The Asset Allocation Decision
There is nothing difficult here, but the material is important because it is likely to be tested and it is the foundation for the portfolio construction material at Level 2 and especially Level 3. You should be ready to explain the what and why of an investment policy statement and know the objectives risk and return and the constraints liquidity, legal, time horizon, tax treatment, and unique circumstances. Know the four common return objectives, why the objectives part of the investment...
I3 h I
The curved lines, Ip I2, and 1 , represent indifference curves because all investments combinations of risk and expected return that lie along each curve are equally preferred. Because we have a good expected return and a bad risk , a higher or more preferred indifference curve lies in the northwest direction more expected return and less risk . Focusing on indifference curve Ij, a risk-averse investor whose preferences are represented by these curves will be equally happy with, or indifferent...
l IRRg l IRRB2 l IRRBy 1 IRRb
The cash flows should be entered as in Table 2 and Table 3 if you haven't changed them, they are still there from the calculation of NPV . With the TI calculator, the IRR can be calculated with IRR CPT to get 14.4888 for Project A and 11.7906 for Project B. Cross-Reference to CFA Institute Assigned Reading 44 - Capital Budgeting With the HP 12C, the IRR can be calculated with Both projects should be accepted because their IRRs are greater than the 10 required rate of return.
Concept Checkers Nri
1. An investor put 60 of his money into a risky asset offering a 10 return with a standard deviation of returns of 8 , and he put the balance of his funds in the risk-free asset offering 5 . What is the expected return and standard deviation of his portfolio 2. What is the risk measure associated with the capital market line CML 3. A portfolio to the right of the market portfolio on the CML is 4. As the number of stocks in a portfolio increases, the portfolio's systematic risk B. decreases at a...
Concept Checkers Paz
Use the following data to answer Questions 1 through 3. An investment has a 50 chance of a 20 return, a 25 chance of a 10 return, and a 25 chance of a -10 return. 1. What is the investment's expected return 2. What is the investment's variance of returns 3. What is the investment's standard deviation of returns 4. Which of the following statements about covariance and correlation is least likely correct A. A zero covariance implies there is no linear relationship between the returns on two...
Answers Concept Checkers Aml
1. B 0.5 x 0.2 0.25 x 0.1 0.25 x-0.1 0.1, or 10 2. B 0.5 0.2 - 0.1 2 0.25 0.1 - 0.1 2 0.25 -0.1 - 0.1 2 0.005 0 0.01 0.015 4. B If the correlation of returns between the two assets is -1, the set of possible portfolio risk return combinations becomes two straight lines see Figure 5 . A portfolio of these two assets will have a positive variance unless their portfolio weights are those that minimize the portfolio variance. Covariance is equal to the correlation coefficient times the product of...
Financial Statement Analysis
This review demonstrates the basic methodology for deriving pro forma financial statements for a company based on a forecast of next period sales. While there are innumerable assumptions and forecasts that can be used in preparing pro forma financial statements, we illustrate the basic methodology under a set of fairly straightforward assumptions. LOS 47 Demonstrate the use of pro forma income and balance sheet statements. Pro forma is from the Latin and means as a matter of form. Pro forma...
Caffeine Plus And Sparklin S
0.255 Cov 0.255 5 0.0510 Correlation. The magnitude of the covariance depends on the magnitude of the individual stocks' standard deviations and the relationship between their co-movements. The covariance is an absolute measure and is measured in return units squared. Covariance can be standardized by dividing by the product of the standard deviations of the two securities being compared. This standardized measure of co-movement is called The term p 2 is called the correlation coefficient...
Factors That Influence a Companys Liquidity Position
In general, a company's liquidity position improves if it can get cash to flow in more quickly and flow out more slowly. Factors that weaken a company's liquidity position are called drags and pulls on liquidity. Drags on liquidity delay or reduce cash inflows, or increase borrowing costs. Examples include uncollected receivables and bad debts, obsolete inventory takes longer to sell and can require sharp price discounts , and tight short-term credit due to economic conditions. Pulls on...
LOS 46e Compute and interpret comparable yields on various securities compare
We covered the yield calculations for short-term discount securities in the Discounted Cash Flow Applications reading in Quantitative Methods. The percentage discount from face value is The discount-basis yield bank discount yield or BDY is where days is days to maturity and price is the purchase price of the security. The bond equivalent yield measure for short-term discount securities is calculated as Professor's Note In Quantitative Methods, the bond equivalent yield was defined differently...
Concept Checkers 1
1. A company has 5 million in debt outstanding with a coupon rate of 12 . Currently the yield to maturity YTM on these bonds is 14 . If the firm's tax rate is 40 , what is the company's after-tax cost of debt 2. The cost of preferred stock is equal to A. the preferred stock dividend divided by its par value. B. 1 - tax rate times the preferred stock dividend divided by price. C. the preferred stock dividend divided by its market price. 3. A company's 100, 8 preferred is currently selling for...
