Corporate Finance Midterm Review
What is the Net Present Value (NPV) for the cash flows provided in the table below? Note: The negative cash flow for year 0 is the initial investment for the project. The required rate of return is 8% and the internal rate of return is 9.70%. Year 0: Cash Flow: -$100,000 Year 1: Cash Flow: $40,000 Year 2: Cash Flow: $40,000 Year 3: Cash Flow: $40,000
$3,083.88
If you won 15,000 shares of stock of Nike and it pays a dividend of $0.21 per share, then what is the total dividend you will receive?
$4,050
What is the Net Present Value (NPV) for the cash flows provided in the table below? Note: The negative cash flow for year 0 is the initial investment for the project. The required rate of return is 10% and the internal rate of return is 8.80%. Year 0: Cash Flow: -$87,000 Year 1: Cash Flow: $40,000 Year 2: Cash Flow: $42,000 Year 3: Cash Flow: $19,000
-$1,650.64
What is the discount factor that is equivalent to a 6% discount rate?
= (1 / 1.06) = 0.9434
Which of the following is a major problem with the IRR method of capital budgeting?
A mix of positive and negative cash flows may result in multiple IRRs.
What rights come with a share of stock?
A share of stock gives its owner the right to elect board members, vote on certain transactions of the firm (such as mergers), and receive periodic dividend payments as a partial return on the investment in the stock.
Which of the following could be considered a form of perpetuity?
A university scholarship endowment that promises to pay out $10,000 per year for an indefinite time period.
Which of the following is NOT a weakness of the payback method of capital budgeting?
All of these are weaknesses with the payback period method.
The appropriate rate to discount a cash flow to determine its value at an earlier time refers to:
Discount Rate
Because the stream of cash flows is infinite, a perpetuity does not have a finite value.
Even though the stream of cash flows is infinite, a perpetuity still has a finite value. The intuition is that the value of the perpetuity is just enough so that the interest earned on that value is equal to the perpetuity payment. That way, the perpetuity can continue forever, only paying the interest on the principal amount. False
If you were able to invest $2,500 at a rate of 6.40% for six months, how much money would you have at the end of that period?
FV = PV(1 + r)^n = $2,500 * (1.064)^0.50 = $2,578.76.
A growing annuity is a stream of cash flows that occurs at regular intervals and grows at a constant rate forever.
False
A natural extension of the sensitivity analysis is to ask at which level of each parameter would the project have an IRR of zero.
False
A stream of cash flows is a series of cash outflows lasting a few periods.
False
Bond prices change as interest rates change. When interest rates rise, bond prices also rise.
False
Car loans, the monthly lease payments for a car lease, and mortgages are all examples of perpetuity.
False
Competitive markets are markets in which a good can not be purchased or sold at the same price due to competition.
False
Compounding interest is a linear representation of the timing of potential cash flows.
False
Depreciation is a non-cash expense, so it should not be added back.
False
Different types of common stock for the same company are restricted from voting.
False
EBIT break-even is the level of a particular parameter for which a projects EBIT is greater than the IRR.
False
Incremental earnings refer to the amount by which a firm's earnings are expected to change as a result of an investment decision foregone.
False
Over head expenses refer to any unrecoverable cost for which a firm is already liable.
False
Pure discount bonds refer to the price at which bonds trade that is less than their face value.
False
Scenario analysis considers the effect on NPV of changing multiple project parameters sequentially.
False
Stock with preference over common shares in payment of dividends and liquidation are called classes.
False
The Law of One Price states that in competitive markets, differing goods or securities must have the same price.
False
The cumulative feature of preferred stock means that preferred dividends cannot be paid until all common dividends have been paid.
False
The final repayment date of a bond is the coupon rate.
False
The net present value method of capital budgeting fails to incorporate opportunity costs.
False
The option to delay provides the option for an investment to cease investing in a project.
False
The term, pro forma refers to a statement that is based on actual data used for forecasting.
False
The time value of money is the difference between money received today and money received in the past.
False
To increase the present value of a future cash flow, you could increase the discount rate.
