Finance 450 Exam 3

Investment in net working capital arises when ___.

-cash is kept for unexpected expenditures -inventory is purchased -credit sales are made

what are some fixed costs?

-cost of equipment -rent on a production facility

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

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

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

not conventional

The ____________ method differs from NPV because it evaluates a project by determining the time needed to recoup the initial investment.

payback

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

payback method

Opportunity costs are classified as ______ costs in project analysis.

relevant

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

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

true

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

won't

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

10.6 "when evaluating projects, were concerned with only the relevant incremental aftertax cash flows. therefore, because depreciation is a non-cash expense, we should ignore its effects when evaluating projects" evaluate this statement

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

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

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

10.4 suppose a financial manager is quoted as saying, "our firm uses the stand-alone principle. because we treat projects like minifirms in our evaluation process, we include financing costs because they are relevant at the firm level". evaluate this statement

Management's discretion to set the firm's capital structure is applicable at the firm level. Since anyone particular project could be financed entirely with equity, another project could be financed with debt, and the firm's overall capital structure remains unchanged. Financing costs are irrelevant in the analysis of a project's incremental cash flows according to the stand-alone principle

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

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

8.5 suppose a company has a preferred stock issue and a common stock issue. both have just paid a $2 dividend. which do you think will have a higher price, a share of the preferred or a share of the common?

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

8.4 under what two assumptions can we use dividend growth model presented in the chapter to determine the value of a share of stock? comment on the reasonableness of these assumptions

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

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

The two components are the dividend yield and the capital gains yield. For most companies, the capital gains yield is larger. This is easy to see for companies that pay no dividends. For companies that do pay dividends, the dividend yields are rarely over 5 percent and are often much less.

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

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

Opportunity costs are ____. Multiple choice question.

benefits lost due to taking on a particular project

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

budgeting

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

9.2 suppose a project has conventional cash flows and a positive NPV what do you know about its payback? its discounted payback? its IRR?

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

8.12 one of the assumptions of the two-stage growth model is that the dividends drop immediately from the high growth rate to the perpetual growth rate. what do you think about this assumption? what happens if this assumption is violated?

If this assumption is violated, the two-stage dividend growth model is not valid. In other words, the price calculated will not be correct. Depending on the stock, it may be more reasonable to assume that the dividends fall from the high growth rate to the low perpetual growth rate over a period of years, rather than in one year

8.3 referring to the previous questions, under what circumstances might a company choose not to pay dividends

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

10.1 In the context of capital budgeting, what is opportunity cost

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

9.6 concerning NPV a. describe how NPV is calcuated, and describe the information this measure provides about a sequence of cashflows. what is the NPV criterion decision rule? b. why is NPV considered a superior method of evaluating the cash flows from a project? suppose the NPV for a project's cash flows is computed to be $2500. what does this number represent with respect to the firm's shareholders?

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

9.3 concerning payback: a. describe how the payback period is calculated, and describe the information this measure provides about a sequence of cash flows. what is the payback criterion decision rule? b. what are the problems associated with using the payback period to evaluate cash flows? c. what are the advantages of using the payback period to evaluate cash flows/ are there any circumstances under which using payback might be appropriate?

a. Payback period is the accounting break-even point of a series of cash flows. To actually compute the payback period, it is assumed that any cash flow occurring during a given period is realized continuously throughout the period, and not at a single point in time. The payback is then the point in time for the series of cash flows when the initial cash outlays are fully recovered. Given some predetermined cutoff for the payback period, the decision rule is to accept projects that payback before this cutoff, and reject projects that take longer to pay back b. The worst problem associated with payback period is that it ignores the time value of money. In addition, the selection of a hurdle point for payback period is an arbitrary exercise that lacks any steadfast rule or method. The payback period is biased towards short-term projects; it fully ignores any cash flows that occur after the cutoff point c. Despite its shortcomings, payback is often used because (1) the analysis is straightforward and simple and (2) accounting numbers and estimates are readily available. Materiality considerations often warrant a payback analysis as sufficient; maintenance projects are another example where the detailed analysis of other methods is often not needed. Since payback is biased towards liquidity, it may be a useful and appropriate analysis method for short-term projects where cash management is most important.

9.7 concerning IRR: a. describe how the IRR is calculated, and describe the information this measure provides about a sequence of cash flows. what is the IRR criterion decision rule? b. what is the relationship between IRR and NPV? are there any situations in which you might prefer one method over the other? c. despite its shortcomings in some situations, why do most financial managers use IRR along with NPV when evaluating projects? can you think of a situation in which IRR might be a more appropriate measure to use than NPV?

a. The IRR is the discount rate that causes the NPV of a series of cash flows to be exactly zero. IRR can thus be interpreted as a financial break-even rate of return; at the IRR, the net present value of the project is zero. The IRR decision rule is to accept projects with IRRs greater than the discount rate, and to reject projects with IRRs less than the discount rate. b. IRR is the interest rate that causes NPV for a series of cash flows to be zero. NPV is preferred in all situations to IRR; IRR can lead to ambiguous results if there are nonconventional cash flows, and it also ambiguously ranks some mutually exclusive projects. However, for stand-alone projects with conventional cash flows, IRR and NPV are interchangeable techniques. c. IRR is frequently used because it is easier for many financial managers and analysts to rate performance in relative terms, such as "12%," than in absolute terms, such as "$46,000." IRR may be a preferred method to NPV in situations where an appropriate discount rate is unknown or uncertain; in this situation, IRR would provide more information about the project than wouldNPV

9.4 concerning discounted payback: a. describe how the discounted payback period is calculated, and describe the information this measure provides about a sequence of cash flows. what is the discounted payback criterion decision rule? b. what are the problems associated with using the discounted payback period to evaluate cash flows? c. what conceptual advantage does the discounted payback method have over the regular payback method? can the discounted payback ever be longer than the regular payback

a. The discounted payback is calculated the same as is regular payback, with the exception that each cash flow in the series is first converted to its present value. Thus discounted payback provides a measure of financial/economic break-even because of this discounting, just as regular payback provides a measure of accounting break-even because it does not discount the cash flows. Given some predetermined cutoff for the discounted payback period, the decision rule is to accept projects whose discounted cash flows pay back before this cutoff period, and to reject all other projects. b. The primary disadvantage to using the discounted payback method is that it ignores all cash flowsthat occur after the cutoff date, thus biasing this criterion towards short-term projects. As a result, the method may reject projects that in fact have positive NPVs, or it may accept projects with large future cash outlays resulting in negative NPVs. In addition, the selection of a cutoff point is again an arbitrary exercise c. Discounted payback is an improvement on regular payback because it takes into account the time value of money. For conventional cash flows and strictly positive discount rates, the discounted payback will always be greater than the regular payback period

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

accepted