Finance Chapter: Present Value Concepts

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Questions and Answers

If the discount rate increases, what happens to the present value of a future cash flow?

The present value cannot be determined without knowing the cash flow.

The present value remains unchanged.

The present value increases.

The present value decreases. (correct)

Which of the following is not a factor that affects the present value of a cash flow?

The size of the cash flow.

The discount rate.

The timing of the cash flow.

The risk of the cash flow. (correct)

How is the present value of a stream of unequal cash flows calculated?

By summing all cash flows and discounting them using a single discount rate.

By calculating the present value of each cash flow individually and then summing them up. (correct)

By calculating the average of all cash flows and applying a present value formula.

By using a single present value interest factor for all cash flows.

If two equal cash flows of $100 are to be received, one in 1 year the other in 2 years, which has the greater present value?

The cash flow received in 1 year has the greater present value. (A) Signup and view all the answers

What does PVIF represent in the present value formula?

The present value of a $1 cash flow. (C) Signup and view all the answers

Using the Present Value of an Annuity (PVA) formula, what does the 'r' variable represent?

The interest rate per period. (B) Signup and view all the answers

Using the information provided in the text, calculate the Future Value (FV) of an initial investment of $2,000 after 3 periods, with an interest rate of 5% per period.

$2,315.25 (A) Signup and view all the answers

If a bond pays an annual interest of 8% and the current inflation rate is 3%, what is the approximate real interest rate, according to the provided Fisher’s equation?

5% (B) Signup and view all the answers

How does the graph about U.S.Interest Rates and Inflation Rates represent the real interest rate?

The difference between the interest rates and the inflation rates, over time, approximates the real interest rate. (B) Signup and view all the answers

What does the term 'nominal interest rate' refer to?

The interest rate banks quote before inflation is accounted for (B) Signup and view all the answers

A coupon bond has a nominal value of 1000 EUR and a coupon rate of 7%. What is the annual coupon payment?

70 EUR (A) Signup and view all the answers

Using the formula provided, what is the present value of a 10-year, 8% coupon bond with a 8% yield to maturity (YTM), using a face value of 1000?

1000 EUR (C) Signup and view all the answers

Suppose you require a 6% return on a bond with a coupon rate of 8% and a nominal value of 1000 EUR. What should be the price of the bond with a 10-year maturity?

1147.20 EUR (B) Signup and view all the answers

Given a bond with a nominal value of 1000 EUR, a coupon rate of 8%, and a 10 year maturity, how would the bond's value change if the required return increases from 6% to 9%?

The bond's value would decrease. (D) Signup and view all the answers

A bond has a coupon rate of 5% and a yield to maturity of 7%. Which of the statements below is correct?

The bond is trading at a discount. (C) Signup and view all the answers

Which formula accurately calculates net income?

Net Income = (Total Revenue + Gains) - (Total Expenses + Losses) - Taxes (C) Signup and view all the answers

What does the average (effective) tax rate represent?

The percentage of income paid as tax. (C) Signup and view all the answers

When making financial decisions, which tax rate is most appropriate to use?

The marginal tax rate (C) Signup and view all the answers

Which of the following is true about the relationship between cash flows from assets and cash flows to investors?

Cash flows from assets equal cash flows to investors (A) Signup and view all the answers

What causes the misalignment between the Income Statement and the Statement of Cash Flows?

Non-cash expenses and uses of cash not included on the income statement (D) Signup and view all the answers

Which section of the statement of cash flows adjusts net income for non-cash operating activities?

Operating Activity (A) Signup and view all the answers

Which of the following describes the analysis of trends over time, in financial analysis?

Analyzing a company's performance across different periods. (D) Signup and view all the answers

Which is NOT a typical source of data for financial analysis?

Academic journals (C) Signup and view all the answers

What is the primary source of data used to calculate the expected return and risk of investments?

Past return data (D) Signup and view all the answers

How is risk typically measured when evaluating the return of investments using historical data?

The standard deviation of returns (C) Signup and view all the answers

If a stock's return in a quarter is -0.18%, what does this indicate about the stock's performance in that period?

The stock had a modest loss in value (D) Signup and view all the answers

How are annual returns calculated from quarterly returns?

By multiplying the returns of each quarter, adding 1, then subtracting 1 (D) Signup and view all the answers

What is meant by the phrase 'don't put all your eggs in one basket' in the context of investments?

Diversify investments to reduce risk (D) Signup and view all the answers

What is the fundamental investment rule related to diversification?

Minimize risk by diversification across assets (B) Signup and view all the answers

According to the information, what can be concluded about the risk of investing in the S&P 500 compared to investing in a single stock?

Investing in the S&P 500 carries less risk due to diversification. (A) Signup and view all the answers

If a stock's annual returns for 2004-2013 average 10% with a standard deviation of 28.8%, what does this indicate about the stock's volatility?

