Risk analysis in capital
budgeting
Sensitivity, Scenario, Break-Even,
Simulation
Each allows us to look behind the NPV number to see
how stable our estimates are.
When working with spreadsheets, try to build your
model so that you can adjust variables i
Term structure of interest
rates
Term structure
Effect of term to maturity of bond on bond value due to changes in
interest rates (YTM)
Plotting maturity against YTM (yield curve)
Normal
Flat
Inverted
Credit spread
Credit spread (spread between YTM on
Cost of Capital: WACC
Rei
RCMoVMva(rReFiF,)M)ei2,M
F
eei
i(R
The Cost of Equity Capital
Expected equity return becomes Cost of Equity
Capital:.if CAPM holds!. then cost of equity can be
given as;
To estimate cost of equity capital, we need to know
three
Market Efficiency
Efficient market
Price = Value
Prices would be random walk in an efficient market and
returns would be normal
If prices are not random walk then they can be forecasted and
can be used for generating abnormal returns without
assuming a
ECONOMICS
CURRENCY EXCHANGE RATES: DETERMINATION AND FORECASTING
Cross-Reference to CFA Institute Assigned Reading #14
Spot Exchange Rates Vol 1, pg 485
Spot exchange rates (S) are quotes for transactions that call for immediate delivery.
When working wit
QUANTITATIVE METHODS
CORRELATION AND REGRESSION
n
Sample covariance = Cov (X,Y) =
S (X - X)(Y - Y)/(n - 1)
i=1
i
i
where:
n = sample size
Xi = ith observation of Variable X
X = mean observation of Variable X
Yi = ith observation of Variable Y
Y = mean obs
EQUITY VALUATION: APPLICATIONS AND PROCESSES
EQUITY VALUATION: APPLICATIONS AND PROCESSES
Perceived mispricing:
Perceived mispricing = True mispricing + Error in the estimate of intrinsic value.
VE P = (V P) + (VE V)
VE = Estimate of intrinsic value
P = M
DERIVATES
DERIVATIVES
FORWARD MARKETS AND CONTRACTS
Value of a Forward Contract
Time
Long Position Value
Zero, as the contract is priced to
prevent arbitrage
At initiation
During life of the
contract
F(0,T)
St -
At expiration
Short Position Value
Zero, as
INVENTORIES: IMPLICATIONS FOR FINANCIAL STATEMENT AND RATIOS
INVENTORIES: IMPLICATIONS FOR FINANCIAL STATEMENTS AND RATIOS
Ending Inventory = Opening Inventory + Purchases - Cost of goods sold
LIFO and FIFO Comparison with Rising Prices and Stable Invento
PORTFOLIO CONCEPTS
PORTFOLIO CONCEPTS
Expected return on Two-Asset Portfolio
E(RP) = w1E(R1) + w2E(R2)
E(R1) = expected return on Asset 1
E(R2) = expected return on Asset 2
w1 = weight of Asset 1 in the portfolio
w2 = weight of Asset 2 in the portfolio
Va
CURRENCY EXCHANGE RATES: DETERMINATION AND FORECASTING
CURRENCY EXCHANGE RATES: DETERMINATION AND FORECASTING
Currency Cross Rates
For example, given the USD/EUR and JPY/USD exchange rates, we can calculate the cross rate
between the JPY and the EUR, JPY/
TERM STRUCTURE AND VOLATILITY OF INTEREST RATES
TERM STRUCTURE AND VOLATILITY OF INTEREST RATES
Measuring Historical Yield Volatility
Xt = 100 ln
( )
yt
yt-1
where
yt = yield on day t
Annualizing the Standard Deviation
Annualized standard deviation = Dail
PRIVATE REAL ESTATE INVESTMENTS
PRIVATE REAL ESTATE INVESTMENTS
Net Operating Income
Rental income at full occupancy
+ Other income (such as parking)
= Potential gross income (PGI)
- Vacancy and collection loss
= Effective gross income (EGI)
- Operating e