FIN357 Exam 2

In our capital budgeting examples, we assumed that firm would recover all of the working capital it invested in a project. Is this a reasonable assumption? When might it not be valid?

It's probably only a mild over-simplification. Current liabilities will all be paid, presumably. The cash portion of current assets will be retrieved. Some receivables won't be collected, and some inventory will not be sold, of course. Counterbalancing these losses is the fact that inventory sold above cost (and not replaced at the end of the project's life) acts to increase working capital. These effects tend to offset one another.

An option can often have more than one source of value. Consider a logging company. The company can log the timber today or wait another year (or more) to log the timber. What advantages would waiting one year potentially have?

There are two sources of value with this decision to wait. Potentially, the price of the timber can increase, and the amount of timber will almost definitely increase, barring a natural catastrophe or forest fire. The option to wait for a logging company is quite valuable, and companies in the industry have models to estimate the future growth of a forest depending on its age.

Given that Nymox Pharmaceutical was up by 720 percent for 2015, why didn't all investors hold Nymox?

They all wish they had! Since they didn't, it must have been the case that the stellar performance was not foreseeable, at least not by most.

What is the difference between arithmetic and geometric returns? Supposed you have invested in a stock for the last 10 years. Which number is more important to you, the arithmetic or geometric return?

To calculate an arithmetic return, you sum the returns and divide by the number of returns. As such, arithmetic returns do not account for the effects of compounding. Geometric returns do account for the effects of compounding. As an investor, the more important return of an asset is the geometric return.

Why does traditional NPV analysis tend to underestimate the true value of a capital budgeting project?

Traditional NPV analysis is often too conservative because it ignores profitable options such as the ability to expand the project if it is profitable, or abandon the project if it is unprofitable. The option to alter a project when it has already been accepted has value, which increases the NPV of the project.

Critically evaluate the following statement: Playing the stock market is like gambling. Such speculative investing has no social value, other than the pleasure people get from this form of gambling.

Unlike gambling, the stock market is a positive sum game; everybody can win. Also, speculators provide liquidity to markets and thus help to promote efficiency.

Porsche was one of the last manufacturers to enter the sports utility vehicle market. Why would one company decide to proceed with a product when other companies, at least initially, decide not to enter the market?

One company may be able to produce at lower incremental cost or market better. Also, of course, one of the two may have made a mistake!

A co-worker claims that looking at all this marginal this and incremental that is just a bunch of nonsense, and states: "Listen, if our average revenue doesn't exceed our average cost, then we will have a negative cash flow, and we will go broke!" How do you respond?

It is true that if average revenue is less than average cost, the firm is losing money. This much of the statement is therefore correct. At the margin, however, accepting a project with marginal revenue in excess of its marginal cost clearly acts to increase operating cash flow.

In evaluating the Cayenne, would you consider the possible damage to Porsche's reputation as erosion?

Definitely. The damage to Porsche's reputation is a factor the company needed to consider. If the reputation was damaged, the company would have lost sales of its existing car lines.

Is it unfair or unethical for corporations to create classes of stock with unequal voting rights?

It wouldn't seem to be. Investors who don't like the voting features of a particular class of stock are under no obligation to buy it.

Consider the following two mutually exclusive projects available to Global Investments, Inc. The appropriate disount rate for the projects is 10%. Global Investments chose to undertake Project A. At a luncheon for shareholders, the manager of a pension fund that owns a substantial amount of the firm's stock asks you why the firm chose Project A instead of Project B, when Project B has a higher profitability index. How would you, the CFO, justify your firm's action? Are there any circumstances under which Global Investments should choose Project B?

Although the profitability index (PI) is higher for Project B than for Project A, Project A should be chosen because it has the greater NPV. Confusion arises because Project B requires a smaller investment than Project A. Since the denominator of the PI ratio is lower for Project B than for Project A, B can have a higher PI yet have a lower NPV. Only in the case of capital rationing could the company's decision have been incorrect.

Given that Chesapeake Energy was down by 76 percent for 2015, why did some investors hold the stock? Why didn't they sell out before the price declined so sharply?

As in the previous question, it's easy to see after the fact that the investment was terrible, but it probably wasn't so easy ahead of time.

If a project with conventional cash flows has a payback period less than the project's life, can you definitively state the algebraic sign of the NPV? Why or why not? If you know that the discounted payback period is less than the project's life, what can you say about NPV? Explain.

Assuming conventional cash flows, a payback period less than the project's life means that the NPV is positive for a zero discount rate, but nothing more definitive can be said. For discount rates greater than zero, the payback period will still be less than the project's life, but the NPV may be positive, zero, or negative, depending on whether the discount rate is less than, equal to, or greater than the IRR. The discounted payback includes the effect of the relevant discount rate. If a project's discounted payback period is less than the project's life, it must be the case that NPV is positive.

Suppose a project has conventional cash flows and a positive NPV. What do you know about its payback? Its discounted payback? Its profitability index? Its IRR? Explain.

