Fixed-income security: claim on specified periodic stream of cash paments

Bond: basic fixed-income security

Typical issuers: fed gov, corporations, states/cities (munis), foreign gov/corporations

If interest rate increases, PV of CFs decreases and bond value decreases

If interest rate decreases, PV of CFs increases, so bond value increases

YTM: aka internal rate of return (IRR) - interest rate required in market for that bond

YTM is discount rate at which formula's value of a bond is equal to its market price

Price risk: higher interest rate means lower price of bond

- Bond CFs are discounted at larger rate

- Risk is greater for bonds w/ longer maturity

- Convexity: bigger ∆ in price when price bigger

Reinvestment risk: what interest rate can you reinvest coupon after it's paid to you?

- YTM is higher, then reinvest at higher rate; risk greater for bonds w/ shorter maturity

YTM = Coupon rate, then par = bond price

YTM > coupon rate, then par > bond price (discount)

YTM < coupon, then par < bond price (premium)

Defines relationship between real rates, nominal rates, and inflation

(1+R) = (1+r)(1+pi)

R=nominal interest rate

r= real interest rate

pi= expected inflation rate

Approximate: R ~ r+pi

Grow at regular intervals forever; treat as perpetuity

P₀ = D/R

P₀ = price at time 0

D = dividend

R = rate

Dividends grow at constant rate g

P_t = D_t+1 / (R-g)

Capital budgeting: planning and managing long-term investments

Capital structure: raising money necessary for investments

Compare market value of project to its cost

NPV = PV of all benefits - PV of all costs

Accept project if NPV > 0

AKA discounted cash flow analysis (DCF)

1. Estimate future CFs

2. Estimate required return for project, given its risk

3. Compute PV of cash flows and subtract initial investment

How long does it take to get initial cost back in nominal sense?

1. Estimate CFs

2. Subtract future CFs from initial cost until cost has been recovered

3. Accept if payback period is less than some present # of years

Calculates return of project over book value of required investment

1. Estimate NI in each year and obtain average book value

2. AAR = average NI / average book value

If AAR is greater than preset rate, then accept project

Compare rates of return of investment opportunities to their opportunity cost of capital

Idea that rate of return = (payoff/investment) - 1

IRR is the discount rate making NPV = 0

If IRR > discount rate, then accept project

Measures benefit per unit cost, based on TV of money

Tries to account for relative size of project

PI = PV(CFs) / Investment

If PI > preset rate, then accept it

Sunk costs: already incurred

 Financing costs

Transfer pricing: prices at which goods/services traded within company; distorts profitability

Allocation overhead (R&D, lighting, etc.): if unaffected, don't include

Opportunity cost: cash asset could generate from another productive use

Side effects (cannibalization and sales creation)

 Changes in NWC: increased inventory, increased sales on credit, decreased payables; need to build NWC

Taxes/depreciation: represents outflows and savings

Net Initial Investment: project's net cash outlay

- Includes any opportunity costs

3 components:

1. Cost of acquiring and placing into service

2. Net proceeds from sale of existing assets

3. Tax effects associated w/ sale of existing assets & replacement w/ new assets

Computing CFs:

OCF = (sales-cost)(1-t) + depreciation*t

CFFA = OCF - NCS - ∆NWC

Tax savings = depreciation tax shield = D*t

t is marginal tax rate

2 methods: straight-line and MACRS

Must adjust CF for taxes on gain or for taxes saved on loss

Which amount, paid each year over life of machine, has the same NPV?

Use basic annuity formula; EAC is "PMT" on calculator