FINA 4315 Exam 2

Chapter 7: What is the NPV of a project that requires an initial outlay of $150,000 that is expected to generate $25,000 in annual cash flows that will grow at a rate of 4% in perpetuity, assuming your required return is 14%?

$100,000 Explanation: The NPV of a project that requires an initial outlay of $150,000 that is expected to generate $25,000 in annual cash flows that will grow at a rate of 4% in perpetuity, assuming your required return is 14%, is $100,000. To compute the answer you must use the constant growth formula to get the present value of the project's perpetual cash flows. So, NPV = -$150,000 + $25,000/(.14 - .04) = -$150,000 + $250,000 = $100,000

Chapter: 8 Giancarlo has received an inheritance from his rich uncle and is contemplating the purchase of a Suzuki XL7. In an attempt to make a rational decision, Giancarlo has identified the following cash flow estimates: Negotiated price of new Suzuki XL 7 $24,675 Taxes and fees on a new car purchase $1,732 Proceeds from the trade-in of old car $9,285 Estimated value of the Suzuki XL7 in 5 years $7,285 Estimated value of old car in 5 years $3,572 Estimated annual repair cost on Suzuki XL7 $350 Estimated annual repair cost on old car $925 What would be Giancarlo's initial investment in the Suzuki XL7?

$17,122 Explanation: Giancarlo's initial investment in the Suzuki XL7 will be $17,122. To arrive at this number you have to include the total out-of-pocket costs for the car and deduct any trade-in value so you can evaluate only incremental cash flows. So, the initial investment = $24,675 + $1,732 - $9,285 = $17,122. If Giancarlo decides to buy this car this will be the amount he will need to complete the transaction.

Chapter 6: A $1,000 face value bond with a 5% coupon rate that is selling for $945 will pay in interest every six months.

$25.00 Explanation: A $1,000 face value bond with a 5% coupon rate that is selling for $945 will pay $25.00 in interest every six months. The coupon interest payment is determined by multiplying the coupon rate by the face value of the bond. If the bond is a semiannual bond you divide that annual coupon amount by two to determine the amount the bondholder will receive every six months. So, in this case $1,000 x .05 = $50 and $50/2 = $25.00 per six month period.

Chapter 6: A $1,000 face value bond with a 5% coupon rate that is selling for $945 will pay ________ in interest every six months.

$25.00 Explanation: A $1,000 face value bond with a 5% coupon rate that is selling for $945 will pay $25.00 in interest every six months. The coupon interest payment is determined by multiplying the coupon rate by the face value of the bond. If the bond is a semiannual bond you divide that annual coupon amount by two to determine the amount the bondholder will receive every six months. So, in this case $1,000 x .05 = $50 and $50/2 = $25.00 per six month period. Additional Learning

Chapter 7: A firm has undertaken a project with an initial investment of $100,000. The firm's cost of capital is 14% Year Cash inflow 1 $50,000 2 $65,000 3 $90,000 What is the NPV for this project?

$54,623 Explanation: The NPV for this project is $54,623. You calculate the NPV for this project by subtracting the initial investment from the present value of the project's cash flows calculated using the firm's cost of capital. So for this project the; NPV = $50,000/(1.14) + $65,000/(1.14)2 + $90,000/(1.14)3 - $100,000 = $43,860 + $50,015 + $60,748 - $100,000 = $54,623

Chapter 6: A zero-coupon bond pays no interest payments to the bondholder. It has a $1,000 par value and matures in 5 years. What is the value of this bond if the market rate of interest on similar risk bonds is 10%?

$620.92 Explanation: A zero-coupon bond pays no interest payments to the bondholder. It has a $1,000 par value and matures in 5 years. The value of this bond when the market rate of interest on similar risk bonds is 10% is $620.92. The value of a zero-coupon bond is easy to calculate. Any bond value is simply the present value of the bond's cash flows and a zero-coupon bond only has one cash flow; the face value received at maturity. So, the value of this bond is equal to, PV = $1,000 / (1.10)^5 = $620.92. To value a zero-coupon bond you always use a discount rate that is equivalent to the current market rates on similar risk bonds.

Chapter 6: What is the value of a $1,000 par value 6% coupon bond with 7 years remaining to maturity assuming annual coupon payments and a market rate of 9% on similar risk bonds?

$849.01 Explanation: The value of a $1,000 par value 6% coupon bond with 7 years remaining to maturity assuming annual coupon payments and a market rate of 9% on similar risk bonds is $849.01. The easiest way to calculate the bond's value is to use a financial calculator with the following inputs, FV = $1,000; PMT = $60; N = 7; I/Y = 9%; CPT PV and you get $849.01. Note that some financial calculators will generate a negative number for PV, but you simply take the absolute value.

Chapter 7: A firm is evaluating an investment proposal, which has an initial investment of $8,000 and discounted cash flows valued at $6,000. The net present value of this investment is:

-$2,000 Explanation: A firm is evaluating an investment proposal, which has an initial investment of $8,000 and discounted cash flows valued at $6,000. The net present value of this investment is -$2,000. The NPV is defined as the present value of the project's cash flows minus the initial investment. In this case: NPV = $6,000 - $8,000 = -$2,000. This project should be rejected since it has a negative NPV. The present value of the project's cash flows needs to be at least as much as the initial investment

Chapter 7: A firm must choose from 5 capital budgeting proposals outlined below. The firm is subject to capital rationing and has a capital budget of $500,000. The firm's cost of capital is 12%. Project Initial IRR NPV - investment 1 $100,000 17% $50,000 2 $200,000 15% 10,000 3 $125,000 14% 30,000 4 $100,000 11% -2,500 5 $75,000 19% 25,000 Using the internal rate of return approach to ranking projects, which projects should the firm accept?

1,2,3 and 5 Explanation: Using the internal rate of return approach to ranking projects, the firm should accept projects 1,2,3 and 5. Using IRR, the firm should accept any project that generates an IRR at least as high as the firm's cost of capital. The only project that does not exceed the firm's 12% cost of capital is project 4.

Chapter 7: Jenna is considering an investment which has a price of $16,000. She expects to receive $3,000 for eight years. What is the investment's internal rate of return?

