FIN 357 Exam 2 - SI

break even analysis in finance

*EAC + FC(1-t) - depreciation*t/p-v*1-t number of units that cause NPV of a project to be 0

total risk

systematic risk + unsystematic risk

When the stock being valued does not pay dividends,

the dividend growth model can still be used.

the more volatile a return is

the greater the return is expected to be

normal distribution

the market does not have

expected return

the return that the market expects a stock to earn over the next period which is based on growth projections

allocated costs

- only be viewed as a cash outflow of a project if it is an incremental cost of the project - cost that is associated with some part of our company but not specific to our project

Owners of most common stock have right to:

- vote for the board of directors - share proportionally in dividends paid - share proportionally in assets remaining after liabilities have been paid in a liquidation - vote on stockholder matters of greater importance such as a merger

Which of the following are expected cash flows to investors in stocks?

1. Capital gains

NASDAQ has which of these features?

1. Computer network of securities dealers

What information do we need to determine the value of stock using the zero-growth model?

1. Discount rate

Once cash flows have been estimated, which of the following investment criteria can be applied to them?

1. IRR

According to Graham and Harvey's 1999 survey of 392 CFOs, which of the following two capital budgeting methods are most used by firms in the United States?

1. Internal rate of return

Which of the following are features of common stock?

1. It generally has voting rights.

Which of the following are reasons why NPV is considered a superior capital budgeting technique?

1. NPV considers all the cash flows.

Preferred stock has preference over common stock in the _____.

1. distribution of corporate assets

The possibility that errors in projected cash flows will lead to incorrect decisions is known as _____.

1. estimation risk

The IRR rule can lead to bad decisions when _____ or _____.

1. projects are mutually exclusive

A 10-year, 5% coupon bond is priced at $1,121.56. Interest is paid semi-annually. What is the bond's current yield?

4.46%

What is a sunk cost?

A cost incurred in the past that is irrelevant to the capital investment decision process.

____ budgeting is the decision-making process for accepting and rejecting projects.

Capital

As an investor in the bond market, why should you be concerned about changes in interest rates?

Changes in interest rates cause changes in bond prices.

What is a bond's current yield?

Current yield = Annual coupon payment/Current price

Which capital budgeting decision method finds the present value of each cash flow before calculating a payback period?

Discounted payback period

____ cash flows come about as a direct consequence of taking a project under consideration.

Incremental

correlation of -1

two securities move perfectly opposite of each other

correlation of 1

two securities move perfectly togther

In a competitive market, positive NPV projects are:

uncommon

debenture bonds are

unsecured bonds

Which one of the following is the most important source of risk from owning bonds?

Market interest rate fluctuations

When to reject a project?

NPV < 0

T-bills have a coupon?

No, zero

tax shield approach

OCF = (Sales - Costs)(1-t) + (Depreciation X T) depreciation tax shield: depreciation * tax rate --> depreciation saves us how much with taxes

What is the equation for estimating operating cash flows using the top-down approach?

OCF = Sales - Costs - Taxes

The formula for valuing a constant growth stock is _____.

P0 = D1/(R − g)

Which of the following are true about variable costs?

The variable cost per unit may remain constant as the number of units produced increases.

True or false: Ultimately, we are more interested in cash flow than accounting income.

True

According to the average accounting return rule, a project is acceptable if its average accounting return exceeds _____.

a target average accounting return

Capital Corp is considering a project whose internal rate of return is 14%. If Capital's required return is 14%, the project's NPV is:

zero

basic IRR rule

accept the project is the IRR is greater than the discount rate, reject the project if IRR is less than the discount rate

A project should be __________ if its NPV is greater than zero.

accepted

coupon payments are an

annuity

which average is overly optimistic for long horizons?

arithmetic average

variance & standard deviation

assess the risk of a security's return

homogenous expectations

assumes that all investors would hold the same portfolio

To be considered good, projected cash flows should _____ actual cash flows.

be close to

Opportunity costs are ____.

benefits lost due to taking on a particular project

Broker

brings buyers and sellers together, but does not maintain an inventory; make the commission for bringing buyers and sellers together; get paid a commission

A person who brings buyers and sellers together is called a(n) ______.

broker

Capital ______ is the decision-making process for accepting and rejecting projects.

budgeting

growth rate

businesses grow by making investments in projects, equipments. If the amount we invested was the same as our depreciation, then earnings would remain the same. g = retention ratio * ROE * sustainable growth rate * based on assumptions: we assume return on reinvestment of future retained earnings is equal to the firms past ROE