Assuming conventional cash flows, if a project has a positive NPV for a certain discount rate, then it will also have a positive NPV for a zero discount rate; thus, the payback period must be less than the project life. Since discounted payback is calculated at the same discount rate as is NPV, if NPV is positive, the discounted payback period must be less than the project's life. If NPV is positive, then the present value of future cash inflows is greater than the initial investment cost; thus, PI must be greater than 1. If NPV is positive for a certain discount rate R, then it will be zero for some larger discount rate R*; thus, the IRR must be greater than the required return.

Is it possible for the risk premium to be negative before an investment is undertaken? Can the risk premium be negative after the fact? Explain.

Before the fact, for most assets the risk premium will be positive; investors demand compensation over and above the risk-free return to invest their money in the risky asset. After the fact, the observed risk premium can be negative if the asset's nominal return is unexpectedly low, the risk-free return is unexpectedly high, or if some combination of these two events occurs.

"When evaluating projects, we're only concerned wit the relevant incremental after-tax cash flows. Therefore, because depreciation is a non-cash expense, we should ignore its effects when evaluating projects." Critically evaluate this statement.

Depreciation is a non-cash expense, but it is tax-deductible on the income statement. Thus depreciation causes taxes paid, an actual cash outflow, to be reduced by an amount equal to the depreciation tax shield, tcD. A reduction in taxes that would otherwise be paid is the same thing as a cash inflow, so the effects of the depreciation tax shield must be added in to get the total incremental aftertax cash flows.

As indicated by a number of examples in this chapter, earnings announcements by companies are closely followed by, and frequently result in, share price revisions. Two issues should come to mind. First, earnings announcements concern past periods. If the market values stocks based on expectations of the future, why are numbers summarizing past performance relevant? Second, these announcements concern accounting earnings. Going back to Ch. 2, such earnings may have little to do with cash flow, so, again, why are they relevant?

Earnings contain information about recent sales and costs. This information is useful for projecting future growth rates and cash flows. Thus, unexpectedly low earnings often lead market participants to reduce estimates of future growth rates and cash flows; price drops are the result. The reverse is often true for unexpectedly high earnings.

True or False: the variances of the individual assets in the portfolio are the most important characteristic in determining the expected return of a well-diversified portfolio. Explain.

False. The variance of the individual assets is a measure of the total risk. The variance on a well-diversified portfolio is a function of systematic risk only.

A project has perpetual cash flows of C per period, a cost of I, and a required return of R. What is the relationship between the project's payback and its IRR? What implications does your answer have for long-lived projects with relatively constant cash flows?

For a project with future cash flows that are an annuity: Payback = I/C And the IRR is: 0 = - I + C/IRR Solving the IRR equation for IRR, we get: IRR = C/I Notice this is just the reciprocal of the payback. So: IRR = 1/PB For long-lived projects with relatively constant cash flows, the sooner the project pays back, the greater is the IRR, and the IRR is approximately equal to the reciprocal of the payback period.

Given the choice, would a firm prefer to use MACRS depreciation or straight-line depreciation? Why?

For tax purposes, a firm would choose MACRS because it provides for larger depreciation deductions earlier. These larger deductions reduce taxes, but have no other cash consequences. Notice that the choice between MACRS and straight-line is purely a time value issue; the total depreciation is the same; only the timing differs.

What is forecasting risk? In general, would the degree of forecasting risk be greater for a new product or a cost-cutting proposal? Why?

Forecasting risk is the risk that a poor decision is made because of errors in projected cash flows. The danger is greatest with a new product because the cash flows are probably harder to predict.

As a shareholder of a firm that is contemplating a new project, would you be more concerned with the accounting break-even point, the cash break-even point (i.e., the point at which operating cash flow is zero), or the financial break-even point? Why?

From the shareholder perspective, the financial break-even point is the most important. A project can exceed the accounting and cash break-even points but still be below the financial break-even point. This causes a reduction in shareholder (your) wealth.

We have seen that over long periods of time stock investments have tended to substantially outperform bond investments. However, it is not all uncommon to observe investors with long horizons holding their investments entirely in bonds. Are such investors irrational?

No, stocks are riskier. Some investors are highly risk averse, and the extra possible return doesn't attract them relative to the extra risk.

Suppose the government announces that, based on a just-completed survey, the growth rate in the economy is likely to be 2% in the coming year, as compared to 5% for the year just completed. Will security prices increase, decrease, or stay the same following this announcement? Does it make any difference whether or not the 2% figure was anticipated by the market? Explain.

If the market expected the growth rate in the coming year to be 2 percent, then there would be no change in security prices if this expectation had been fully anticipated and priced. However, if the market had been expecting a growth rate other than 2 percent and the expectation was incorporated into security prices, then the government's announcement would most likely cause security prices in general to change; prices would drop if the anticipated growth rate had been more than 2 percent, and prices would rise if the anticipated growth rate had been less than 2 percent.

Consider the following quotation from a leading investment manager: "The shares of Mid-South Electric have traded close to $12 for most of the past three years. Since Mid-South's stock has demonstrated very little price movement, the stock has a low beta. Tech Flyer, on the other hand, has traded as high as $150 and as low as its current $75. Since Tech Flyer's stock has demonstrated a large amount of price movement, the stock has a very high beta." Do you agree with this analysis? Explain.

