final exam fn 390
true
True or false: Two challenges with the IRR approach when comparing two mutually exclusive projects are scale and cash flow timing.
WACC and FCF
the impact of capital structure on value depends upon the effect of debt on...
stop price
trigger or activation point if reached or passed, the order becomes a market order to be executed at the best available price risk: if price suddenly plummets or rises and the execution price is much different than expected
That's why valuation ratios are so important in determining a company's worth. A valuation ratio shows the relationship between the market value of a company or its equity and some fundamental financial metric
why are valuation ratios import
accepting positive npv benefits stock holders -npv uses cash flows -npv uses al cash flows of the project -npv discounts the cash flows properly
why is npv used
Dividend Yield Growth rate
In the dividend discount model, the expected return for investors comes from which two sources? Tax rate Dividend Yield Growth rate Amount of last year's earnings
Operating Leverage is the change in EBIT caused by a change in quantity sold the higher the proportion of fixed costs relative to variable costs, the greater the operating leverage
what is operating leverage and how does it affect a firm's business risk
- does not distinguish between investing and borrowing - IRR may not exist, or there may be multiple IRRs - Problems with mutually exclusive investments
disadvantages of IRR
WACC
The ______ is the overall expected return the firm must earn on its existing assets to maintain its value if the firm is levered.
- problems with mutually exclusive investments
disadvantages of profitability index
a higher beta would increase the cost of equity capital
the impact of beta in determining the firms cost of equity capital
accept if the IRR is less than R
For a project with a positive initial cash flow followed by negative cash flows, we should ___.
also increase
If a firm increases its level of debt, its beta will ___.
- easy to understand - biased toward liquidity
advantages of payback period method
- may be useful when available investment funds are limited - easy to understand and communicate - correct decision when evaluating independent projects
advantages of profitability index
Market orders
you specify ticker and quantity immediate, and best available price market buy will be executed at lowest ask market sell will be executed at highest bid
limit orders
you specify ticker, quantity, and price only executed at limit price or better limit buy only done at limit price or lower limit sell only done at limit price or higher
rejected
A project with a negative NPV should be: rejected accepted indifferent
incremental
A way to evaluate mutually exclusive projects is to analyze the _________cash flows.
20.00 P0 = $2/0.10 = $20
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 1.81 12.29
Net present value Internal rate of return
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 U.S. and Canada? -Accounting rate of return -Payback method -Net present value -Profitability index -Internal rate of return
be indifferent towards accepting a project if NPV is equal to zero reject a project if NPV is less than zero. accept a project if the NPV is greater than zero.
According to the basic investment rule for NPV, a firm should ____. -be indifferent towards accepting a project if NPV is equal to zero -reject a project if NPV is less than zero. -accept a project if the discount rate is greater than zero. -accept a project if the NPV is greater than zero.
positive NPV projects growth opportunities
Firms may retain all their earnings if they have identified:
false
True or false: Projects should always be discounted at the firm's overall cost of capital.
an EV ratio should reflect the ability of productive assets to create cash flow many firms hold more cash than necessary
When enterprise value is calculated, cash is subtracted from the market value of debt and equity because ____.
Discounted payback period
Which capital budgeting decision method finds the present value of each cash flow before calculating a payback period?
Operating leverage The cyclical nature of revenues Financial leverage
Which of the following are factors that affect beta? Operating leverage The cyclical nature of revenues Financial leverage Changes in the market risk premium
They have never defaulted. They are not expected to default at this time.
Which of the following are true about U.S. Treasury instruments?
returns
Dividends and capital gains given to the new shareholders represent ______ to the shareholders.
The comparables method The dividend discount model the firm cash flow model
In theory, which of the following models are mutually consistent and can be used to determine the value of a share of stock? The comparables method the bond valuation model The dividend discount model the Baumol-Riggs model the firm cash flow model
the firm cash flow model The comparables method The dividend discount model
In theory, which of the following models are mutually consistent and can be used to determine the value of a share of stock? the firm cash flow model The comparables method the Baumol-Riggs model the bond valuation model The dividend discount model
primary
Initial public offerings of stock occur in the ____ market. . commodities secondary futures primary
the future sales price dividends
Investors select a stock based on the cash they expect to receive from that stock. That cash comes in the form of ____. the future sales price dividends commissions interest payments
Pt = [Dt × (1 + g)]/(R − g) P9 = D10/(R − g) P9 = $15.75/(.12 − .048) P9 = $218.75 P0 = $218.75/1.12^9 P0 = $78.88
Metallica Bearings, Inc., is a young start-up company. No dividends will be paid on the stock over the next 9 years, because the firm needs to plow back its earnings to fuel growth. The company will pay a dividend of $15.75 per share in 10 years and will increase the dividend by 4.8 percent per year thereafter. If the required return on this stock is 12 percent, what is the current share price?
