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Evaluating Returns and Cash Flow Streams- Assessment 4

Evaluating Returns and Cash Flow Streams
Evaluating Returns and Cash Flow Streams

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Evaluating Returns and Cash Flow Streams

Overview

Solve nine problems addressing a range of issues related to valuation of stocks, bonds, annuities, and cash flow streams.

The result of a financial manager’s efforts is ultimately reflected in stock price; maximizing shareowner wealth is what finance is all about. This assessment examines the classic financial tradeoff of risk versus reward.

By successfully completing this assessment, you will demonstrate your proficiency in the following course competencies and assessment criteria:

  • Competency 1. Maximize shareholder wealth. 
    • Calculate the required return on a portfolio fund.
    • Calculate the required rate of return.
    • Compute the present values of ordinary annuities.
  • Competency 3. Evaluate capital expenditure investment projects. 
    • Calculate bond evaluation.
    • Apply computations to explain yield to call.
    • Calculate yield to maturity using correct calculations.
    • Compute the after tax cost of debt.
  • Competency 5. Apply evaluation principles of various financial instruments.
    • Explain uneven cash flow streams.

Evaluating Returns and Cash Flow Streams

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Context

Stocks

Maximizing shareowner wealth is all about increasing the stock price. Risky investments require higher returns, so when financial managers take greater risks, the logical reaction of shareowners is to demand a higher return. How do they accomplish this? If you were a bondholder, you would require a higher interest payment, but as a shareowner, you get higher returns by lowering the stock price.

So it may appear that a business should be averse to risk because it runs counter to the notion of a higher stock price, but in fact, businesses must take risks to get those higher returns. When relatively risky ventures pay off, or when shareowners believe management can pull it off, the stock price can soar.

Bonds

It is important to examine the main categories of bonds, long-term instruments such as Treasury bonds, corporate bonds, municipal bonds, and foreign bonds. All bonds share certain common features such as face or par value, coupon rate, maturity date, and other provisions. Some bonds are sold at a deep discount and do not provide any coupon interest payments; these are called zero-coupon bonds.

Previously we have talked about the fact that the value of any financial asset should be based on the present value of its future cash flows. This holds true for the valuation of bonds as well. There are different numerical tools used in assessing and comparing different bonds such as yield-to-maturity, current yield, and yield-to-call for callable bonds.

Our analysis of bonds would certainly be incomplete if we did not consider the risks involved in purchasing different types of bonds. Interest rate, reinvestment rate, and default risks are all associated with the investment in bonds. One important observation regarding the bond markets is that they rely on several independent bond rating agencies providing continuous monitoring of the most important bond issuers.

Evaluating Returns and Cash Flow Streams

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Cash Flow

An asset’s value depends on the valuation of the after-tax cash flows this asset is expected to produce.

Questions to consider

To deepen your understanding, you are encouraged to consider the questions below and discuss them with a fellow learner, a work associate, an interested friend, or a member of the business community.

  • Analyze some of the most important elements of the current tax laws, such as the differences between the treatment of dividends and interest paid and interest and dividend income received. How can financial managers increase shareholder value through managing tax obligations?
  • Examine the company you work for (if your company is not publicly held, pick a company you are familiar with), and consider the following.
    • Would you consider this company to be relatively risky? Does the stock rise and fall faster than the market?
    • What things contribute to the riskiness or stability of the stock?
    • What is the CAPM and security market line, and how can they be used in assessing share price?
  • The time value of money is defined as the math of finance for which interest is earned over time by saving or investing money. Why does time value affect almost any financial decision? Under what situations might time value matter less?
  • Examine the importance of bond ratings and some of the criteria used to rate bonds. Differentiate between interest rate risk, reinvestment rate risk, and default risk. How would a financial manager use bond ratings to increase the value of the firm?
  • Examine what is meant by the statement that a preferred stock is a hybrid between a common stock and a bond. What factors determine the value of a share of preferred stock?
  • Identify some of the factors that would cause you to rely more on either NPV or IRR. Does MIRR solve all of IRR’s shortcomings?

Evaluating Returns and Cash Flow Streams

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Resources

The following optional resources are provided to support you in completing the assessment or to provide a helpful context. For additional resources, refer to the Research Resources and Supplemental Resources in the left navigation menu of your courseroom.

  • Brigham, E. F., & Houston, J. F. (2016). Fundamentals of financial management (14th ed.). Boston, MA: Cengage.

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Assessment instructions

For this assessment, complete Problems 1–9 to apply the necessary knowledge to assess returns and cash flow streams. You may solve the problems algebraically, or you may use a financial calculator or an Excel spreadsheet. In addition to your solution to each computational problem, you must show the supporting work leading to your solution to receive credit for your answer. Note the following:

  • You may need an HP 10B II business calculator.
  • You may use Word or Excel, but you will find Excel to be most helpful for creating spreadsheets.
  • If you choose to solve the problems algebraically, be sure to show your computations.
  • If you use a financial calculator, show your input values.
  • If you use an Excel spreadsheet, show your input values and formulas.