If we assume that the market has not stayed constant during the past three years, then the lack in movement of Mid-South Electric's stock price only indicates that the stock either has a standard deviation or a beta that is very near to zero. The large amount of movement in Tech Flyer's stock price does not imply that the firm's beta is high. Total volatility (the price fluctuation) is a function of both systematic and unsystematic risk. The beta only reflects the systematic risk. Observing the standard deviation of price movements does not indicate whether the price changes were due to systematic factors or firm specific factors. Thus, if you observe large stock price movements like that of Tech Flyer, you cannot claim that the beta of the stock is high. All you know is that the total risk of Tech Flyer is high.

Porsche's Cayenne

In 2003, Porsche unveiled its new SUV, the Cayenne. With a price tag of over $40,000, the original Cayenne went from 0 to 62 mph in 9.7 seconds. Porsche's decision to enter the SUV market was in response to the runaway success of other high-priced SUVs such as the Mercedes-Benz M-class. Vehicles in this class had generated years of very high profits. The Cayenne certainly spiced up the market, and Porsche subsequently introduced the Cayenne Turbo S, which goes from 0 to 62 mph in 3.8 seconds and has a top speed of 176 mph. The price tag for the Cayenne Turbo S in 2016 was over $157,000! Some analysts questioned Porsche's entry into the luxury SUV market. The analysts were concerned not only that Porsche was a late entry into the market, but also that the introduction of the Cayenne would damage Porsche's reputation as a maker of high-performance automobiles.

When it comes to voting in elections, what are the differences between U.S. political democracy and U.S. corporate democracy?

In a corporate election, you can buy votes (by buying shares), so money can be used to influence or even determine the outcome. Many would argue the same is true in political elections, but, in principle at least, no one has more than one vote.

Referring to the previous questions, under what circumstances might a company choose not to pay dividends?

In general, companies that need the cash will often forgo dividends since dividends are a cash expense. Young, growing companies with profitable investment opportunities are one example; another example is a company in financial distress.

In the context of capital budgeting, what is an opportunity cost?

In this context, an opportunity cost refers to the value of an asset or other input that will be used in a project. The relevant cost is what the asset or input is actually worth today, not, for example, what it cost to acquire.

A substantial percentage of the companies listed on the NYSE and the NASDAQ don't pay dividends, but investors are nonetheless willing to buy shares in them. How is this possible given your answer to the previous question?

Investors believe the company will eventually start paying dividends (or be sold to another company).

Some companies, such as Under Armour, have created classes of stock with no voting rights at all. Why would investors buy such stock?

Investors buy such stock because they want it, recognizing that the shares have no voting power. Presumably, investors pay a little less for such shares than they would otherwise.

Your company currently produces and sells steel shaft golf clubs. The board of directors wants you to consider the introduction of a new line of titanium bubble woods with graphite shafts. Which of the following costs are not relevant? (a) Land you already own that will be used for the project, but otherwise will be sold for $700,000, its market value (b) A $300,000 drop in your sales of steel shaft clubs in the titanium woods with graphite shafts are introduced (c) $200,000 spent on research and development last year on graphite shafts

Item a is a relevant cost because the opportunity to sell the land is lost if the new golf club is produced. Item b is also relevant because the firm must take into account the erosion of sales of existing products when a new product is introduced. If the firm produces the new club, the earnings from the existing clubs will decrease, effectively creating a cost that must be included in the decision. Item c is not relevant because the costs of research and development are sunk costs. Decisions made in the past cannot be changed. They are not relevant to the production of the new clubs.

Suppose a financial manager is quoted as saying, "Our firm uses the standalone principle. Because we treat projects like mini-firms in our evaluation process, we include financing costs because they are relevant at the firm level." Critically evaluate this statement.

Management's discretion to set the firm's capital structure is applicable at the firm level. Since any one particular project could be financed entirely with equity, another project could be financed with debt, and the firm's overall capital structure would remain unchanged, financing costs are not relevant in the analysis of a project's incremental cash flows according to the stand-alone principle.

Define net present value, discuss its potential shortcomings, and state the criterion for accepting or rejecting independent project under this rule.

NPV is the present value of a project's cash flows, including the initial outlay. NPV specifically measures, after considering the time value of money, the net increase or decrease in firm wealth due to the project. The decision rule is to accept projects that have a positive NPV, and reject projects with a negative NPV. NPV is superior to the other methods of analysis presented in the text because it has no serious flaws. The method unambiguously ranks mutually exclusive projects, and it can differentiate between projects of different scale and time horizon. The only drawback to NPV is that it relies on cash flow and discount rate values that are often estimates and thus not certain, but this is a problem shared by the other performance criteria as well. A project with NPV = $2,500 implies that the total shareholder wealth of the firm will increase by $2,500 if the project is accepted.

If a portfolio has a positive investment in every asset, can the expected return on the portfolio be greater than that on every asset in the portfolio? Can it be less than that on every asset in the portfolio? If you answer yes to one or both of these questions, give an example to support your answer.

No to both questions. The portfolio expected return is a weighted average of the asset returns, so it must be less than the largest asset return and greater than the smallest asset return.

Define payback period, discuss its potential shortcomings, and state the criterion for accepting or rejecting independent project under this rule.

