Junior Debt
What Does Junior Debt Mean?
Junior debt is debt that is either unsecured or has a lower priority than of another debt claim on the same asset or property. It is a debt that is lower in repayment priority than other debts in the event of the issuer's default. Junior debt is usually an unsecured form of debt, meaning there is no collateral behind the debt.
Investopedia explains Junior Debt
In the event that the issuing company goes out of business, the junior debt has a smaller probability of being paid back, either with money or with assets, since all higher-ranking debt will be given priority. Junior debt is also called subordinated debt, due to its position in the debt hierarchy. One common junior debt is the seconds mortgage which ranks behind the first mortgage and has a lesser claim in the event of default.
Discount Rate
What Does Discount Rate Mean?
1. The interest rate that an eligible depository institution is charged to borrow short-term funds directly from a Federal Reserve Bank.
2. The interest rate used in determining the present value of future cash flows.
Investopedia explains Discount Rate
1. This type of borrowing from the Fed is fairly limited. Institutions will often seek other means of meeting short-term liquidity needs. The Federal funds discount rate is one of two interest rates the Fed sets, the other being the overnight lending rate, or the Fed funds rate.
2. For example, let's say you expect $1,000 dollars in one year's time. To determine the present value of this $1,000 (what it is worth to you today) you would need to discount it by a particular rate of interest (often the risk-free rate but not always). Assuming a discount rate of 10%, the $1,000 in a year's time would be the equivalent of $909.09 to you today (1000/[1.00 + 0.10]).
Hurdle Rate
What Does Hurdle Rate Mean?
The minimum amount of return that a person requires before they will make an investment in something.
Investopedia explains Hurdle Rate
This is the rate of return that will get someone "over the hurdle" and invest their money.
Required Rate Of Return (RRR)
What Does Required Rate Of Return (RRR) Mean?
The rate of return needed to induce investors or companies to invest in something.
Investopedia explains Required Rate Of Return (RRR)
For example, if you invest in a stock, your required return might be 10% per year. Your reasoning is that if you don't receive 10% return, then you'd be better off paying down your outstanding mortgage, on which you are paying 10% interest.
Internal Rate Of Return – IRR
The internal rate of return (IRR) is a rate of return used in capital budgeting to measure and compare the profitability of investments. It is also called the discounted cash flow rate of return (DCFROR) or simply the rate of return (ROR).[1] In the context of savings and loans the IRR is also called the effective interest rate. The term internal refers to the fact that its calculation does not incorporate environmental factors (e.g., the interest rate or inflation).
Calculation
Given a collection of pairs (time, cash flow) involved in a project, the internal rate of return follows from the net present value as a function of the rate of return. A rate of return for which this function is zero is an internal rate of return.
Given the (period, cash flow) pairs (n, Cn) where n is a positive integer, the total number of periods N, and the net present value NPV, the internal rate of return is given by r in:
Note that the period is usually given in years, but the calculation may be made simpler if r is calculated using the period in which the majority of the problem is defined (e.g., using months if most of the cash flows occur at monthly intervals) and converted to a yearly period thereafter.
Note that any fixed time can be used in place of the present (e.g., the end of one interval of an annuity); the value obtained is zero if and only if the NPV is zero.
In the case that the cash flows are random variables, such as in the case of a life annuity, the expected values are put into the above formula.
Often, the value of r cannot be found analytically. In this case, numerical methods or graphical methods must be used.
Example if an investment may be given by the sequence of cash flows
Year (n)
Cash Flow (Cn)
0
?4000
1
1200
2
1410
3
1875
4
1050
then the IRR r is given by
.
In this case, the answer is 14.3%.
Numerical solution
Since the above is a manifestation of the general problem of finding the roots of the equation NPV(r), there are many numerical methods that can be used to estimate r. For example, using the secant method, r is given by
.
where rn is considered the nth approximation of the IRR.
This r can be found to an arbitrary degree of accuracy
This makes IRR a suitable (and popular) choice for analyzing venture capital and other private equity investments, as these strategies usually require several cash investments throughout the project, but only see one cash outflow at the end of the project (e.g., via IPO or M&A).
