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Tutor profile: Kendall P.

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Kendall P.
Finance, economics and statistics tutor
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Questions

Subject: Corporate Finance

TutorMe
Question:

The NPV analysis is commonly used as an investment project analysis tool. Please explain briefly how this tool works, when the outcome should be followed, and when the outcome should be disregarded.

Inactive
Kendall P.
Answer:

• The Net Present Value takes all the future free cash flows and discounts them at the weighted average cost of capital. The initial outlay is also subtracted. • If the outcome is positive, it means that you should invest as it maximizes the value of the firm. The outcome then indicates that the value of the shares would increase when executing the project as more cash flow are generated than what the financiers of the firm (i.e. shareholders and debtholders) require for the risk and opportunity costs that they face, being reflected in the discount rate. Also, the NPV takes the time value of money properly into consideration. • Investors should not blindly follow the NPV rule. In case that the project does not fit with the general strategy of the company, it might be wise not to pursue the project as it might not be value enhancing in the long run or even lead to cannibalisation. • NPV analyses are based on numerous assumptions and it might be useful to apply scenario analysis, sensitivity analysis, and/or simulation analysis to see whether the results remain robust.

Subject: Finance

TutorMe
Question:

Several methods exist to calculate Jensen’s alpha. Please explain what Jensen’s alpha is and four methods to calculate it, thereby each time showing a pro and a con. Also, do you believe that these models will always generate a positive alpha?

Inactive
Kendall P.
Answer:

Jensen’s alpha is a risk-adjusted performance measure that represents the average return on a portfolio or investments above, or below, the predicted equity returns. It shows is an investor could ‘beat the market’. Basically, it is the difference between the observed returns ex post and the predicted returns ex ante. In order to estimate Jensen’s alpha, it is first necessary to predict what the equity returns would be. Several models have been developed in the literature: • Capital Assets pricing model: the expected return is based on the expected excess return on the market. o PRO = easy model and has been used considerably in the past. o CON = it assumes that there is only a single factor that linearly impacts expected returns. • Arbitrage pricing theory: each stock return depends on macro-economic influences or ‘factors’. o PRO = the model takes into account that multiple risk factors could drive equity returns. o CON = the theory does not say what the factors should be. • Fama and French (1992) three-factor model: the return on equity is driven by the excess return on the market but also by a) a factor illustrating the excess return on whether the company is a small cap over a big cap and b) the excess return on whether the company has a high book-to-market (i.e. value stock) or low book-to-market (i.e. growth stock) ratio. o PRO = the model takes into account that multiple risk factors could drive equity returns and the factors are, in contrast to arbitrage pricing theory, defined. o CON = there seems to be more factors that drive equity returns not being captured by the model. • Carhart (1997) four-factor model: starts from the Fama and French (1992) three-factor model and adds a momentum factor. o PRO = the model takes into account that multiple risk factors could drive equity returns and the factors are, in contrast to arbitrage pricing theory, defined. The model is more ‘complete’ compared to Fama and French (1992). o CON = there seems to be more factors that drive equity returns not being captured. Until now, no model is complete in order to perfectly predict equity returns and it is thus not possible to persistently obtain a positive Jensen’s alpha. When an investor would know exactly how to obtain a positive alpha, it is likely that he/she would not share it as it represents his/her competitive advantage. Until now, hundreds of models have been developed and some seem to generate excess returns in the short term, but this is not a competitive advantage in the long run. Models remain to have an error and are based on numerous assumptions which do not always hold (see e.g. Roll’s critique on the CAPM).

Subject: Business

TutorMe
Question:

Do you believe that hands-on investors create value for their portfolio companies? You can perhaps take buyout investing as an example.

Inactive
Kendall P.
Answer:

Most US studies conducted in the 1980s and 1990s point to a significantly positive impact on post-buyout performance in terms of target profitability, growth and liquidity. Leveraged buyouts have been hailed as an efficient form of organisation, which apply governance, operational and financial engineering to their portfolio companies. In doing so, buyout financiers improve the firm’s operations, generate economic efficiencies and create economic value. Aside from the UK, previous research in Europe points to mixed or negative post-buyout performance. The reasons why are less clear but some scholars believe that investors provide money to lower-quality target companies.

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