The stock has high volatility relative to it's return. (B) Signup and view all the answers

According to the Dividend-Discount Model for a one-year investor, what happens if the current stock price is lower than the calculated present value?

Investors would rush to buy, driving the stock price up. (B) Signup and view all the answers

In the Dividend-Discount Model, what does 'rE' represent?

The equity cost of capital. (D) Signup and view all the answers

If the current stock price exceeded the price computed using the Dividend Discount Model, what outcome would be expected?

Selling pressure would cause the stock price value to decrease. (A) Signup and view all the answers

According to the Dividend-Discount Model, what primarily determines the value of a share in the long term?

The expected future dividend payouts. (D) Signup and view all the answers

Why are future cash flows discounted in the Dividend-Discount model?

To reflect the risk associated with those cash flows. (D) Signup and view all the answers

In the context of the Dividend-Discount Model, what does V₀ represent?

The present value of all future dividends. (C) Signup and view all the answers

What does the formula P0 = (Div1 + P1) / (1 + rE) represent in the context of the Dividend Discount Model?

The current price of a stock based on expected dividends and future price. (C) Signup and view all the answers

What happens to the present value of future stock sales (V) as the time horizon extends towards infinity?

The present value approaches zero. (C) Signup and view all the answers

Study Notes

Corporate Finance 1 - Overview

Course offered by AS. PROF. RISTE ICHEV
Offered at SEB LU
Dates: October 2024 - January 2025
Contact information for professor provided

Introduction

Subject matter of Corporate Finance 1 presented visually with coins
Relationships between various stakeholders in a corporation visualized in a diagram
Stakeholders include Owners/Shareholders, Managers (CEO, CFO), Suppliers, Employees, Creditors, Customers, and the State

