Advanced Financial Management

ROI & Accounting Rate of Return

average EBIT / (average) Initial Investment

average EBIT = opeating profit = Cashflow - depreciation

average Initial Investment = Initial Investment + Scrap Value / 2

1/r

= 1.02^-1*1.01^-1

1+r = (1+R)^1/n

r= periodic discount rate

R = annual discount rate

IRR = discount rate at which PV of project's CF is zero

The return the project itself is expected to generate.

• If IRR > Cost of Capital → Accept the project

• If IRR < Cost of Capital → Reject the project

IRR = A+ (Na / (Na-Nb))* (b-a)

A = lower discount rate

b = higher discount rate

only include future, incremental cash flows

(e.g. no interest, no sunk costs, non-cashflows, book values, unavoidable costs etc)

interest = cost of finance is measured in the cost of capital/discount rate

1. Allocative Efficiency
   1. does the market attract funds to the best companies
2. Operational Efficiency
   1. does the market have low transaction costs & a convenient tradingn platform
3. Informational Efficiency
   1. Is all info available to investors at all times
4. Pricing Efficiency
   1. do share prices quickly & accurately reflect all known info about the company

the value of share is based on expectations of future CF from owning the shares. The strength of the link between company performance & share price depends on pricing efficiency of markets.

1. weaj form efficiency
   1. current shareprices reflect all information in record of past prices
   2. price movements cant be forecasted based on past trends
2. semi strong form efficiency
   1. current shareprices reflect all publicly available information 
   2. price only alters with new info & share prices follow random wallk
   3. to beat: insider trading
3. strong form efficiency
   1. share price reflects all published & unpublished information
   2. predictio not possible & insider trading not possible

Market efficiency relies on investors researchiing public information to find under-over priced shares. However, if market is effiicient, there will be no mispriced shares.

= market becomes more efficient when investors believe it is inefficient and do research to discover information

P0 = D1/1+re + D2//1+re^2 etc

P0 = D/Re (constant dividend to infinity)

P0 = current ex-div market value

re = shareholders required rate of return = cost of equity ke

• theoretical FV of shares in unlisted companies where a quoted market price is unknown
• for listed companies w. known share price: required rate of return of shareholders / companies cost of equity finance ke

b = proportion of profits retained = retained profit / profit

re = actual return = RoE = Profit / Net assets

same as of shares with constant dividend to annuity

ke=re=D/P0

Po = I / kd

kd = bondholders required return

P0 = ex interest market price

MV of coupon interest + redemption price discounted at investors required rate of return (=kd = yield to maturity)

yield to maturity = 

100 treasury note, 4%, trading at 98

ytm = 104/98

PV of future interest payments

plus higher of

• redemption value
• forecast conversion value 

both discounted at bondholders required rate of return (kd)

kd = IRR of pre-tax cash flows
from the bond

(1+semi annual cost)^2-1

if market interest rates increase,market price of bonds will decrease.

Bond prices fall when market interest rates rise because existing bonds become less attractive compared to new bonds.

Bond prices fall when market interest rates rise because existing bonds with lower fixed coupons must drop in price to offer investors the new higher required return.