysis

Discount incremental cash flows:

◮ In particular, you need to be careful about:

⋆ Include both direct and indirect effects of a project

⋆ Ignore sunk costs

⋆ Include opportunity costs (i.e. alternative uses of the investment inthe project)

⋆ Include investment in working capital

⋆ Include allocated overhead costs if resulted directly from the project,ignored otherwise



Total cash flows from a project are the sum of the following 3components:

1 Cash flow from investments in plant and equipment

⋆ Most projects need initial capital investments

2 Cash flow from investment in working capital

⋆ For example: cash, accounts receivable, and inventories etc.

3 Cash flow from operations (CFO)

⋆ Three equivalent methods to compute cash flow from operations



In Canada, taxable income is based on capital cost allowance (CCA)

Taxable income = Revenues - expenses - CCA

◮ We use a declining balance method to compute CCA

◮ The CCA tax shield = CCA × tax rate

◮ Undepreciated capital cost (UCC)

◮ The half-year rule

◮ The Blooper Industries example in Section 8.4



In this course, we assume that there are always assets remaining inthe asset class even after the end of the project

◮ As a result, we have to compute the PV of CFO separately from thePV of CCA tax shield

Also be aware of the possible salvage value of the assets at the end ofthe project


Measuring risk

Measures of risk:

◮ Variance

⋆ Unit of variance?

◮ Standard deviation: square root of variance

⋆ Unit of standard deviation?

Portfolio: mean (expected) return, variance, and standard deviation


Measuring risk

Diversification reduces risk

◮ But diversification can only eliminate unique risk, but not market risk

⋆ What is unique risk?

⋆ What is market risk?

Correlation coefficient matters!

◮ How to compute covariance?

⋆ Unit of covariance?

◮ How to calculate correlation coefficient?


Beta and CAPM

Beta:

◮ Meaning?

◮ How to measure it?

◮ Beta of a portfolio

CAPM and SMLrj = rf + βj(rm − rf )

◮ Market risk premium: rm − rf

◮ Market expected return: rm

◮ The risk premium on asset j : βj(rm − rf )


Beta and CAPM

In the CAPM formula, there are in total four variables: rj , rf , βj , andrm

◮ Given any three of the above four variables, you should be able to usethe CAPM to solve for the fourth one

The SML sets a benchmark for other investments

CAPM and DDM: the link is rj

Company vs. project risk


Review Question 1

Consider the following information on two stocks and the market portfolio:

Return on Return on Return onScenario Probability A B Market PortfolioBoom 0.4 0.20 0.60 0.30Normal 0.4 0.15 0.05 0.10Bust 0.2 0.01 -0.25 -0.10

1 Calculate the expected return, variance and standard deviations forinvestment in A. Also do that for B and the market portfolio.

2 Calculate the covariance and the correlation between stock A and themarket portfolio. Also calculate the covariance and the correlation betweenstock B and the market portfolio.

3 Find the beta’s for both stocks.

4 Suppose the risk-free rate of return is 4 percent. Using CAPM calculate theexpected return for Stock’s A and B. Which stocks would you recommendpurchasing?


Review Question 2

You have $100,000 to invest in a portfolio containing Stock X, Stock Yand a risk-free asset. You must invest all of your money. Your goal is tocreate a portfolio that has an expected return of 15.7 percent and that hasonly 75 percent of the risk of the overall market. If X has an expectedreturn of 31 percent and a beta of 1.8, Y has an expected return of 20percent and a beta of 1.3, and the risk-free rate is 7 percent, how muchmoney will you invest in Stocks X, Y and the risk-free asset?


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