A positive NPV exists when the market value of a project exceeds its cost. Unfortunately, most of the time the market value of a project _____.

cannot be observed

mutually exclusive projects

cannot both be accepted, one or another must be chosen, pick project with highest NPV

T-notes & T-bonds are traded on

capital markets

real cash flow

cash flows purchasing power must be discounted at the real rate

portfolio

combination of securities

portfolio

combination of securities * want a high expected return & low standard deviation of return

A zero-growth model for stock valuation is distinguished by a ____.

constant dividend amount

The _____ yield is the bond's annual coupon divided by its price.

current

efficient frontier

curve from MV to supertech

Including a sinking fund in the indenture agreement will __________ the investors' required rate of return

decrease

When interest rates in the market rise, we can expect the price of bonds to ____.

decrease

mortgage bonds are secured with collateral, what happens to risk and rate

decrease risk, decrease rate

sinking fund, what happens to risk and rate

decrease risk, decrease rate

variance of a portfolio

depends on both the variances of the individual securities & covariance btw the two securities

An NYSE member who acts as a dealer in particular stocks is called a ____ market maker.

designated

How to calculate standard deviation

deviation - expected return^2 * probability , add them together for variance, sq root for SD

Incremental cash flows come about as a(n) ________ consequence of taking a project under consideration.

direct

When the coupon rate is less than the prevailing market (or YTM or required rate of return) for similar bonds, the bond will sell at a

discount

an increase in market interest rates will cause the price of an outstanding bond to sell at

discount

discount rate

discount rate on a risky project is the return that one can expect to earn on a financial asset of comparable risk - opportunity cost

Total dollar return

dividend income + capital gain * change in price + coupon payment * doesnt tell us a lot, dont know what you invested V your return

Common stock as no special preference either in receiving ____ or in bankruptcy.

dividends

stocks can provide two kinds of cash flows

dividends and sales price when sell the stock

problems with average accounting return

does not use actual financial cash flows - uses accounting numbers does not consider the timing of cash flows and ignores the time value of money uses an arbitrary return target

if the interest rate for all investments of equivalent risk goes up, the rate at which you can sell your used bond goes

down

which average is overly pessimistic for short horizons?

geometric average

the greater the term to maturity, the

greater the interest rate risk

YTM

is the annual return earned if you buy the bond @ today's price and hold it till maturity

beta of a portfolio

is the weighted average of the beta of the individual investments in the portfolio

principal is a

lump sum

what rate do you use to calculate the bond's PV?

market interest rate, required rate of return, YTM

T-bills are traded on

money markets

A share of common stock is (less/more) difficult to value in practice than a bond.

more

With nonconventional cash flows, there is a possibility that more than one discount rate will make the NPV of an investment zero. This is called the ____ rates of return problem.

multiple

synergy

new project increases the cash flows of an existing project

can coupon interest rate change?

no

can systematic risk be eliminated by diversification?

no, doesnt go away no matter what

real rate

nominal rate - inflation rate

When voting for the board of directors, the number of votes a shareholder is entitled to is generally determined as follows:

one vote per share held

independent project

one whose acceptance or rejections is independent of the acceptance or rejection of other projects

real options

option to abandon a project half way through and model that three different options *market value = NPV + Options * like when items do a bunch of stuff and are not specialized

when current market interest rates equal the bond's coupon rate, the bond sells at

par

expected return on a security

risk free rate + beta of the security * difference btw expected return on market & risk free rate

Corporate managers care about the break-even point because it indicates the level to which _____ can fall before a project will start losing money.

sales

In simulation analysis, a combination of _____ analysis and _____ analysis is used.

scenario; sensitivity

T-notes & T-bonds have coupons that are

semi-annual

Multiple choice question.

sensitivity analysis

A zero-growth stock pays a dividend of $2 per share and has a discount rate of 10%. What will the stock's price be?

$20.00

Legolas Inc. paid an annual dividend of $1.25 per share yesterday. You expect the dividend to grow, indefinitely, at a rate of 4% per year. If similar companies provide an expected return of 8% per year, what is the most you would be willing to pay for a share of Legolas stock?

$32.50/share

A bond pays annual interest payments of $50, has a par value of $1,000, and a market price of $1,200. How is the coupon rate computed?

$50/$1,000

Broadband, Inc. has estimated preliminary cash flows for a project and found that the NPV for those cash flows is $400,000. The company now plans to perform a scenario analysis on the cash flow and NPV estimates. It will use an NPV of _____ as the base case.