Payback period is the accounting break-even point of a series of cash flows. To actually compute the payback period, it is assumed that any cash flow occurring during a given period is realized continuously throughout the period, and not at a single point in time. The payback is then the point in time for the series of cash flows when the initial cash outlays are fully recovered. Given some predetermined cutoff for the payback period, the decision rule is to accept projects that pay back before this cutoff, and reject projects that take longer to pay back. The worst problem associated with the payback period is that it ignores the time value of money. In addition, the selection of a hurdle point for the payback period is an arbitrary exercise that lacks any steadfast rule or method. The payback period is biased towards short-term projects; it fully ignores any cash flows that occur after the cutoff point.

In evaluating the Cayenne, what do you think Porsche needs to assume regarding the substantial profit margins that exist in this market? Is it likely that they will be maintained as the market becomes more competitive, or will Porsche be able to maintain the profit margin because of its image and the performance of the Cayenne?

Porsche would recognize that the outsized profits would dwindle as more products come to market and competition becomes more intense.

Evaluate the following statement: Managers should not focus on the current stock value because doing so will lead to an overemphasis on short-term profits at the expense of long-term profits.

Presumably, the current stock value reflects the risk, timing and magnitude of all future cash flows, both short-term and long-term. If this is correct, then the statement is false.

You are evaluating two projects, Project A and Project B. Project A has a short period of future cash flows, while Project B has relatively long future cash flows. Which project will be more sensitive to changes in the required return? Why?

Project B's NPV would be more sensitive to changes in the discount rate. The reason is the time value of money. Cash flows that occur further out in the future are always more sensitive to changes in the interest rate. This sensitivity is similar to the interest rate risk of a bond.

The historical asset class returns presented in the chapter are not adjusted for inflation. What would happen to the estimated risk premium if we did account for inflation? The returns are also not adjusted for taxes. What would happen to the returns if we accounted for taxes? What would happen to the volatility?

Risk premiums are about the same whether or not we account for inflation. The reason is that risk premiums are the difference between two returns, so inflation essentially nets out. Returns, risk premiums, and volatility would all be lower than we estimated because aftertax returns are smaller than pretax returns.

How does sensitivity analysis interact with break-even analysis?

Sensitivity analysis can determine how the financial break-even point changes when some factors (such as fixed costs, variable costs, or revenue) change.

In broad terms, why is some risk diversifiable? Why are some risk non-diversifiable? Does it follow that an investor can control the level of unsystematic risk in a portfolio, but not the level of systematic risk?

Some of the risk in holding any asset is unique to the asset in question. By investing in a variety of assets, this unique portion of the total risk can be eliminated at little cost. On the other hand, there are some risks that affect all investments. This portion of the total risk of an asset cannot be costlessly eliminated. In other words, systematic risk can be controlled, but only by a costly reduction in expected returns.

In recent years, it has been common for companies to experience significant stock price changes in reaction to announcements of massive layoffs. Critics charge that such events encourage companies to fire longtime employees and that Wall Street is cheering them on. Do you agree or disagree?

Such layoffs generally occur in the context of corporate restructurings. To the extent that the market views a restructuring as value-creating, stock prices will rise. So, it's not layoffs per se that are being cheered on. Nonetheless, Wall Street does encourage corporations to takes actions to create value, even if such actions involve layoffs.

Look at Table 10.1 and Figure 10.7 in the text. When were T-bill rates at their highest over the period from 1926 through 2015? Why do you think they were so high during this period? What relationship underlies your answer?

T-bill rates were highest in the early eighties. This was during a period of high inflation and is consistent with the Fisher effect.

When is EAC analysis appropriate for comparing two or more projects? Why is this method used? Are there any implicit assumptions required by this method that you find troubling? Explain.

The EAC approach is appropriate when comparing mutually exclusive projects with different lives that will be replaced when they wear out. This type of analysis is necessary so that the projects have a common life span over which they can be compared. For example, if one project has a three-year life and the other has a five-year life, then a 15-year horizon is the minimum necessary to place the two projects on an equal footing, implying that one project will be repeated five times and the other will be repeated three times. Note the shortest common life may be quite long when there are more than two alternatives and/or the individual project lives are relatively long. Assuming this type of analysis is valid implies that the project cash flows remain the same over the common life, thus ignoring the possible effects of, among other things: (1) inflation, (2) changing economic conditions, (3) the increasing unreliability of cash flow estimates that occur far into the future, and (4) the possible effects of future technology improvement that could alter the project cash flows.

Define internal rate of return, discuss its potential shortcomings, and state the criterion for accepting or rejecting independent project under this rule.

The IRR is the discount rate that causes the NPV of a series of cash flows to be identically zero. IRR can thus be interpreted as a financial break-even rate of return; at the IRR discount rate, the net value of the project is zero. The acceptance and rejection criteria are: -If C0 < 0 and all future cash flows are positive, accept the project if the internal rate of return is greater than or equal to the discount rate. -If C0 < 0 and all future cash flows are positive, reject the project if the internal rate of return is less than the discount rate. -If C0 > 0 and all future cash flows are negative, accept the project if the internal rate of return is less than or equal to the discount rate. -If C0 > 0 and all future cash flows are negative, reject the project if the internal rate of return is greater than the discount rate. IRR is the discount rate that causes NPV for a series of cash flows to be zero. NPV is preferred in all situations to IRR; IRR can lead to ambiguous results if there are non-conventional cash flows, and it also may ambiguously rank some mutually exclusive projects. However, for stand-alone projects with conventional cash flows, IRR and NPV are interchangeable techniques.

