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Finance and Growth Strategies
QUESTION 1
a) Distinguish between systematic and unsystematic risk. Which is often regardedas the only relevant risk and why?
b) In the context of the Capital Asset Pricing Model how would you define beta?How are betas determined and where can they be obtained? What are the
limitations of betas?
c) What information does beta give to a financial manager?
QUESTION 2
a) What is the time value of money? Why is it important to discount future cashflows?
b) What factors need to be taken into account when choosing an appropriatediscount rate?
c) What do you understand by the terms (i) net present value (NPV) and (ii)internal rate of return (IRR)?
d) Compare and contrast the NPV and IRR.
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CONTENTS
PART ONE: QUESTION 1
1. INTRODUCTION . . . . . . . . . . . . 32. RISK . . . . . . . . . . . . . . 3
2.1 Systematic Risk and Unsystematic Risk . . . . . . 4
2.2 Why Systematic Risk is OftenRegarded?. . . . . . . 5
3. BETA () . . . . . . . . . . . . . 63.1 Definition of Beta . . . . . . . . . . 6
3.2 How to Determine Betas . . . . . . . . . . 7
3.3 Limitations of Betas . . . . . . . . . . 7
3.4 Information Given to a Financial Manager. .. . . . . . 8
4. CONCLUSION . . . . . . . . . . . . 10PART TWO: QUESTION 2
5. INTRODUCTION . . . . . . . . . . . . 116. UNDERSTANDING THE TIME VALUE OF MONEY? . . . . 127. THE IMPORTANT OF DISCOUNT FUTURE CASH FLOWS . . 138. FACTORS OF CHOOSING A DISCOUNT RATE . . . . . 159. NET PRESENT VALUE AND INTERNAL RATE RETURN . . . 16
9.1 Definition of Net Present Value(NPV) . . . . . . . 18
9.2 Definition of Internal Rate Return.(IRR). . .. . . . . 18
9.3 Contradiction between NPV and IRR . . . . . . . 19
10. CONCLUSION . . . . . . . . . . . . 2011. REFERENCES . . . . . . . . . . . .
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PART ONE: QUESTION 1
1. INTRODUCTIONWhat is the ultimate goal in a diversification strategy? Most investors must say it is to
improve the investment performance by reducing the risk. Certainly, everyone knows
risk is an essential element of strategic management and often appears as on an element of
empirical studies reported in the strategic management literature. It figures prominently
in both management and many empirical studies of industry, firm and business unit
performance (Bettis and Mahajan, 1990).
Two measures of risk have predominated in the strategic management literature: one or
both of the parameters (alpha or beta ) derived from the Capital Asset Pricing Model
(CAPM), including risk-adjusted returns from the CAPM, and variance or its derivatives,
for instance, standard deviation.
Thereinafter, this assignment will concentrate on categorizing risk and evaluating its
relationship with betas from an asset pricing perspective.
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2. RISK
One way to categorize risk is to distinguish between systematic risk and unsystematic risk.
Total risk is the sum of systematic (market) risk and unsystematic (non-market or specific)
risk. Simply, systematic risk is non-diversifiable component of total risk and
unsystematic risk is the diversifiable component of total risk.
Here below is the methods to represent total risk.
Total risk = Systematic risk + Unsystematic risk
= Undiversifiable risk + Diversifiable risk
= Market risk + Issuer risk
2.1Systematic and Unsystematic Risk
William Sharpe (1964) and John Lintner (1965) developed the CAPM to mark the birth of
asset pricing theory. The CAPM extend the model of portfolio choice developed by
Harry Markowitz (1959). In the portfolio theory, Harry Markowitz (1952) introduced the
notions of systematic and specific (unsystematic) risk.
Systematic risk is the risk of holding the market portfolio. As the market moves, each
individual asset is more or less affected. To the extent that an asset participates in such
general market moves, it entails systematic risk. This is a risk that can affect all
companies at the same times, including such occurrences as inflation, fluctuating interest
rates, recession and wars. All those of sources are inherent to the entire market or a broad
range of securiteis.. As a result, it is also known as market risk (Hertz, 1964) or
undiversifiable risk, which is not able to be avoided through diverfication.
