Fin 325 Final Exam
12.4a: In words, how do we calculate a variance? A standard deviation?
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13.1a: How do we calculate the expected return on a security?
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13.6d: How do you calculate a portfolio beta?
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12.6a: What is an efficient market?
A market in which security prices reflect available information.
13.6b: What does a beta coefficient measure?
A beta coefficient is an index (measure) of an asset's systematic risk. An asset's beta depends on two factors The volatility (standard deviation) of an asset's return relative to the volatility of the "market portfolio." The linkage (correlation) between the return on the asset and the return on the "market portfolio."
10.2b: Explain what erosion is and why it is relevant?
A negative impact on the cash flows of an existing product from the intro of a new product is called erosion. In this case, the cash flows from the new line should be adjusted downward to reflect the lost profits on other lines. In accounting for erosion, it is important to recognize that any sales lost as a result of launching a new product might be lost anyway because of future competition. Erosion is relevant only when the sales would not otherwise be lost.
11.1b: What are some potential sources of value in a new project?
Are we certain that our new product is significantly better than that of the competition? Can we truly manufacture at lower cost, or distribute more effectively, or identify undeveloped market niches, or gain control of a market?
10.3b: For the shark attractant project, why did we add back the firm's net working capital investment in the final year?
At the end of the project's life, the fixed assets will be worthless, but the firm will recover the money that was tied up in working capital. This will lead to cash inflow in the last year. On a purely mechanical level, notice that whenever we have an investment in net working capital, the same investment has to be recovered; in other words, the same number needs to appear at some time in the future with the opposite sign.
10.5a: What are the top-down and bottom-up definitions of operating cash flow?
In the Top-down approach: we start at the top of the income statement with sales and work our way down to net cash flow by subtracting costs,taxes,and other expenses. Along the way, we simply leave out any non cash items such as depreciation. The bottom-up approach, we start with the accountant's bottom line( net income) and add back any non cash deductions such as depreciation. It is crucial to remember that this definition of operating cash flow as net income plus depreciation is correct only if there is no interest expense subtracted in the calculation of net income.
14.4b: Why do we multiply the cost of debt by (1-Tc) when we compute the WACC?
Interest paid to bondholders is tax deductible. We multiply the cost of debt by (1-Tc) to factor in the portion of the interest that the government pays. This is the post-tax cost of debt.
14.4c: Under what conditions is it correct to use the WACC to determine NPV?
It is correct to use the WACC to determine NPV is the proposed investment is a replica of the firm's existing operations or if the investment is closely related to the firm's operations.
10.4a: Why is it important to consider changes in net working capital in developing cash flows? What is the effect of doing so?
It is important to consider changes in net working capital in developing cash flows because net working capital requirements change as sales change. Every year businesses will generally either add to or recover some of its project net working capital. An increase in net working capital is a cash outflow it shows positive sign represents net working capital returning to the firm.
How is operating leverage measured?
Operating leverage is measured by the percentage change in operating cash flow relative to the percentage change in quantity sold. It is calculated using the equation:- DOL=1+ FC/OCF Where: FC-fixed costs OCF-operating cash flow DOL- Degree of operating leverage
11.5a: What is operating leverage?
Operating leverage is the degree to which a project or firm is committed to fixed production costs. In other words, the degree to which a firm or project relies on fixed costs. ( The ability to have low fix costs, so that you can afford to have higher variable cost.) Your fixed cost should be low, so you have a better operating leverage.
11.1a: What is forecasting risk? Why is it a concern for the financial manager?
Possibility that errors in projected cash flows will lead to incorrect decisions. It is a concern for a financial manager because he is forecasting this risk and deciding whether or not to go forward with this particular project or investment.
10.3a: What is the definition of project operating cash flow? How does this differ from net income?
Project Operating Cash Flow is defined as the operating cash flow required for the day to day operation of the project. Project operating cash flow= Project cash flow+Project change in net working capital+Project capital spending
10.1a: What are the relevant incremental cash flows for project evaluation?
The incremental cash flows for project evaluation consist of any and all changes in the firm's future cash flows that are a direct consequence of taking the project.
14.5a: What are the likely consequences if a firm uses its WACC to evaluate all proposed investments?
The likely consequences include accepting projects with more risk than the overall firm and rejected projects with less risk than the firm.
13.2a: What is a portfolio weight?
The percentage of a portfolio's total value that is invested in a particular asset.
11.6b: What problems does capital rationing create for discounted cash flow analysis?
The problems capital rationing creates for discounted cash flow analysis are > Profitable projects cannot be funded. > NPV is not necessarily the appropriate criterion. > Bankruptcy is possibility.
14.1b: What is the relationship between the required return on an investment and the cost of capital associated with that investment?
The required return and the cost of capital are essentially the same. The required return is what the firm must earn to compensate the investors for their use of capital required to finance the project.
13.7b: What is the security market line? Why must all assets plot directly on it in a well-functioning market?
The security market line is the theoretical line on which all capital investments lie. Investors want higher expected returns for more risk
14.1a: What is the primary determinant of the cost of capital for an investment?
The use of the funds.
10.4b: How is depreciation calculated for fixed assets under current tax law? What effects do expected salvage value and estimated economic life have on the calculated depreciation deduction?
Under Modified ACRS Depreciation( MACRS) is that every asset is assigned to a particular class. An asset's class establishes its life for tax purposes. Once an asset's tax life is determined, the depreciation for each year is computed by multiplying the cost of the asset by a fixed percentage. The expected salvage value( what we think the asset will be worth when we dispose of it) and the expected economic life( how long we expect the asset to be in service) are not explicitly considered in the calculation of depreciation.