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Returns Estimating and Refinancing Decisions

Returns Estimating and Refinancing Decisions
Returns Estimating and Refinancing Decisions

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Returns Estimating and Refinancing Decisions

Part 1 – Estimating Returns

In the given scenario where the company estimates three possible economic outcomes: poor, average, and above-average. In each case, the company speculates a probability of occurrence of 20%, 40%, and 40% respectively. Further, the company also forecasts the possible returns for each possible economic outcome at 10% for a poor economy, 18% for an average economy, and 30% for an above-average economy.

Calculation of expected returns

Given these scenarios, we can estimate the expected returns for the company. The expected returns are calculated for each expected economic forecast and then summed to give the expected returns for the company. This data is tabulated below.

Expected return
ScenarioProbabilityPossible returnsER
Poor economy20%10%2.0%
Average economy40%18%7.2%
Above-average economy40%30%12.0%
Expected return:21.2%

Returns Estimating and Refinancing Decisions

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Calculation of standard deviation

In addition to the expected return, we can also calculate the standard deviation. In a similar fashion to the expected return calculations, the calculation of the standard deviation involves calculation for each economic forecast and a square root of the summation of the same to indicate the forecast for the company. These calculations are tabulated below.

Standard deviation
ScenarioProbabilityPossible returnsSD 
Poor economy20%10%0.25% 
Average economy40%18%0.04% 
Above-average economy40%30%0.31% 
0.60% 
Standard deviation:7.76% 
How the standard deviation helps better understand what to expect in terms of a return

The standard deviation is useful in the understanding of a return, and in particular the volatility of the return. The standard deviation of the return is a measure of how much the actual return deviates from the expected return. A high standard deviation value implies an increase in the volatility of the company (Gibson, Michayluk, & Van de Venter, 2013). This high level of volatility suggests a higher risk level for the firm.

Returns Estimating and Refinancing Decisions

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Part 2 – Deciding on refinancing

The scenario that requires a decision on whether to refinance the current loan facility is outlined below.

Current loan details:
Principal (Mortgage value)$100,000
Interest7%
Years left14
Negotiated (years ago)2
Closing costs$2,000
Amount to be repaid:$98,000
$200,000

Upon refinancing, the new terms change to those in the table below.

Refinancing:
Interest5.50%
Years left15
Closing costs$1,500
Amount to be repaid:$82,500
$184,000

Returns Estimating and Refinancing Decisions

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The decision and reasons to refinance

Given the two scenarios above, I would decide the refinance the loan facility. The main reasons behind this decision would be the fact that the amount to be repaid reduces with the refinancing. In addition, the period remaining to pay back the loan facility increases with the decrease in the interest rate payable per year.

Qualitative considerations to consider in the decision to refinance or not refinance

Prior to considering a decision on whether or not to refinance a loan facility, several qualitative considerations are made. These considerations include whether the amount payable decreases or not. A second consideration is whether the payback period for the loan changes upwards or downwards. A third consideration is whether the interest rate reduces or increases with the refinancing. A fourth consideration is whether there is a change in the closing costs associated with the loan facility (Parameswaran, 2011).

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Calculations to help you make the decision to refinance or not to refinance

The sample calculations tabulated above help guide the decision on whether to refinance or not to refinance. In the current loan terms, the amount to be repaid is $98,000. This is calculated using the formula below.

Amount payable =Principal * Interest rate * Number of years

The total amount payable is the sum of the amount payable ($98,000), the closing costs, and the principal amount. The sum of these figures comes to $200,000.

The refinancing scenario terms alter these terms by increasing the number of years, reducing the interest rate, and decreasing the closing costs. As such, the refinancing satisfies three of the qualitative considerations. In order to test for the fourth qualitative consideration, we apply the same formula to the loan facility using the new terms of the refinancing (Brigham & Houston, 2016). In this case, the amount payable comes to $82,500 and the total amount payable is $184,000.

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Therefore, given the reduction in the total amount payable from $200,000 to $184,000, as well as the satisfaction of the qualitative consideration for a refinancing, a refinancing is a better option in this case compared to not refinancing.

References

Brigham, E. F., & Houston, J. F. (2016). Fundamentals of financial management (14th ed.). Boston, MA: Cengage.

Gibson, R., Michayluk, D., & Van de Venter, G. (2013). Financial risk tolerance: An analysis of unexplored factors. Financial Services Review, 22(1), 23–50.

Parameswaran, S. (2011). Fundamentals of financial instruments: Stocks, bonds, foreign exchange, and derivatives. Hoboken, NJ: John Wiley & Sons. 

