CFA 2018 smart summary, study session 02, reading 07 copy 1

2017, Study Session # 2, Reading # “DISCOUNTED CASH FLOW APPLICATIONS” NPV = Net Present Value D.R = Discount Rate IRR NPV: The D.R at which NPV = The rate of return at which; PV inflows = PV outflows It assumes reinvestment at IRR PV of expected – PV of expected cash inflows cash outflows NPV = IRR > r ⇒ Accept IRR < r ⇒ Reject Decision rule: Select the project with the greatest NPV Problems in IRR NPV Decision +ve (IRR> r) Accept - -ve (IRR< r) Reject Money-Weighted Return (MWR) IRR of an investment It is highly sensitive to the timing & amount of withdrawals from & additions to a portfolio If one has complete control over the timings of the cash flows then it is more appropriate Funds contributed prior to a period of relatively IRR / NPV rules lead to exactly the same accept /reject decision For Mutually Exclusive Projects: Decision rule D.R used is the market based opportunity cost of capital NPV assumes reinvestment at D.R For Independent Project: For mutually exclusive projects, NPV & IRR may give conflicting project rankings due to: Impact shareholder’s wealth Size of the company rises but shareholder’s wealth is not affected Different sizes of project’s initial cost shareholder’s wealth Time-Weighted Return (TWR) It measures compound growth (Geometric return) It is not affected by the timings of cash flows It is preferred over MWR TWR cannot be calculated if we not know the period end values of investment Poor returns MWR < TWR High returns MWR > TWR Copyright © FinQuiz.com All rights reserved Differences in timings of cash flows 2017, Study Session # 2, Reading # Holding Period Yield or Holding Period Return (HPR) Money Market Yield (CD equivalent yield) rMM Total return an investor earns between the purchase date & the sale or maturity date ܲଵ −ܲ଴ + ‫ܦ‬ଵ ܲଵ + ‫ܦ‬ଵ = −1 ܲ଴ ܲ଴ It is the actual return an investor receives ‫= ܴܲܪ ݎ݋ ܻܲܪ‬ Annualized HPY Assumes 360-day year Does not incorporate effects of compounding ‫ݎ‬ெெ = ‫ × ܻܲܪ‬360 /‫ݐ‬ Bank Discount Yield (rBD) Dollar discount from the face (par) value as a fraction of the face value Based on face value Not based on market or purchase price ‫ ݎ‬஻஽ = ‫ܦ‬/‫ × ܨ‬360/‫ݐ‬ Effective Annual Yield (EAY) Annualized HPY Assumes 365-day year Incorporates effects of compounding 365/ t EAY =(1+HPY) -1 Converting rBD into rMM ‫ݎ‬ெெ = 360 × ‫ݎ‬஻஽ 360 – (‫ݎ × ݐ‬஻஽ ) Bond –equivalent yield (BEY) BEY = ì (semi annual effective yield.) Copyright â FinQuiz.com All rights reserved  ...2 017 , Study Session # 2, Reading # Holding Period Yield or Holding Period Return (HPR) Money Market Yield (CD... compounding 365/ t EAY = (1+ HPY) -1 Converting rBD into rMM ‫ݎ‬ெெ = 360 × ‫ݎ‬஻஽ 360 – (‫ݎ × ݐ‬஻஽ ) Bond –equivalent yield (BEY) BEY = × (semi annual effective yield.) Copyright © FinQuiz.com All... investor earns between the purchase date & the sale or maturity date ܲଵ −ܲ଴ + ‫ܦ‬ଵ ܲଵ + ‫ܦ‬ଵ = 1 ܲ଴ ܲ଴ It is the actual return an investor receives ‫= ܴܲܪ ݎ݋ ܻܲܪ‬ Annualized HPY Assumes 360-day