10% Explanation: Jenna is considering an investment which has a price of $16,000. She expects to receive $3,000 for eight years. The investment's internal rate of return is 10%. When you have a series of cash flows that represent an annuity it is very easy to calculate the IRR with your financial calculator using the following inputs: PV = -$16,000 N = 8; FV = 0 PMT = $3,000 CPT I/Y, which gives you 10.0082 or approximately 10%. Note that you would then compare this interest rate to your required return or hurdle rate to determine whether or not to accept this project.

Chapter 8: The U.S. tax code allows firms to take current year losses and carry back for _____ years, or carry forward for _____ years.

2; 20 Explanation: The U.S. tax code allows firms to take current year losses and carry back for 2 years, or carry forward for 20 years. In other words a firm can take current year losses and use those to offset gains in the previous two years or offset gains in the next 20 years. This provision enables firms to minimize their tax liability and is treated as a cash inflow.

Chapter 5: Cambridge State Bank is paying 7% interest on its one-year certificates of deposit. If the inflation rate is 4%, which of the following is the best approximation for the real rate of interest that Cambridge State Bank is paying?

3% Explanation: Cambridge State Bank is paying 7% interest on its one-year certificates of deposit. If the inflation rate is 4%, the best approximation for the real rate of interest that Cambridge State Bank is paying is 3%. The nominal or stated rate of interest can be viewed as the real rate plus an inflation premium so, Stated rate = real rate of interest + expected inflation premium Given the nominal rate of 7% and an inflation rate of 4%, we can simply plug those numbers into the simple formula and solve for an approximation of the real interest rate. So, 7% = real rate + 4% Real rate = 3%

Chapter 7: A firm is evaluating a proposal which has an initial investment of $45,000 and has cash flows of $5,000 in year 1, $20,000 in year 2, $15,000 in year 3, and $10,000 in year 4. The payback period of the project is:

3.5 years Explanation: A firm is evaluating a proposal which has an initial investment of $45,000 and has cash flows of $5,000 in year 1, $20,000 in year 2, $15,000 in year 3, and $10,000 in year 4. The payback period of the project is 3.5 years. The payback period is the length of time it takes to recover the initial investment so in this case you see that a total of $40,000 is recovered in the first three years, which leaves $5,000 to be recovered. In the fourth year, you will generate $10,000 so the fraction of the year required to capture the remaining $5,000 investment is $5,000/$10,000 or 0.5. The payback period is, therefore, 3.5 years.

Chapter 5: What is the effective annual rate when a quoted annual rate of 5% is compounded quarterly?

5.09% Explanation: The effective annual rate when a quoted annual rate of 5% is compounded quarterly is 5.09%. To compute this rate you use the formula; 1 + EAR = [1 + APR/k]k where k = number of compounding periods per year. So, 1 + EAR = [1 + .05/4]4 = 1.0509 So EAR = 5.09%

Chapter 5: What is the effective annual rate for an investment with an APR of 8% compounded monthly?

8.30% Explanation: The effective annual rate when a quoted annual rate (APR) of 8% is compounded monthly is 8.30%. To compute this rate you use the formula; 1 + EAR = [1 + APR/k]^k where k = number of compounding periods per year. So, 1 + EAR = [1 + .08/12]12 = 1.08299 So EAR = 8.30%

Chapter 6: What is the yield to maturity on a zero coupon bond currently selling for $527.32 that has a $1,000 par value and will mature in 8 years?

8.33% Explanation: The yield to maturity on a zero coupon bond currently selling for $527.32 that has a $1,000 par value and will mature in 8 years is 8.33%. The easiest way to calculate the yield to maturity (YTM) is to use a financial calculator. The inputs are: PV = -$527.32; FV = $1,000; N = 8; CPT I / Y and you get 8.33%.

Chapter 8: Which of the following is an example of a sunk cost?

Amount spent on a test market. Explanation: The amount spent on a test market is an example of a sunk cost. This money has already been spent and cannot be recovered. While this money will be attached to the project from an accounting perspective, as a relevant expense it should be excluded from the financial analysis of whether to undertake the project. The other two cash flows have not occurred yet and are therefore not sunk costs. The capital expenditure needed is a relevant incremental cash flow. However, interest expense is not a sunk cost but it should also be excluded as a relevant cash flow since it is already factored into the discount rate used to compute the present value of the project's expected cash flows.

Chapter 5: Two firms are issuing 20-year bonds. Firm 1 is offering a 5% coupon bond and Firm 2 is offering a 7% coupon bond. What is the likely reason for the difference in coupon rates?

Firm 2 is riskier than Firm 1

Chapter 5: A steeply upward-sloping yield curve indicates that:

Interest rates are expected to rise in the future. Explanation: According to expectations theory, the shape of the yield curve is determined by investor expectations about future interest rates. Therefore, a yield curve that sharply rises indicates that future interest rates are expected to be higher for some reason. Since the yield curve is constructed using nominal interest rates, it does not provide information on real interest rates. Therefore, without information on the inflation rates there is not enough information to determine the current real rate of return.

Chapter 7: To evaluate differences in project scale, a financial manager should always use ___________ as the primary capital budgeting evaluation tool.

NPV Explanation: To evaluate differences in project scale, a financial manager should always use NPV as the primary capital budgeting evaluation tool. If a manager looks only at the IRR as an evaluation tool they will always select the highest IRR. However, a project with a 100% IRR that only requires an initial investment of $5 is likely not preferred to a much larger scale project with a lower IRR such as one where you invest $100,000 and get a 50% IRR. Using the NPV would highlight those scale differences immediately. The IRR gives you an easy to use percentage return but should always be used in conjunction with the NPV. The MIRR is a modification of the IRR that is typically used when cash flows change direction and is not used to correct for scale differences.

Chapter 7: The profitability index is a ratio of:

NPV to investment cost Explanation: The profitability index (PI) is calculated by taking a project's NPV and dividing it by the cost. This gives us a measure of "bang for the buck", or how much NPV will you generate per unit of resources (costs) consumed. The PI allows you to rank projects if resources are limited. Profit to cost and profit to assets are not typically used in project analysis but are instead used to analyze efficiency in operations.

Chapter 7: Chris has been offered the chance to invest $120,000 in a partnership, which is expected to return $25,000 per year. If Chris is in the 30% tax bracket and limits investments to those with a payback of six years, should Chris invest?