False
What is the relationship between the return from reinvesting cash flows and the change in the price of stock?
In general, if the return is greater than the firm's cost of capital, then reinvesting cash flows will increase the stock price increases. If the return is less than the firm's cost of capital, the stock price will fall.
What is the Internal Rate of Return (IRR) for the cash flows provided in the table below? Note: The negative cash flow for year 0 is the initial investment for the project. The required rate of return is 12.0% Year 0: Cash Flow: -$100,000 Year 1: Cash Flow: $55,000 Year 2: Cash Flow: $35,000 Year 3: Cash Flow: $15,000
N = 3, PV = -100,000, PMT = 55,000, 35,000, 15,000, FV = 0, Solve for r = IRR = 3.07%.
________ is the cost of a foregone alternative.
Opportunity cost
Achi Corp. has preferred stock with an annual dividend of $3. If the required return on Achi's preferred stock is 8%, what is its price? (Hint: For a preferred stock, the dividend growth rate is zero.)
P = Div1/(r - g) = 3/(0.08 - 0) = 37.50
Calculate the payback period (PP) for the cash flows provided in the table below. Note: The negative cash flow for year 0 is the initial investment for the project. Year 0: Cash Flow: -$80,000 Year 1: Cash Flow: $32,000 Year 2: Cash Flow: $32,000 Year 3: Cash Flow: $32,000
PP = $80,000/$62,000 = 2.5 years.
What is the present value of $3,500 received 3 years from today if the prevailing interest rate is 6.10%?
PV = FV/(1+r)^n = $3,500/((1.0610)^3) = $2,930.37.
What are share repurchases, and how can they be incorporated into the valuation of a stock?
Share repurchases are the investment of a firm's cash flow in its own stock. This reduces the number of shares outstanding. To incorporate share repurchases in the valuation of a stock, it is best to use the total payout model instead of the dividend-discount model.
Assume you can earn 9% per year on your investments. If you wait until age 40 to invest the $100,000, how much will you have 25 years later for retirement?
The FV of 100,000 invested for 25 years at 9% is 100,000 × (1.09)25 = 862,308
Assume you can earn 9% per year on your investments. If you invested $100,000 for retirement at age 30, how much will you have in 35 years later for retirement?
The FV of 100,000 invested for 35 years at 9% is 100,000 × (1.09)35 = 2,041,397
Which of the following is NOT a major strength of the IRR method of capital budgeting?
The IRR cutoff interest rate is arbitrary.
How can the dividend-discount model be used with changing growth rates in future dividends?
The dividend discount model is easily adaptable to multiple growth rates in dividends. Just forecast the dividends until the growth rate stays constant into perpetuity, then take the present value of the dividends.
What must be true about the growth rate in order for a growing perpetuity to have a finite value?
The growth rate must be less than the discount rate, otherwise the perpetuity will not have a finite value. As the growth rate gets closer and closer to the discount rate, the value of the perpetuity increases rapidly approaching infinity.
Which of the following is NOT a strength of the payback method of capital budgeting?
The payback method uses all project cash flows in establishing the project payback period.
Which two components make up the total return to an investor in a share of stock?
The two components of the total return of the stock are the dividend payments and the capital appreciation (price change) of the stock.
Calculate the payback period (PP) for the cash flows provided in the table below. Note: The negative cash flow for year 0 is the initial investment for the project. Year 0: Cash Flow: -$47,000 Year 1: Cash Flow: $18,000 Year 2: Cash Flow: $14,000 Year 3: Cash Flow: $12,000
This project never fully repays its initial investment based on the information provided.
A capital budget lists the projects and investments that a company plans to undertake during the next period.
True
A competitive market refers to a market in which a good can be bought and sold at the same price.
True
A ticker symbol is a unique abbreviation assigned to a publicly traded company.
True
A written authorization for someone else to vote your shares is referred to as a proxy.
True
An annuity is a stream of constant cash flows paid every period for a finite amount of time, while a perpetuity is a stream of constant cash flows paid every period, forever.
True
An annuity refers to a stream of equal cash flows arriving at a regular interval and ending after a specified time period.