Since IRR does not consider cost of capital, it should not be used to compare projects of different duration. Modified Internal Rate of Return (MIRR) does consider cost of capital and provides a better indication of a project's efficiency in contributing to the firm's discounted cash flow.
In the case of positive cash flows followed by negative ones and then by positive ones (for example, + + - - - +) the IRR may have multiple values. In this case a discount rate may be used for the borrowing cash flow and the IRR calculated for the investment cash flow. This applies for example when a customer makes a deposit before a specific machine is built.
In a series of cash flows like (-10, 21, -11), one initially invests money, so a high rate of return is best, but then receives more than one possesses, so then one owes money, so now a low rate of return is best. In this case it is not even clear whether a high or a low IRR is better. There may even be multiple IRRs for a single project, like in the example 0% as well as 10%. Examples of this type of project are strip mines and nuclear power plants, where there is usually a large cash outflow at the end of the project.
In general, the IRR can be calculated by solving a polynomial equation. Sturm's theorem can be used to determine if that equation has a unique real solution. In general the IRR equation cannot be solved analytically but only iteratively.
When a project has multiple IRRs it may be more convenient to compute the IRR of the project with the benefits reinvested.[3] Accordingly, MIRR is used, which has an assumed reinvestment rate, usually equal to the project's cost of capital.
It has been shown[4] that with multiple internal rates of return, the IRR approach can still be interpreted in a way that is consistent with the present value approach provided that the underlying investment stream is correctly identified as net investment or net borrowing.
See also [5] for a way of identifying the relevant value of the IRR from a set of multiple IRR solutions.
Despite a strong academic preference for NPV, surveys indicate that executives prefer IRR over NPV.[6] Apparently, managers find it easier to compare investments of different sizes in terms of percentage rates of return than by dollars of NPV. However, NPV remains the "more accurate" reflection of value to the business. IRR, as a measure of investment efficiency may give better insights in capital constrained situations. However, when comparing mutually exclusive projects, NPV is the appropriate measure.
The discount rate often used in capital budgeting that makes the net present value of all cash flows from a particular project equal to zero. Generally speaking, the higher a project's internal rate of return, the more desirable it is to undertake the project. As such, IRR can be used to rank several prospective projects a firm is considering. Assuming all other factors are equal among the various projects, the project with the highest IRR would probably be considered the best and undertaken first.
IRR is sometimes referred to as "economic rate of return (ERR)".
Investopedia explains Internal Rate Of Return - IRR
You can think of IRR as the rate of growth a project is expected to generate. While the actual rate of return that a given project ends up generating will often differ from its estimated IRR rate, a project with a substantially higher IRR value than other available options would still provide a much better chance of strong growth.
IRRs can also be compared against prevailing rates of return in the securities market. If a firm can't find any projects with IRRs greater than the returns that can be generated in the financial markets, it may simply choose to invest its retained earnings into the market.
The risk-free rate of return is one of the most basic components of modern finance and many of its most famous theories - the capital asset pricing model (CAPM), modern portfolio theory (MPT) and the Black-Scholes model - use the risk-free rate as the primary component from which other valuations are derived. The risk-free asset only applies in theory, but its actual safety rarely comes into question until events fall far beyond the normal daily volatile markets. Although it's easy to take shots at theories that have a risk-free asset as their base, there are limited options to use as a proxy.
This article looks at the risk-free security in theory and in reality (as a government security), evaluating how truly risk free it is. The model assumes that investors are risk averse and will expect a certain rate of return for excess risk extending from the intercept, which is the risk-free rate of return.
The T-Bill Base
The risk-free rate is an important building block for MPT. As referenced in Figure 1, the risk-free rate is the base of the line where the lowest return can be found with the least amount of risk.
Risk-free assets under MPT, while theoretical, typically are represented by Treasury bills (T-bills), which have the following characteristics:
T-bills are assumed to have zero default risk because they represent and are backed by the good faith of the U.S. government. (Read Why do commercial bills have higher yields than T-bills? to learn more.)
T-bills are sold at auction in a weekly competitive bidding process and are sold at a discount from par. (Read Bond Market Pricing Conventions for more on how prices are determined.)
They don't pay traditional interest payments like their cousins, the Treasury notes and Treasury bonds.
They're sold in various maturities in denominations of $1,000.