R = D/P0 R = $3.75/$81 R = .0463, or 4.63%
Meteora, Inc., has an issue of preferred stock outstanding that pays a $3.75 dividend every year, in perpetuity. This issue currently sells for $81 per share. What is the required return?
RWACC = .118(1/1.40) + .065(.40/1.40)(1 − .21) RWACC = .0990, or 9.90%
Miller Manufacturing has a target debt-equity ratio of .40. Its cost of equity is 11.8 percent and its cost of debt is 6.5 percent. If the tax rate is 21 percent, what is the company's WACC?
RWACC = .70(.109) + .30(.057)(1 − .23) RWACC = .0895, or 8.95%
Mullineaux Corporation has a target capital structure of 70 percent common stock and 30 percent debt. Its cost of equity is 10.9 percent and the cost of debt is 5.7 percent. The relevant tax rate is 23 percent. What is the company's WACC?
not considered in the analysis
One of the flaws of the payback period method is that cash flows after the cutoff date are ___.
P0 = $18/1.11 + $21/1.11^2 + $24/1.11^3 + $27/1.11^4 + $30/1.11^5 P0 = $86.40
Stoneworks, Inc., has an odd dividend policy. The company has just paid a dividend of $15 per share and has announced that it will increase the dividend by $3 per share for each of the next five years, and then never pay another dividend. If you require a return of 11 percent on the company's stock, how much will you pay for a share today?
a single rate of return
The IRR rule summarizes the information about the project in: -a dollar figure of value -a single rate of return -multiple rates of return
firm's discount rate stock's risk
The PE ratio is negatively related to the ____. market's pricing perceptions firm's discount rate stock's risk firm's growth opportunities
additivity
The value of a firm is simply the combined value of the firm's projects, divisions, and entities owned by the firm is due to the property called value __________
growth discount
The value of a firm is the function of its______ rate and its _____rate.
false
True or false: A market order allows the investor to choose the price they will transact at. True False
Dividends to preferred stockholders are fixed. Dividends to common stockholders are not fixed.
What can we say about the dividends paid to common and preferred stockholders?
Earnings must be retained to fund projects. Projects must have positive net present values.
What conditions must be met for a firm to increase value? Projects must increase dividends. Earnings must be retained to fund projects. Projects must have positive net present values. Projects must be complete in one year.
Betas can change over time. Betas are more likely to be stable if the firm remains in the same industry.
What do we know about the stability of a firm's beta? Betas can change over time. Betas are more likely to be stable if the firm remains in the same industry. Betas do not change over time. Betas are more likely to change if the firm remains in the same industry.
$80 P0 = $3.20/(.09 - .05) = $80
What is the price of a stock if its dividend a year from now is expected to be $3.20, the discount rate is 9 percent, and the constant rate of growth is 5 percent? Multiple choice question. $83.50 $78 $80 $85
10% R = ($2/$100) + .08 = .10, or 10%
What is the total return for a stock that currently sells for $100, pays a dividend in one year of $2, and has a constant growth rate of 8 percent? 11.8% 9.8% 10% 10.8%
discount
When calculating NPV, the present value of the nth cash flow is found by dividing the nth cash flow by 1 plus the ______ rate raised to the nth power. coupon prime discount federal funds
negative
When cash flows are conventional, NPV is ______ if the discount rate is above the IRR. negative zero positive
NPV, IRR
You must know the discount rate to compute ____, while the discount rate is necessary to apply ___. -IRR, NPV -NPV, IRR -either IRR or NPV; either IRR or NPV
easy to understand and communicate
advantages of IRR
flotation costs represent the expenses incurred upon the issue or float of new bonds or stocks these incremental cash flows of the project, which typically reduce the npv since they increase the initial project cost Amount raised = necessary proceeds / 1 - % flotation the % flotation cost is weighted average based on the average cost of issuance for each funding source and the firm's target capital structure
how do flotation costs affect the capital budgeting process
R = (D1/P0) + g R = ($2.95/$53.10) + .048 R = .1036, or 10.36%
The next dividend payment by Skippy, Inc., will be $2.95 per share. The dividends are anticipated to maintain a growth rate of 4.8 percent, forever. The stock currently sells for $53.10 per share. What is the required return?
