Ivo Welch
Professor of Finance and Economics Brown University Have I hie godda deal for you. To be published by Addison-Wesley-Pearson-Prentice-Hall P amp C . Far and away, the most important contributor to this book was Mary-Clare McEwing. As editor, she helped me improve the substance of the book tremendously. Donna Battista and Matthew Spiegel also played very important roles. The reviewers of earlier drafts of the book spent an enormous amount of time and provided me with many great ideas. I owe them...
End of Main Chapter Problems 1
Q 5.21 Are you better off if a project first returns -10 followed by 30 , or if it first returns 30 and then -10 Q 5.22 Compare two stocks. Both have earned on average 8 per year. However, the first has oscillated between 6 and 10 . The second has oscillated between 3 and 13 . For simplicity, say, that they alternated. If you had purchased 500 in each stock, how much would you have had 10 years later Q 5.23 Stock A alternates between 20 and -10 with equal probability. Stock B earns 4.5 per...
End of Chapter Problems Mrr
Q 4.25 Would you be willing to pay extra for a project that bears fruit during your lifetime rather than after you are gone Q4.26 How bad a mistake is it to misestimate the cost of capital in a short-term project Please illustrate. Q 4.27 How bad a mistake is it to misestimate the cost of capital in a long-term project Please illustrate. Q4.28 What is the difference between YTM and IRR Q4.29 Aproject has cash flows of - 1,000, 600, and 300 in consecutive years. What is the IRR Q4.30 What is the...
B Annualized Rates of Return
Time-varying rates of return create a new complication that is best explained by an analogy. Is a car traveling 258,720 yards in 93 minutes fast or slow It is not easy to say, because you are used to thinking in miles per sixty minutes, not in yards per ninety-three minutes. It makes sense to translate speeds into miles per hour for the purpose of comparing them. You can even do this for sprinters, who run for only 10 seconds. Speeds are just a standard measure of the rate of accumulation of...
Summary Ceq
The chapter covered the following major points gt - Figure 7.4 showed an analysis of historical rate-of-return patterns of investments in cash, bonds, stock indexes, and individual stocks. Stocks, on average, had higher average rates of return than bonds, which in turn had higher average rates of return than cash investments. Individual stocks were most risky. Large stock market portfolios had lower risk than individual stock holdings. Bonds had lower risk yet, and cash was least risky. gt -...
A The Security Market Line SML
An example of what rate of returns individual securities should offer. The Security Market Line, or SML, is just the CAPM formula. The Security Market Line in an Ideal CAPM World Let's apply the CAPM in a specific example. Assume that the risk-free rate is 3 per year, and that the stock market offers an expected rate of return of 8 per year. The CAPM formula then states that a stock with a beta of 1 should offer an expected rate of return of 3 8 -3 -1 8 per year that a stock with a beta of 0...
The Capital Asset Pricing Model Mej
Market Betas Based on Economic Intuition If you really cannot think of a good publicly traded firm that you trust to be a good comparable, you may have to rely more heavily on your judgment. Think about how the rate of return of your project is likely to covary with the stock market. If you can make such a judgment, you can rearrange the CAPM Formula to obtain a beta estimate The right side of this formula helps translate your intuition into a beta estimate. You can ask such questions as What...
End of Chapter Problems
Q 1.7 A degree program costs 50,000 in total expenses 30,000 in tuition and 20,000 in housing and books. The U.S. government provides a grant for 10,000 of the tuition. Moreover, the university pays 20,000 of the 30,000 tuition in salary to your instructors. Being in the program is so much fun, you would be willing to pay a net of 5,000 for the pleasure, relative to your alternatives. What is the net cost of the education to you Q 1.8 What is the difference between investing in the stock and...
End of Chapter Problems 1
Q 2.43 What is a perfect market What were the assumptions made in this chapter that were not part of the perfect market scenario Q 2.44 What is the difference between a bond and a loan Q 2.45 In the text, I assumed you received the dividend at the end of the period. In the real world, if you received the dividend at the beginning of the period instead of the end of the period, could this change your effective rate of return Why Q2.46 Your stock costs 100 today, pays 5 in dividends, and then...
The Profitability Index
How it is computed. A less prominent measure that is sometimes used in capital budgeting is the profitability index PI . It divides the present value of future cash flows by the project cost the negative of the first cash flow . For example, if you have a project with cash flows Project A Cash Flow - 100 70 60 50 128.94 and the interest rate is 20 per annum, you would first compute the present value of future cash flows as Subtract the 100 upfront cost, and the NPV is 28.94. The profitability...
Npv
IRR is safe to use whe there is only one positive or only one negative cash flow. It often fails in a non-obvious way whe there are multiple negative or positive cash flows. Project 1 -S5 S10 100 S5.46 Project 2 -SI,000 1,100 10 47.62 If you can only take one project, then you should take project 2, even though its IRR is much lower than that of project 1. 2. Cost of Capital Comparison The next chapter explains that long-term interest rates are often higher than short-term interest rates. For...