Week 5

• Taxation


  Tax allowance
• Depreciation


  Decrease in fair value of an asset
• Capital allowance


  Tax allowance
• Written-down value (WDV)


  Accounting approach to find out how much of the asset value is used in any specific period
• Cash flow timing


  Cash flows do not in practice occur at the year ends
• Inflation, Nominal and Real terms

  Nominal terms - cash flows refer to the forecast cash flows including inflation adjustments

  Real terms - cash flows are all given in terms of today's values, prices are today's price not forecast future prices
• The NPV formula is quite easy. We must be consistent with time units.
• NPV = −Investment + Σ CFt / (1 + r)^t
• If r is given as per year then times are in years, if it is given as per month then times are in months and so on.
• Since rates of return are commonly quoted per year we prefer to use annual rate and time in fractions of years.
• Nominal terms

  Cash flows refer to the forecast cash flows including inflation adjustments
• Real terms


  Cash flows are all given in terms of today's values, prices are today's price not forecast future prices
• Nominal rate (rn)


  Actual monetary returns
• Real rate (rr)


  Rate of return in today's money
• PT

  Portfolio Theory
• PTE


  Portfolio Theory and CAPM
• Inflation rate (i)


  Rate at which the purchasing power of a currency declines over time
• PC


  Portfolio Construction
• CAPM


  Capital Asset Pricing Model
• Relationship between nominal rate, real rate and inflation rate: (1 + rn) = (1 + i)(1 + rr)
• BS2214: Strategic Finance


  Course code and name
• When working in real terms, ensure all cash flows are valued in terms of today's money and convert the nominal discount rate to real terms using the formula: rr = (1 + rn) / (1 + i) - 1

  
• L6 Portfolio Theory & CAPM

  Course level and topics
• Academic year


  FY 2021-22
• When working in nominal terms, all cash flows must be in nominal terms. If a cash flow is in real terms, convert it to nominal terms using: Cnominal = (1 + i)^s * Creal
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• Learning Objectives


  • Taxation
  • Depreciation
  • Capital allowance
  • Tax allowance
  • Written-down value (WDV)
  • Cash flow timing
  • Inflation, Nominal and Real terms
• Using nominal terms is generally recommended as it better captures the effects of inflation on tax payments and cash flow triggers
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• Payback period calculation


  • Using real cash flows vs nominal cash flows gives different results
• Basic Statistics
• Depreciation


  Decrease in fair value of an asset over time
• Random variable, X


  A number that specifies the outcome of an event that depends on a random occurrence
• Depreciation is used in the income statement instead of capital expenses, to account for the use of an asset over time
• Replacement problem: When given more than one alternative with differing replacement cycles, we need to choose the cheapest option
• Random variable, X

  • Number observed from throwing a dice
  • Return on a share
• Machine A vs Machine B replacement options

  • Machine A has 3 year cycle, Machine B has 2 year cycle. Comparing NPVs shows Machine B is cheaper
• Realisation of a random variable

  The set of values it actually takes, derived from collected data
• Opportunity cost

  The cost of a resource even when no cash payment is required, e.g. using owned land for a project instead of renting it out
• Realisation of a random variable

  • Series of thrown dice
  • Daily share returns