One of the less flattering interpretations of the acronym MIRR is "meaningless internal rate of return." Why do you think this term is applied to MIRR?

The MIRR is calculated by finding the present value of all cash outflows, the future value of all cash inflows to the end of the project, and then calculating the IRR of the two cash flows. As a result, the cash flows have been discounted or compounded by one interest rate (the required return), and then the interest rate between the two remaining cash flows is calculated. As such, the MIRR is not a true interest rate. In contrast, consider the IRR. If you take the initial investment, and calculate the future value at the IRR, you can replicate the future cash flows of the project exactly.

Define average accounting return, discuss its potential shortcomings, and state the criterion for accepting or rejecting independent project under this rule.

The average accounting return is interpreted as an average measure of the accounting performance of a project over time, computed as some average profit measure attributable to the project divided by some average balance sheet value for the project. This text computes AAR as average net income with respect to average (total) book value. Given some predetermined cutoff for AAR, the decision rule is to accept projects with an AAR in excess of the target measure, and reject all other projects. AAR is not a measure of cash flows or market value, but is rather a measure of financial statement accounts that often bear little resemblance to the relevant value of a project. In addition, the selection of a cutoff is arbitrary, and the time value of money is ignored. For a financial manager, both the reliance on accounting numbers rather than relevant market data and the exclusion of time value of money considerations are troubling. Despite these problems, AAR continues to be used in practice because (1) the accounting information is usually available, (2) analysts often use accounting ratios to analyze firm performance, and (3) managerial compensation is often tied to the attainment of target accounting ratio goals.

Suppose a company has a preferred stock issue and a common stock issue. Both have just paid a $2 dividend. Which do you think will have a higher price, a share of the preferred or a share of the common?

The common stock probably has a higher price because the dividend can grow, whereas it is fixed on the preferred. However, the preferred is less risky because of the dividend and liquidation preference, so it is possible the preferred could be worth more, depending on the circumstances.

Briefly explain why the covariance of a security with the rest of a well-diversified portfolio is a more appropriate measure of the risk of the security than the security's variance.

The covariance is a more appropriate measure of a security's risk in a well-diversified portfolio because the covariance reflects the effect of the security on the variance of the portfolio. Investors are concerned with the variance of their portfolios and not the variance of the individual securities. Since covariance measures the impact of an individual security on the variance of the portfolio, covariance is the appropriate measure of risk.

Under what two assumptions can we use the dividend growth model presented in the chapter to determine the value of a share of stock? Comment on the reasonableness of these assumption.

The general method for valuing a share of stock is to find the present value of all expected future dividends. The dividend growth model presented in the text is only valid (1) if dividends are expected to occur forever; that is, the stock provides dividends in perpetuity, and (2) if a constant growth rate of dividends occurs forever. A violation of the first assumption might be a company that is expected to cease operations and dissolve itself some finite number of years from now. The stock of such a company would be valued by applying the general method of valuation explained in this chapter. A violation of the second assumption might be a start-up firm that isn't currently paying any dividends, but is expected to eventually start making dividend payments some number of years from now. This stock would also be valued by the general dividend valuation method explained in this chapter.

Define profitability index, discuss its potential shortcomings, and state the criterion for accepting or rejecting independent project under this rule.

The profitability index is the present value of cash inflows relative to the project cost. As such, it is a benefit/cost ratio, providing a measure of the relative profitability of a project. The profitability index decision rule is to accept projects with a PI greater than one, and to reject projects with a PI less than one. The profitability index can be expressed as: PI = (NPV + cost)/cost = 1 + (NPV/cost). If a firm has a basket of positive NPV projects and is subject to capital rationing, PI may provide a good ranking measure of the projects, indicating the "bang for the buck" of each particular project.

Assume a firm is considering a new project that requires an initial investment and has equal sales and costs over its life. Will the project reach the accounting, cash, or financial break-even point first? Which will it reach next? Last? Will this ordering always apply?

The project will reach the cash break-even first, the accounting break-even next and finally the financial break-even. For a project with an initial investment and sales after, this ordering will always apply. The cash break-even is achieved first since it excludes depreciation. The accounting break-even is next since it includes depreciation. Finally, the financial break-even, which includes the time value of money, is achieved.

What are some of the difficulties that might come up in actual applications of the various criteria we discussed in this chapter? Which one would be the easiest to implement in actual applications? The most difficult?

The single biggest difficulty, by far, is coming up with reliable cash flow estimates. Determining an appropriate discount rate is also not a simple task. These issues are discussed in greater depth in the next several chapters. The payback approach is probably the simplest, followed by the AAR, but even these require revenue and cost projections. The discounted cash flow measures (discounted payback, NPV, IRR, and profitability index) are really only slightly more difficult in practice.

Is the following statement true or false? A risky security cannot have an expected return that is less than the risk-free rate because no risk-averse investor would be willing to hold this asset in equilibrium. Explain.

