Finance - Exam 2

mutually exclusive

taking one investment means that we cannot take the other

book value formula

initial investment - accumulated depreciation

straight-line depreciation

initial investment / years

simple interest formula

Interest = Principal x Rate x Time

Assume you are investing $100 today in a savings account. Which of the following terms refers to the total value of this investment one year from now? a. Future Value b. Present Value c. Principal Amount d. Discounted Value e. Invested Principle

a. Future Value

discounted cash flow (DCF) valuation

calculating the present value of a future cash flow to determine its value today

ordinary annuity

equal payments made at the end of the period

NPV rule

** accept if positive ** reject if negative if the present value of all the cash inflows is greater than the present value of all the cash outflows, the project should be accepted

how to calculate APR

APR = period rate x the number of periods per year

how to calculate EAR

EAR = (1 + monthly rate) ^ # of periods

operating cash flow

EBIT + depreciation -taxes net income + depreciation

2 decision making techniques used in business

NPV & IRR

EBIT

Revenue - Cost - Depreciation

Bui Bakery has a required payback period of two years for all of its projects. Currently, the firm is analyzing two independent projects. Project X has an expected payback period of 1.4 years and a net present value of $6,100. Project Z has an expected payback period of 2.6 years with a net present value of $18,600. Which project(s) should be accepted based on the payback decision rule? a. project X only b. project Z only c. both X and Z d. neither X nor Z e. either, but not both

a. project X only

IRR rule

an investment is acceptable if the IRR exceeds the required return. It should be rejected otherwise.

Which one of the following statements related to loan interest rates is correct? a. the annual percentage rate considers the compounding of interest b. when comparing leans you should compare the effective annual rates. c. lenders are most apt to quote the effective annual rate d. regardless of the compounding period, the effective annual rate will always be higher than the annual percentage rate e. the more frequent the compounding period, the lower the effect annual rate given a fixed annual percentage rate.

b. when comparing loans you should compare the effective annual rates.

If a firm accepts Project X it will not be feasible to also accept Project Z because both projects would require the simultaneous and exclusive use of the same piece of machinery. These projects are considered to be: a. independent. b. interdependent. c. mutually exclusive. d. economically scaled. e. operationally distinct.

c. mutually exclusive.

A perpetuity is defined as: a. a limited number of equal payments paid in even time increments. b. payments of equal amounts that are paid irregularly but indefinitely c. varying amounts that are paid at even intervals forever d. unending equal payments paid at equal time intervals e. unending equal payments paid at either equal or unequal time intervals

d. unending equal payments paid at equal time intervals

incremental cash flows

difference between a firm's future cash flows with a project and those without the project

net present value

difference in market costs & its costs

interest only loan

loan where borrower pays only interest with principal balance unchanged

impact of interest rates on PV cash flows

the longer the time period, the lower the PV higher the interest rate, the smaller the PV

opportunity costs

the most desirable alternative given up as the result of a decision

how to convert an APR to an EAR

EAR = (1 + APR/m) ^ m - 1

compounding interest formula

Principal amount ( 1 + rate) ^ t t = terms/number of years

compounding

accumulating interest over time & reinvesting interest

MACRS deprecation schedule

cost of the asset x fixed percentage

initial investment cash flow

total money that is available when a project or business is in the planning stages

perpetuity

type of annuity that lasts forever, into perpetuity

sunk costs

cost that has already been incurred and cannot be removed and therefore should not be considered in an investment decision.

factors of FV

- depends on assumed interest rate - calculates how much an investment can grow by

disadvantages of payback

-Ignores the time value of money -Requires an arbitrary cutoff point -Ignores cash flows beyond the cutoff date -Biased against long-term projects, such as research and development, and new projects

IRR disadvantages

-can produce multiple answers -cannot rank mutually exclusive projects -reinvestment assumption flawed

advantages of payback

-easy to understand -adjusts for uncertainty of later cash flows -biased toward liquidity

IRR advantages

-easy to understand and communicate -closely related to NPV, leads to identical decisions

The interest rate that is most commonly quoted by a lender is referred to as the: a. annual percentage rate b. compound rate c. effective annual rate d. simple rate e. common rate

a. annual percentage rate

Net present value: a. is the best method of analyzing mutually exclusive projects. b. is less useful than the internal rate of return when comparing different-sized projects. c. is the easiest method of evaluation for nonfinancial managers. d. cannot be applied when comparing mutually exclusive projects. e. is very similar in its methodology to the average accounting return.

a. is the best method of analyzing mutually exclusive projects.

payback

amount required to "payback" official investment

payback rule

an investment is acceptable if its calculated payback period is less than some prespecified number of years