not needed
When computing the IRR, the discount rate is: not needed necessary
undervalued
sell bonds if stock is
overvalued
sell stock is stock is
higher than
In a stock price quote, the ask price is ______ the bid price. Multiple choice question. lower than equal to higher than
positive for discount rates below the IRR. negative for discount rates above the IRR. equal to zero when the discount rate equals the IRR.
In general, NPV is ___.
Dividend Yield Growth rate
In the dividend discount model, the expected return for investors comes from which two sources? Dividend Yield Tax rate Amount of last year's earnings Growth rate
Computer network of securities dealers Multiple market maker system not a physical exchange multiple market makers electronic communications 3 levels of information 1 timely accurate quotes freely available 2 view quotes from all nasdaq market makers small fee 3 view and update quotes market makers only
NASDAQ has which of these features? Physical trading floor Single DMM system Computer network of securities dealers Multiple market maker system
dealer
Someone who maintains an inventory of stocks and buys and sells those stocks is known as a ____.
a. P0 = D0(1 + g)/(R − g) P0 = $2.07(1.043)/(.11 − .043) P0 = $32.22 b. P3 = D3(1 + g)/(R − g) P0 = D0(1 + g)^4/(R − g) P3 = $2.07(1.043)^4/(.11 − .043) P3 = $36.56 or P3 = P0(1 + g)^3 P3 = $32.22(1 + .043)3P3 = $36.56 c. P15 = D15(1 + g)/(R − g) P15 = D0(1 + g)^16/(R − g) P15 = $2.07(1.043)^16/(.11 − .043) P15 = $60.60 or P15 = P0(1 + g)^15 P15 = $32.22(1 + .043)^15 P15 = $60.60
The Nearside Co. just paid a dividend of $2.07 per share on its stock. The dividends are expected to grow at a constant rate of 4.3 percent per year, indefinitely. Investors require a return of 11 percent on the stock. a.What is the current price? b.What will the price be in 3 years? c.What will the price be in 15 years?
beta slope
The ____ of the characteristic line of a stock's returns versus those of the market measures the stock's systematic risk. Multiple select question. beta width slope length
financial leverage
is the sensitivity to a firms fixed cost of financing Always increases the equity beta relative to the asset beta
too high
A calculated stock price that discounts earnings instead of dividends will usually be:
too high
A calculated stock price that discounts earnings instead of dividends will usually be: too low more accurate too high
down
A cyclical firm is one in which revenues go ______ in the contraction phase of the business cycle.
40 Retention ratio = .08/.2 = .4, or 40%
A firm with an 8 percent dividend growth rate and a return on equity of 20 percent must have a retention ratio of ______ percent. 16 2.5 40 1.6
1
A firm's target capital structure weights are evenly split between debt and equity. What is the firm's target debt-equity ratio?
$1,000,000 - 50,000 = $950,000
A project's NPV without flotation costs is $1,000,000 and its flotation costs are $50,000. What is the true NPV?
$725,000
A project's NPV without flotation costs is $750,000 and its flotation costs are $25,000. What is the true NPV?
profitability index
According to Graham and Harvey's 1999 survey of 392 CFOs, which of the following capital budgeting techniques is least used.
