FIN 3000 - Quiz 4 Review

Discounted Cash Flow (DCF):

(a) Calculating the present value of a future cash flow to determine its value. (b) The process of valuing an investment by discounting its future cash flows

Corporate Finance seeks to address the following three questions:

1. What long-term investments should the firm make? 2. How will the firm finance such investments? 3. How to manage the day-to-day financial activities of the firm? We are concerned with decision making and firm value

Relevant cash flows:

A change in the firm's overall future cash flow that comes about as a direct consequence of the decision to take that project.

Sunk cost:

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

Net present value profile:

A graphical representation of the relationship between an investment's NPVs and various discount rates.

Mutually exclusive investment decision:

A situation in which taking one investment prevents the taking of another.

Mutually exclusive projects:

Competing projects which both require the use of the same limited resource.

20. The option that is forgone so that an asset can be utilized by a specific project is referred to as which one of the following? A. Salvage value B. Wasted value C. Sunk cost D. Opportunity cost E. Initial investment

D. Opportunity cost

26. _____ is the minimum required return on a new investment. A. Cost of equity B. Cost of debt C. Internal rate of return D. Yield to maturity E. Cost of capital

E. Cost of capital

4. The IRR that causes the NPV of the differences between two project's cash flows to equal zero is called the: A. Required return B. Zero-sum rate C. Present value rate D. Break-even rate E. Crossover rate

E. Crossover rate

16. _____ is the possibility that errors in projected cash flows will lead to incorrect decisions. A. Sensitivity analysis B. Scenario analysis C. Discounted cash flow analysis D. Incremental cash flow analysis E. Forecasting risk

E. Forecasting risk

11. _____ is the possibility that more than one discount rate will make the NPV of an investment zero. A. IRR risk B. Hurdle rates of return C. Required rates of return D. Mutual rates of return E. Multiple rates of return

E. Multiple rates of return

Operating Cash Flow =

EBIT (Earnings Before Interest and Taxes) + Depreciation - Taxes

Pro forma financial statements:

Financial statements projecting future years' operations.

Sensitivity analysis:

Investigation of what happens to net present value when only one variable is changed.

Project Cash Flow =

Project Operating Cash Flow - Project Capital Spending - Project Change in Net Working Capital

Payback period:

The amount of time required for an investment to generate cash flows sufficient to recover its initial cost. Equation: o Payback = Years before cost recovery + (Remaining cost to recover/Cash flow during the year)

27. _____ is the return that equity investors require on their investment in the firm. A. Cost of equity B. Cost of debt C. Weighted average cost of capital D. Coupon rate E. Cost of capital

A. Cost of equity

1. The _____ criterion is the best way to evaluate proposed investments. A. NPV B. IRR C. MIRR D. Payback period E. Profitability index

A. NPV

29. The WACC is always the interest rate firms should use when discounting project cash flows in capital budgeting analysis. A. True B. False

B. False

17. _____ is the determination of what happens to net present value estimates when we ask "what-if" questions. A. Sensitivity analysis B. Scenario analysis C. Discounted cash flow analysis D. Incremental cash flow analysis E. Forecasting risk

B. Scenario analysis

24. When you assign the highest anticipated sales price and the lowest anticipated costs to a project, you are analyzing the project under the condition known as: A. Best case sensitivity analysis B. Worst case sensitivity analysis C. Best case scenario analysis D. Worst case scenario analysis E. Base case scenario analysis

C. Best case scenario analysis

3. Which one of the following methods of project analysis is defined as computing the value of a project based on the present value of the project's anticipated cash flows? A. Constant dividend growth model B. Average accounting return C. Discounted cash flow valuation D. Expected earnings model E. Internal rate of return

C. Discounted cash flow valuation

Net working capital:

Current assets less current liabilities.

Stand-Alone principle:

The assumption that evaluation of a project may be based on the project's incremental cash flows.

Erosion:

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

Weighted average cost of capital (WACC):

The cost of capital for the firm as a whole, and it can be interpreted as the required return on the overall firm. It is the weighted average of the cost of the different forms of financing (such as common stock, debt, and preferred stock). - Use this for the firm as a whole

Scenario analysis:

The determination of what happens to net present value estimates when we ask "what-if" questions. • Examine several possible situations: o Worst case o Base case (most likely) o Best case • Provides a range of possible outcomes

Incremental cash flows:

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

Net present value (NPV):

The difference between an investment's market value and its costs.

Internal rate of return (IRR):

The discount rate that makes the NPV of an investment zero.

25. The _____ represents the tax saving that results from the depreciation deduction, calculated as depreciation multiplied by the corporate tax rate. A. Depreciation tax shield B. Depreciation expense C. After-tax cost of capital D. Equipment tax rate E. Discounted tax flow analysis

A. Depreciation tax shield

18. The difference between a firm's future cash flows if it accepts a project and the firm's future cash flows if it does not accept the project is referred to as the project's: A. Incremental cash flows B. Internal cash flows C. External cash flows D. Erosion effects E. Financing cash flows

A. Incremental cash flows

23. The procedure of allocating a fixed amount of funds for capital spending to each business unit is called: A. Marginal spending B. Capital preservation C. Soft rationing D. Hard rationing E. Marginal rationing

C. Soft rationing

19. Which one of the following best describes the concept of erosion? A. Expenses that have already been incurred and cannot be recovered. B. Change in net working capital related to implementing a new project. C. The cash flows of a new project that come at the expense of a firm's existing cash flows. D. The alternative that is forfeited when a fixed asset is utilized by a project. E. The differences in a firm's cash flows with and without a particular project

C. The cash flows of a new project that come at the expense of a firm's existing cash flows.

28. Textile Mills borrows money at a rate of 13.5 percent. This interest rate is referred to as the: A. WACC B. Compound rate C. Current yield D. Cost of debt E. Cost of capital

D. Cost of debt

2. 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 it 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.

10. _____ are competing projects which both require the use of the same limited resource. A. Conventional projects B. Non-conventional projects C. Sunk cost projects D. Mutually exclusive projects E. Cost competing projects

D. Mutually exclusive projects

Cost of capital:

The minimum required return on a new investment. It is also called: required return, appropriate discount rate, cost of capital. - Use this for new projects

Capital structure:

The mixture of debt and equity maintained by the firm.

Opportunity cost:

The most valuable alternative that is given up if a particular investment is undertaken.

Forecasting risk:

The possibility that errors in projected cash flows will lead to incorrect decisions. • Sensitivity of NPV to changes in cash flow estimates. • The more sensitive NPV the greater the forecasting risk.

Multiple rates of return:

The possibility that more than one discount rate will make the NPV of an investment zero.

Profitability index (benefit-cost ratio):

The present value of an investment's future cash flows divided by its initial cost.

Capital budgeting:

The process of planning and managing a firm's long-term investments.

Cost of equity:

The return that equity investors require on their investment in the firm.

Cost of debt:

The return that the firm's creditors demand on new borrowing and the return currently being offered on bonds of similar risk (the yield-to-maturity).

Capital rationing:

The situation that exists if a firm has positive NPV projects but cannot find the necessary financing.

Hard rationing:

The situation that occurs when a business cannot raise financing for a project under any circumstances.

Soft rationing:

The situation that occurs when units in a business are allocated a certain amount of financing for capital budgeting. Example: o The corporation as a whole is not short on capital, but a specific business unit is short on capital. The business unit should try to get more capital.

Depreciation tax shield:

The tax saving that results from the depreciation deduction, calculated as depreciation multiplied by the corporate tax rate.