$400,000

holding period return

(1+r1)(1+r2)..... - 1

Benefits of NPV

* NPV uses cash flow * NPV uses all cash flows of a project * NPV discounts cash flows properly(aware and uses the time value of money) *NPV IS THE INCREASE IN THE VALUE OF THE FIRM FROM THE PROJECT

covariance

* a statistic that measures the interrelationship between two securities * measure variability of individual stocks

sensitivity analysis

* examines how sensitive a particular NPV calculation is to changes in the underlying assumptions of the project * way to determine how closely actual numbers will be to the planned numbers * all variables are calculated as the expected case, only variable that changes is the specific variable being tested

cases of discounted cash flow analysis

* setting the bid price * evaluating equipment options w/different lives * the general decision to replace

the top-down approach

* start at the top of the income statement with sales and work down to net cash flows subtracting costs, taxes and other expenses - leave out noncash items * sales - costs - taxes

opportunity/feasible set

* can create different portfolios of our two stocks by varying percentage of each stocks that will be held * if it is on the line the correlation is 1 * curve allows us to select the risk/return tradeoff that best suits us.

value of stock is equal to

* discounted present value of all future dividends which also means : discounted present value of the sum of next periods dividends plus next periods stock price

2008: financial crisis

* dont try to time the market - markets always eventually recover * stocks were down * market gained in 2009 by 65% * global phenomenon: no economy unscathed * S&P decreased by 37% *485/500 stocks were down * bonds benefitted, long term bonds increased by 20%

Straight voting

* each shareholder gets votes equaling the number of shares they own and must vote in each election position * only way to guarantee seat is to own 50% + 1 of the shares * vote one at a time * each shareholder gets their percentage of holding in votes for EACH election

capital asset pricing model

* expected return on a security is a linearly related to its beta

the equivalent annual cost method

* find NPV * create an annuity to determine the average annual cost over the life of each machine * costs on a per year basis

Payback Period Method

* how long it takes for a project to bring in enough cash flows to break even or pay itself off

correlation

* how to measure the relationship btw 2 stocks * return on individual securities are related to one another * measures variability of individual stocks

NWC

* increases over the early years of the project as expansion occurs * all working capital is assumed to be recovered at the end * increase in working capital over a year that leads to a cash outflow in that year * less liabilities more assets as time passes

examples of investments in NWC

* inventory is purchased * cash is kept in the project as a buffer against unexpected expenditures * credit sales are made, generating accounts receivable rather than cash

new york stock exchange - NYSE

* largest stock market in the world * became NYSE group in 2006 publicly owned corporation * exchange members purchase licenses * hybrid exchange: some face to face but there are also some big computers * face to face trade done by license holders * goal: generate as much liquidity as possible

Dealer

* maintains an inventory and stands ready to buy and sell at any time * willing to buy and sell at all times * when sell they are selling out of their own inventory - get a mark up * price willing to pay is the bid price/ willing to sell ask price

monte carlo simulation

* named after famous gamble center of europe * step 1: specify the basic model * step 2: specify a distribution for each variable * step 3: computer draws one outcome: generates cash flow for each year from a single outcome *step 4: computer repeats this procedure: distribution of cash flow for each year, can compute thousands * step 5: calculate NPV

three different real options

* option to expand : value if demands turn out to be higher than expected, uncertainty concerning annual cash flows * option to abandon * option to delay

holding period return

* return earned from the act of holding an asset over a given period of time - what was your return over the time frame when you held the stock * can be calculated two ways 1. multiplying rates + 1 * each year - 1 2. income + (end of period value - initial value) / initial value

decision trees

* used to sort through the variety of decisions that are usually involved with NPV project analysis * always start on the right hand side and work backwards * Expected Payoff = ( Probability of success * payoff if successful) + ( probability of failure * payoff if failure) * square means decision * circle means more information

what are some instances where the payback method makes sense?

*firms with good investment opportunities but no available cash *majority of companies use this method * most companies have rule that says if we are going to spend more than a certain amount of money must do an analysis * desirable features for managerial control *under NPV a long time may pass before one decides whether or not a decision was correct

A corporate bond's yield to maturity ____.

1. changes over time

Three special case patterns of dividend growth include _____.