No, because the payback period is 6.86 years. Explanation: To calculate the payback you need to calculate Chris' annual cash return which is equal to $25,000 (1 - 0.30) = $17,500 per year in after-tax proceeds from the investment. Given that annual amount, his payback is equal to $120,000 / $17,500 = 6.86 years. Since the payback exceeds his six year cut off he should not make the investment.

Chapter 6: A yield curve can be constructed using similar risk corporate bonds. The yield curves constructed with corporate bonds will __________ the U.S. Treasury yield curve.

Plot above Explanation:

Chapter 8: _____ allows us the see how much the NPV changes when the underlying project assumptions change.

Sensitivity analysis Explanation: Sensitivity analysis allows us the see how much the NPV changes when the underlying project assumptions change. For example, we may be concerned that our sales forecast is too high. We can plug in different sales numbers and see how NPV changes to give us a better understanding of how sensitive the NPV is to reduced sales. This additional information can give us a greater level of confidence about the project, or cause us to rethink our forecasts. Scenario analysis is similar but you change multiple parameters to determine the impact on NPV. We may change costs, sales revenues, pricing strategies or numerous other factors and see how it affects the NPV. Break-even analysis is used to determine the minimum sales needed for NPV to equal zero.

Chapter 6: Which of the following is one of the top three bond rating firms?

Standard and Poor's Explanation: Standard and Poor's is one of the top three bond rating firms. The other two large bond rating firms are Moody's and Fitch Ratings. All three of these firms rate debt issues with regard to default risk. The highest rated bonds are the ones that are less likely to default. The other two answer options are fictitious firms.

Chapter 5: Justin is considering an investment that will pay him $5,000 a year for the next 20 years. Which of the following should Justin use to discount these future cash flows to the present?

The opportunity cost of capital Explanation: Justin is considering an investment that will pay him $5,000 a year for the next 20 years. When he makes his calculations to discount these future cash flows to the present, he needs to use the opportunity cost of capital. The opportunity cost of capital is the best rate Justin could earn on a similar risk and maturity investment. He needs to make at least as much as he could on the next best comparable option or he should not make the investment. The opportunity cost of capital will exceed the real rate of return and the rate of inflation since any market rate of return should include both of those components. The annual percentage rate (APR) divided by the effective annual rate (EAR) is simply a detractor and not used in any market in this form.

Chapter 6: Which of these is an example of a sovereign bond?

U.S. Treaury bonds Explanation: U.S. Treasury bonds are an example of a sovereign bond. Any bond issued by a national government is a sovereign bond. This market has received scrutiny over recent credit downgrades of bonds issued by the governments of Greece, Spain, Portugal and many others. The other bonds are corporate bonds since they are issued by firms in order to raise funds.

Chapter 6: A bond will sell at __________ if the required return is greater than the coupon rate.

a discount Explanation: A bond will sell at a discount if the required return is greater than the coupon rate. If investors demand a higher return than can be earned on the coupon rate, the value of the bond will fall until investors can buy the bond and earn a return consistent with the return they could earn on other similar risk bonds. If they buy at a discount, they will receive the coupon payments and also earn some return on the increase in value the bond will experience as it approaches maturity. If the bond is selling at a premium, the reverse will occur. The investor will still receive the coupon payment, but will now lose money on the bond's value as it moves toward maturity and par value.

Chapter 7: An NPV profile is __________.

a graph of a project's NPV over a range of different discount rates Explanation: An NPV profile is useful when there is uncertainty surrounding a project's cost of capital. Some firms may use different costs of capital for projects with different levels of risk. When this is the case, the NPV profile provides some additional information regarding the discount rate where the NPV turns negative. The NPV of a project should be calculated using all cash flows and so looking at an NPV at various points in time is meaningless. Estimating the IRR using trial-and-error is cumbersome given the computing tools available today and it has no bearing on a project's NPV.

Chapter 8: A conventional cash flow pattern associated with capital investment projects consists of an initial outflow followed by:

a series of inflows Explanation: A conventional cash flow pattern associated with capital investment projects consists of an initial outflow followed by a series of inflows. In most cases, a firm will make an initial investment that will then begin generating cash inflows for the firm. This is the conventional cash flow pattern. However, the firm may be evaluating a project that will require an initial outflow followed by a series of outflows. A piece of pollution control equipment would fall under this category. For these projects, you are looking for the piece of equipment that will accomplish your goals at the least cost. Other projects may have some costs associated with termination that would require an additional outlay at the end of the project. A mining project that required land reclamation at the end would fall into this category.

Chapter 8: A conventional cash flow pattern associated with capital investment projects consists of an initial outflow followed by:

a series of inflows Explanation: A conventional cash flow pattern associated with capital investment projects consists of an initial outflow followed by a series of inflows. In most cases, a firm will make an initial investment that will then begin generating cash inflows for the firm. This is the conventional cash flow pattern. However, the firm may be evaluating a project that will require an initial outflow followed by a series of outflows. A piece of pollution control equipment would fall under this category. For these projects, you are looking for the piece of equipment that will accomplish your goals at the least cost. Other projects may have some costs associated with termination that would require an additional outlay at the end of the project. A mining project that required land reclamation at the end would fall into this category.

Chapter 6: The cash flows of a 10% coupon bond with four years to maturity and a $1,000 par value can be replicated with:

a series of zero coupon bonds Explanation: The cash flows of a 10% coupon bond with four years to maturity and a $1,000 par value can be replicated with a series of zero coupon bonds. Each coupon payment of $100 can be viewed as a zero coupon bond with a specific maturity. The final zero coupon bond will also include the $1,000 maturity value of the bond, so it will be $1,100. The total value of the bond is therefore, equivalent to the sum of present value of these 4 different zero-coupon bonds.

Chapter 8: We only want to consider incremental earnings in the capital budgeting process. Incremental earnings are the:

additional sales and costs associated with the project. Explanation: We only want to consider incremental earnings in the capital budgeting process. Incremental earnings are the additional sales and costs associated with the project. Incremental earnings will be the incremental revenues minus the incremental expenses, or any change in net earnings that occurs as a result of accepting the project. Externalities include any change in cash flows from other projects that occur as a result of undertaking a specific project. These can include cannibalization of other product sales, or synergies that might arise from undertaking a particular project. Capital expenditures are typically a component of the initial investment but might also be needed over the life of a project at specific points in time.