They can be purchased by individuals directly from the government. (Buy Treasuries Directly From The Fed can show you how.)
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Because there are limited options to use instead of the United States T-bill, it helps to have a grasp of other areas of risk that can have indirect effects on risk-free assumptions.
Sources of Risk
The term risk is often taken for granted and used very loosely, especially when it comes to the risk-free rate. At its most basic level, risk is the probability of events or outcomes. When applied to investments, risk can be broken down a number of ways:
Absolute risk as defined by volatility: Absolute risk as defined by volatility can be easily quantified by common measures like standard deviation. Since risk-free assets typically mature in three months or less, the volatility measure is very short-term in nature. While daily prices relating to yield can be used to measure volatility, they are not commonly used. (For more insight, read The Uses And Limits Of Volatility.)
Relative risk: Relative risk when applied to investments is usually represented by the relation of price fluctuation of an asset to an index or base. One important differentiation is that relative risk tells very little about absolute risk - it only tells how risky the asset is compared to a base. Again, since the risk-free asset used in the theories is so short-term, relative risk does not always apply. (To learn more about degrees of risk, read Determining Risk And The Risk Pyramid.)
Default risk: What risk is assumed when investing in the three-month T-bill? Default risk, which in this case is the risk that the U.S. government would default on its debt obligations. Credit-risk evaluation measures deployed by securities analysts and lenders can help define the ultimate risk of default. (Learn more about credit risk in Corporate Bonds: An Introduction To Credit Risk.)
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Although the U.S. government has never defaulted on any of its debt obligations, the risk of default has been raised during extreme economic events, when the U.S. government has stepped in to provide a level of security,which provided a perception of safety. The U.S. government can spin the ultimate security of its debt in unlimited ways, but the reality is that the U.S. dollar is no longer backed by gold, so the only true security for its debt is the government's ability to make the payments from current balances or tax revenues. (Read more about the relationship between gold and the U.S. dollar in The Gold Standard Revisited and Does It Still Pay To Invest In Gold?)
This raises many questions of the reality of a risk-free asset. For example, say the economic environment is such that there is a large deficit being funded by debt, and the current administration plans to reduce taxes and provide tax incentives to both individuals and companies to spur economic growth. If this plan were used by a publicly held company, how could the company justify its credit quality if the plan were to basically decrease revenue and increase spending? That in itself is the rub: there really is no justification or alternative for the risk-free asset. There have been attempts to use other options, but the U.S. T-bill remains the best option, because it is the closest investment – in theory and reality – to a short-term riskless security.
Conclusion
The risk-free rate is rarely called into question until the economic environment falls into disarray. Catastrophic events, like credit-market collapses, war, stock market collapses and dramatic currency devaluations, can all lead people to question the safety and security of the U.S. government as a lender. The best way to evaluate the riskless security would be to use standard credit evaluation techniques, such as those an analyst would use to evaluate the creditworthiness of any company. Unfortunately, when the rubber hits the road, the metrics applied to the U.S. government rarely hold up, due to the fact that they exist in perpetuity by nature and have unlimited powers to raise funds both short- and long-term for spending and funding.
Net Present Value - NPV
In finance, the net present value (NPV) or net present worth (NPW)[1] of a time series of cash flows, both incoming and outgoing, is defined as the sum of the present values (PVs) of the individual cash flows. In the case when all future cash flows are incoming (such as coupons and principal of a bond) and the only outflow of cash is the purchase price, the NPV is simply the PV of future cash flows minus the purchase price (which is its own PV). NPV is a central tool in discounted cash flow (DCF) analysis, and is a standard method for using the time value of money to appraise long-term projects. Used for capital budgeting, and widely throughout economics, finance, and accounting, it measures the excess or shortfall of cash flows, in present value terms, once financing charges are met.
The NPV of a sequence of cash flows takes as input the cash flows and a discount rate or discount curve and outputs a price; the converse process in DCF analysis - taking a sequence of cash flows and a price as input and inferring as output a discount rate (the discount rate which would yield the given price as NPV) - is called the yield, and is more widely used in bond trading.
What Does Net Present Value - NPV Mean?
The difference between the present value of cash inflows and the present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of an investment or project.
