MGT201 SOLVED SUBJECTIVED QUIZS

122. What is MIRR?

Answer. MIRR is that discount rate which equates the future value of cash inflows to the present value of cash out flows. We use Common Life or EAA Approach to adjust NPV of projects with different lives.

123. Reasons for Capital Rationing:

1. The best project may have a very high initial investment and you may not have that money. So, you are forced to reject that project as an option.

2. The company does not have the human resource, knowledge, or talent, which is required to undertake the project. The project might have high NPV but if you cannot manage it, you are forced not to invest in that project.

3. The companies have the prevailing fear of debt. In case of Muslim countries, there is a major issue of “Riba” (interest) among Muslim investors and the companies due to this religious constraint choose not to borrow money.

124. Types of Problems in Capital Rationing:

1. Size Difference of cash flows

2. Timing Difference of cash flows

3. Different (or Unequal) Lives of different projects

125. Disadvantage of project with very long life

Does not give you the opportunity (or option) to replace the equipment quickly in order to keep pace with technology, better quality, and lower costs

Disadvantage of project with very short life

Your money will have to be reinvested in some other project with an uncertain NPV and return so it is risky. If a good project is not available, the money will earn only a minimal return at the risk free interest rate.

126. What is the Difference between Real Assets & Securities?

Real assets are physical property such as Land, Machinery, equipments and Building etc. Where as securities basically, are legal contractual piece of paper.

Reference handouts page no 63

127. If the Company raises money using Bonds, then it will have to pay a fixed amount of interest (or mark-up) regularly for a limited amount of time. You do not share the profits of the company. But there as legal risk attached to the failure to pay interest can force company to close down.

If the Company raises money using Equity, then it is forced to bring in new shareholders who can interfere in the management and will get a share of the net profits (or dividends) for as long as the company is in operation! The amount of dividends can vary.

Reference handouts page no 63

128. Bonds: Numerical Features

• Maturity or Tenure or Life: Measured in years. On the Maturity Date when the bond expires, the Issuer returns all the money (Principal/par and Interest/coupon) to the Investor (thereby terminating or Redeeming the bond) i.e. 6 months, 1 year, 3 years, 5 years, 10 years,

• Par Value or Face Value: Principal Amount (generally printed on the bond paper) returned at maturity i.e. Rs 1,000 or Rs. 10,000. Contrast this to Market Value (or Actual Price based on Supply/Demand) and Intrinsic or Fair Value (estimated using Bond Pricing or Present Value Formula)

• Coupon Interest Rate: percentage of Par Value paid out as interest irrespective of changes in Market Value i.e. 5 % pa, 10 % pa, 15% pa, … etc. Coupon Receipt = Coupon Rate x Par Value. Coupon Receipts can be paid out monthly, quarterly, six-monthly, annually…etc. Contrast to Market Interest Rate (macro-economic).

Bonds: Characteristics & Legal Points

Indenture”: Long Legal Agreement between the Issuer (or Borrower) and the Bond Trustee (generally a bank of financial institution that acts as the representative for all Bondholders). Basically protects Bondholders from mis-management by the bond issuer, default, other security holders, etc

128. Call Provision:

The right (or option) of the Issuer to call back (redeem) or retire the bond by paying-off the Bondholders before the Maturity Date. When market interest rates drop, Issuers (or Borrowers) often call back the old bonds and issue new ones at lower interest rates

Types of Bonds:

Mortgage Bonds: backed & secured by real assets

Subordinated Debt and General Credit: lower rank and claim than Mortgage Bonds.

Debentures:

These are not secured by real property, risky

Floating Rate Bond:

It is defined as a type of bond bearing a yield that may rise and fall within a specified range according to fluctuations in the market. The bond has been used in the housing bond market

Eurobonds: it issued from a foreign country

Zero Bonds & Low Coupon Bonds: no regular interest payments (+ for lender), not callable (+ for investor)

Junk Bonds & High Yield Bonds: Corporations that are small in size, or lack an established operating track record are also likely to be considered speculative grade. Junk bonds are most commonly associated with corporate issuers. They are high-risk debt with rating below BB by S&P

Convertible Bonds:

A convertible bond is a bond which can be converted into the company's common stock

129. Present Value formula for the bond:

n

PV= Σ CFt / (1+rD)t =CF1/(1+rD)+CFn/(1+rD)2 +..+CFn/ (1+rD) n +PAR/ (1+rD) n

t =1

In this formula

PV = Intrinsic Value of Bond or Fair Price (in rupees) paid to invest in the bond.

Coupon Rate derived from Macroeconomic or Market Interest Rate.

130. When Market Interest Rate (i.e. Investors’ Required Rate of Return) Increases, the Value (or Price) of Bond Decreases. Check using formula. This is known as Interest Rate Risk.