Chapter 8: An incremental cash flow valuation considers:

all project cash flows including cannibalization. Explanation: An incremental cash flow valuation considers all project cash flows including cannibalization. The only relevant cash flows are the ones that you would not realize or would not be incurred unless you undertake a particular project. If you are considering undertaking a project that will generate sales that will reduce your sales in other products (cannibalize them) then that is a relevant cash flow. If your new product is expected to sell $5 million in the first year but it will reduce your other sales by $1 million then the relevant cash flow is the $4 million increase in sales. You should always include the impact of cannibalization of existing sales as an incremental cash flow. Conversely previously spent funds, or sunk costs, cannot be recovered and should not be considered as a relevant cash flow. Including them can lead to an incorrect reject decision of an investment that may have allowed you to recover a portion of those costs instead of losing all of them.

Chapter 7: Which of these is a pitfall of using the IRR that will result in failure of the technique?

cash flows changing signs. Explanation: One pitfall of using the IRR occurs when cash flows change signs. The IRR technique will generate a unique IRR every time the cash flows change signs and result in multiple IRRs. There is no clear way to tell which one to use so the technique is invalid with cash flows that change directions. The IRR works well for stand alone projects and projects that begin immediately as long as all the cash inflows are positive. Delayed projects can result in an inaccurate accept decision.

Chapter 6: The present value of a bond's __________ determines the value of the bond.

coupon payment and maturity value Explanation: The present value of a bond's coupon payment and maturity value determines the value of the bond. The value of any asset is the present value of that asset's cash flows. For a coupon bond, the two cash flows are the periodic coupon payments (typically, every 6 months) and the bond's face value the bondholder receives at maturity. Dividend payments are made to stockholders or shareholders and not bondholders.

Chapter 6: The __________ measures how sensitive a bond's price is to changes in interest rates.

duration Explanation: The duration measures how sensitive a bond's price is to changes in interest rates. A bond's price moves up or down as market rates of interest change. The amount of the price change depends on coupon payments, the amount of time until the maturity date, and the amount of the change in market rates of interest. Duration is a metric used to measure a specific bond's price sensitivity to changes in interest rates. A bond rating is an assessment of default risk assigned by an external rating agency such as Standard and Poor's, Moody's, or Fitch. It does not measure the bond's sensitivity to changes in market rates of interest.

Chapter 8: Capital budgeting is the process of:

evaluating a firm's investment choices. Explanation: Capital budgeting is the process of evaluating a firm's investment choices. Viable firms constantly seek out ways to invest funds in order to increase shareholder wealth. After potential investment options are identified they need to be evaluated. Capital budgeting is the process of identifying and evaluating these options and then investing in the ones that will increase shareholder wealth. Making cash budgets for the firm and preparing a statement of cash flows are also critical activities for the firm but are not considered to be capital budgeting.

Chapter 5: The interest rate banks charge each other for overnight loan is known as the:

fed funds rate Explanation: The Federal Reserve uses monetary policy to achieve a targeted fed funds rate in order to stimulate economic growth or slow the economy. The Fed can influence the fed funds rate through increasing or decreasing the money supply. In contrast, the Fed sets the discount rate, which is the rate the Fed charges to loan money to member banks that need additional reserves. The T-bill rate is the market determined rate of short-term Treasury securities known as Treasury bills. The prime rate is the interest rate that lenders charge their best (prime) customers.

Chapter 7: Unlike the IRR criteria, the NPV approach assumes an interest rate equal to the:

firm's cost of capital Explanation: Unlike the IRR criteria, the NPV approach assumes an interest rate equal to the firm's cost of capital. The NPV uses the firm's cost of capital to discount the project cash flows back to the present. Therefore, any positive NPV project earns at least the firm's cost of capital. The market rate of interest can be quite different depending on the riskiness of the firm's business activities and the project's internal rate of return is the discount rate that makes the project's NPV = 0. This rate will likely have no resemblance to the firm's cost of capital for most projects.

Chapter 6: All other things equal, a corporation will pay a __________ coupon rate on __________ bonds.

higher, higher risk Explanation: As the risk of a bond increases, corporations will have to offer a higher rate to compensate investors enough to hold higher risk bonds. Conversely, lower risk bonds will carry lower coupon rates because they have a lower chance of default.

Chapter 7: When resources are limited you should select the projects with the:

highest NPV Explanation: When resources are limited you should select the projects with the highest NPV. The highest NPV project will contribute the most toward increasing shareholder wealth. If the payback period is used as a selection tool, you select the projects with shorter paybacks instead of longer ones. However, payback should never be used in isolation but instead used in conjunction with the NPV. When you use IRR as the selection tool, you will be looking for the highest IRR, not the lowest. The IRR should also be used in conjunction with the NPV and never in isolation.

Chapter 8: A common use of break-even analysis is to determine:

how many units of sales are needed to cover all costs. Explanation: A common use of break-even analysis is to determine how many units of sales are needed to cover all costs. Break-even analysis can be adapted to look at a number of variables but it is commonly used to identify the exact number of units that will have to be sold in order to cover all the project's costs. Once that number is identified then the financial manager can meet with the sales force to determine whether this sales level is possible. That response can either reinforce a good project or cause management to rethink their assumptions and potentially reject the project. The level of cash needed to start a project will be determined independent of any break-even analysis but it will become one of the inputs. And, the point where the present value of the project's cash flows is equal to the initial outlay is the point where the project's NPV is equal to zero. The level of sales, either in terms of revenue or units, where the NPV is equal to zero is the break-even point.

Chapter 8: When a business undertakes a new project it will often need to invest additional funds in net working capital to cover items such as:

increased inventory levels. Explanation: When a business undertakes a new project it will often need to invest additional funds in net working capital to cover items such as increased inventory levels. Changes in net working capital are easy to forget about but any increased level of business typically requires additional investment in inventory, accounts receivables, and other current asset accounts. While a portion of this will be funded through a natural increase in liabilities in most cases this will not fund the entire increase in current assets. Installation costs are typically included in the initial outlay and the impact of product cannibalization should be netted out of sales.

Chapter 8: The relevant cash flows of a project are best described as:

incremental cash flows Explanation: The relevant cash flows of a project are best described as incremental cash flows. For financial decision-making, the only relevant cash flows are the marginal or incremental cash flows. These include any costs that you would not incur unless you undertake the project and only the addition to current revenues that you would receive if you accepted the project. Accounting cash flows are the starting point to help you identify relevant cash flows but then you will make adjustments for expenses that are non-cash outlays. Since accounting profits are also impacted by numerous non-incremental cash flows, they can only serve as a starting point to identify relevant incremental cash flows.