True
True or false: The crossover rate is the rate at which the NPVs of two projects are equal. True false question.
multiples
Comparable firms are assumed to have similar: costs multiples accounting systems
a. P = D/R P = $720,000/.11 P = $6,545,454.55 PE = Price/Earnings PE = $6,545,454.55/$720,000 PE = 9.09 b. P = D/R P = ($720,000 + 150,000)/.11 P = $7,909,090.91 PE = Price/Earnings PE = $7,909,090.91/$720,000 PE = 10.98 times c. P = D/R P = ($720,000 + 300,000)/.11 P = $9,272,727.27 PE = Price/Earnings PE = $9,272,727.27/$720,000 PE = 12.88 times
Consider Pacific Energy Company and Atlantic Energy, Inc., both of which reported earnings of $720,000. Without new projects, both firms will continue to generate earnings of $720,000 in perpetuity. Assume that all earnings are paid as dividends and that both firms require a return of 11 percent. a. What is the current PE ratio for each company? b. Pacific Energy Company has a new project that will generate additional earnings of $150,000 each year in perpetuity. Calculate the new PE ratio of the company. c. Atlantic Energy has a new project that will increase earnings by $300,000 in perpetuity. Calculate the new PE ratio of the firm.
CAPM
For both academics and practitioners, the pendulum has swung over to the _______ for estimating the cost of equity capital.
similar
For debt, book values and market values are typically:
P3 = D3(1 + g)/(R − g) = D0(1 + g1)^3(1 + g2)/(R − g2) P3 = $3.24(1.20)^3 (1.05)/(.11 − .05) P3 = $97.98 P0 = $3.24(1.20)/1.11 + $3.24(1.20)^2/1.11^2 + $3.24(1.20)^3/1.11^3 + $97.98/1.11^3 P0 = $83.02
Fuji Co. is growing quickly. Dividends are expected to grow at a rate of 20 percent for the next three years, with the growth rate falling off to a constant 5 percent thereafter. If the required return is 11 percent and the company just paid a dividend of $3.24, what is the current share price?
higher
Higher growth opportunities create ______ value today. Multiple choice question. lower no higher
decrease
If the discount rate increases, the PE ratio will ______. decrease remain the same increase
lower
In an inflationary environment, reported earnings are _____ if a firm uses LIFO rather than FIFO accounting. higher lower the same
lower
In an inflationary environment, reported earnings are _____ if a firm uses LIFO rather than FIFO accounting. the same higher lower
LIFO; FIFO
In an inflationary environment, reported earnings are lower if a firm uses ______ rather than ______ accounting.
pays dividends in perpetuity pays a constant dividend
Preferred stock ___.
RS = .027 + .95(.10 − .027) RS = .0964, or 9.64%
The Nixon Corporation's common stock has a beta of .95. If the risk-free rate is 2.7 percent and the expected return on the market is 10 percent, what is the company's cost of equity capital?
a. P = Benchmark PE ratio × EPS So, with a PE ratio of 18, we find: P = 18($3.41)P = $61.38 b. P = 21($3.41) P = $71.61
The Rose Co. has earnings of $3.41 per share. The benchmark PE for the company is 18. a. What stock price would you consider appropriate? b. What if the benchmark PE were 21?
reject; greater accept; less
The decision rule for a project for which the first cash flow is an inflow and subsequent cash flows are negative states that we should ____ the project when the IRR is ____ than the discount rate.
does; does not
The discounted payback period ______ account for time value of money and the payback period ______ account for time value of money.
flotation
The issuance costs of bonds and stocks are referred to as ______ costs.
a. g = ROE × bg = .13(.80) g =.1040, or 10.40% b. Next year's earnings = Current earnings(1 + g) Next year's earnings = $17,500,00(1 +.1040) Next year's earnings = $19,320,000
The newspaper reported last week that Bennington Enterprises earned $17.5 million this year. The report also stated that the firm's return on equity is 13 percent. The firm retains 80 percent of its earnings. a. What is the firm's earnings growth rate? b. What will next year's earnings be?
a. Dividend yield = D1/P0 Dividend yield = $2.95/$53.10 Dividend yield = .0556, or 5.56% b Capital gains yield = 4.8%
The next dividend payment by Skippy, Inc., will be $2.95 per share. The dividends are anticipated to maintain a growth rate of 4.8 percent, forever. The stock currently sells for $53.10 per share. a What is the dividend yield? b What is the expected capital gains yield?
value
The weighted average cost of capital (RWACC) is the overall expected return the firm must earn on its existing assets to maintain its ___.
Payback method
This capital budgeting method allows lower management to make smaller, everyday financial decisions easily is
Payback method
This capital budgeting method allows lower management to make smaller, everyday financial decisions easily is: Average accounting return Net present value Payback method Internal rate of return
default
U.S. Treasury securities considered to be risk-free because they have minimal, if any, ____ risk. . inflation interest rate price default
real estate
Valuing companies using the comparables approach is similar to valuation in _______ ________
Accept if NPV is greater than zero. Reject if IRR is less than market rate of financing.
