Finance 450 Exam 3 Concepts
The capital gains yield =
(Pt+1 - Pt)/Pt
capital gains yield=
(ending price - beginning price) / beginning price
Among the three main sources of cash flow, which source of cash flow is the most important and also the most difficult to forecast?
The operating cash flows from net sales over the life of the project
True or false: The operating cash flows of a project include erosion effects
True
True or false: To prepare proforma financial statements, estimates of quantities such as unit sales, selling price per unit, variable cost per unit, and total fixed costs are required.
True
Which one of the following statements is correct? Assume cash flows are conventional.
When the internal rate of return is greater than the required return, the net present value is positive.
The internal rate of return is a function of ____.
a project's cash flows
According to the average accounting return rule, a project is acceptable if its average accounting return exceeds:
a target average accounting return
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
The geometric rate of return takes ______ into account.
compounding
Normally, the excess rate of return is ___.
positive
The first step in estimating cash flow is to determine the _________ cash flows.
relevant
If the IRR is greater than the _______ ________, we should accept the project.
required return
Which of the following is a disadvantage of the payback period rule?
requires an arbitrary cutoff point
The arithmetic average rate of return measures the ____.
return in an average year over a given period
If a study of a firm's financial information will not lead to gains in the market, then the market must be at least _____ efficient.
semi-strong form
____________ analysis is useful in pinpointing variables that deserve the most attention.
sensitivity
To investigate the impact on NPV of a change in one variable, you would employ ________.
sensitivity analysis
Dan is a chemist for ABC, a major drug manufacturer. Dan cannot earn excess profits on ABC stock based on the knowledge he has related to his experiments if the financial markets are:
strong form efficient
The discounted (DCF) valuation estimates
the NPV as the difference between the present value of the future cash flows and the cost of the investment.
capital gains yield
the capital gain during a given year divided by the beginning price
Scenario Analysis
the determination of what happens to NPV estimates when we ask what-if questions (change multiple variables)
When calculating NPV, the present value of the nth cash flow is found by dividing the nth cash flow by 1 plus ______ rate raised to the nth power.
the discount
The higher the risk,
the higher the return
Capital rationing exists when a company has identified positive NPV projects but cannot (or will not) find:
the necessary financing
Which of the following are ways to make money by investing in stocks?
-capital gains -dividends
In general, NPV is ___.
-equal to zero when the discount rate equals the IRR -negative for discount rates above the IRR -positive for discount rates below the IRR
We underestimate NPV because of the option(s) to ______.
-expand -abandon -wait
The internal rate of return is unreliable as an indicator of whether or not an investment should be accepted given which one of the following?
The investment is mutually exclusive with another investment of a different size.
True or false: The value of managerial options is taken into account when performing conventional NPV analysis.
false
Roger Ibbotson and Rex Sinquefield presented year-to-year historical rates of return on _____ types of financial investments
five, 5
The profitability index is calculated by dividing the PV of the _________ cash inflows by the initial investment.
future
If we find that our estimated NPV is sensitive to a variable that is difficult to forecast, then the degree of forecasting risk is _____.
high
What is the primary concern of the payback period rule?
how long it will take to recover your initial investment
Interest expenses incurred on debt financing are ______ when computing cash flows from a project.
ignored
An efficient market is one in which any change in available information will be reflected in the company's stock price ___.
immediately
Dividends are the ______ component of the total return from investing in a stock.
income
Total Dollar Return
income from investment (dividends) + capital gain (loss) due to change in price
Synergy will _____ the sales of existing products
increase
The stand-alone principle assumes that evaluation of a project may be based on the project's ________________ cash flows.
incremental
An efficient market is one that fully reflects all available ______.
information
Stock prices fluctuate from day to day because of:
information flow
The capital gains yield can be found by finding the difference between the ending stock price and the initial stock price and dividing it by the:
initial stock price
If the dispersion of returns on a particular security is very spread out from the security's mean return, the security ____.
is highly risky
Which of the following is a disadvantage of the Profitability Index?