Chapter 6: The top four categories of bond ratings are collectively known as __________.

investment-grade bonds Explanation: The top four categories of bond ratings are collectively known as investment-grade bonds. Investment-grade bonds have a much lower risk of default than the lower rated bonds. The bottom five categories, which includes any bonds rated below Baa and BBB by Moody's and Standard and Poor's respectively, are known as speculative bonds or junk bonds. Junk bonds have to offer a higher return in order to compensate investors to assume a higher level of risk so they are also known as high-yield bonds.

Chapter 7: The IRR can lead to incorrect project rankings because projects with much higher NPVs may also have:

longer project lives Explanation: A particular project could have a very high IRR and only last one year. Therefore, a project with a slightly lower IRR that lasts several years may be preferred over the higher IRR. The NPV will correctly rank these projects if you rank them from the highest NPV to the lowest NPV. A shorter project life may or may not be the best project but the IRR will not make a distinction in project life. And, if the NPV is computed with a required return higher than the IRR it will generate a negative result and, therefore, should not be accepted.

Chapter 8: The most rapid method of depreciation allowed under U.S. tax code is the;

modified accelerated cost recovery system. Explanation: The most rapid method of depreciation allowed under U.S. tax code is the modified accelerated cost recovery system, or MACRS. From a financial standpoint it is in the firm's best interest to expense any assets acquired in the fastest manner. MACRS is the method that will depreciate assets the quickest. Assets are categorized according to an IRS recovery period schedule and then the fraction of the value of the asset that can be depreciated each year is determined from the IRS MACRS table. Straight line depreciation is much slower and the accelerated depreciation code is a fictional construct.

Chapter 5: The ________ interest rate is the interest rate that has not been adjusted for inflation.

nominal Explanation: The nominal interest rate is the interest rate that has not been adjusted for inflation. The nominal rate, or the quoted rate, does not factor in the impact of inflation. In contrast, the real interest rate is the nominal rate adjusted for the impact of inflation. The yield curve is constructed using interest rates of varying maturity securities from the same issuer which is typically the U.S. government.

Chapter 5: The discount rate an investor uses to evaluate investment options should be the;

opportunity cost of capital. Explanation: The discount rate an investor uses to evaluate investment options should be the opportunity cost of capital. This rate is the best available expected return offered in the market for similar risk investments. Both the nominal rate of return and the market rate of return are too ambiguous given there is no assessment of risk.

Chapter 8: Sunk costs are:

previous cash outflows not relevant to the project decision. Explanation: Sunk costs are previous cash outflows not relevant to the project decision. At times a firm may do a pilot program, a test market, or incur some other cost that either aided product development or helped provide additional information about a specific project. These expenses have already been incurred, and from an accounting perspective may be assigned to this project, but they are not relevant to the financial analysis of whether to accept or reject this project. Incorrectly including these sunk costs can lead you to reject a good project. Accounting losses are therefore not relevant to the financial analysis and only those cash outflows that have already occurred are considered to be sunk costs. There are numerous cash outflows that are relevant and should be considered.

Chapter 7: The first step in the capital budgeting process is:

proposal generation Explanation: The first step in the capital budgeting process is proposal generation. In order to evaluate a project you need to identify some promising capital budgeting projects that are consistent with your firm's mission and strategy. These ideas are often generated by the executive team but they can emerge from suggestions made by the sales force, research and development, or a number of other avenues. Once you have identified some possible proposals you will need to identify all relevant cash flows and then you can analyze the project using tools such as NPV, IRR, and payback.

Chapter 5: The __________ the cash flows, the ________the discount rate that should be used to compute the present value of the cash flows.

riskier; higher

Chapter 8: A method for evaluating a project that uses a number of possible values for a given variable, such as cash inflows, to assess its impact on the firm's return is:

sensitivity analysis. Explanation: A method for evaluating a project that uses a number of possible values for a given variable, such as cash inflows, to assess its impact on the firm's return is sensitivity analysis. In sensitivity analysis you identify a key variable that has a significant impact on profits and do some "what if" analysis by changing the value of that one variable and seeing how sensitive profits are to that change. This type of analysis allows you to determine the threshold values where the project becomes unprofitable. For example, if you make cattle feed you might see how sensitive profits are to fluctuations in the price of corn. In scenario analysis you look at changing several variables at one time. This may often result in a "best case" and "worst case" set of scenarios so you can evaluate profitability in a poor economy, a booming economy, or some other scenario. Risk-adjusted discount rates are sometimes used to adjust for a perceived difference in risk associated with a project's cash flows. Higher risk projects will be evaluated with a higher discount rate to ensure that the project's return is sufficient to compensate for the higher risk.

Chapter 5: The risk-free rate of interest is used in a number of financial models. The best approximation for the risk-free rate is:

short-term U.S. Treasuries

Chapter 8: A statistically based behavioral approach to project analysis that applies predetermined probability distributions is the:

simulation method. Explanation: A statistically based behavioral approach to project analysis that applies predetermined probability distributions is the simulation method. A simulation approach sets ranges of values for critical inputs and then allows a computer to run thousands of iterations based on all variable combinations. One possible output is to see what percentage of the mathematical iterations results in a positive NPV. Using this method gives the financial manager a higher level of confidence and essentially provides a probability of success. The scenario method is similar but you are typically only looking at a few scenarios such as a worst case, base case, and best case scenario. The certainty equivalent method reduces cash flows that occur further in the future and therefore lowers the project's NPV to account for the higher risk associated with more distant cash flows.

Chapter 6: Default-free, zero-coupon yields are also referred to as interest rates by some financial professionals.

spot Explanation: Default-free, zero-coupon yields are also referred to as spot interest rates by some financial professionals. This interest rate is also known as the risk-free rate of interest and will be used in successive chapters in the Capital Asset Pricing Model (CAPM). Real interest rates are nominal interest rates that have been adjusted for inflation and the prime interest rate is the rate that lenders charge their best clients for a loan.

