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CFA Level 1

Compounding You Lend me Rs.2,00,000 @ 10% p.a. for 2 years, how much do I return? Discounting You need Rs.2,00,000 at the end of 2 years from now. 2 year Term deposit rates are 8% p.a. How much do you deposit? Amortizing Loans You need Rs.2,00,000 to purchase a motorbike. SBI offers you auto loan @ 10% rate, 5 Equated Annual Installments. What is the EAI? Non-Amortizing Loans (Bullet Payments) Bonds

Rs.2,00,000 loan 10% interest rate 5 EAIs t=0


-2,00,000

t=1
X

t=2
X

t=3
X

t=4
X

t=5
X

200000 = (X/1.1) + (X/1.1^2) + (X/1.1^3) + (X/1.1^4) + (X/1.1^5) X is Rs.52,759.49

Year 1

Principal 200000

EAI 52759

Interest Component 20000

Principal Component 32759

Principal Outstanding 167241

2
3 4 5

167241
131205 91566 47963

52759
52759 52759 52759

16724
13121 9157 4796

36035
39639 43603 47963

131205
91566 47963 0

Every payment wipes a little bit off the Principal Outstanding!

Types of Projects Expansion Projects Replacement Projects New Product Development Mandatory Projects Other Projects

5 key Principles of Capital Budgeting 1. Cash flows only, not accounting income 2. Cash flows are based on opportunity costs 3. Cash flows should be timed properly 4. Cash flows are always after-tax 5. Financing costs are reflected in required rate of return

Independent Projects Project decisions are unrelated to each other Mutually Exclusive Projects Only one of the projects can be done Capital Rationing Firm should maximize shareholder value with the limited capital available

2 mutually exclusive projects with given after-tax cash flow estimates.

Cost of Capital is 10%


Year 0 1 2 3 4 Project A -2000 1000 800 600 200 Project B -2000 200 600 800 1200 Rule with NPV Method If NPV > 0, project increases shareholder value, hence Accept It

NPV of Project A = $157.64 NPV of Project B = $98.36 Solution Go with Project A!

2 mutually exclusive projects with given after-tax cash flow estimates.

Cost of Capital is 10%


Year 0 1 2 3 4 Project A -2000 1000 800 600 200 Project B -2000 200 600 800 1200 Rule with IRR Method If IRR > Cost of Capital, accept the project If IRR < Cost of Capital, reject the project

IRR of Project A = 14.48% IRR of Project B = 11.79% Solution Go with Project A!

2 mutually exclusive projects with given after-tax cash flow estimates.

Cost of Capital is 10%


Year 0 Project A -2000 Cum. Cash Flows of A -2000 Project B -2000 Cum. Cash Flows of B -2000

1 2
3 4

1000 800
600 200

-1000 -200
400 600

200 600
800 1200

-1800 -1200
-400 800

Payback Period of A = 2 + (200/600) = 2.33 years Payback Period of B = 3 + (400/1200) = 3.33 years

Discounted Payback Method takes discounted cash flows into account

Profitability Index = 1 + (NPV / CF0)

If PI > 1, accept the project


If PI < 1, reject the project

NPV assumes cash flows are re-invested at the cost of capital NPV does not take project size into consideration Multiple IRR / No IRR arise when sign of cash flows change more than once Each method has its advantages and disadvantages

When faced with a conflict between NPV and IRR, always go with NPV
European firms prefer PBP and DPBP methods Larger firms prefer NPV and IRR methods Public firms prefer NPV & IRR. Private firms prefer PBP Firms run by MBAs and CFAs prefer NPV and IRR

A firms capital has 3 main components Common Equity Preferred Equity Debt Weighted Average Cost of Capital (WACC) is:

WACC

{Wd * kd * (1-tax)} + {We * ke} + {Wpe * kpe}


Cost of Debt Cost of debt is straight-forward. Kd is always multiplied by (1-tax rate)

Cost of Preferred Equity Kpe is given by preferred dividend CMP of preferred equity Cost of Equity 3 methods CAPM Method DDM Method Bond yield plus risk premium approach

Capital Asset Pricing Model Dividend Discount Model


growth rate = ROE * RR

Cost of equity = RFR + Beta*(Expected market returns RFR)

Cost of equity = (Next year Dividend / CMP) + growth rate

Bond yield plus risk premium approach

Cost of equity = bond yield + risk premium

What is Beta measures the systematic risk of a stock Beta formula = covariance (stock, market)
variance (market)

What if the beta is not available Pure Play Method

De-levered Beta = Beta (1 / [1+(1-t)*D/E]) Re-levered Beta = D-L Beta * (1+(1-t)*D/E)

Sometimes CRP is multiplied with beta and added

CRP = sovereign yield spread * (annualized sd of equity index / annualized sd of sovereign bond market in terms of developed market currency

Marginal Cost of Capital shows the WACC for different amounts of financing Break Point = amt. of capital at which components cost of capital changes
weight of the component in the capital structure

Include floatation costs in the numerator, never along with the discount rate

Degree of Operating Leverage - % change in operating income for a given % change in sales DOL = (change in EBIT / EBIT) / (change in sales / sales) DOL = Q*(P-V) / Q*(P-V) F Degree of Financial Leverage - % change in EPS for a given % change in EBIT DFL = EBIT / EBIT Interest Degree of Total Leverage = DOL * DFL