Agenda for Review Session 7
Review for Quiz 3
> 10 multiple choice questions
> 120 mins
> Open book
> 3 conceptual questions + 7 computational questions
> Cover everything up through Nov 3 class session
> NPV
> CAPM and Diversification
> WACC
> Efficient Market Hypothesis (EMH)
> Cases (e.g. Empirical Chemicals)
(Net) Present Value and Business Valuation
Practice Problem 1: Consider an investment that costs $10m upfront and returns cash flows of $3m per year for 7 years.
Additionally, the project has a year 4 cash outflow of $4m for refitting. If the discount rate is 8%, what is the NPV of the
investment?
Discount Rate
Year
Cash Outflows
Cash Inflows
Total Cash Flows
NPV
8.00%
0
-10
-10
1
2
3
3
3
3
3
3
3
4
-4
3
-1
5
6
3
3
3
3
2.48
Correct? NO. The NPV formula is improperly calculated because it includes the Year 0 cash flow!
Correct answer
NPV
2.68
Practice Problem 2: A share of ABCDE promises dividends of $2.4 next year, $3.6 in two years, and dividends growing at
7% thereafter. The cost of equity capital for ABCDE is 24%. What is the appropriate value per share under these
assumptions?
Discount Rate
Terminal Growth Rate
24%
7%
Year
Cash Flow
Terminal Value
Total CFs + TV
1
$2.40
2
$3.60
$2.40
$3.60
NPV
3
$22.66
$22.66
$16.16
Correct? NO. The TV formula provides the PV of future cash flows at time T, where the first cash flow
time T+1. The above takes the year 3 dividend and computes a TV as of year 3t should be o
Year 2
Correct answer
Total CFs +TV
NPV
$2.40
$19.01
$26.26
Note: the solution holds if we replace the terminal value with the firm’s future pric
ation
m per year for 7 years.
what is the NPV of the
7
3
3
the Year 0 cash flow!
d dividends growing at
e under these
, where the first cash flow is at
as of year 3t should be on
the firm’s future price.
The CAPM formula:
???? = ?? + ???? ???? ? ??
or
??[???? ] = ???? + ???? ???? ? ????
The term in the parentheses is usually called the “market risk premium”. Depending on the assumptions used, you
could measure the market risk premium very differently. Further, regardless of the measure you use, it varies across
time. The most commonly used market risk premium is available on Kenneth French’s website, and it varies from as
5% – 10%.
For this class, we will assume a market risk premium of 7%.
Variable Descriptions
Variable
Definition
Usual Source
????
Expected return on the asset (equity)
Calculated
??
Return on “risk-free” asset
Treasury Bonds
????
????
Measure of covariance risk with market portfolio
Determined via Regression
Return on the market
S&P 500 or other index returns
Practice Problem
“Historical S&P 500 Return”
10-year Treasury Rate
Market Risk Premium
9.07%
TAP
2.07%
DIS
7.00%
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