Question

please write a brief essay describing the important concepts you have learned so far on FIN555. Be as specific as possible and provide example of things you consider important. 1) present value concept 2) alter ative to npv; stock valuation 3)financial statements; free cash flow 4)capital budgeting; bond valuation

Answer 1

Important concepts-

1. Present value: Present value (PV) is the current value of a future sum of money or stream of cash flows given a specified rate of return. Future cash flows are discounted at the discount rate, and the higher the discount rate, the lower the present value of the future cash flows

PV Formula and Calculation= Future value/(1+rate of interest)^n

Example- You want to purchase a book which will be available in market for $100 after 1 year. Book is available after one year, hence you can start saving from now. What amount should you save today?

If Interest rate is 10% in bank, if you invest $91 in bank today at end of year your bank balance would be $100. Thus $91 is present value of any future cash inflow/outflow. It excludes effect of interest.

2. Alternative to NPV:

When Present value of Inflows > Present value of outflow, project is considered to have positive NPV thus one is earning on projects.

However NPV is sensitive of discounting rate, if discounting rate is too high then Present value of inflows would be low thus reflecting lower NPV due to which decision might be affected. Hence alternative to NPV is IRR method.

The internal rate of return is a discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero

Because of the nature of the formula, however, IRR cannot be calculated analytically and must instead be calculated either through trial-and-error or using software programmed to calculate IRR.

The higher a project's internal rate of return, the more desirable it is to undertake. IRR is uniform for investments of varying types and, as such, IRR can be used to rank multiple prospective projects on a relatively even basis. Assuming the costs of investment are equal among the various projects, the project with the highest IRR would probably be considered the best and be undertaken first.

3) Stock Valuation -

Stock valuation methods include the dividend discount model (DDM) and CAPM

DDM-

The DDM is based on the assumption that the company’s dividends represent the company’s cash flow to its shareholders.

Dividend Discount Model formula = Intrinsic Value = Sum of Present Value of Dividends + Present Value of Stock Sale Price

Essentially, the model states that the intrinsic value of the company’s stock price equals the present value of the company’s future dividends.

Note that the dividend discount model is applicable only if a company distributes dividends regularly and the distribution is stable.

1. D = the estimated value of next year's dividend.
2. r = the company's cost of capital equity.
3. g = the constant growth rate for dividends, in perpetuity

Present value of stock = D/r-g

4) Financial Statements-

Financial statements include:

• Balance sheet
• Income statement
• Cash flow statement.
• Movement in share capital

1. Financial statements are written records that convey the business activities and the financial performance of a company.
2. The balance sheet provides an overview of assets, liabilities, and stockholders' equity as a snapshot in time.
3. The income statement primarily focuses on a company’s revenues and expenses during a particular period. Once expenses are subtracted from revenues, the statement produces a company's profit figure called net income.
4. The cash flow statement (CFS) measures how well a company generates cash to pay its debt obligations, fund its operating expenses, and fund investments.
5. Movement in Share capital measures movement in Equity and profit for the period.

Note - Only first 4 explained