The statement is false. If a security has a negative beta, investors would want to hold the asset to reduce the variability of their portfolios. Those assets will have expected returns that are lower than the risk-free rate. To see this, examine the Capital Asset Pricing Model: E(RS) = Rf + Beta(S)[E(RM) - Rf] If Beta(S) < 0, then the E(RS) < Rf.

The investment in Project A is $1 million, and the investment in Project B is $2 million. Both projects have a unique internal rate of return of 20 percent. Is the following statement true or false? For any discount rate from 0% to 20%, Project B has an NPV twice as great as that of Project A.

The statement is false. If the cash flows of Project B occur early and the cash flows of Project A occur late, then for a low discount rate the NPV of A can exceed the NPV of B. However, in one particular case, the statement is true for equally risky projects. If the lives of the two projects are equal and the cash flows of Project B are twice the cash flows of Project A in every time period, the NPV of Project B will be twice the NPV of Project A.

One potential criticism of the internal rate of return technique is that there is an implicit assumption that the intermediate cash flows of the project are reinvested at the internal rate of return. In other words, if you calculate the future value of the intermediate cash flows to the end of the project at the required return, sum the future values, and calculate the internal rate of return of the two cash flows, you will get the same internal rate of return as the original calculation. If the reinvestment rate used to calculate the future value is different than the internal rate of return, the internal rate of return calculated for the two cash flows will be different. How would you evaluate this criticism?

The statement is incorrect. It is true that if you calculate the future value of all intermediate cash flows to the end of the project at the IRR, then calculate the IRR of this future value and the initial investment, you will get the same IRR. However, as in the previous question, what is done with the cash flows once they are generated does not affect the IRR. Suppose this $100 is a deposit into a bank account. The IRR of the cash flows is 10 percent. Does the IRR change if the Year 1 cash flow is reinvested in the account, or if it is withdrawn and spent on pizza? No. Finally, consider the yield to maturity calculation on a bond. If you think about it, the YTM is the IRR on the bond, but no mention of a reinvestment assumption for the bond coupons is suggested. The reason is that reinvestment is irrelevant to the YTM calculation; in the same way, reinvestment is irrelevant in the IRR calculation. Our caveat about blocked funds applies here as well

A major college textbook publisher has an existing finance textbook. The publisher is debating whether or not to product an "essentialized" version, meaning a shorter (and lower-priced) book. What are some of the considerations that should come into play?

There are two particularly important considerations. The first is erosion. Will the "essentialized" book displace copies of the existing book that would have otherwise been sold? This is of special concern given the lower price. The second consideration is competition. Will other publishers step in and produce such a product? If so, then any erosion is much less relevant. A particular concern to book publishers (and producers of a variety of other product types) is that the publisher only makes money from the sale of new books. Thus, it is important to examine whether the new book would displace sales of used books (good from the publisher's perspective) or new books (not good). This concern arises any time there is an active market for used product.

One potential criticism of the net present value technique is that there is an implicit assumption that the intermediate cash flows of the project are reinvested at the required return. In other words, if you calculate the future value of the intermediate cash flows to the end of the project at the required return, sum the future values, and find the net present value of the two cash flows, you will get the same net present value as the original calculation. If the reinvestment rate used to calculate the future value is lower than the required return, the net present value will decrease. How would you evaluate this criticism?

The statement is incorrect. It is true that if you calculate the future value of all intermediate cash flows to the end of the project at the required return, then calculate the NPV of this future value and the initial investment, you will get the same NPV. However, NPV says nothing about reinvestment of intermediate cash flows. The NPV is the present value of the project cash flows. What is actually done with those cash flows once they are generated is not relevant. Put differently, the value of a project depends on the cash flows generated by the project, not on the future value of those cash flows. The fact that the reinvestment "works" only if you use the required return as the reinvestment rate is also irrelevant because reinvestment is not relevant in the first place to the value of the project. One caveat: Our discussion here assumes that the cash flows are truly available once they are generated, meaning that it is up to firm management to decide what to do with the cash flows. In certain cases, there may be a requirement that the cash flows be reinvested. For example, in international investing, a company may be required to reinvest the cash flows in the country in which they are generated and not "repatriate" the money. Such funds are said to be "blocked" and reinvestment becomes relevant because the cash flows are not truly available.

Two years ago, the Lake Minerals and Small Town Furniture stock prices were the same. The average annual return for both stocks over the past two years was 10 percent. LM's stock price increased 10 percent each year. STF's stock price increased 25 percent in the first year and lost 5 percent last year. Do these two stocks have the same price today?

The stock prices are not the same. The return quoted for each stock is the arithmetic return, not the geometric return. The geometric return tells you the wealth increase from the beginning of the period to the end of the period, assuming the asset had the same return each year. As such, it is a better measure of ending wealth. To see this, assuming each stock had a beginning price of $100 per share, the ending price for each stock would be: Lake Minerals ending price = $100(1.10)(1.10) = $121.00 Small Town Furniture ending price = $100(1.25)(.95) = $118.75 Whenever there is any variance in returns, the asset with the larger variance will always have the greater difference between the arithmetic and geometric return.