Chapter 7: Projects that do not compete with one another so that the acceptance of one project will have no bearing on the acceptance of other projects being considered by the firm are known as;

stand-alone projects. Explanation: Projects that do not compete with one another so that the acceptance of one project will have no bearing on the acceptance of other projects being considered by the firm are known as stand-alone projects. Accepting an independent project does not automatically reject a competing project so the accept/reject decision is a stand-alone decision. Mutually exclusive projects are projects where the acceptance of one project automatically means we are rejecting other options. This type of capital budgeting decision is common in equipment replacement decisions.

Chapter 6: The no-arbitrage price of a coupon bond can be calculated by discounting the annual cash flows using the respective yields of:

zero-coupon bonds with the same maturities Explanation: The no-arbitrage price of a coupon bond can be calculated by discounting the annual cash flows using the respective yields of zero-coupon bonds with the same maturities. Note that each year's discount rate may vary slightly since longer maturity debts typically have higher return requirements. However, this method should generate the same value as you would find using the yield to maturity as a discount rate for the overall bond value.

Chapter 8: Giancarlo has received an inheritance from his rich uncle and is contemplating the purchase of a Suzuki XL7. In an attempt to make a rational decision, Giancarlo has identified the following cash flow estimates: Negotiated price of new Suzuki XL 7 $24,675 Taxes and fees on a new car purchase $1,732 Proceeds from the trade-in of old car $9,285 Estimated value of the Suzuki XL7 in 5 years $7,285 Estimated value of old car in 5 years $3,572 Estimated annual repair cost on Suzuki XL7 $350 Estimated annual repair cost on old car $925 What would be Giancarlo's operating cash flow in year 5?

-$575 Explanation: Giancarlo's operating cash flow in year 5 would be -$575. To evaluate his operating cash flows from accepting the project you need to determine the incremental difference. In this case he would have spent $925 but instead spent $350. So his operating cash flows for buying the new car would be $350 - $925 = -$575. The formula is; Replacement cash flows = cash flow for new asset - cash flow for the old asset.

Chapter 5: An inverted yield curve indicates that most investors believe interest rates will;

Decrease

Chapter 8: Break-even analysis has numerous applications. For example, we could compute EBIT break-even which is the level of sales where;

EBIT is equal to zero. Explanation: Break-even analysis has numerous applications. For example, we could compute EBIT break-even which is the level of sales where EBIT is equal to zero. However, while this method helps us understand the level of sales needed to break even from operations it does not factor in the up front costs of the project. The NPV break-even is a better tool that incorporates all the project's cash flows.

Chapter 8: Which of the following is a relevant opportunity cost that should be considered an incremental cash flow?

Lost facility rental income Explanation: Lost facility rental income is a relevant opportunity cost that should be considered an incremental cash flow. This is due to the fact that you are now using a facility for your new project that could be rented out to someone else. Since this resource has a valuable alternative use you need to factor that lost income in as a relevant cash flow. Lost interest income is factored into the discount rate and is not an opportunity cost even though you are no longer receiving the interest. Lost revenue from reduced sales in other products is a relevant incremental cost that is considered a product externality that is often dubbed cannibalization. However, it is not an opportunity cost.

Chapter 7: According to the IRR investment rule you should _______ any project where the IRR ______the cost of capital.

accept; exceeds Explanation: According to the IRR investment rule you should accept any project where the IRR exceeds the cost of capital. For example, if a project is expected to generate an IRR of 15% and the firm's cost of capital is 12% undertaking this project will create shareholder wealth.

Chapter 8: The _____ value is the value of all cash flows beyond the project's forecast horizon.

continuation Explanation: The continuation value is the value of all cash flows beyond the project's forecast horizon. For example, a project life for evaluation purposes may be 8 years. However, many projects may continue to generate cash flows beyond that 8 year period. To account for those additional cash flows you will determine a continuation value, or terminal value, which is a lump sum amount that you will use for a final cash flow for all cash flows that occur beyond the forecast horizon. A liquidation value, or salvage value, is the value of all assets sold at the project's end. Sometimes this value will be negative if there are disposal fees or reclamation costs.

Chapter 6: U.S. Treasury notes have maturities that range;

from one to ten years. Explanation: U.S. Treasury notes have maturities that range from one to ten years. U.S. Treasury bills have maturities up to one year and U.S. Treasury bonds have maturities that exceed ten years. All are issued by the U.S. government and therefore have low to no default risk depending on who you ask.

Chapter 5: How much will Jessica's monthly car payment be if she finances $22,500 for five years at 2.9%?

$403.30

Chapter 5: What is the monthly payment on a car loan if you finance $35,000 for 72 months at an APR of 5.9%?

$578.41

Chapter 5: The __________ is a graphical representation of the term structure of interest rates.

yield curve Explanation: The yield curve is a graphical representation of the term structure of interest rates. A yield curve is constructed from U.S. Treasury securities of differing maturities and plots yield on the y-axis and time to maturity on the x-axis. The resulting line that shows this relationship is known as the yield curve and it is typically upward sloping and to the right (normal yield curve). A time line is a tool used in finance that plots the amount and timing of a project's cash flows. Opportunity costs and real interest rates are not often graphed.

Chapter 6: The no-arbitrage price of a coupon bond can be calculated by discounting the annual cash flows using the respective yields of

zero-coupon bonds with the same maturities Explanation: The no-arbitrage price of a coupon bond can be calculated by discounting the annual cash flows using the respective yields of zero-coupon bonds with the same maturities. Note that each year's discount rate may vary slightly since longer maturity debts typically have higher return requirements. However, this method should generate the same value as you would find using the yield to maturity as a discount rate for the overall bond value.

Chapter 5: An example of a loan with a non-constant interest rate is a(n);

ARM Explanation: An example of a loan with a non-constant interest rate is an ARM, or adjustable rate mortgage. These mortgages are initially fixed for a short period of time, commonly three to five years, and then adjust every year thereafter based on a market based interest rate. These types of mortgages shift the risk of changing interest rates from the lender to the borrower. The real interest rate is the nominal interest rate adjusted for inflation. The Fed funds rate is the rate that Federal Reserve member banks charge each other for overnight loans.

Chapter 5: Which of the following statements about amortizing a loan is true?