1. constant growth

how to calculate correlation & covariance

1. multiply the deviations from expected return together 2. multiply by the associated probability 3. add together gives covariance 4. covariance / Asd* Bsd = correlation * the sign of correlation between two variables must be the same as that of the covariance between two variables

Suppose Price per Unit is $6, variable cost per unit is $2, fixed costs are $400 and the depreciation allowance per year is $500. The relationship between operating cash flow (OCF) and sales volume (Q) can be expressed as:

OCF = −400 + 4*Q

Profitability Index

PV of cash flows after initial investment / initial investment accept project is the profitability index > 1 application of profitability index: * independent project * mutually exclusive projects: has scale problem: use incremental * capital rationing: the case when the firm does not have enough capital to fund all positive NPV projects: rank them according to the ratio of present value to initial investment

EPS

Payout(dividend) + Retained Earnings - can be retained by a company or it can be paid out to the shareholders as a dividend

Which of the following statements is true in the context of comparing accounting profit and present value break-even point?

Present value is superior to accounting profit because it adjusts for time value and considers the depreciation tax shield effect.

PE Ratio

Price per share / EPS * assumed similiar firms have similiar PE ratios * equity ratio Three things PE is affected by: * related to growth opportunities * PE ratio is negatively related to firms discount rate & risk * more conservative accounting principles have higher PE ratio

Preferred Stocks

have priority in bankruptcy and dividends, usually have no voting rights * usually owned by company * get a stated value * seen as a debt besides in tax purposes * sometimes convertible to common stock and callable

A firm with higher operating leverage will have (low/high) fixed costs relative to a firm with low operating leverage.

high

lower rated bonds have

higher rates of return

geometric return

holding period method ^(1/n) -1 what was your actual return each year on average, compounded annually over a particular period?

standard error

how much can we have in out historical average of 7.2% of equity risk premium * we can be % confident that our estimate of the US equity risk premium from historical data is in the range of 2SE's

Interest expenses incurred on debt financing are ______ when computing cash flows from a project.

ignored

The payback period can lead to incorrect decisions if it is used too literally because it ____.

ignores cash flows after the cutoff date

An increase in depreciation expense will ____ cash flows from operations.

increase

call provisions, what happens to risk and rate

increase risk, increase rate

The price of a bond is found by discounting the bond's future cash flows using the

market rate/required rate of return/YTM

By ignoring time value, the payback period rule may incorrectly accept projects with a (positive/negative) NPV.

negative

There is a(n) ______ relationship between market interest rates and bond values.

negative

Accounts receivable and accounts payable are not an issue with project cash flow estimation unless changes in ______________ are overlooked.

net working capital

diversification effect

occurs when the correlation between two securities is below 1; no diversification effect is correlation = 1; diversification effect rises as correlation declines;

The amount of time needed for the cash flows from an investment to pay for its initial cost is the _____ period.

payback

market portfolio

portfolio everyone holds, S&P 500 is often considered it but the wilshire 5000 can also be considered * perfectly diversified by having eliminated all unsystematic risk

Hobbit inc. issued bonds with an annual coupon rate of 5%. The prevailing market rate for similar bonds is 4%. Investors will pay a

premium

When the coupon rate is more than the prevailing market rate (or YTM or required rate of return) for similar bonds, the bond will sell at a

premium

Erosion will ______ the sales of existing products.

reduce

West Corporation estimated cash flows for a project, evaluated those cash flows using NPV, and determined that the project was acceptable. Unfortunately West Corporation lost money on the project. This may have been avoided had they assessed the ______ of the cash flow estimates.

reliability

When the term structure of interest rates is downward sloping, ____.

short-term rates are higher than long-term rates

Discounted Payback Period Method

start with each cash flow but discount each of them back to 0 * first discount cash flows * then ask how long it takes for the discounted cash flows to equal the initial investment * as long as the cash flows are positive, the discounted payback period will never be smaller than the payback period because discounting reduces the value of the cash flows

Payback Period Rule

states that all projects must be paid back before a particular cutoff date - arbitrary - up to management to select

How to fix inflation?

stop expectation of inflation, raise interest rate, people stopped spending money

With ____ voting, the directors are elected one at a time and the only way to guarantee a seat is to own 50 percent plus one share.

straight

security market line

straight line connecting the risk free rate and the return on a stock if its beta = 1, at 1 will have the return of the market

incremental irr

subtract the smaller project from the larger project then find the IRR of difference if the irr of difference is greater than the discount rate, accept the larger project

The payback period rule ______ a project if it has a payback period that is less than or equal to a particular cutoff date.

suggests accepting

preemptive right

the right to share proportionally in any new stock sold - company that wishes to sell stock must first offer it to the existing stockholders

A firm will start generating profits when ___.

the total number of units sold exceeds the accounting break-even point

unsystematic risk

unique or asset specific risk - news surprises that only affect a small number of companies

average risk free rate

use fisher equation

modified accelerated cost recovery system ( MACRS)

use tax code - getting more depreciation earlier in the life of the project; good for a company because of the time value

value additivity

value of the firm is merely the sum of the values of different project division, or other entities within the firm

Enterprise Value Ratio

EV/EBITDA

Which of the following entities declares a dividend?