it cannot rank mutually exclusive projects
The payback period can lead to foolish decisions if it is used too literally because:
it ignores cash flows after the cutoff date
The profitability index rule for an independent project states that, if a project has a positive NPV, then the present value of the future cash flows must be _________ than the initial investment.
larger
The primary risk in estimation errors is the potential to __________.
make incorrect capital budgeting decisions
The normal distribution is completely described by the _______ and ________.
mean, standard deviation/variance
The project cash flow equals the project operating cash flow _____________ project change in NWC minus project capital spending.
minus
The discounted cash flow valuation shows that higher cash flows earlier in a project's life are ______ valuable than higher cash flows later on.
more
If a firm is evaluating two possible projects, both of which require the use of the same production facilities, and taking one project means that we cannot take the other, these projects would be considered _______________.
mutually exclusive
Accounts receivable and accounts payable are included in project cash flow estimation as part of changes in ______________.
net working capital
Which type of stock price adjustment time path occurs when there is a bubble (price run up) in the path followed by a decline after the market receives information about the stock?
overreaction and correction
The ______ method evaluates a project by determining the time needed to recoup the initial investment.
payback
The __________ is best suited for decisions on relatively small, minor projects while ______ is more appropriate for large complex projects.
payback period, NPV
If you use a geometric average to project short-run wealth levels, your results will most likely be _______ .
pessimistic
The NPV is ______ if the required return is less than the IRR, and it is ______ if the required return is greater than the IRR.
positive; negative
Given a level of investment in net working capital, that same investment must be ____________ at some time in the future.
recovered
Erosion will ______ the sales of existing products.
reduce
According to the basic IRR rule, we should:
reject a project if the IRR is less than the required return
The average risk premium on long-term government bonds for the period 1926-2014 was equal to:
the rate of return on the bonds minus the T-bill rate.
risk-free rate
the rate of return that can be earned with certainty
depreciation tax shield
the tax saving that results from the depreciation deduction (calculated as depreciation multiplied by the corporate tax rate)
In a competitive market, positive NPV projects are:
uncommon
In order to analyze the risk of a project's NPV estimate, we should establish ___________ for each important estimate variable.
upper and lower bounds
The square of the standard deviation is equal to the ____.
variance
The basic approach to evaluating cash flow and NPV estimates involves asking:
what-if quesitons
The IRR is the discount rate that makes NPV equal to ______.
zero
The Average Accounting Return is defined as:
average net Income/average book value
The risk premium can be interpreted as a reward for
bearing risk
A disadvantage of the AAR is that it is based on
book values, not market values.
When a company declares a dividend, shareholders generally receive ____.
cash
the geometric average return is the average ____________ return earned per year over a multiyear period.
compound
Managerial options are taken into consideration in ___________ planning.
contingency
The Profitability Index is also called the __________ ratio.
cost-benefit
Net Working Capital=
current assets - current liabilities
Incremental cash flows come about as a(n) ________ consequence of taking a project under consideration.
direct
total return percentage
dividend yield+capital gains yield
The total dollar return on a stock is the sum of the ____ and the _____.
dividends, capital gains
The ______ rate of return is the difference between the rate of return on a risky asset and the risk-free rate of return.
excess
The basic NPV investment rule is:
-If the NPV is equal to zero, acceptance or rejection of the project is a matter of indifference. -Accept a project if the NPV is greater than zero -Reject a project if its NPV is less than zero
Which of the following are reasons why NPV is considered a superior capital budgeting technique?
-It considers the riskiness of the project. -It properly chooses among mutually exclusive projects -It considers time value of money. -It considers all the cash flows.
Operating cash flow is a function of:
-Taxes -Earnings Before Interest and Taxes (EBIT) -Depreciation
A manager has estimated a positive NPV for a project. What could drive this result?
-The cash flow estimations are inaccurate. -The project is a good investment. -Overly optimistic management
What are the advantages of the payback period method for management?
-The payback period method is ideal for minor projects. -It allows lower level managers to make small decisions effectively. -The payback period method is easy to use.
If a new project requires an investment in net working capital when it is launched, then at the end of the project, NWC will be
100% reversed
The probability of a return being within ± one standard deviation of the mean in a normal distribution is approximately ___ percent.