SelfTest Corporate Finance
Based on the NPV profiles for two potential capital projects of the same risk class shown in the figure above, which of the following statements is least likely correct A. The IRR of Project A is less than that of Project B. B. If the projects are independent and the cost of capital is 15 , both projects should be accepted. C. At some discount rate less than 15 the expected increase in firm value from undertaking Project A is exactly the same as the expected increase from Project B. 2. Which of...
Concept Checkers Xsk
Firm A and Firm B have the same quick ratio but Firm A has a greater current ratio than Firm B. Compared to Firm B, it is most likely that Firm A has C. a higher receivables turnover ratio. An increase in Rowley Corps cash conversion cycle and a decrease in Rowley's operating cycle could result from Cash conversion cycle A. Decreased receivables turnover B. Decreased receivables turnover C. Increased inventory turnover Operating cycle J, Increased payables turnover Decrease in days of inventory...
LOS 46f Assess the performance of a companys accounts receivable inventory
The management of accounts receivable begins with calculating the average days of receivables and comparing this ratio to the firm's historical performance or to the average ratios for a group of comparable companies. More detail about the accounts receivable performance can be gained by using an aging schedule such as that presented in Figure 1. Figure 1 Receivables Aging 000's Figure 1 Receivables Aging 000's In March, 200,000 of accounts receivable were current that is, had been outstanding...
LOS 46a Describe primary and secondary sources of liquidity and factors that
A company's primary sources of liquidity are the sources of cash it uses in its normal day-to-day operations. The company's cash balances result from selling goods and services, collecting receivables, and generating cash from other sources such as short-term investments. Typical sources of short-term funding include trade credit from vendors and lines of credit from banks. Effective cash flow management of a firm's collections and payments can also be a source of liquidity for a company....
Concept Checkers
Which of the following statements concerning the principles underlying the capital budgeting process is most accurate A. Cash flows should be based on opportunity costs. B. Financing costs should be reflected in a project's incremental cash flows. C. The net income for a project is essential for making a correct capital budgeting decision. Which of the following statements about the payback period method is least A. provides a rough measure of a project's liquidity. B. considers all cash flows...
Example Determining target capital structure weights
The market values of a firm's capital are as follows Debt outstanding 8 million Preferred stock outstanding 2 million Common stock outstanding 10 million Total capital 20 million What is the firm's target capital structure based on its existing capital structure preferred stock 10 , wps 0.10 common stock 50 , wce 0.50 For the industry average approach, we would simply use the arithmetic average of the current market weights for each capital source from a sample of industry firms. LOS 45.d...
Payback Period
The payback period PBP is the number of years it takes to recover the initial cost of an investment. Calculate the payback periods for the two projects that have the cash flows presented in Table 1. Note the Year 0 cash flow represents the initial cost of each project. Note that the cumulative net cash flow NCF is just the running total of the cash flows at the end of each time period. Payback will occur when the cumulative NCF equals zero. To find the payback periods, construct Table 4. Year...
Calculating a Companys Weighted Average Cost of Capital
WACC wd kd l - t w k wce kce WACC wd kd l - t w k wce kce S ppose Dexter, Inc.'s target capital structure is as follows wd 0.45, wps 0.05, and wce 0.50 Its before-tax cost of debt is 8 , its cost of equity is 12 , its cost of preferred stock is 8.4 , and its marginal tax rate is 40 . Calculate Dexter's WACC. WACC wd kd l - t wps kps wce kce WACC 0.45 0.08 0.6 0.05 0.084 0.50 0.12 0.0858 8.6 LOS 45.c Describe alternative methods of calculating the weights used in the WACC, including the use of...
LOS 44e Explain the NPV profile compare and contrast the NPV and IRR methods
A project's NPV profile is a graph that shows a project's NPV for different discount rates. The NPV profiles for the two projects described in the previous example are presented in Figure 1. The project NPVs are summarized in the table below the graph. The discount rates are on the x-axis of the NPV profile, and the corresponding NPVs are plotted on the y-axis. Note that the projects' IRRs are the discount rates where the NPV profiles intersect the x-axis, since these are the discount rates for...
The Relative Advantages and Disadvantages of the NPV and IRR Methods
A key advantage of NPV is that it is a direct measure of the expected increase in the value of the firm. NPV is theoretically the best method. Its main weakness is that it does not include any consideration of the size of the project. For example, an NPV of 100 is great for a project costing 100 but not so great for a project costing 1 million. A key advantage of IRR is that it measures profitability as a percentage, showing the return on each dollar invested. The IRR provides information on...
LOS 44a Explain the capital budgeting process including the typical steps of
The capital budgeting process is the process of identifying and evaluating capital projects, that is, projects where the cash flow to the firm will be received over a period longer than a year. Any corporate decisions with an impact on future earnings can be examined using this framework. Decisions about whether to buy a new machine, expand business in another geographic area, move the corporate headquarters to Cleveland, or replace a delivery truck, to name a few, can be examined using a...