The board of directors

Why does a bond's value fluctuate over time?

The coupon rate and par value are fixed, while market interest rates change

True or false: Cumulative voting means board members are elected one at a time, with each shareholder casting his or her allotted votes for each seat on the board.

false

if sell stock at end of year/ total cash if stock is sold

initial investment + total dollar return

expected return on portfolio

is weighted average of returns of the individual investments in the portfolio

What makes a high P/E ratio more likely

low-risk stocks

arithmetic return

normal average what was your return in an average year? - doesn't help deciding in the future

The IRR rule can lead to bad decisions when cash flows are _____ or projects are mutually exclusive.

not conventional

A stock with dividend priority over tis called a ____ stock.

preferred

a decrease in market interest rates will cause the price of an outstanding bond to sell at

premium

Net ____ value is a measure of how much value is created or added today by undertaking an investment.

present

In capital budgeting, the net ______ determines the value of a project to the company.

present value

average return

sum of returns/number of returns past annual returns on the stock market

Investment firms that are active participants in stocks assigned to them are called ____ liquidity providers.

supplemental

Using the top-down approach, OCF is calculated by subtracting costs and ____ from sales.

taxes

If you own corporate bonds, you will be concerned about interest rate risk as it affects ____.

the market price of the bonds

unexpected return

the returns which are uncertain that come from unexpected news about a company such as: * GDP, unemployement * good or bad news *company announcement

if the correlation of investments in portfolio is less than 1

the standard deviation will be less than weighted average of the SD of the individual securities

When evaluating cost-cutting proposals, how are operating cash flows affected?

1. The decrease in costs increases operating income.

Which of the following institutions issue bonds that are traded in the bond market?

1. The federal government

Which of the following are reasons why it is more difficult to value common stock than it is to value bonds?

1. The life of a common stock is essentially forever.

Which of these are required to calculate the current value of a bond?

1. Time remaining to maturity

Which of the following are fixed costs?

1. rent on a production facility

Constant growth of stock

Po = Div / R - g Dividend grows at a rate of G Div is the dividend at the end of the first period * same as a growing perpetuity

Value of stock at zero growth

Po = Div/r

In evaluating capital projects, the decisions using the NPV method and the IRR method may disagree under which of the following circumstances?

The projects being evaluated are mutually exclusive

T-notes & T-bonds interest is

an interest only loan

Ibbotson Chart

asset classes, type of assets, invest $ in each of them, what will they be worth today? * large company common stock: 2nd highest return over time * small company common stocks: give highest return over time / also gives you the highest risk *long term corporate bonds * long term government bonds * US treasury bills * riskier if the line is spiky and moves up&down - the more risked I am asked to take the better the return there needs to be

A firm will start generating positive accounting profits _____.

beyond the break-even sales point

The AAR is calculated by taking the average net income and dividing it by the average ____ value.

book

investing on margin

borrowing money to invest

incremental profitability index

if mutually exclusive, subtract smaller project cash flows from the larger project cash flow to get incremental cash flows

Including a call provision in the indenture agreement will __________ the investors' required rate of return

increase

With cost-cutting proposals, when costs decrease, operating cash flows (decrease/increase).

increase

A humped term structure of interest rates indicates that interest rates are expected to _____ as the time to maturity increases.

increase and then decline

debenture bonds, what happens to risk and rate

increase risk, increase rate

As a practical matter, it is easier to (decrease/increase) operating leverage than it is to (decrease/increase) it.

increase; decrease

When interest rates in the market fall, bond values are likely to increase because the present value of the bond's remaining cash flows ____.

increases

The present value of all cash flows (after the initial investment) is divided by the ______ to calculate the profitability index.

initial investment

separation principle

investors decisions consist of two separate steps: * estimating expected return, variance, covariance and calculating the efficient set of risky assets is completed. Then determination of which risky portfolio will be held is made * the investor now determines how much riskless asset to ad to the portfolio