Although the payment is the same each month, the interest that accrues each month decreases. Explanation: The loan payment is calculated to be an equal monthly amount that will fully repay the loan, including any interest, by the end of the loan. Each payment will have a component that repays accrued interest to date, and then the remainder reduces the principal balance. Therefore, each successive payment has a slightly smaller interest component and a slightly larger fraction dedicated to reducing the principal. At the end of the amortization period, your equal monthly payments will have fully repaid the loan.

Chapter 8: Which of the following cash flows should be included in incremental free cash flows?

Capital expenditures necessary to fund the new project. Explanation: Capital expenditures necessary to fund the new project should be included in incremental free cash flows. While the accounting cost of new assets will be depreciated over the asset's useful life the actual cash outlay to purchase the asset typically occurs on the front end of the project and is a relevant incremental cash flow. Interest expense and stock flotation costs should not be included in incremental free cash flows since these costs are associated with how the project is financed and are therefore embedded in the discount rate used to evaluate the project.

Chapter 6: A bond's ______ price is the bond's cash price minus an adjustment for accrued interest.

Clean Explanation: A bond's clean price is the bond's cash price minus an adjustment for accrued interest. Bonds are often quoted in clean price although bond traders know there will be an adjustment made for the accrued interest. The invoice price, or dirty price, will be the actual price paid for the bond that includes the accrued interest.

Chapter 6: What is the yield to maturity of a $100,000 face value U.S. Treasury bill that matures in one year and is currently selling for $98,742?

1.274% Explanation: The yield to maturity of a $100,000 face value U.S. Treasury bill that matures in one year and is currently selling for $98,742 is 1.274%. To compute the YTM you can use your financial calculator with the following inputs; PV = -98,742 FV = 100,000 NPER or N = 1 PMT or C = 0 CPT YTM or I/Y = 1.274%

Chapter 6: A long-term debt instrument issued by a business or government to raise capital is known as a:

Bond Explanation: A long-term debt instrument issued by a business or government to raise capital is known as a bond. Bonds are issued to raise money for operations or to acquire or improve assets. A bond typically pays interest every six months based on the coupon rate and then at maturity the bondholder will receive the face value of the bond, typically $1,000. Stocks are a fractional ownership in a company and therefore a part of equity and not debt. Dividends are a periodic distribution of cash to the stockholders of a firm.

Chapter 6: Credit risk, or default risk, is the risk that:

Bond interest payments or the principal payment will not be made. Explanation: Credit risk, or default risk, is the risk that bond interest payments or the principal payment will not be made. No investor can know for certain whether a corporation will be able to service its debt. This possibility of non-payment is known as credit risk or default risk and higher credit risk bonds must pay higher interest rates to compensate investors for assuming this level of risk. Coupon rates remain fixed for the life of a bond and the risk associated with changing market rates of interest is known as interest rate risk.

Chapter 5: Which of these bonds should have the highest risk and therefore return?

Bonds issued by the Gap Explanation: Bonds issued by the Gap should have the highest risk and therefore return. In contrast U.S. Treasury bonds will have the lowest risk since they are backed by the U.S. government. In addition, Johnson & Johnson is a diversified blue chip firm that has a very low risk of default compared to the Gap and will have very low rates.

Chapter 7: Jenna is considering an investment which has a price of $16,000. She expects to receive $3,000 for eight years. What is the investment's internal rate of return?

10% Explanation: When you have a series of cash flows that represent an annuity it is very easy to calculate the IRR with your financial calculator using the following inputs: PV = -$16,000 N = 8; FV = 0 PMT = $3,000 CPT I/Y, which gives you 10.0082 or approximately 10%. Note that you would then compare this interest rate to your required return or hurdle rate to determine whether or not to accept this project.

Chapter 5: What is the after-tax return on an 8% coupon rate bond for an investor in a 25% marginal tax bracket?

6% Explanation: The after-tax return on an 8% coupon rate bond for an investor in a 25% marginal tax bracket is 6%. To compute the after-tax return you multiply the nominal rate by (1 - T) where T = marginal tax rate. So, 8% x (1-.25) = 6%.

Chapter 7: Technology firm QUALCOMM Inc. evaluates projects with discount rates ranging from;

6% to 50% or more Explanation: Technology firm QUALCOMM Inc. evaluates projects with discount rates ranging from 6% to 50% or more. Very low risk projects may be evaluated using a 6% rate while high risk international projects with a lot of cash flow uncertainty may be evaluated with a discount rate of 50% or more.

Chapter 6: What is the yield to maturity (YTM) for a $1,000 par value bond selling for $1,100 that matures in 5 years and pays a 10% coupon one time a year?

7.5% Explanation: The yield to maturity (YTM) for a $1,000 par value bond selling for $1,100 that matures in 5 years and pays a 10% annual coupon one time a year is 7.5%. The easiest way to solve for YTM is with a financial calculator using the following inputs, PV = -$1,100; FV = $1,000; N = 5; PMT = $100; CPT I / Y and get 7.52%. Note that you multiply the coupon rate times the face value to get the dollar value of the coupon payment. It is also worth noting that when a bond is selling for a premium, as in this case, the YTM will be lower than the coupon rate. So the YTM had to be below 10%.

Chapter 7: Approximately _____ percent of firms use the NPV technique when evaluating investment options.

75% Explanation: Approximately 75 percent of firms use the NPV technique when evaluating investment options. However this information is from a survey conducted in 2001 so the number is likely higher now. As more and more recent business graduates move up in the work force the technique will probably grow in popularity.

Chapter 6: As market interest rates increase, the value of a bond will __________ all other things equal.

Decrease Explanation: As market interest rates increase, the value of a bond will decrease all other things equal. There is an inverse relationship between the values of outstanding bonds and market rates of interest. When interest rates go up, it decreases the present value of the cash flows associated with an outstanding bond and pushes price (value) lower. When interest rates go down, it increases the present value of the cash flows associated with an outstanding bond and bond prices will move higher.

Chapter 6: Bonds mature on a specific date and the is repaid to the bondholder at that time.

Face Value Explanation: Bonds mature on a specific date and the face value is repaid to the bondholder at that time. The bond's principal, also known as face value or par value, is typically $1,000 or some multiple of $1,000. When the bond reaches its specified maturity date that amount is returned to the bondholder. For coupon bonds the interest is paid periodically, typically every six months, over the life of the bond. When bonds are called prior to the maturity date the bondholders will receive a call premium that is added to the face value of the bond.