Lecture Outline

What is corporate finance?
Financial management
The goal of the organization
Firm value
Agency problems
Investment Decisions
Balance sheet and financial management
The role of the CFO (including FP&A)
Organizational chart of a typical corporation
The goal of the firm
The goal of the joint stock firm - listed firms
The goal of the firm – in practice
Common problems surrounding the objectives within the firm
The goal of the joint stock firm – solution to the problems
How do we maximize the value of the firm?
Cash Flow (CF)
The Cost of Capital
The big picture
Example: The goal of the firm
Corporate goals – European firms (CFOs)
Corporate goals – Slovenian firms' CFOs
The agency problem, corporate governance, and agency costs
Principle-Agent relationships and different pairs of opposite interests
Principle-Agent relationship problem
Solution to the principle-agent problem
CEOs/managers compensation - Google
CEOs(managers) compensation – global
CEOs(managers) compensation - Slovenia
Corporate governance
Financial statements and reporting
The balance sheet
The balance sheet-cont.
Example: Global Conglomerate corporation
balance sheet
Net Working Capital
Market value vs. Book value
Market value vs. Book value - example
The income statement
Taxes
The statement of cash flows
Global Conglomerate Corporation statement of cash flows
Why misalignment between Income statement and Cash flow statement
Financial analysis
Financial indicators/ratios
Liquidity Ratios
Leverage ratios
Leverage ratios - continue
Working capital ratios
Operating returns
The DuPont Identity - scheme
Valuation ratios
Coca-Cola example: Trend analysis of the income statement
Coca-Cola example cont
Coca-Cola example: Trend analysis of the balance sheet
Coca-Cola example cont
Coca-Cola percentage trend analysis
Coca-Cola percentage trend analysis chart presentation
The Time Value of Money
The basic concepts and tools in CF
How to determine the time value (TV) of money
Time line example
Future value (FV)
Future value (FV) – cont.
FV example: investment in the capital markets vs. Investment in a bank deposit
FV as a function of time and interest rate
FV example 2
Example: calculating the rate of return – interest rate earned
Example: calculating the time period – n
More frequent compounding (than annually)
Compounding interest rate within the year
Example: FV with more frequent compounding
Example 2: FV with more frequent compounding
Effective annual interest rate (EAR)
Example: EAR of an investment
Future value of a stream of cash flows
Present value (PV)
Example: the value of the deposit today
PV as a function of time and discount rate
More frequent discounting i.e. within the year
Present value of a stream of cash flows
Present value of a stream of cash flows – cont.
Example: determining the present value of an annuity
To sum up: The Three Rules of Time Travel
Interest rates and inflation rates
U.S. Interest rates and inflation on rates, 1962-2017
Financial Securities
The value of an investment
What is a bond and which components determine bond's value?
Example: Coupon bond
Example: Coupon bond
Example: Coupon bond
Dynamic behaviour of bond prices
Dynamic behavior of bond prices
Example: value of a bond with semiannual coupons
Example: value of a bond with semiannual coupons
Example: the current yield of a bond and the yield to maturity
Example: the current yield of a bond and the yield to maturity
Example: the current yield of a bond and the yield to maturity
Other types of bonds
Bonds listed on the market
Market price of a bond and accrued interest
Example: accrued interest and bond value
Financial securities - the big picture
What is a stock (share) and which components determine stock's value?
What is a stock (share) and which components determine stock's value - Dividend-Discount Model
What is a stock (share) and which components determine stock's value - Dividend-Discount Model
What is a stock (share) and which components determine stock's value? Cont.
What is a stock (share) and which components determine stock's value? Cont.
Constant dividend and share value
Constant dividend growth and share value
Example: calculate share value today
Example: Calculating the value of a share in which constant growth is expected
Example: Calculating the value of a share
Dividend yield, capital gain rate, total return
Example: Calculating the return on a stock
Example: Calculating the return on a stock
Dividends Versus Investment and Growth
What about young firms?
The value of a non-dividend paying share
Competition and Efficient Markets
Risk and Return
Why are we talking about risk and return?
Risk and Return: Insights from 92 Years of Investor History
Risk and Return: Insights from 92 Years of Investor History
What does financial risk mean?
Investors' attitude to risk
Two ways at looking into the risk
The risk of an individual investment (asset/stock)
Probability distribution and investment (asset) risk
Let's see the probability distribution in money terms
Expected return
Returns' variance and standard deviation
What does the standard deviation tell us?
Which investment is better?
Coefficient of variation
When evaluating the expected return and the risk of investments
Example: Calculating the expected return and risk of Microsoft stock
Example: Calculating the expected return and risk of Microsoft stock
Historical risk and return on investments
Assets and portfolio risk
Expected return of a portfolio
Example: Portfolio return
Variance/standard deviation of a portfolio
Determining the correlation
Example: risk and return of a risky portfolio
Example: risk and return of a portfolio
Example: risk and return of a portfolio of two risky assets
Example: risk and return of a portfolio of two risky assets
Example: risk and return of a portfolio of two risky assets
Example: risk and return of a portfolio of two risky assets
Example: risk and return of a portfolio of two risky assets
Example: risk and return of a portfolio of two risky assets
Example: risk and return of a portfolio of two risky assets
Example: risk and return of a portfolio of more than two risky assets
Diversification and risk - conclusion
Market risk and Beta
Estimating the Beta (β)
Interpreting the Beta coefficient
Beta coefficients across U.S. industries
Risk and required return
Risk and required return
Cost of capital
When using investors funds, the organization has to know the cost of capital
Investments and capital structure
Taxes and the cost of capital
Example: why the cost of debt after tax?
Weighted average cost of capital (WACC)
Estimating the cost of debt
Estimating the cost of debt
Example: estimating the cost of debt
Estimating the cost of equity
Example: estimating the cost of equity capital
Example: estimating the cost of equity capital
Example: estimating the cost of equity capital
Estimating capital structure
Example: Calculating the weighted average cost of capital
Example: Calculating the weighted average cost of capital
WACC in practice (US industries)
WACC in practice (US industries)
The use of WACC
Investment criteria
Net present value (NPV)
What info does NPV tell us and how do we make investment decisions using NPV criteria?
Example: calculating NPV and making the investment decision
Example: calculating NPV and making the investment decision
Features of the NPV (criteria)
Internal rate of return (IRR)
What info does IRR tell us and how do we make investment decisions using IRR criteria?
Example: calculating IRR and making the investment decision
Example: calculating IRR and making the investment decision
Features of the IRR (criteria)
IRR is not a 100% reliable criterion when making investment decisions
IRR is not a 100% reliable criterion when making investment decisions
Modified Internal Rate of Return (MIRR)
Example: MIRR
Payback Period (PP)
Profitability Index (PI)
Conclusion on the application of investment criteria
The use of investment criteria in practice
Project evaluation in practice
Calculation of investment criteria
Project cash flow
Incremental cash flow
Typical dilemmas when estimating project cash flows
Net working capital
Types of investment projects and estimation of cash flows
Estimation of project cash flows
The role of CFO in cash flow estimation
Example: Estimating the net cash flows
Assessment of investment costs and other expenditure(s)
Estimation of operating cash flows
Estimation of operating cash flows
Estimating the cash flow(s) at the end of project's life
Risk assessment and the required return
Assessing project's cost of capital
Assessing project's cost of capital in practise
Calculating the investment criteria
Project risk analysis
Methods of project risk analysis
Sensitivity analysis
Example: Sensitivity analysis
Example: Sensitivity analysis
Limitations of the sensitivity analysis
Scenario analysis
Example: scenario analysis
Example: scenario analysis
Advantages/Disadvantages of scenario analyses
Monte Carlo simulation
Break-even point analysis
Example: break-even point analysis

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Test your understanding of present value concepts in finance, including factors affecting present value, the calculation of cash flows, and the relationship with interest rates. This quiz covers both theoretical and practical aspects of present value and future value calculations, ensuring a well-rounded grasp of the topic.