In general, a corporate bond's coupon rate ____,

is fixed until the bond matures

The federal government can raise money from financial markets to finance its deficits by ___.

issuing bonds

According to Graham and Harvey's 1999 survey of 392 CFOs, in addition to IRR and NPV, which were the two most widely used techniques, over half of the respondents always, or almost always, used which of the following methods?

payback method

This capital budgeting method allows lower management to make smaller, everyday financial decisions effectively.

payback method

Problems with discounted payback method

payments after the payback period are ignored arbitrary standards for payback period

T-bills interest?

pure discount loan

The first step in estimating cash flow is to determine the _________ cash flows.

relevant

why is EBITDA used in the denominator or EV/EBITDA

since EV involves debt and equity, denominator is unaffected by interest payments

The payback period method allows lower management to make (smaller/larger), everyday financial decisions effectively.

smaller

The Omega Division of Alpha Corporation has been allocated $4 million for capital spending but has identified $4.6 million in positive NPV projects. Omega's manager thinks he can convince the company to fund the additional $0.6 million dollars because Omega uses _______ rationing to control overall spending.

soft --- Soft rationing occurs when units in a business are allocated a certain amount of financing for capital budgeting.

investment of unequal lives

sometimes when NPV could give you a misleading number, if projects have unequal lives * the replacement chain * The equivalent annual cost method

The NYSE member who acts as a dealer in a small number of securities is called a(n) _____.

specialist

According to the _________ principle, once the incremental cash flows from a project have been identified, the project can be viewed as a "minifirm."

stand-alone

True or false: Equity represents an ownership interest.

true

The _____ cost is equal to the quantity of output times the cost per unit of output.

variable

expected return for a portfolio

weighted average of the returns of the individual investments in the portfolio XaE(Ra) + XbE(Rb)

The basic approach to evaluating cash flow and NPV estimates involves asking ---- -if questions.

what

Zero growth

when a stock pays the same dividend each period

staggering

where only a fraction of directorships are up for election at a particular time has two basic effects: * more difficult for a minority to elect a director when there is cumulative voting * takeover attempts less likely to be successful because it makes it more difficult to vote in a majority of new directors

When analyzing a proposed investment, we (will/won't) include interest paid or any other financing costs.

won't

can you value company without dividends?

yes, if you make projections

standard deviation of the annual return on a portfolio of 500 large common stocks

20% per year

NASDAQ

* 2nd largest stock market * not a physical exchange * tech stocks * completely computerized

break even analysis for accounting

* FC + depreciation / price - variable cost * determines the sales needed to break even on a project * losing money * depreciation understates the true costs of recovering initial investment: losing the opportunity cost of the initial investment

Two set of books

* IRS: tax books *annual report: stockholders books * income on municipal bonds ignored for tax purposes but treated as income for stockholders * have different rules

2 key differences between NASDAQ and NYSE

* NASDAQ is computer generated and has no physical location * NASDAQ has multiple market maker systems rather than a DMM system

betas

* best way to think about risk of individual securities within a diversified portfolio * best measure of risk * measures the responsiveness of a security to movements in the market portfolio * if stocks with a beta > 1 are correlated w/the market & have greater magnitudes of movement * if stocks with a beta = 1 are correlated w/the market & have a similar magnitude of movements as the market * if stocks with a beta <1 are less correlated with the market & have a smaller magnitude of movement * measure of systematic risk

the bottom-up approach

* start with accounting bottom line and add back any non cash deductions * net income + depreciation

Problems with Payback Method

* timing of cash flows within payback period is not considered * payments after the payback period are ignored * arbitrary standards for payback period

net investment

* total investment - depreciation * will be positive only if some earnings are not paid out as dividends

how to solve multiple IRR problem

* use the NPV rule instead * modified IRR: combining cash flows until only one change in sign remains: violates the spirit of IRR

Capital Asset Pricing Model (CAPM)

* used to find the expected return on different securities

average accounting return method

* uses net income generated by projects to analyze whether they will add value to a company * three steps: **determine average net income **determine average investment **divide by each other * one value more than time periods you have on net income

scenario analysis

* variant of sensitivity analysis where multiple variables are changed at one time to create different scenarios * save problem of assuming variable effects are isolated

incremental cash flows

* when valuing a firm as a whole discount cash flows not earnings * only use cash flows that are pertinent to the project * if you would have the cash flow without the project wouldn't use it * sunk costs should never be used to value a new project * consider opportunity costs