True
Any decision in which the value of the benefits exceeds the costs will increase the value of the firm.
True
Arbitrage opportunities refer to situations in which it is possible to make a profit without taking any risk or making any investment.
True
Arbitrage refers to the practice of buying and selling equivalent goods to take advantage of a price difference.
True
Bond ratings summarize the creditworthiness of the bonds for investors.
True
Capital budgeting is the process of analyzing investment opportunities and deciding which ones to accept.
True
Common shares are perpetual instruments, lasting as long as the firm itself lasts.
True
Coupons are the promised interest payments of a bond, paid periodically until the maturity date of the bond.
True
Free cash flows refers to the incremental effect of a project on a firm's available cash.
True
If the discount rate used to compare the present value of two annuities is 0%, then the timing of the cash flows is unimportant in the present value calculation.
True
If the price (or present value) of the combined cash flows was greater than the price of the individual cash flows, an astute investor could buy the combined cash flows, separate them into individual cash flows, and then sell each individual cash flow.
True
In general, any regular level cash flow with a prespecified ending point is an example of an annuity.
True
Long-term zero coupon bonds are more sensitive to changes in interest rates than are short-term zero-coupon bonds.
True
Most loans are good examples of annuities.
True
One weakness of the net present value method is that it provides an answer in dollar terms while many managers focus on percentage returns when assessing projects.
True
Perpetuities last "forever" but annuities have a finite life.
True
Real options provide the right to make a particular business decision, such as a capital investment.
True
The IRR rule states that a firm should accept any project with an internal rate of return greater than or equal to a pre-specified hurdle rate.
True
The difference between yields on Treasury securities and yields on corporate bonds is called the credit spread or default spread.
True
The maturity date refers to the final repayment date of a bond.
True
The opportunity cost refers to the value a resource could have provided in its best alternative use.
True
The price of the bond determines the yield to maturity. The price of the bond is determined by the interest rate yield curve for the bond. The yield to maturity is just the single discount rate that implies the observed market price of the bond.
True
The risk that default can occur is called default or credit risk. United States Treasury securities are free of default risk.
True
The time remaining until the repayment date refers to the term.
True
The time value of money implies that one dollar today is worth more than one dollar tomorrow, due primarily to the opportunity cost of foregoing consumption today.
True
The yield to maturity refers to the rate of return of an investment in a bond that is held to its maturity date or the discount rate that sets the present value of the promised bond payments equal to the current market price of the bond.
True
To increase the future value of a present cash flow, you could increase the interest rate.
True
Under the Dividend-discount model, profitability determines the company's ability to pay dividends, so, implicitly the forecasted dividend stream, we are forecasting the company's profitability.
True
Under the rules of the NPV, as long as the NPV is positive, the decision increases the value of the firm and considered a good decision regardless of the current cash needs or preferences.
True
We compute free cash flows from incremental earnings by eliminating all non-cash expenses and including all capital investments.
True
When a bond issuer does not make a bond payment in full, the issuer has defaulted.
True
is the return on an investment over a long horizon by multiplying the return factors associated with each intervening period.
True
You want to endow a scholarship that will pay $10,000 per year forever, starting one year from today. if the school's endowment discount rate is 7%, what is the amount that must be donated to the scholarship today?
With a donation of $142,857.14 today and 7% interest, the university can withdraw the interest every year ($10,000) and leave the endowment intact to generate the next year's $10,000. It can keep doing this forever. 10,000/0.07 = 142,857.14
You have $100 and a bank is offering 5% interest on deposits. If you deposit the money in the bank, in one year, you will have $105?
You need to compute the future value (FV) based on a 5% interest rate and a present value (PV) of $100. 5% interest rate means for every $1 today, you get $1.05 in a year. FV = $100 Today x ($1.05 in one year / $ today) = $105 in one year.
A price at which coupon bonds trade that is greater than their face value is called:
a premium
Complete the sentence. A perpetuity is
a stream of equal cash flows that occurs at regular intervals and lasts forever.