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Unsystematic risk affects a very specific group of security or an individual security, and
will often relate to unexpected pieces of good news and bad news relating either to the
company concerned. This is not correlated with general market moves and considered
highly diversifiable (Wanger and Lau, 1971). Also, there is no specific formula to
calculate it and it can be eliminated by a perfectly diversified portfolio. Conversely,
systematic risk cannot be eliminated by diversification, even though the investor has a
portfolio of well diversified assets, but cannot be mitigated by being hedged.
Systematic risk can be measured by using beta. In CAPM approach, this theory suggests
that the expected return of a security equals the risk free rate plus a risk premium (KmRf),
see below CAPM formula. Also, investors will often focus on the impact of systematic
risk.
r = Rf + x (KmRf)
where r is the expected return rate on a security;
Rfis the rate of a risk-free investment, i.e. cash and Treasury bill
Km is the return rate of the appropriate asset class.
2.2Why Systematic Risk is Often Regarded?
According to CAPM, the market compensates investors for taking systematic risk but not
for taking unsystematic risk (Peansell, 1986). This is because specific risk can be
diversified away by investing in several companies operating in many different industries,
leaving only the systematic risk relating to the market as a whole.
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Therefore, finance theory suggests that, when assessing an individual company for your
portfolio, you need only yourself with the effect that the market as a whole will have on
that business. Some companies will be more sensitive to market forces than others and
will, therefore, have a higher systematic risk.
When an investor holds the market portfolio, each individual asset in that portfolio
encompasses specific risk, but through diversification, the investors net exposure is just
the systematic risk.
3. BETA ()
Although investors understand that the risk is tied into the market, which can never go
away. However, it can be measured so that investors can make better decisions.
According to the CAPM approach, beta is a key component, which is used to calculate cost
of equity.
3.1.Definition of BetaAs Fama and French (1992) summarized, the central prediction of CAPM is that the market
portfolio of invested wealth is mean-variance efficient in the sense of Markowitz (1959).
The efficiency of the market portfolio implies that expected returns on securities are a
positive linear function of their market betas (the slope in the regression of a securitys
return on the market return), and market betas suffice to describe the cross-section of
expected returns.
In terms of finance and investing, beta is a measure of a portfolios volatility in relation to
the rest of the market. Also, it is a measure of co-movement, not risk. Instead, it is a
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relative risk measurement tool in the CAPM. Stock analysts use this measure all the time
to get a sense of stocks risk profiles.
The formula for Beta is:
= [Cov (r, Km)] / [Standard Deviation (Km)]
where r is the expected return rate of investment;
Km is the return rate of the appropriate asset class.
The measure of risk for a particular company against the market as a whole is called its
beta, where a beta of 1.0 indicates that firm will react exactly as the market does. A more
sensitive company has a beta of more than 1.0 and a less sensitive company will have a
beta of less than 1.0. Company with high beta is supposed to be riskier but provide a
potential for higher returns; conversely, low-beta company pose less risk but also lower
returns.
3.2.How to Determine BetasThere are several factors to determine the Beta Coefficient: (1) the variability of the
individual stock return, (2) the variability of the market return, and (3) the correlation
between the return on the security and the return on the market.
The reason is that beta is based on the historical performance of a stock. It should not be
used as an indication of how the stock may perform in the future.
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3.3.Limitations of Betas
Unfortunately, betas have limitations. There is uncertainty about CAPM beta. The
CAPM beta is derived from estimation procedures and is subject to error. It may not be
constant through time.
In particular that time-statistic for the estimated beta appearing in a CAPM regression
output should be statistically significant, and the regression should be reasonably high
before we draw any conclusions about beta.
