Summary: Quantitative Methods - Basic Concepts

Read the summary and the most important questions on Quantitative Methods - Basic Concepts

• Reading 5 - The Time Value of Money

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• What is simple and compounding interest?

  Simple interest is the interest rate times the principal, which is the amount of funds originally invested. Compounding means interest earned on interest, i.e. reinvest the earned interest at the same rate.

• What types of cash flows do we have?

  - An annuity is a finite set of level sequential cash flows.
  - An ordinary annuity has a first cash flow that occurs one period from now (indexed at t = 1).
  - An annuity due has a first cash flow that occurs immediately (indexed at t = 0).
  - A perpetuity is a perpetual annuity, or a set of level never-ending sequential cash flows, with the first cash flow occurring one period from now. 

• What are the formulas for PV and FV?

  See equation file.
  Note that PVs and FVs are reciprocals.

• Reading 6 - Discounted Cash Flow Applications

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• What are the main areas of financial decision making in business?

  1) Capital budgeting, is the allocation of funds to relatively long-range projects or investments.
  2) Capital structure, is the choice of long-term financing for the investments the company wants to make.
  3) Worcking capital management, is the management of the company's short-term assets (such as inventory) and short-term liabilities (such as money owed to suppliers).

• What is the Internal Rate of Return (IRR)?

  Is the discount rate that makes the NPV equal to zero. It equates the present value of the outflows and inflows. Also known as Yield-to-Maturity (YTM), or as later explained the money-weighted rate of return.
  
  The IRR Rule states that projects should be accepted if the IRR is greater than the opportunity cost of capital (i.e. the hurdle rate).

• What problems can you encounter if projects are not independent?

  i.e. if projects are mutually exclusive, NPV and IRR may rank differently:
  - The size or scale of the projects differ (size of investment)
  - The timing of the cash flows differ
  
  NPV has the preference, because it represents the expected addition to shareholder wealth. With the basic financial objective to maximize this.

• What tasks do you have in assessing succes of investements?

  1) Performance measurement, by calculating returns in a logical and consistent manner.
  2) Performance appraisal.
  
  Central here is holding period return, the return an investor earns over a specific holding period.

• What do we mean by money-weighted rate of return?

  The internal rate of return (IRR) on an investment, money weighted, because it takes into account the timing and amount of all cash flows into an out the portfolio.
  
  As a consequence it puts a larger weight on position where more money is invested, e.g. having two stocks instead of one. This is a serious drawback in appraisal, as an investment manager should be evaluated on what he/she can influence (the actions), which is not the case for the total amount of investment as that is provided and determined by the clients.

• What do we mean by time-weighted rate of return?

  A measure that is not sensitive to withdrawals or additions of funds, it measures the compounded growth rate (e.g. CAGR) of $1 initially invested. Steps to take:
  1) Price at t=0, make subperiods based on out- and inflows. This can be very costly, but we can approximate with regular/interval periods (e.g. day).
  2) Calculate HPR for all subperiods.
  3) Link or compound all HPR's to get an annual rate of return. If more then a year, take the geometric mean.

• Reading 7 - Statistical Concepts and Market Returns

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• What are the four properties of return distributions?

  1) Central tendency (where returns are centered)
  2) Dispersion (how far returns are dispersed)
  3) Skewness (whether distribution is symmetrically shaped or lopsided
  4) Kurtosis (whether extreme outcomes are likely