Chapter 5: The interest rate banks charge each other for overnight loan is known as the:

Fed fund rate

Chapter 5: Investors, analysts and managers often use the yield curve to:

Forecast interest rates.

Chapter 7: Which of the following decision rules is always correct because it is directly tied to the goal of maximizing shareholder wealth?

NPV rule Explanation: Any project that generates a positive NPV will provide the firm's required return since it was used as the discount rate to compute the present value of the project's cash flows. Therefore, any positive NPV project will continue to increase shareholder wealth since a positive number means it generates returns even higher than the required return. The IRR rule can generate incorrect accept/reject decisions if the project's cash flows change signs. The payback rule ignores the time value of money and can be inaccurate as well, particularly in rejecting good projects that have large cash flows occurring later in the project's life.

Chapter 7: Software Design Inc. is considering a number of capital budgeting projects. However, the company is currently constrained by the number of programmers that it employs. The company has 20 programmers on its staff and will not be able to hire any new programmers in the near future. Which of the following methods should the company use to choose which projects to accept?

Rank the projects based on profitability index (PI) and select the highest PIs. Explanation: When you are resource constrained, the PI will give you a metric that tells you how much "bang for the buck" you get. In this case, you would generate a PI that gives you the amount of NPV per programmer and select the highest ones until you have allocated 20 programmers. The payback period and the IRR do not take into consideration the resource shortage you face. In this case, it is a skilled labor shortage and you need to select the projects that give the highest return per unit of skilled labor.

Chapter 8: Which of the following is an example of an externality that will generate relevant cash flows?

The additional sales revenue of complementary products. Explanation: The additional sales revenue of complementary products is an example of an externality that will generate relevant cash flows. If you introduce a new product that stimulates the sales of an existing product then the increase in sales is an externality that is a relevant cash flow. Any lost rental income is relevant but that is an opportunity cost and not an externality. Overhead should not be considered as a relevant incremental cash flow unless there is an increase in overhead costs that is directly related to the project and would not be incurred otherwise. While the CEO may spend a lot of time on the project they should not have any of their salary allocated as a project cost since the company would pay that anyway. This is an example of overhead costs that are not incremental so should therefore be ignored for financial decision making.

Chapter 5: A very conservative investor that was seeking a low-risk investment would be most interested in which of these investments?

U.S. Treasuries

Chapter 7: The payback investment rule states that the firm should only invest in projects that will generate sufficient cash flows to pay back the initial investment within;

a prespecified period of time. Explanation: The payback investment rule states that the firm should only invest in projects that will generate sufficient cash flows to pay back the initial investment within a prespecified period of time. Most payback periods are a few years and two years is commonly used as a threshold. However, each firm will identify its payback period in advance and apply the rule accordingly.

Chapter 6: Treasury bills have maturities of up to one year and;

are zero-coupon bonds. Explanation: Treasury bills have maturities of up to one year and are zero-coupon bonds. U.S. Treasury bills are sold at a discount so investors make their return on the gain in bond value since they pay less than face value for bonds that pay face value to the bondholder at maturity. The interest rate earned is very low, given the risk-free nature of Treasury bills, but no coupon payment is paid out.

Chapter 5: If cash flows from an investment are taxed, the investor's actual cash flow from a specific investment will;

be reduced by the amount of the tax payments.

Chapter 8: In the context of capital budgeting, risk refers to the:

degree of variability of the cash inflows. Explanation: In the context of capital budgeting, risk refers to the degree of variability of the cash inflows. In finance risk is typically defined as the likelihood something will be different than we expect and in capital budgeting we make forecasts of the project's cash flows that may or may not ultimately be accurate. While financial managers always attempt to base their forecasts on the best possible information they still do not have crystal balls and forecasting the future is challenging at best. In general the amount of the initial investment is known with relative certainty so there is little risk in this known cash flow. And, if NPV is greater than zero that is a positive result and therefore not risk per se.

Chapter 5: When converting an APR to a discount rate you need to;

divide the APR by the annual compounding frequency.

Chapter 8: A project is said to break-even when the project's NPV;

equals zero. Explanation: A project is said to break-even when the project's NPV equals zero. When the NPV is equal to zero that means the project's return is expected to be exactly the cost of capital. That's why we accept any project with an NPV of zero or higher. Negative NPVs indicate the project will not make the required return which is the firm's cost of capital.

Chapter 5: Market rates of interest are partially determined by the Federal Reserve Bank through:

increasing or decreasing the money supply

Chapter 5: The term structure of interest rates refers to the different:

interest rates of securities with the same risk but different maturity dates

Chapter 8: The sale of an ordinary asset for its book value results in:

no tax benefit. Explanation: The sale of an ordinary asset for its book value results in no tax benefit. There is no tax impact of any kind when an asset is sold for its book value. If an asset is sold for more than its book value the firm will have a capital gain known as recaptured depreciation and it will have to pay taxes on that gain. If the firm sells the asset for less than its book value it will have a capital loss that may be used to offset other gains.

Chapter 8: The tax savings generated due to the ability to expense or depreciate an asset for tax purposes is known as:

the depreciation tax shield. Explanation: The tax savings generated due to the ability to expense or depreciate an asset for tax purposes is known as the depreciation tax shield. Being able to depreciate an asset reduces your tax liability and therefore is a relevant cash flow that is known as the depreciation tax shield. Depreciation expense is the actual amount you are allowed to expense in a given year for that asset. The modified accelerated cost recovery system (MACRS) is a legal IRS depreciation method that allows you to expense an asset more rapidly and therefore generate higher depreciation tax shields in the early years of a project.

Chapter 7: For mutually exclusive projects you should select the one with;

the highest NPV. Explanation: For mutually exclusive projects you should select the one with the highest NPV. Projects with the highest NPV will increase the investor's wealth more since that is the cash value expressed in today's dollars. The payback period should only be used in conjunction with the NPV and never as a stand alone tool.

Chapter 7: The incremental IRR tells us the discount rate at which it becomes profitable;

to switch from one project to another. Explanation: The incremental IRR tells us the discount rate at which it becomes profitable to switch from one project to another. This IRR is the IRR of the incremental cash flows that would result from switching from one project to another. Using this method allows us the evaluate the switch using the IRR rule and not have to directly compare the projects. This method is useful when two projects differ in risk and thus have two different cost of capital hurdle rates to compare with the IRR.