What are the three factors that determine a company's price-earnings ratio?

The three factors are: 1) the company's future growth opportunities, 2) the company's level of risk, which determines the interest rate used to discount cash flows, 3) the accounting method used

Based on the dividend growth model, what are the two components of the total return on a share of stock? Which do you think is typically larger?

The two components are the dividend yield and the capital gains yield. For most companies, the capital gains yield is larger. This is easy to see for companies that pay no dividends. For companies that do pay dividends, the dividend yields are rarely over five percent and are often much less.

The Mango Republic has just liberalized its markets and is now permitting foreign investors. Tesla Manufacturing has analyzed starting a project in the country and has determined that the project has a negative NPV. Why might the company go ahead with the project? What type of option is most likely to add value to this project?

The type of option most likely to affect the decision is the option to expand. If the country just liberalized its markets, there is likely the potential for growth. First entry into a market, whether an entirely new market, or with a new product, can give a company name recognition and market share. This may make it more difficult for competitors entering the market.

Why does the value of a share of stock depend on dividends?

The value of any investment depends on the present value of its cash flows; i.e., what investors will actually receive. The cash flows from a share of stock are the dividends.

A broker has advised you not to invest in oil industry stocks because they have high standard deviations. Is the broker's advice sound for a risk-averse investor like yourself? Why or why not?

The wide fluctuations in the price of oil stocks do not indicate that these stocks are a poor investment. If an oil stock is purchased as part of a well-diversified portfolio, only its contribution to the risk of the entire portfolio matters. This contribution is measured by systematic risk or beta. Since price fluctuations in oil stocks reflect diversifiable plus non-diversifiable risk, observing the standard deviation of price movements is not an adequate measure of the appropriateness of adding oil stocks to a portfolio.

In early 2016, the manufacturer Continental, which is based in Germany, announced plans to invest $1.4 billion to manufacture commercial vehicle tires at a plant the company planned to build in Mississippi. Continental apparently felt that it would be better able to compete and create value with U.S.-based facilities. Other companies such as Fujifilm and Swiss chemical company Lonza have reach similar conclusions and taken similar actions. What are some of the reasons that foreign manufacturers of products as diverse as automobiles, film, and chemicals might arrive at this same conclusion?

There are a number of reasons. Two of the most important have to do with transportation costs and exchange rates. Manufacturing in the U.S. places the finished product much closer to the point of sale, resulting in significant savings in transportation costs. It also reduces inventories because goods spend less time in transit. Higher labor costs tend to offset these savings to some degree, at least compared to other possible manufacturing locations. Of great importance is the fact that manufacturing in the U.S. means that a much higher proportion of the costs are paid in dollars. Since sales are in dollars, the net effect is to immunize profits to a large extent against fluctuations in exchange rates. This issue is discussed in greater detail in the chapter on international finance.

You are discussing a project analysis with a co-worker. The project involves real options, such as expanding the project if successful, or abandoning the project if it fails. Your co-worker makes the following statement: "This analysis is ridiculous. We looked at expanding or abandoning the project in two years, but there are many other options we should consider. For example, we could expand in one year, and expand further in two years. Or we could expand in one year, and abandon the project in two years. There are too many options for us to examine. Because of this, anything this analysis would give us is worthless." How would you evaluate this statement? Considering that with any capital budgeting project there are an infinite number of real options, when do you stop the option analysis on an individual project?

When the additional analysis has a negative NPV. Since the additional analysis is likely to occur almost immediately, this means when the benefits of the additional analysis outweigh the costs. The benefits of the additional analysis are the reduction in the possibility of making a bad decision. Of course, the additional benefits are often difficult, if not impossible, to measure, so much of this decision is based on experience.

What is the essential difference between sensitivity analysis and scenario analysis?

With a sensitivity analysis, one variable is examined over a broad range of values. With a scenario analysis, all variables are examined for a limited range of values.

If a portfolio has a positive investment in every asset, can the standard deviation on the portfolio be less than that on every asset in the portfolio? What about the portfolio beta?

Yes, the standard deviation can be less than that of every asset in the portfolio. However, Beta(p) cannot be less than the smallest beta because Beta(p) is a weighted average of the individual asset betas.

Two years ago, General Materials' and Standard Fixtures' stock prices were the same. During the first year, GM's stock price increased by 10 percent while SF's stock price decreased by 10 percent. During the second year, GM's stock price decreased by 10 percent and SF's stock price increased by 10 percent. Do these two stocks have the same price today? Explain.

Yes, the stock prices are currently the same. Below is a table that depicts the stocks' price movements. Two years ago, each stock had the same price, P0. Over the first year, General Materials' stock price increased by 10 percent, or (1.1) P0. Standard Fixtures' stock price declined by 10 percent, or (.9) P0. Over the second year, General Materials' stock price decreased by 10 percent, or (.9)(1.1) P0, while Standard Fixtures' stock price increased by 10 percent, or (1.1)(.9) P0. Today, each of the stocks is worth 99 percent of its original value.

Are the capital budgeting criteria we discussed applicable to not for profit companies? How should such entities make capital budgeting decisions? What about the U.S. government? Should it evaluate spending proposals using these techniques?