Which of the following are true for a project with a negative initial cash flow followed by positive cash flows? Accept if NPV is greater than zero. Accept if IRR is less than the market rate of financing Reason: In this case, you should accept if IRR is greater than the market rate of financing. Reject if IRR is less than market rate of financing.
Book values are often similar to market values for debt. Ideally, we should use market values in the WACC.
Which of the following are true? Book values are often similar to market values for debt. Ideally, we should use market values in the WACC. Ideally, we should use book values in the WACC. Book values are often similar to market values for equity.
Ideally, we should use market values in the WACC. Book values are often similar to market values for debt.
Which of the following are true? Ideally, we should use book values in the WACC. Book values are often similar to market values for equity. Ideally, we should use market values in the WACC. Book values are often similar to market values for debt.
-The cutoff date is arbitrary. -Time value of money principles are ignored. -Cash flows received after the payback period are ignored.
Which of the following are weaknesses of the payback method? -The cutoff date is arbitrary. -Time value of money principles are ignored. -Cash flows received after the payback period are ignored. -All cash flows are included in the payback period.
scale of cash flows timing of cash flows
Which of the following cause issues when comparing two mutually exclusive projects using IRR? -the independence of projects -scale of cash flows -timing of cash flows
NYSE
Which of the following has a physical trading floor? Multiple choice question. NASDAQ NYSE
It is also referred to as the discount rate that is used to discount cash flows in capital budgeting problems. It represents the marginal cost of capital.
Which of the following is true about the WACC? The WACC will always increase if the level of debt in the capital structure increases. It is also referred to as the discount rate that is used to discount cash flows in capital budgeting problems. It represents the marginal cost of capital. The WACC does not change over time.
A company can deduct interest paid on debt up to 30% of EBIT when computing taxable income.
Which of the following is true? A company can deduct dividends paid to shareholders when computing taxable income. A company cannot deduct interest paid on debt when computing taxable income. A company can deduct interest paid on debt up to 30% of EBIT when computing taxable income.
Newly-issued stocks are initially sold
Which of the following occurs in the primary market? Issuers repurchase shares Outstanding shares are resold Newly-issued stocks are initially sold Shareholders gift shares to charities
The covariance between the stock and the market index's returns. The variance of the market index's returns.
Which of the following variables do we need to compute the beta for a company's stock?
The variance of the market index's returns. The covariance between the stock and the market index's returns.
Which of the following variables do we need to compute the beta for a company's stock? The correlation between the stock's returns and the CPI index. The variance of the market index's returns. The covariance between the stock and the market index's returns. The covariance between the stock and the industry index's returns.
Dividends may grow at a constant rate.
Which one of the following is true about dividend growth patterns? Dividends always grow at a constant rate. Dividends may grow at a constant rate. Dividends never grow. Dividends always grow at a differential rate.
Under U.S. tax law, a corporation's interest payments up to 30% of EBIT are tax deductible.
Which one of the following is true? Under international tax law, all company interest payments are tax deductible. Under U.S. tax law, all company interest payments are taxable to the company. Under U.S. tax law, a corporation's interest payments up to 30% of EBIT are tax deductible. Under international tax law, all company interest payments are taxable to the company.
comparables
_____ are used to value companies based on primarily multiples -price earnings ratios enterprise value ratios
More
______ companies prefer the CAPM to the DDM. Multiple choice question. Less An equal amount of More
cap budgeting and project risk
a firm that uses one discount rate for all projects may over time increase the risk of the firm while decreasing its value
corporate tax
corporate tax favors debt financing since corporations can deduct interest expense
- ignores the time value of money - ignores cash flows after the payback period - biased against long-term projects - requires an arbitrary acceptance criteria - a project accepted based on the payback criteria may not have a positive NPV
disadvantages of payback period method
bring new security issues to the market
flotation costs are costs incurred to ____.
personal taxes
personal taxes favor equity financing, since no gain is reported until stock is sold, and long-term gains are taxed at a lower rate
operating leverage
refers to the sensitivity to the firms fixed costs of production