Seven classes of depreciable property

*3 year class *5 year class * 7 year class *10 year class *15 year class *20 year class * real property: non residential and residential

risk premium

*average real return - average risk real free rate * the additional return resulting from the riskiness of common stocks difference between risky and risk free are excess return on the risky asset

Cumulative Voting

*each shareholder gets votes equaling *all directors are elected at one * if there are 4 positions, then the top 4 vote getters win spots * can put all your votes in one position * permit minority participation * if there are N directors up for election, then 1/(N+1) percent of stock + 1 share will guarantee you a seat

internal rate of return

*interest rate that would make a project have a 0 NPV - way to figure out if its NPV is + or not *most commonly used by companies *provides a single number summarizing the merits of a project - does not depend on interest rates * number is intrinsic to project * only depends on cash flow

percentage returns

*total dollar return/initial price * how much return do we get for each dollar? * using the yields dividend yield & capital gains yield * formula for it but hard to write out * can determine how much you would profit on any amount when have return percentage * better approach

How to compare mutually exclusive projects

- compare NPVs of two choices - calculate the incremental NPV from taking the larger project - compare the incremental IRR to the discount rate

reasons to use IRR

- having a single rate of return seems to aid people in discussing and thinking about projects - most companies that use IRR do understand its flaws and take them into account

According to Graham and Harvey's 1999 survey of 392 CFOs, which of the following two capital budgeting methods are most used by firms in the United States?

1. Net present value

When the U.S. government wants to borrow money for the long-term (more than one year) it issues:

1. Treasury bonds

The U.S. government borrows money by issuing:

1. Treasury bonds.

Which three of the following are common shapes for the term structure of interest rates?

1. Upward sloping

What is a corporate bond's yield to maturity (YTM)?

1. YTM is the prevailing market interest rate for bonds with similar features.

A benchmark PE ratio can be determined using:

1. a company's own historical PEs

Investment in net working capital arises when ___.

1. cash is kept for unexpected expenditures

3. it will never cost the firm more than calculated in the cash flow analysis

1. should be accepted if there is no capital rationing constraint

What is the coupon rate on a bond that has a par value of $1,000, a market value of $1,100, and a coupon interest payment of $100 per year?

10%

In terms of time to maturity, U.S. Treasury notes and bonds have initial maturities ranging from ___ years.

2 to 30

Assume your marginal income tax rate on all income is 33% and that you own a corporate bond that yields 6% per year. What annual rate would you need to earn on the municipal bond to ensure that you earn the same after-tax income as on the corporate bond?

4.02%

Suppose Bob owns 20 shares and Vikki owns 30 shares in Good Company, and there are five members of the board of directors. Under which voting arrangement can Bob assure himself of a board member that represents his interests?

Cumulative voting

Capital Gains Yield

Div/ Po + g * rate at which the value of the investment grows * determination of r highly dependent on determination of g * doesn't work well when firm is currently paying no dividends * if estimate of g is equal to or above R there is a problem

Dividend Yield

Dividend price/ initial price of the stock * conceptually similiar to current yield on bond

Which one of the following is true about dividend growth patterns?

Dividends may grow at a constant rate.

Which of the following equations correctly relates OCF to sales volume?

OCF = (P − v) × Q − FC

License Holders

entitled to buy or sell on the exchange three different types: DMMs: specialists, act as dealers in particular stocks, maintain two-sided market Floor Brokers: execute trade for customers - employees of Merrill lynch SLPs: investment firms who agree to be active participants in stocks assigned to them - one sided market; trade purely for their own accounts, dont operate on the floor

coupon payment =

face value * coupon rate / m

For investors in the stock market, dividends from stocks are fixed and guaranteed, while capital gains are variable and not guaranteed.

false

True or false: A bond's value is not affected by changes in the market rate of interest.

false

True or false: The MIRR function eliminates multiple IRRs and should replace NPV.

false

Municipal Gov bonds are exempt from

federal income taxes

The ____ break-even is the sales level that results in a zero NPV.

financial

Coupon rate is

fixed, can never change

An NYSE member who executes customer buy and sell orders is called a ____ broker.

floor

order flow

flow of customers orders to buy and sell shares; business of NYSE is to attract and process this

Proxy

grant of authority by a shareholder to someone else to vote his/her shares ; they represent you * if shareholders upset with management, can give outside group the proxy to replace management - proxy fight

the lower the coupon rate, the

greater the interest rate risk

What has the greatest impact on P/E ratios?