131. Bond Portfolio Theory:

Changes in Market / Macro Interest Rates have 2 Major Impacts on the Portfolio (collection of bond investments) of the Bondholder:

(1) Interest Rate Risk: In this, the value of Bond Portfolio Drops if interest rates Rise) and

(2) Reinvestment Risk: In this, the overall Rate of Return (or Yield) on the Bond Portfolio Rises when interest rates rise the opportunity cost for the bond holder has changed.

132. Bond Yield to Maturity (YTM)

PV = Bond Market Price = CFt / (1+rD) t

YTM =Total or Overall Yield = Interest Yield + Capital Gains Yield

Interest Yield or Current Yield = Coupon / Market Price

Capital Gains Yield = YTM - Interest Yield

133. Perpetual Investment with Fixed Regular Dividends

PV = Po* = DIV 1 / r PE

Where r PE = Minimum Required Rate of Return on Preferred Stock Equity for the individual investor, PV = Present Market Value (or Estimated Present Price) which depends on DIV 1 = Forecasted Future Dividend in the next period (i.e. Year 1 and all other years since DIV 1=DIV2= DIV3=...) basically, it is a Perpetuity Formula.

Finite Investment:

Finite Investment means you plan to buy this Stock and then sell it in a few days or years (n). Formula similar to Bond.

PV = Po* = DIVt / (1+ rPE) t + Pn / (1+ rPE) n.

t=year. Sum from t = 1 to n. Pn = Final Expected Selling Price

PV (Share Price) = Dividend Value + Capital Gain /Loss.

The Dividend Value derived from Dividend Cash Stream and Capital Gain /Loss from Difference between Buying & Selling Price.

144. Finite Investment

In this duration of our investment is limited. Cash inflow from Forecasted Selling Price must be taken into account in price estimate.

2. Perpetual Investment

It is very long term horizon for long term investment. It is Perpetual so Forecasted Selling Price not significant and can be eliminated. If you are planning to buy and hold the share for 20 or 30 years then you can consider it as a long term assets. Similarly, an investment in the share for the period of one or two years

Reference handouts page no 78

145. If Market Price < Fair Value: then Stock is under valued by the Market

If Market Price > Fair Value then Stock is Over Valued

Zero Growth Model Pricing

PV = Po* = DIV1 / rCE

Constant Growth Model Pricing (assume g=10%)

PV = Po* = DIV1 / (rCE -g)

g= plowback ratio x ROE.

Reference handouts page no 81

146. This particular formula the way it is mentioned above is known as Gordon’s formula and we use this formula to calculate the required rate of return.

Gordon’s Formula: Estimated Fair Present Price (or Present Value) of Share calculated using Forecasted Future Cash Flows of Dividend Payouts to Shareholders and their growth rCE*= (DIV 1 / Po) + g

Reference handouts page no 81

147. EPS Approach

In EPS approach, we estimate the price of common stock under very long term investment.

EPS Stock Price Estimation Formula

PV = Po* = EPS 1 / rCE + PVGO

Po = Estimated Present Fair Price,

EPS 1 = Forecasted Earnings per Share in the next year (i.e. Year 1),

rCE = Required Rate of Return on Investment in Common Stock Equity.

PVGO = Present Value of Growth Opportunities

Reference handouts page no 82

148. Growth Stock:

It is growth share where the value of the share is determined by the potential of this company to grow its business as oppose to company which have low growth rate. Particularly, for IT internet companies where we expect a high rate of growth for the business the PVGO term is large percent of the price of the share.

149. Diversifiable Risk: random risk specific to one company, can be virtually eliminated.

Market Risk: It is defined as uncertainty caused by broad movement in market or economy. More significant

Range of Possible Outcomes, Expected Return:

Overall Return on Stock = Dividend Yield + Capital Gains Yield (Gordon’s Formula)

ROR is the SUM of the weighted returns for ALL possible Outcomes.

Expected ROR = < r > = pi ri

Risk = Std Dev = σ = √ ( r i - < r i > )2 p i . = “Sigma”

Portfolio:

Portfolio is defined as a Collection of Multiple Investments. Most organization maintains large collection or portfolio of investments and when we talk about the risk and return then we have to consider overall risk and return for the entire portfolio. Portfolios may have 2 or more stocks, bonds, other securities and investments or a mix of all

150. Total Stock Risk = Diversifiable Risk + Market Risk

Portfolio Expected ROR Formula:

rP * = r1 x1 + r2 x2 + r3 x3 + … + rn xn .

Terms in Boxes on Diagonal (Top Left to Bottom Right) are called “VARIANCE” terms associated with individual magnitude of risk for each stock.

Terms in all other (or NON-DIAGONAL) Boxes are called “COVARIANCE” terms which account for affect of one stock’s movement on another stock’s movement