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Portfolio Required Return

Portfolio Required Return
Portfolio Required Return

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Portfolio Required Return

             You are the money manager of a $10 million investment fund, which consists of four stocks. This fund has the following investments and betas:

StockInvestmentBeta
A$3,000,0001.50
B$1,000,000(0.50)
C$2,000,0001.25
D$4,000,0000.75

If the market’s required rate of return is 12 percent, and the risk-free rate is 4 percent, what is the fund’s required rate of return?

The required rate of return (RRR) is the minimum return an investor will accept for owning a company’s stock, as compensation for a given level of risk associated with holding the stock. The RRR is also used in corporate finance to analyze the profitability of potential investment projects

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CAPM and Required Return

CAPM and Required Return
CAPM and Required Return

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CAPM and Required Return

Calculate the required rate of return for XYZ Inc. using the following information:

  • The investors expect a 3.0 percent rate of inflation.
  • The real risk-free rate is 2.0 percent.
  • The market risk premium is 6.0 percent.
  • XYZ Inc. has a beta of 1.7.
  • Over the past 5 years, the realized rate of return has averaged 13.0 percent.

A principal advantage of CAPM is the objective nature of the estimated costs of equity that the model can yield. CAPM cannot be used in isolation because it necessarily simplifies the world of financial markets. But financial managers can use it to supplement other techniques and their own judgment in their attempts to develop realistic and useful cost of equity calculations.

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Bond Valuation

Bond Valuation
Bond Valuation

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Bond Valuation

You have two bonds in your portfolio. Each bond has a face value of $1000 and pays an 8 percent annual coupon. Bond X matures in 1 year, and Bond Y matures in 15 years.

  1. If the going interest rate is 4 percent, 9 percent, and 14 percent, what will the value of each bond be? Assume Bond X only has one more interest payment to be made at maturity. Assume there are 15 more payments to be made on Bond Y.
  2. The longer-term bond’s price varies more than the shorter-term bond‘s price when interest rates change. Explain why.

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After-Tax Cost of Debt

After-Tax Cost of Debt
After-Tax Cost of Debt

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After-Tax Cost of Debt

The XYZ Inc.’s currently outstanding bonds have a 10 percent yield to maturity and an 8 percent coupon. It can issue new bonds at par that would provide a similar yield to maturity. If its marginal tax rate is 40 percent, what is XYZ’s after-tax cost of debt?

What Is the Cost of Debt?

The cost of debt is the effective interest rate that a company pays on its debts, such as bonds and loans. The cost of debt can refer to the before-tax cost of debt, which is the company’s cost of debt before taking taxes into account, or the after-tax cost of debt. The key difference in the cost of debt before and after taxes lies in the fact that interest expenses are tax-deductible.

Impact of Taxes on Cost of Debt

Since interest paid on debts is often treated favorably by tax codes, the tax deductions due to outstanding debts can lower the effective cost of debt paid by a borrower. The after-tax cost of debt is the interest paid on debt less any income tax savings due to deductible interest expenses. To calculate the after-tax cost of debt, subtract a company’s effective tax rate from 1, and multiply the difference by its cost of debt. The company’s marginal tax rate is not used; rather, the company’s state and federal tax rates are added together to ascertain its effective tax rate.

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Yield to Maturity Assignment

Yield to Maturity
Yield to Maturity

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Yield to Maturity

XYZ Inc. bonds have 5 years left to maturity. Interest is paid annually, and the bonds have a $1,000 par value and a coupon rate of 8 percent.

  1. What is the yield to maturity at a current market price of (1) $800 and (2) $1,200?
  2. If a “fair” market interest rate for such bonds was 12 percent—that is, is rd=12%—would you pay $800 for each bond? Why or why not?

YTM – otherwise referred to as redemption or book yield – is the speculative rate of return or interest rate of a fixed-rate security, such as a bond. The YTM is based on the belief or understanding that an investor purchases the security at the current market price and holds it until the security has matured (reached its full value), and that all interest and coupon payments are made in a timely fashion.

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Present Value of an Annuity

Present Value of an Annuity
Present Value of an Annuity

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Present Value of an Annuity

Find the present values of the following ordinary annuities if discounting occurs once a year:

  1. $300 per year for 10 years at 10 percent.
  2. $150 per year for 5 years at 5 percent.
  3. $350 per year for 5 years at 0 percent.

Annuities are contracts issued and distributed (or sold) by financial institutions where the funds are invested with the goal of paying out a fixed income stream later on. They are mainly used for retirement purposes and help individuals address the risk of outliving their savings. Upon annuitization, the holding institution will issue a stream of payments at a later point in time.

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Yield to Call Esay Assignment

Yield to Call
Yield to Call

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Yield to Call

Five years ago, XYZ Inc. issued 20-year bonds with a 12 percent annual coupon rate at their $1,000 par value. The bonds had 5 years of call protection and an 8 percent call premium. Yesterday, XYZ Inc. called the bonds.

For this problem, imagine that the investor who purchased the bonds when they were issued held them until they were called. Considering this, compute the realized rate of return. Should the investor be happy with XYZ Inc. calling the bonds? Why or why not?

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