68
How does the timing and the size of cash flows affect the payback method? Assume the project does pay back within the project's lifetime.
An increase in the size of the first cash inflow will decrease the payback period, all else held constant.
If discount rate is infinite, NPV=
CF0
The pro forma income statements for a proposed investment should include all of the following except:
Changes in Net Working Capital
Dividend Yield Formula
D1/P0, dividend amount/beg. stock price
True or false: In calculating cash flows, you should consider all financing costs.
False
What is an important drawback of traditional NPV analysis?
It ignores managerial options in investment decisions.
Generally speaking, payback is best used to evaluate which type of projects?
Low-cost, short-term
Which of the following techniques will provide the most consistently correct result?
NPV
Graham and Harveys' survey: 2 most popular capital budgeting methods
NPV and IRR
The discounted (DCF) valuation estimates the
NPV as the difference between the present value of the future cash flows and the cost of the investment.
If a project has multiple internal rates of return, which of the following methods should be used?
NPV or MIRR
_______ is a measure of how much value is created or added by undertaking an investment.
Net Present Value
The Tax Shield Approach:
OCF = (Sales - Costs) x (1-TC) + Depreciation x TC
Which of the following is the equation for estimating operating cash flows using the tax shield approach?
OCF = (Sales - Costs) × (1 - Tax rate) + Depreciation × Tax rate
Which one of the following indicators offers the best assurance that a project will produce value for its owners?
Positive NPV
You were recently hired by a firm as a project analyst. The owner of the firm is unfamiliar with financial analysis and wants to know only what the expected dollar return is per dollar spent on a given project. Which financial method of analysis will provide the information that the owner requests?
Profitability index
Which of the following is an example of an opportunity cost?
Rental income likely to be lost by using a vacant building for an upcoming project
Side effects from investing in a project refer to cash flows from:
-beneficial spillover effects -erosion effects
Which of the following are considered relevant cash flows?
-Cash flows from beneficial spillover effects -Cash flows from external costs -Cash flows from erosion effects
Identify the three main sources of cash flows over the life of a typical project.
-Cash outflows from investment in plant and equipment at the inception of the project -Net cash flows from salvage value at the end of the project -Net cash flows from sales and expenses over the life of the project
Which of the following are components of project cash flow?
-Change in net working capital -Operating cash flow -Capital spending
lowest historical risk premium to highest historical risk premium:
-Treasury Bills -Long-term Gov Bonds -Large-company stocks -Small-company stocks
Cash flows used in project estimation should always reflect:
-after-tax cash flows -cash flows when they occur
Percentage returns are more convenient than dollar returns because they:
-apply to any amount invested -allow comparison against other investments
Which of the following is true relative to capital rationing?
-hard rationing implies the firm is unable to raise funds for projects -soft rationing is typically internal in that the firm allocates funds to divisions for capital projects
The goals of risk analysis in capital budgeting include:
-identifying critical components -assessing the degree of financing risk
Though depreciation is a non-cash expense, it is important to capital budgeting for these reasons:
-it determines the book value of assets which affects net salvage value -it determines taxes owed on fixed assets when they are sold -it affects a firm's annual tax liability
Which of the following present problems when using the IRR method?
-mutually exclusive projects -non-conventional cash flows
An option on a real asset rather than a financial asset is known as a:
-real option -managerial option
capital gains yield
The percentage change in the price of a stock over a period of time
Profitability Index (PI)
The present value of an investment's future cash flows divided by its initial cost. (PV/initial cost)
True or false: A project with non-conventional cash flows will produce two or more IRRs.
True
True or false: The measure of average accounting profit is in the numerator of the average accounting return (AAR) formula.
True
The PI rule for an independent project is to ______ the project if the PI is greater than 1.
accept
Based on the average accounting return rule, a project is _____ if its average accounting return exceeds a target average accounting return.
acceptable
The payback period rule ______ a project if it has a payback period that is less than or equal to a particular cutoff date.
accepts
Cash flows should always be considered on a(n) _______________ basis.
after-tax
In an efficient market ______ investments have a _____ NPV.
all, zero
A positive capital gain on a stock results from ___.
an increase in price