While beta does say something about price risk, it does have its limits for financial
manager looking for fundamental risk factors. Beta says nothing about the price paid for
the stock in relation to its future cash flows. For example, a value investor would argue
that a company represents a lower-risk investment after it falls in value. Investors can get
the same stock at a lower price despite the rise in the stocks beta following its decline.
3.4.Information Given to a Financial ManagerIf the financial manager is the follower of CAPM, beta is a useful measure. Financial
manager can utilize beta to assess the risk, which is important to be considered for the
stocks price variability. Also, beta offers a clear, quantifiable measure of its systematic
risk. Surely, there are variations on beta depending on things, such as the market index
used and the time period measured, but broadly speaking, the notion of beta is fairly easy to
understand.
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For example, to estimate the cost of equity (Ke) we can use the following formula of
CAPM in a Company ABC:
Ke = Rf + x (KmRf)
where Rfis the rate of a risk-free investment, i.e. cash and Treasury bill
Km is the return rate on the market portfolio.
is the Company ABCs beta
The Company ABCs beta is a measure of its systematic risk. This risk is function of the
sensitivity of a company ABCs share price to micro-economic factors, such as inflation
and interest rates. The more sensitive a Company ABCs share price to these factors the
higher beta. An average company will have a beta of one. A company with more
systematic risk than average will have a beta in excess of one and a company with less
systematic risk than the average will have a beta of less than one.
If Company ABC has a beta 1.5, the risk free rate of return is 5% and the market return is
10%, the required rate of return according to the CAPM is:
Ke = 5% + 1.5 x (10% 5%)
= 12.5%
Besides, on the individual asset level, measuring beta can give clues to volatility and
liquidity in the marketplace. For example, Company ABC has a beta 1.5. A beta of 1.5
implies that an investments returns will likely be 1.5 times as volatile as that of the market.
While Company ABCs beta drop down to 0.75, which less than 1.0, it means the security
moves in the same direction as the market, but not as far as the market. Besides, a beta of
0.75 means the security is 25% less volatile than the market.
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Based on the betas, there are the clues given to financial manager to well understand the
volatility and liquidity in the marketplace. Also, the cost of capital represents the discount
rate used to arrive at the present value of a companys future cash flows. All things being
equal, the higher a companys beta is, the higher its cost of capital discount rate. The
higher the discount rate, the lower the present value placed on the companys future cash
flows. In short, beta can impact a companys share valuation.
4. CONCLUSIONNo matter you are a value investor or fundamental investor, risk will be always a cause for
concern. It is important to clearly make the distinction between systematic risk and
unsystematic risk, although there is always a fear of unknown.
How to measure the risk and volatility on a portfolio level? Beta is an useful tool, even
though it goes to some lengths but also deal with the limitations as mentioned in the above
paragraphs. Please remember that beta is based on the historical performance of a stock.
High betas may mean price volality over the near term, but they do not always rule out
long-term opportunity. Also, we should not confused the beta with the attractiveness of
the investment.
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PART ONE: QUESTION 2
5. INTRODUCTION
We all know that money deposited in a savings account will earn interest. Because of this
universal fact, everyone would prefer to receive money today rather than the same amount
in the future. The concern is whether the money available at the present time is worth
more than the same amount in the future or not.
But how do we know if it is worth or not? In financial, there are a variety of measures
evolved over time for analyzing a capital budgeting proposal. One of older methods is the
payback period, which has the deficiency of not using time value techniques and will
eventually fall by the wayside. However, they are replaced in companies by the newer,
superior methods of evaluation. The newer methods use time value of money (TVM)
concept. (Gallager and Andrew, 1996).
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6. UNDERSTANDING THE TIME VALUE OF MONEY
One of the most fundamental concepts in finance is that money has a time value.
According to time value of money (TVM), money in hand today is worth more than
money you expected to be received in the future. The reason is straightforward: A
dollar you receive today can be invested such that you will have more than a dollar at some
future time. You could use this money to pay off an all or part of a loan, or invest this
money in an interest-bearing account and earn interest on it.
