Corporate Finance Test 2

what are the four steps when choosing which machine has the lower equivalent annual cost?

1) calculate PV of costs for each machine 2) calculate PVAF 3) calculate EAC 4) choose cheaper machine

what is one disadvantage of profitability index?

it may lead to incorrect decisions in comparisons of mutually exclusive investments

an order to buy or sell shares at a predetermined price, to be executed when the market price reaches the requested price

limit order

risk gets ________ as the number of stocks _________ in the portfolio

lower, increase

what is expected return also called?

market capitalization rate

an order to buy or sell shares at the best currently available market price

market order

this is a portfolio of all assets in the economy

market portfolio

economy-wide sources of risk that affect the overall stock market (aka: systematic risk)

market risk

financial statement that uses market value of assets and liabilities

market value balance sheet

what is a tax shield?

money saved for tax

the net increase in sales revenue from the new project less outlays

operating cash flow (OCF)

what is a commonly used secondary investment criteria?

payback

which method uses an arbitrary value?

payback method

the _______ _______ of a project is the number of years it takes before the cumulative forecasted cash flow equals the initial outlay (number of years to recover your original investment)

payback period

the _______ ________ says only accept projects that "payback" in the desired time frame

payback rule

ratio of dividends to earnings per share

payout ratio

fraction of earnings retained by the firm

plowback ratio

the price of any share of stock can be thought of as the ______ _______ of the future cash flows

present value

- net present value of a firm's future investments - price difference of a company's growth and non-growth values ( ex from above: 100 - 55.53 = 44.4 )

present value of growth opportunities (PVGO)

market for the sale of new shares by corporations (ex: IPO)

primary market

when resources are limited, what provides a tool for selecting among various project combinations and alternatives?

profitability index

the value of a business or project is usually computed at the discounted value of free cash flows out to a _______ _______

valuation horizon (H)

the expected squared deviation from the expected return

variance

what two are a measure of volatility

variance and standard deviation

what is the E.A.C. formula?

E.A.C. (annuity) = PV of CF / annuity factor

what is the internal rate of return rule

invest in any project offering a rate of return that is higher than the opportunity cost of capital

this represents a negative cash flow

investment in working capital

what is the formula for annual tax shield?

(annual depreciation x tax rate)

(T/F): a dollar today is worth more than a dollar tomorrow

true

what are 4 disadvantages of payback?

1. Ignores the time value of money 2. Requires an arbitrary cutoff point 3. Ignores cash flows beyond the cutoff date 4. Biased against long-term projects, such as research and development, and new projects

what are the two steps to calculate profitability index?

1. calculate NPV for each project 2. calculate PI = NPV / investment

what are the three elements of project cash flows?

1. capital investment 2. operating cash flow 3. investment in working capital

what are the 3 pitfalls of internal rate of return?

1. change in CF sign -- multiple IRRs 2. mutually exclusive projects 3. there is more than one opportunity cost of capital

what are 3 advantages of payback?

1. easy to understand 2. adjusts for uncertainty of later cash flows 3. biased toward liquidity

what are two advantages of profitability index?

1. easy to understand and communicate 2. useful when available investment funds are limited

what are three advantages of IRR?

1. knowing a return is intuitively appealing 2. it is a simple way to communicate the value of a project to someone who doesn't know all the estimate details 3. if the IRR is high enough, you may not need to estimate a required return, which is often difficult

how many IRRs are possible for the following set of cash flows? CF0 = -$1,000, C1 = $500, C2 = -$300, C3 = $1,000, C4 = $200

2 possible IRRs

what is the total/net cash flow formula?

CF from capital investment and disposal + OCF + CF from working capital

what can you not use if there are more than one negative cash flows?

IRR (because there is more than one IRR when there are more than one negative cash flows)

why are mutually exclusive projects a pitfall?

IRR sometimes ignores the magnitude of the project

the discount rate at which NPV = 0

Internal Rate of Return (IRR)

What decision rule should be the primary decision method?

NPV

what are the most commonly used primary investment criteria?

NPV and IRR

price per share dividend by earnings per share

P/E ratio

if Project D has an IRR of 100% and NPV of +8,182, and Project E has an IRR of 75% and NPV of +11,818, which project is the better choice?

Project E (look at NPV over IRR, Project E has a much higher NPV)

trailing twelve months

TTM

(T/F): new law allows companies to take bonus depreciation to write off 100% of investment immediately - it is a temporary provision and will soon start to phase out

True (depreciation)

(T/F): a set of limited resources and projects can yield various combinations

True - profitability index

what act dropped the corporate tax rate from 35% to 21% in 2018?