The MIRR eliminates the following statements regarding the IRR and how it solves problems with the IRR is not accurate?
a. The MIRR eliminates the problem of multiple IRRs. b. The MIRR eliminates the problem of the assumption of always reinvesting at the IRR. c. The MIRR eliminates the problem of arbitrarily choosing a required rate of return (AKA the hurdle rate). All of these are accurate.
Complete the sentence. The depreciation tax shield refers to the tax savings that result from the ability to:
deduct depreciation
What is the discount factor that is equivalent to a 6% discount rate?
discount factor = (1 / 1.06) = 0.9434
The notational amount of a bond used to compute its interest payments refers to the
face value
A person at the NYSE with a trading license who represents orders on the floor, balancing speed and price to get the best execution is called a:
floor broker
The final repayment date of the bond refers to the:
maturity date
Capital budgeting techniques are ________ assessment tools to determine whether a firm should proceed with an investment in ________.
quantitative; a project.
Complete the sentence. An important capital budgeting tool for assessing the effect of uncertainty in forecasts is:
sensitivity analysis
Complete the sentence. A method of depreciation in which the asset's cost is divided equally over its life is called:
straight-line depreciation
A firm's cost of capital may also be known as:
the cost of financing.
The present value refers to:
the value of a cost or benefit computed in terms of cash today.
The present value refers to:
the value of a cost or benefit coputed in terms of cash today.
Complete the sentence. The difference between receivables and payables (the net amount of a firm's capital consumed as a result of these credit transactions); is:
trade credit
Net income that does not include interest expenses associated with debt is called:
unlevered net income
A bond that makes only one payment at maturity is a
zero-coupon bond
Suppose you have a balance of $1,000 on an open credit account that charges 2% interest per month. You have not made payments on this account for 6 months, therefore your future balance in one year will be:
$1126.16
How is a bond like a loan?
A bond is like a loan because of the structure of the payments. The bond pays a regular coupon payment, which closely resembles an interest payment on a loan. At the maturity of the bond, the par value is paid, which is like repaying the principal of the loan. Any missed payment on a bond is considered a default on the loan, similar to defaulting on a loan.
If the cost of buying a CD and ripping the tracks to your IPod (including your timeline) is $25, what is the most Apple could charge on iTunes for a whole 15-track CD?
Apple cannot charge more than the cost of doing it yourself, so the maximum is $25, the same as the cost of buying the CD and ripping the tracks to your iPod.
What must be true about a cash flow stream in order for us to be able to use the shortcut formulas?
In order to use the shortcut formulas, the cash flows have to be constant (or in the case of the growing perpetuities and growing annuities, growing at a constant rate), the cash flows must be paid every period, and the same discount rate must be used on each cash flow.
What are some of the drawbacks of the dividend-discount model?
The dividend-discount model relies on forecasting dividends, which can be very uncertain. It also does not apply to non-dividend paying stocks.
What does the dividend - discount model say about valuing shares of stock?
The dividend-discount model states that the value of a share of stock should equal the present value of all future payments to be received from the stock. It is a direct application of the Valuation Principle.
How is yield to maturity related to the concept of rate of return?
The internal rate of return is the single discount rate that implies that the PV of the benefits of an investment is equal to the PV of the costs of the investment. The yield to maturity is the internal rate of return for a bond. The yield to maturity is the single discount rate that implies that the PV of the bond's cash flows is equal to its price.
Preferred stock refers to stock with preference over common shares in payment of dividends and in liquidation.
True
Scholarships and other endowments, such as the Nobel Prize, that make payments on a regular basis forever are both examples of perpetuities.
True
The Dividend-discount model has two fundamental limitations, its reliance on the dividend forecasts and the lack of applicability to non-dividend-paying stocks.
True
The value of a commodity or an asset to the firm or its investors is determined by its competitive market price.
True
You own 20% of the stock of a company that has 10 directors on its board. How much representation can you get on the board if the company has cumulative voting?
With cumulative voting, you are able to get proportional representation by putting all of your votes toward two directors, allowing you to elect representatives to two seats (20% of 10 seats) on the board.
As a bond approaches maturity, the price of the bond approaches
its face value