To summarize the concept of time value, it is A dollar today is worth more than a dollar
tomorrow. This explains in part why the value of money is related to time, Also, it
refers to as present discount value.
Besides, TVM is related to another concept called opportunity cost. The cost of any
decision includes the cost of the best-forgone opportunity. Applying this concept, if you
spend your $500 on any other use, it will endure you with opportunity cost and lose the
value of initial money ($500) would grow over time.
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7. THE IMPORTANT OF DISCOUNTED FUTURE CASH FLOWS
Using the TVM concept, discounted future cash flow (DCF) analysis is widely used to
value a project, company, or asset, and is the process of finding the present value of
amount of cash generated in future period. All future cash flows are estimated and
discounted to give their present values. The discount rate used is normally equivalent to
the appropriate cost of capital.
To calculate for only one future cash flow in one future period, mathematically it is
expressed as:
FV
DPV=
(1 +r )n
where DPVis the discounted present value of the future cash flow (FV)
FVis the nominal value of a cash flow amount in a future period;
ris the discount rate
n is the time in years before the future cash flow occurs.
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For a decision which generates multiple cash flows in multiple time periods, all the cash
flows must be discounted and then summed into a single net present value. For example,
where the investor invests $100,000 in cash (at time 0 = now) to earn the following cash
flow (totally $165,000) and the given discount rate (r) is 15% per year, then:
Year Future Cash Flow
(Future Value $)Calculation Discounted ($)
1 10,000 10,000 / (1.15)1 8,696
2 20,000 20,000 / (1.15)2 15,123
3 40,000 40,000 / (1.15)3 26,301
4 60,000 60,000 / (1.15)4 34,305
5 35,000 35,000 / (1.15)5 17,401
Total Amount of Discounted Cash Flow: 101,826
The new present value (NPV) is (101,826-100,000) = 1,826.
Based on the above calculation, the net present value is positive. This is an importance
that the net present value of the decision after discounting all future cash flows at least be
positive. If negative, it means that the investment decision would actually lose money
even if it appears to generate a nominal profit. For instance, if the expected sales price of
investment in the above example was less than $165,000 in five years, but $130,000 in five
years or 165,000 in six years, then on the above assumptions the investment would actually
cause investor to lose money in present-value terms.
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8. FACTORS OF CHOOSING A DISCOUNT RATE
Discount rate is also a key variable of the DCF analysis. It is often to use the weighted
average cost of capital (after tax) in firm as discount rate. Since the NPV is very sensitive
to changes in the discount rate, the prudent investor will test a range of reasonable discount
rate to get a sense of the range of possible results.
To some extent, the selection of the discount rate is dependent on the rate of return for the
NPV calculation, and the use to which it will be put. If determining whether the
investment will add value to the value to the firm, using the firms weighted average cost
of capital may be appropriate. Besides, the reinvestment rate may be a better choice while
investor is trying to decide between alternative investments in order to maximize the value
of the firm.
There is another approach to choosing the discount rate factor. It is to decide the rate
which reflects the opportunity cost of investment. For example, using reinvestment rate
of the firm, it can be defined as the rate of return for the investment on average. In a
capital constrained environment, it is useful to value the investment by the reinvestment
rate rather than the possibly lower cost of capital as the discount factor.
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9. NET PRESENT VALUE AND INTERNAL RATE RETURN
The two most-used measures for evaluating an investment are the net present value and the
internal rate of return.
Thereinafter, we will discuss these two measures in connection with this income stream of
Project Y:
Year 0 1 2 3 4 5 6
Income $ (10,000) 2,000 2,000 2,000 2,000 2,000 2,000
9.1.Definition of Net Present Value (NPV)The net present value (NPV) is simply the sum of the present value (PV) of a projects cash
flow. The formula of NPV is:
where NPVis the net present value of a whole income stream
Iis income amounts for each year
ris the discount rate
n is the time in years before the future cash flow occurs.
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The given discount rate (r) is 5% per year.