growth opportunities

option to abandon

has value if demand turns out to be lower than expected * increases value of potential project * 50% * success 50% * if abandon

option to delay

has value if the underlying variables are changing with a favorable trend * can yield benefit if costs are falling * use discount rate and determine the year which gives the highest NPV today

index

list of stocks, can't invest directly in an index - invest in investment that invest just like index - can invest in ETF(exchange traded fund) -pick an index and spread the money out according to all the stocks in the index - the larger the stock the larger percentage of your money goes there - not equally weighted

The computation of equivalent annual costs is useful when comparing projects with unequal _____.

lives

If the term structure of interest rates is upward sloping, then ____.

long-term rates are higher than short-term rates

systematic risk

market risk - affects the market - ex: increased unemployment levels and GDP contraction - affects large number of assets

Enterprise Value

market value of equity + market value of debt - cash * the price you would have to pay if you wanted to buy a company and pay off all its debt

Primary Market

market where initial sales of securities take place- sell securities to raise money

why does the denominator of EV/EBITDA ignore depreciation and amortization?

merely reflect sunk cost of previous purchase

standard deviation of a portfolio

not the weighted average of returns of the individual investments in the portfolio * as long as correlation <1 ; the standard deviation of a portfolio of two securities is less than the weighted average of the standard deviations of individual securities

When voting for the board of directors, the number of votes a shareholder is entitled to is usually ____ vote per share held.

one

True or false: IRR approach may lead to incorrect decisions in comparison of two mutually exclusive projects.

true

True or false: Some projects, such as mines, have cash outflows followed by cash inflows, which are then followed by cash outflows, giving the project multiple rates of return.

true

True or false: When developing cash flows for capital budgeting, it is easy to overlook important items.

true

True or false: When a business does hard rationing, the firm's DCF analysis breaks down.

true --- When a business does hard rationing, the firm's DCF analysis breaks down and the best course of action is ambiguous.

Valuation Multiple

value a company by estimating the value of the firm based on the value of other comparable firms; PE ratio most commonly used multiple for valuation; if PE is 12 and company's earnings are 10 million, company is valued at 120 million

Differential Growth

when dividends grow at different rates over different periods of time

An accounting break-even point of 1,000 units means that ____.

when the firm sells 1,000 units, profits will be equal to zero

When a firm finances new investments, it may set up accounts payable with suppliers, but the balance that the firm must supply is called the investment in net ____ capital.

working

is there any advantage to the EV/EBITDA ratio over the PE ratio

yes, companies in the same industry may differ in leverage(ratio of debt to equity); leverage increases the risk of equity impacting the discount rate; impact of leverage on EV/EBITDA is less

return on any stock

* expected return * uncertain & risky

problems with internal rate of return

Problems for Both Independent and Mutually Exclusive: * investing or financing: if cash inflow comes before cash outflow then accept the project when IRR is less than the discount rate *multiple rates of return - flip flops - exhibits two changes in signs - lead to multiple IRR values - cash flow stream can with K changes in signs can have up to K sensible IRR's Problems for Mutually Exclusive Projects: *scale problem: ignores issue of scales: incremental IRR solves this *Timing problem: cash flows occur at different times

What are the two major forms of long-term debt?

Public issue and privately placed

Free Cash Flows

Revenue - expenses - taxes - net investment net investment = change in net working capital + capital expenditures - depreciation

____ analysis involves estimating the best-case, worst-case, and base-case cash flows and calculating the corresponding NPVs.

Scenario

Which of the following variables are required to calculate the value of a bond?

1. Remaining life of bond

nominal cash flows

actual dollars to be received - must be discounted at a nominal rate

equity risk premium

additional return resulting from the riskiness of common stocks

Secondary Market

after the initial shares are purchased from the issuing company, all purchases of stock are from stockholders

Multiple choice question.

aftertax

diversification

allows us to almost completely eliminate unsystematic risk - reduce riskiness from individual investments in diversifiable portfolio; only have systematic risk

financial erosion

already have a product line, if you create a new line you will reduce the sales of your other line - cause cash flow of another project to decrease

contribution margin

amount by which each additional unit contributes to after tax profit revenue - variable costs

announcement

expected part + surprise

total return

expected return + unexpected return

When to accept a project?

NPV > 0 * accepting positive NPV projects benefits the stockholders

Using the payback period rule will bias toward accepting which type of investment?

Short-term investment

4. Bonus to top management

Test marketing expenses