U.S. Tax Cuts and Jobs Act

what is the formula for finding real rate?

[(1 + nominal) / (1 + inflation)] - 1

accept/reject: IRR > discount rate

accept

If a firm elects to pay a lower dividend and reinvest the funds, the stock price may ________ because future dividends may be higher

increase

the prices at which current shareholders are willing to sell their shares

ask price

why is the payback method flawed?

because it ignores later year cash flows and the present value of future cash flows

this is the sensitivity of a stock's return to the return on the market portfolio

beta

the prices at which investors are willing to buy shares

bid price

the difference between the bid price and the ask price

bid-ask price

net worth of the firm according to the balance sheet

book value

what are the two aspects of applying the net present value rule, rule 1: discount cash flows, not profits?

capital expenses and working capital

the up-front investment in plant, equipment, research, start-up costs, and diverse other outlays

capital investment

ownership shares in a publicly held corporation

common stock

what is a noncash expense?

depreciation

to determine cash flow from income, add back ___________ and subtract _________________

depreciation, capital expenditure

when applying the net present value rule, what is the first rule?

discount cash flows, not profits

when applying the net present value rule, what is the second rule?

discount incremental cash flows

a strategy designed to reduce risk by spreading the portfolio across many investments

diversification

periodic cash distribution from the firm to the shareholders

dividend

computation of today's stock, price which states that share value equals the present value of all expected future dividends

dividend discount model

___________ can also be derived from applying the return on equity to the percentage of earnings plowed back into operations

dividend growth rate

for a stock, the future cash flows are _________ and the ultimate ______ _______ of the stock

dividends; sales price

how do we choose between long and short-lived equipment?

equivalent annual cash flow (E.A.C.)

the cash flow per period with the same present value as the actual cash flow as the project

equivalent annual cash flow (E.A.C.)

the percentage yield that an investor forecasts from a specific investment over a set period of time

expected return

when estimating the cost of equity capital, the expected return on a stock investment plus the expected growth in the dividends.

expected return

net present value depends solely on the ______ ______ ______ from the project and the opportunity cost of capital

forecasted cash flows

dividends represent the ____ _____ ______ of the firm

future cash flows

the (lowest/highest) weighted average PI (profitability index) can indicate which projects to select?

highest

the number of (-) cash flows indicates what?

how many IRRs

what is the formula for finding nominal value?

real value x (1+inflation)^t

accept/reject: IRR < discount rate

reject

when applying the net present value rule, what is the fifth rule?

remember to deduct taxes

when estimating return that investors expect to receive use the following:

required rate of return = rf + market risk premium

what are the two operating cash flow (OCF) formulas?

revenue - cash expenses - taxes and (revenue - expenses)(1 - tax rate) + (annual depreciation x tax rate)

both variance and standard deviation are measure of what?

risk

what rule does all of the following: - include all incidental effects - do not confuse average with incremental payoffs - forecast product sales today but also recognize after-sales cash flows - include opportunity costs - forget sunk costs - beware of allocated overhead costs - remember salvage value

rule 2: discount incremental cash flows

what rule does all of the following: - be consistent in how you handle inflation - use nominal interest rates to discount nominal cash flows - use real interest rates to discount real cash flows - you will get the same results, whether you use nominal or real figures

rule 3: treat inflation consistently

what rule does all of the following: - cash flows should be estimated on after-tax basis - subtract cash outflows for taxes from pretax cash flows and discount net amount - be careful to subtract cash taxes - cash taxes paid are usually different from taxes reported on the income statement

rule 5: remember to deduct taxes

market in which previously issued shares are traded among investors

secondary market

when applying the net present value rule, what is the fourth rule?

separate investment and financing decision

can specific risk or market risk be eliminated by diversification?

specific risk

risk factors affecting only that firm (aka: diversifiable risk)

specific risk (unique)

the square root of the variance equals what

standard deviation

steady rate at which a firm can grow: plowback ratio x return on equity

sustainable growth rate

the valuation horizon is sometimes called the _____ ______ and is calculated like PVGO

terminal value

what does the "H" in some formulas stand for?

time horizon for your investment

when applying the net present value rule, what is the third rule?

treat inflation consistently

what is the third pitfall of internal rate of return?

what happens when there is more than one opportunity cost of capital

when do you record capital expenditures?

when they occur

what is the difference between company's short-term assets and liabilities (CA-CL)

working capital

how should you treat the proceeds from the debt issue and the interest and principal payments on the debt?

you ignore it first and calculate NPV. afterwards, you can see which financing method (all equity or using debt) gives you a better alternative