Year 0 1 2 3 4 5 6
Income $ (10,000) 2,000 2,000 2,000 2,000 2,000 2,000
Discount $ 1,905 1,814 1,728 1,645 1,567 1,492
The NPV of Project Y is ($10,151 10,000) = $151.
If the NPV is positive, it says that the company expects to receive benefits that are large
enough to repay the company for (1) the assets cost, (2) the cost of financing the project,
and (3) a rate of return that adequately compensates the company for the risk found in the
cash flow estimates. If the NPV is negative, the benefits are not large enough to cover all
three of the above, and therefore the project should be rejected.
If the project has NPV = $0, then the project generates exactly enough cash flows to
recover the cost of the investment and to enable to company to earn their required
rate of return.
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9.2.Definition of Internal Rate Return (IRR)
The Internal Rate of Return (IRR) is the discount rate that forces the present value of the
benefits to equal the present value of the cost, then, the NPV will be equal to zero. It is
the rate of return the project is expected to generate.
Based on the Project Y example, IRR is found by trial and error.
IRR 4% 5% 5.47% 6%
NPV ($) 485 151 0 (165)
In the example, while setting the discount rate to 0.0547, the NPV becomes zero. This
discount rate, 5.47%, is the internal rate of return for this investment.
The particular discount rate, IRR, forces the projects NPV to equal to zero rather than
using the cost of capital. Thus, these two approaches differ in only one respect. In NPV
method, a discount rate is specified and the equation is solved for NPV. In the IRR
method, the NPV specified to equal zero and the discount rate (IRR) that forces this
equality is found.
9.3.Contradiction between NPV and IRRTo understand how the NPV and IRR can give seemingly different advice is to use, it can
be found the cues from the net present value curve (NPV curve). The NPV curve shows
the relationship between the discount rate and the net present value for a range of discount
rates.
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The NPV curve, the relationship between the discount rate and the net present value has a
formula that can be written like this:
where NPVis the net present value of a whole income stream
I is income amounts for specific year. The subscripts (which are also the
exponents in the denominators) are the year numbers, starting with 0, which is
this year.
ris the constant discount rate
n is the number of years the investment lasts.
The underlying cause of ranking conflicts between NPV and IRR is the reinvestment rate
assumption. All discounted cash flow methods implicitly assume that cash flows can be
reinvested at some rate, regardless of that actually is done with the cash flows.
The process of discounting is the reverse of compounding. Because compounding
assumes reinvestment, so does discounting. NPV and IRR are both found by discounting,
so they both implicitly assume some discount rate. Inherent in the NPV calculation is the
assumption that cash flows can be reinvested at the required rate of return in project, or
cost of capital, while the IRR calculation assumes reinvestment at the IRR rate.
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10.. CONCLUSION
To do only one investment, we should choose the one with the highest NPV at the discount
rate appropriate to us. A problem with that advice, though, is that discount rates can
change with general economic conditions. Thus, we are more confident about choosing
one investment over another if your chosen investment has a higher NPV over a board
range of possible discount rates.
Regardless of what happens in the future to discount rates, we will be better off with the
higher NPV investment than with the lower NPV investment at all discount rates.
But which capital budgeting methods are better? NPV method or IRR method? The
IRR method seems to be the more popular of the two methods (by a small margin).
However, the NPV method is superior to IRR method. The reason is the cash inflows
generally are used as substitutes for outside capital. That is, cash flows replace outside
capital, and save the firm the cost of outside capital.
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11.. REFERENCES
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2007.
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measurement, in R. A. Bettis and H. Thomas (eds.), Risk, Stategy and Management, JAI
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Fama, E. F. and K. R. French (1992). The cross-section of expected stock returns,
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Gallager, T and Andrew Jr., J., (1996). Financial Management : Principals and Practices,
Upper Saddle River, NJ: Prentice Hall.
Hertz, D. B. (1964). Risk Analysis in Capital Investment, Harvard Business Review,
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Lintner, J. (1965). The Valuation of Risk Assets and the Selection of Risky Investments
in Stock Portfolios and Capital Budgets,Review of Economics and Statistics, 47:1, 13-37.