NPV analysis is sensitive to the reliability of future cash inflows that an investment or project will yield.
Formula:
In addition to the formula, net present value can often be calculated using tables, and spreadsheets such as Microsoft Excel.
Investopedia explains Net Present Value - NPV
NPV compares the value of a dollar today to the value of that same dollar in the future, taking inflation and returns into account. If the NPV of a prospective project is positive, it should be accepted. However, if NPV is negative, the project should probably be rejected because cash flows will also be negative.
For example, if a retail clothing business wants to purchase an existing store, it would first estimate the future cash flows that store would generate, and then discount those cash flows into one lump-sum present value amount, say $565,000. If the owner of the store was willing to sell his business for less than $565,000, the purchasing company would likely accept the offer as it presents a positive NPV investment. Conversely, if the owner would not sell for less than $565,000, the purchaser would not buy the store, as the investment would present a negative NPV at that time and would, therefore, reduce the overall value of the clothing company.
Which is a better measure for capital budgeting, IRR or NPV?
The net present value (NPV) and the internal rate of return (IRR) could as well be defined as two faces of the same coin as both reflect on the anticipated performance of a firm or business over a particular period of time. The main difference however should be more evident in the method or should I say the units used. While NPV is calculated in cash, the IRR is a percentage value expected in return from a capital project.
Due to the fact that NPV is calculated in currency, it always seems to resonate more easily with the general public as the general public comprehends monetary value better as compared to other values. This does not necessarily mean that the NPV is automatically the best option when evaluating a firm’s progress. The best option would depend on the perception of the individual doing the calculation, as well as, his objective in the whole exercise. It is evident that managers and administrators would prefer the IRR as a method, as percentages give a better outlook that can be used to make strategic decisions over the firm.
Another major shortfall associated with the IRR method is the fact that it cannot be conclusively used in circumstances where the cash flow is inconsistent. While working out figures in such fluctuating circumstances may prove tricky for the IRR method, it would pose no challenge for the NPV method since all that it would take is the collection of all the inflows-outflows and finding an average over the entire period in focus.
Evaluating the viability of a project using the IRR method could cloud the true picture if the figures on the inflow and outflow remain to fluctuate persistently. It may even give the false impression that a short term venture with high return in a short time is more viable as compared to a bigger long-term venture that would otherwise make more profits.
In order to make a decision between any of the two methods, it is important to take note of the following significant differences.
Summary:
1. While the NPV will work better in helping other people such as investors in understanding the actual figures in so far as the evaluation of a project is concerned, the IRR will give percentages which can be better understood by managers
2. As much as discrepancies in discounts will most likely lead to similar recommendations from both methods, it is important to note that the NPV method can evaluate big long-term projects better as opposed to the IRR which gives better accuracy on short term projects with consistent inflow or outflow figures.
Key differences between the most popular methods, the NPV (Net Present Value) Method and IRR (Internal Rate of Return) Method, include:
• NPV is calculated in terms of currency while IRR is expressed in terms of the percentage return a firm expects the capital project to return;
• Academic evidence suggests that the NPV Method is preferred over other methods since it calculates additional wealth and the IRR Method does not;
• The IRR Method cannot be used to evaluate projects where there are changing cash flows (e.g., an initial outflow followed by in-flows and a later out-flow, such as may be required in the case of land reclamation by a mining firm);
• However, the IRR Method does have one significant advantage -- managers tend to better understand the concept of returns stated in percentages and find it easy to compare to the required cost of capital; and, finally,
• While both the NPV Method and the IRR Method are both DCF models and can even reach similar conclusions about a single project, the use of the IRR Method can lead to the belief that a smaller project with a shorter life and earlier cash inflows, is preferable to a larger project that will generate more cash.
• Applying NPV using different discount rates will result in different recommendations. The IRR method always gives the same recomendation.
In capital budgeting, there are a number of different approaches that can be used to evaluate any given project, and each approach has its own distinct advantages and disadvantages.
All other things being equal, using internal rate of return (IRR) and net present value (NPV) measurements to evaluate projects often results in the same findings. However, there are a number of projects for which using IRR is not as effective as using NPV to discount cash flows. IRR's major limitation is also its greatest strength: it uses one single discount rate to evaluate every investment.
Although using on