Yes, they are. Such entities generally need to allocate available capital efficiently, just as for-profits do. However, it is frequently the case that the "revenues" from not-for-profit ventures are not tangible. For example, charitable giving has real opportunity costs, but the benefits are generally hard to measure. To the extent that benefits are measurable, the question of an appropriate required return remains. Payback rules are commonly used in such cases. Finally, realistic cost/benefit analysis along the lines indicated should definitely be used by the U.S. government and would go a long way toward balancing the budget!

In the context of the dividend growth model, is it true that the growth rate in dividends and the growth rate in the price of the stock are identical?

Yes. If the dividend grows at a steady rate, so does the stock price. In other words, the dividend growth rate and the capital gains yield are the same.

Is it possible that a risky asset could have a beta of zero? Explain. Based on the CAPM, what is the expected return on on such an asset? Is it possible that a risky asset could have a negative beta? What does the CAPM predict about the expected return on such an asset? Can you give an explanation for your answer?

Yes. It is possible, in theory, to construct a zero beta portfolio of risky assets whose return would be equal to the risk-free rate. It is also possible to have a negative beta; the return would be less than the risk-free rate. A negative beta asset would carry a negative risk premium because of its value as a diversification instrument.

Indicate whether the following events might cause stocks in general to change price, and whether they might cause Big Widget Corp.'s stock to change price: a. The government announces that inflation unexpectedly jumped by 2% last month b. Big Widget's quarterly earnings report, just issued, generally fell in line with analysts' expectations c. The government reports that economic growth last year was at 3%, which generally agreed with most economists' forecasts d. The directors of Big Widget die in a plane crash e. Congress approves changes to the tax code that will increase the top marginal corporate tax rate. The legislation had been debated for the previous six months

a. a change in systematic risk has occurred; market prices in general will most likely decline. b. no change in unsystematic risk; company price will most likely stay constant. c. no change in systematic risk; market prices in general will most likely stay constant. d. a change in unsystematic risk has occurred; company price will most likely decline. e. no change in systematic risk; market prices in general will most likely stay constant.

Projects A and B have the following cash flows (check page 220). If the cash flows from the projects are identical, which of the two projects would have a higher IRR? Why? If C1B=2C1A, C2B=2C2A, and C3B=2C3A, then is IRR in year 4 equal to IRR in year B?

a. Project A would have a higher IRR since initial investment for Project A is less than that of Project B, if the cash flows for the two projects are identical. b. Yes, since both the cash flows as well as the initial investment are twice that of Project B.

Which of the following should be treated as an incremental cash flow when computing the NPV of an investment? (a) A reduction in the sales of a company's other products caused by the investment (b) An expenditure on plant and equipment that has not yet been made and will be made only if the project is accepted (c) Costs of research and development undertaken in connection with the product during the past three years (d) Annual depreciation expense from the investment (e) Dividend payments by the firm (f) The resale value of plant and equipment at the end of the project's life (g) Salary and medical costs for production personnel who will be employed only if the project is accepted

a. Yes, the reduction in the sales of the company's other products, referred to as erosion, should be treated as an incremental cash flow. These lost sales are included because they are a cost (a revenue reduction) that the firm must bear if it chooses to produce the new product. b. Yes, expenditures on plant and equipment should be treated as incremental cash flows. These are costs of the new product line. However, if these expenditures have already occurred (and cannot be recaptured through a sale of the plant and equipment), they are sunk costs and are not included as incremental cash flows. c. No, the research and development costs should not be treated as incremental cash flows. The costs of research and development undertaken on the product during the past three years are sunk costs and should not be included in the evaluation of the project. Decisions made and costs incurred in the past cannot be changed. They should not affect the decision to accept or reject the project. d. Yes, the annual depreciation expense must be taken into account when calculating the cash flows related to a given project. While depreciation is not a cash expense that directly affects cash flow, it decreases a firm's net income and hence, lowers its tax bill for the year. Because of this depreciation tax shield, the firm has more cash on hand at the end of the year than it would have had without expensing depreciation. e. No, dividend payments should not be treated as incremental cash flows. A firm's decision to pay or not pay dividends is independent of the decision to accept or reject any given investment project. For this reason, dividends are not an incremental cash flow to a given project. Dividend policy is discussed in more detail in later chapters. f. Yes, the resale value of plant and equipment at the end of a project's life should be treated as an incremental cash flow. The price at which the firm sells the equipment is a cash inflow, and any difference between the book value of the equipment and its sale price will create accounting gains or losses that result in either a tax credit or liability. g. Yes, salary and medical costs for production employees hired for a project should be treated as incremental cash flows. The salaries of all personnel connected to the project must be included as costs of that project.

Classify the following events as mostly systematic or mostly unsystematic. Is the distinction clear in every case? a. Short-term interest rates increase unexpectedly b. The interest rate a company pays on its short-term debt borrowing is increased by its bank c. Oil prices unexpectedly decline d. An oil tanker ruptures, creating a large oil spill e. A manufacturer loses a multimillion-dollar product liability suit f. A supreme court decision substantially broadens producer liability for injuries suffered by product users

a. systematic b. unsystematic c. both; probably mostly systematic d. unsystematic e. unsystematic f. systematic