Which one of the following is an example of a sunk cost? a. $2,000 in lost sales because an item was out of stock b. $2,000 paid last year to rent equipment c. $2,000 project that must be forfeited if another project is accepted d. $2,000 reduction in Product A revenue if a firm commences selling Product B e. $2,000 increase in comic book sales if a store ceases selling puzzles

b. $2,000 paid last year to rent equipment

The fact that a proposed project is analyzed based on the project's incremental cash flows is the assumption behind which one of the following principles? a. underlying value principle b. stand-alone principle c. equivalent cost principle d. salvage principle e. fundamental principle

b. Stand-alone principle

Cullen invested $5,000 five years ago and earns 6 percent annual interest. By leaving his interest earnings in her account, he increases the amount of interest he earns each year. His investment is best described as benefitting from: a. simplifying b. compounding c. aggregating d. accumulating e. discounting

b. compounding

Isaac has analyzed two mutually exclusive projects that have 3-year lives. Project A has an NPV of $81,406, a payback period of 2.48 years, and an AAR of 9.31 percent. Project B has an NPV of $82,909, a payback period of 2.57 years, and an AAR of 9.22 percent. The required return for Project A is 11.5 percent while it is 12 percent for Project B. Both projects have a required AAR of 9.25 percent. Isaac must make a recommendation and justify it in 15 words or less. What should his recommendation be? a. accept both projects because both NPVs are positive b. accept Project A because it has the shortest payback period c. accept Project B and reject Project A based on the NPVs d. accept Project A and reject Project B based on their AARs e. accept Project A because it has the lower required return

c. accept Project B and reject Project A based on the NPVs

Nirav just opened a savings account paying 2 percent interest, compounded annually. After four years, the savings account will be worth $5,000. Assume there are no additional deposits or withdrawals. Given this information, Nirav: a. will earn the same amount of interest each year for four years. b. will earn simple interest on his savings every year for four years c. could have deposited less money today and still had $5,000 in four years if the account paid a higher rate of interest. d. has an account currently valued at $5,000 e. could earn more interest on this account if the interest earnings were withdrawn annually

c. could have deposited less money today and still had $5,000 in four years if the account paid a higher rate of interest.

Eunchae invested $2,000 six years ago at 4.5 percent interest. She spends all of her interest earnings immediately so she only receives interest on her initial $2,000 investment. Which type of interest is she earning? a. free interest b. complex interest c. simple interest d. interest on interest e. compounding interest

c. simple interest

Which one of the following types of costs was incurred in the past and cannot be recouped? a. incremental b. side c. sunk d. opportunity e. erosion

c. sunk

Which one of the following statements related to the internal rate of return (IRR) is correct? a. the IRR yields the same accept and reject decisions as the net present value method given mutually exclusive projects. b. a project with an IRR equal to the required return would reduce the value of a firm if accepted. c. the IRR is equal to the required return when the net present value is equal to zero. d. financing type projects should be accepted if the IRR exceeds the required return. e. the average accounting return is a better method of analysis than the IRR from a financial point of view.

c. the IRR is equal to the required return when the net present value is equal to zero.

Which one of the following statements concerning interest rates is correct? a. savers would prefer annual compounding over monthly compounding given the same annual percentage rate. b. the effective annual rate decreases as the number of compounding periods per year increases. c. the effective annual rate equals the annual percentage rate when interest is compounded annually. d. borrowers would prefer monthly compounding over annual compounding given the same annual percentage rate. e. for any positive rate of interest, the annual percentage rate will always exceed the effective annual rate.

c. the effective annual rate equals the annual percentage rate when interest is compounded annually.

The internal rate of return is defined as the: a. maximum rate of return a firm expects to earn on a project. b. rate of return a project will generate if the project is financed solely with internal funds. c. discount rate that equates the net cash inflows of a project to zero. d. discount rate which causes the net present value of a project to equal zero. e. discount rate that causes the profitability index for a project to equal zero.

d. discount rate which causes the net present value of a project to equal zero.

The stand-alone principle advocates that project analysis should be based solely on which one of the following costs? a. sunk b. total c. variable d. incremental e. fixed

d. incremental

Salazar's Salads is considering two projects. Project X consists of creating an outdoor eating area on the unused portion of the restaurant's property. Project Z would instead use that outdoor space for creating a drive-thru service window. When trying to decide which project to accept, the firm should rely most heavily on which one of the following analytical methods? a. profitability index b. internal rate of return c. payback d. net present value e. accounting rate of return

d. net present value

compounding interest

interest earned on both the initial principle & the interest reinvested from prior periods

simple interest

interest earned only on the original principal amount invest

annuity due

repeating payment made at the beginning ** 2nd enter to change to BGN, 2nd CPT to exit setting

aftertax salvage value

salvage - (salvage - book value) If book is 0, salvage x (1 - tax rate) recognized in the final year cash flow

net working capital investment

taken out in year 0 cash flows and added in during the final year cash flow

depreciation tax shield

tax saving that results from the depreciation deduction depreciation multiplied by the corporate tax rate

relationship between NPV, discount rate, and IRR for a project with a $0 NPV

the IRR on an investment is the required return that results in a zero NPV when it is used as the discount rate

erosion

the cash flows of a new project that come at the expense of a firm's existing projects