Finance 301 Final
Security Market Line (SML)
A positively sloped line displaying the relationship between expected return [E(Ri)] and beta [Bi]
What does the CAPM graph look like
A straight upward-sloping line relationship between Return and Beta
Which return does not incorporate discounted cash flow valuation into its calculation?
Average Accounting Return
the CAPM:
capital asset pricing model; Equation of SML
When we employ ____ we are evaluating a project on the basis of its incremental cash flows, thereby ignoring the other cash flows for the firm.
the stand-alone principle
The cost of capital depends primarily on _______, not the ______
the use of funds; Source
In capital budgeting, it is important to identify and use only incremental cash flows because... _____
ultimately it is the change in a firm's overall future cash flows that matter
Capital rationing occurs...
when a firm has more positive NPV investment projects than it has capital to fund them; Hard rationing - when you're fresh outta money
Sunk Cost:
A cost that has already been incurred and cannot be removed; Along with financing costs, it should not be considered in an investment decision
The capitalization rate when evaluating a capital investment project is called the _____
Cost of capital = The discount rate = the required rate of return
A firm experiences _____ when the cash flows of a new project come at the expense of a firm's existing project
Erosion
T/F: Systematic risk is essentially eliminated by diversification, so a portfolio with many assets has almost no systematic risk
FALSE: Unsystematic
T/F When we are evaluating investments w/ risks different than our overall firm's risks, the use of the WACC is a good call
FALSE; The use of the WACC will give you an idea of your overall risk; It will lead you to a poor decision
WACC of firm B is 15%, WACC for firm A is 12%. What can we conclude?
Firm B is riskier
Diversification typically reduces
Firm-specific, Unique risk
____ describes the possibility that errors in projected cash flows will lead to incorrect decisions
Forecasting Risk
Systematic Risk=
Market Risk= Undiversifiable
Estimates of the WACC should ideally be based on _____
Market rates
The most valuable investment given up if an alternative investment is chosen is called ______
Opportunity Cost:
the determination of what happens to NPV when we ask what-if questions; Usually +/- 10%
Scenario Analysis:
In ____ we investigate the impact on NPV of allowing one variable to change while holding all other variables constant
Sensitivity Analysis
Order of return, highest to lowest:
Small company stocks, Corporate bonds, Treasury bonds, treasury bills
___ is one of the most commonly used measures of return volatility
Standard deviation
Which of the following is NOT an incremental cash flow in capital budgeting analysis?
Sunk Cost
Operating Leverage:
The degree to which a firm or project relies on fixed costs
Systematic Risk Principle:
The expected return on an asset depends only on that asset's systematic risk; Market Risk=Systematic Risk, We normally evaluate market risks in investing
The lessons from capital market history tell us:
The greater the risk, the greater the potential reward from owning a risky asset
Cost of Capital:
The minimum required return on a new investment; required return=discount rate
Opportunity Cost:
The most valuable alternative that is given up if an investment is undertaken; Consider this in an investing decision along with taxes
Equivalent Annual Cost (EAC):
The present value of a project's costs calculated on an annual basis
The principle of Diversification:
The process of reducing the riskiness associated with individual assets by spreading an investment across numerous assets
Arithmetic average return
The return earned in *an average year over a multiyear period; basic average
Cash Break-even:
The sales level that results in a zero operating cash flow
Accounting Break-even:
The sales level that results in zero project net income
Depreciation tax shield:
The tax saving that results from the depreciation deduction, calculated as D*T
T/F An asset's systematic risk can be measured by its beta coefficient
True
T/F: The expected return on a risky asset depends ONLY on that assets systematic (market, non-diversifiable) risk.
True; if it's diversifiable then you can eliminate all firm-specific risk
The cost of debt capital for a firm is the _____
Yield to Maturity (YTM) that the firm's creditors demand on new borrowing
In an efficient market, security prices reflect _____
available information
Unsystematic Risk =
diversifiable = asset-specific= Unique
Financial break-even:
the sales level that results in a zero NPV
beta Coefficient
the amount of systematic risk present in a particular risky asset relative to that in an average risky asset
Stand-alone Principle:
the assumption that evaluation of a project may be based on the project's incremental cash flows
Geometric average return
the average compounded return earned per year over a multi-year period
Risk premium is:
the excess return required from an investment in a risky asset over a risk-free investment
The slope of SML is _____
the market risk premium; difference b/t [Rm] and [Rf]
WACC is interpreted as:
the overall return the firm must earn on its existing assets to maintain the value of its stock
Cost of debt:
the return that lenders require on a firm's debt; the Yield to Maturity on a bond
(For a capital budgeting project) the cost of capital associated with the project is ____
the risk associated with the project