Markowitz, H. M. (1952). Portfolio selection,Journal of Finance, 7:1, 77-99.
Markowitz, H. M. (1959). Portfolio sections: Efficient Deversification of Investments,
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Peansell, K. (1986). The Capital Asset Pricing Model, Issues in France, M. Firth 1986,
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Sharpe, W. F. (1964). Capital Asset Prices: A Theory of Market Equilibrium under
Conditions of Risk,Journal of Finance, 19:3, pp. 425-442.
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Sharpe, W.F. (1964). Capital Asset Prices: A Theory of Market Equilibrium under
Conditions of Risk,Journal of Finance, 19:3, pp. 425-442.
Wanger, W. H. and S. Lau (1971). The Effects of Diversification on Risk, Financial
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Websites
Part One
a) http://www.cowlitzbank.com/resources/public/downloads/Reduce%20risk.diversify.pdf
http://findarticles.com/p/articles/mi_qa5386/is_200609?pnum=4&opg=n21399513&tag
=artBody;col1
b) and c)
http://www.investopedia.com/articles/stocks/04/113004.asp
Part Two
a) www.investopedia.com/articles/03/082703.asp
www.12manage.com/methods_npv_zh.html
b) http://www.answers.com/topic/discounted-cash-flow
c) and d)
http://www.realdata.com/ls/alphabet-soup.html
http://www.peoi.org/Courses/finanal/ch/ch10e5.html#anchor2350002
http://www.pdffactory.com/http://www.pdffactory.com/http://www.pdffactory.com/http://www.pdffactory.com/http://www.pdffactory.com/http://www.pdffactory.com/http://www.pdffactory.com/http://www.pdffactory.com/http://www.pdffactory.com/http://www.pdffactory.com/http://www.pdffactory.com/http://www.pdffactory.com/http://www.pdffactory.com/http://www.pdffactory.com/http://www.pdffactory.com/http://www.pdffactory.com/http://www.pdffactory.com/http://www.pdffactory.com/http://www.pdffactory.com/http://www.pdffactory.com/http://www.pdffactory.com/http://www.cowlitzbank.com/resources/public/downloads/Reduce%20risk.diversify.pdfhttp://www.cowlitzbank.com/resources/public/downloads/Reduce%20risk.diversify.pdfhttp://findarticles.com/p/articles/mi_qa5386/is_200609?pnum=4&opg=n21399513&taghttp://findarticles.com/p/articles/mi_qa5386/is_200609?pnum=4&opg=n21399513&taghttp://www.investopedia.com/articles/stocks/04/113004.asphttp://www.investopedia.com/articles/stocks/04/113004.asphttp://www.investopedia.com/articles/03/082703.asphttp://www.investopedia.com/articles/03/082703.asphttp://www.12manage.com/methods_npv_zh.htmlhttp://www.12manage.com/methods_npv_zh.htmlhttp://www.answers.com/topic/discounted-cash-flowhttp://www.answers.com/topic/discounted-cash-flowhttp://www.realdata.com/ls/alphabet-soup.htmlhttp://www.realdata.com/ls/alphabet-soup.htmlhttp://www.peoi.org/Courses/finanal/ch/ch10e5.html#anchor2350002http://www.peoi.org/Courses/finanal/ch/ch10e5.html#anchor2350002http://www.peoi.org/Courses/finanal/ch/ch10e5.html#anchor2350002http://www.realdata.com/ls/alphabet-soup.htmlhttp://www.answers.com/topic/discounted-cash-flowhttp://www.12manage.com/methods_npv_zh.htmlhttp://www.investopedia.com/articles/03/082703.asphttp://www.investopedia.com/articles/stocks/04/113004.asphttp://findarticles.com/p/articles/mi_qa5386/is_200609?pnum=4&opg=n21399513&taghttp://www.cowlitzbank.com/resources/public/downloads/Reduce%20risk.diversify.pdfTop Related