13.3b: Under what conditions will a company's announcement have no effect on common stock prices?
When the information in the announcement was fully expected (there was no surprise; all of the information had already been discounted)
13.6c: True or false: The expected return on a risky asset depends on that asset's total risk. Explain.
false. the expected run on assets depends only on that assets systematic risk
13.5a: What happens to the standard deviation of return for a portfolio if we increase the number of securities in the portfolio?
standard deviation declines and the number of securities increase
10.5b: What is meant by the term depreciation tax shield?
Depreciation tax shield is defined as the tax saving that results from the depreciation deduction, calculated as depreciation multiplied by the corporate tax rate.
12.3a: What do we mean by excess return and risk premium?
Differences between treasury bills and common stock on the average risky asset.
12.1a: What are the two parts of total return?
Dividend yield, and capital gains yield
13.3a: What are the two basic parts of a return?
Expected + Unexpected
11.3c: Why might a financial manager be interested in the accounting break-even point?
Financial managers are often concerned with the contribution that a project will make to the firm's total accounting earnings. A project that does not break even in an accounting sense actually reduces total earnings. A project that just breaks even on an accounting basis loses money in a financial or opportunity cost sense.
11.6a: What is capital rationing? What types are there?
Firm or organizations limiting of new investment or restriction of new investment due to some budgetary decisions. > Soft rationing- The situation that occurs when in a business are allocated a certain amount of financing for capital budgeting. > Hard rationing- the situation that occurs when a business cannot raise financing for a capital budgeting.
10.2c: Explain why interest paid is not a relevant cash flow for project evaluation
Interest paid is a financing expense, not a component of operating cash flow
12.2a: With 20/20 hindsight, what do you say was the best investment for the period from 1926 through 1935?
Large company stocks, then small company stocks
10.1b: What is the stand-alone principle?
Once we identify the effect of undertaking the proposed project on the firm's cash flows, we need focus only on the project's resulting incremental cash flows. What the stand-alone principle says is that once we have determined the incremental cash flows from undertaking a project, we can view that project as a kind of "minifirm" with its own future revenues and costs, its own assets, and, of course, its own cash flows
13.6a: What is the systematic risk principle?
Only risk important to the well diversified investor. Affects all stocks.
13.4a: What are the two basic types of risk?
Systematic Risk Unsystematic Risk
13.5b: What is the principle of diversification?
The Portfolio consists of different sorts of assets which are correlated differently with one another have negligible unsystematic risk
14.2b: What are two approaches to estimating the cost of equity capital?
The dividend growth model approach and the SML approach.
11.2a: What are scenario, sensitivity, and simulation analysis?
Scenario: The determination of what happens to NPV estimates when we ask what-if questions. Sensitivity: Investigation of what happens to NPV when only one variable is changed. Simulation: the process of modeling a situation under uncertainty to predict the statistical probability of potential outcomes. -provides a model to account for uncertainty in customized and individualistic way -is a good method when a model has many assumptions and it is not possible to get an optimal answer.
10.6a: In setting a bid price, we used a zero NPV as our benchmark. Explain why this is appropriate.
Setting a zero NPV is appropriate because it ensures that underbidding does not happen. Since a zero NPV takes into account your expected rate of return, it ensures that the bidder does not lose out by lowering the bids too much.
10.2a: What is a sunk cost? An opportunity cost?
Sunk Cost: cost that is already paid or incurred liability today. Such costs cannot be changed by the decision today to accept or reject a project.
13.4b: What is the distinction between the two types of risk?
Systematic risk factors affect ALL stocks to some degree. Unsystematic risk factors affect only one or a small group assets.
13.2b: How do we calculate the expected return on a portfolio?
Take the boom and the bust of each stock and multiply it times the economy state and then add them together. Example .10(.40) +.08(.60) for each one. Then you would take the percentage and multiply it times the amount each stock is weighted so if there was 3 and they were all equally weighted it would be 1/3 times each of the other percentages.
13.7c: What is the capital asset pricing model (CAPM)? What does it tell us about the required return on a risky investment?
The CAPM is the equation of the SML; it describes the relationship between the expected return of an asset and its systematic risk, or beta. It tells us that the expected return depends on the pure time value of money (Rf), the market risk premium E(Rm)-Rf, and the beta for the asset (Bi) relative to the average asset.
10.6b: Under what circumstances do we have to worry about unequal economic lives? How do you interpret the EAC?
The EAC( Equivalent annual cost) approach is appropriate when comparing mutually exclusive projects with different lives that will replaced when they wear out. This type of analysis is necessary so that the projects have a common life span over which they can be compared. For example, if one project has a three-year life and the other has a five-year life, then a 15- year horizon is the minimum necessary to a place the two projects on an equal footing, implying that one project will be repeated five times and the other will be repeated three times. Note the shortest common life may be quite long when there are more than two alternatives and/or the individual project lives are relatively long. Assuming this type of analysis is valid, implies that the project cash flows remain the same over the common life, thus ignoring the possible effects of inflation, changing economic conditions, increasing unreliability of cash flow estimates that occur far into the future, and the possible effects of future technology improvement that could alter the project cash flows.
14.4a: How is the WACC calculated?
The WACC is calculated by adding the products of the cost of equity by its capital structure weight and the cost of debt by its capital structure weight. If the firm is financed by preferred stock, then the product of the cost of preferred stock and its capital structure weight must be added to the equation. WACC = (E/V) Re + (D/V) Rd (1-Tc)
11.3b: What is net income at the accounting break-even point? What about taxes?
The accounting break-even point is simply the sales level that results in a zero project net income. When net income is zero so are pretax income and of course, taxes, in accounting terms our revenues are equal to our costs, so there is no profit, which means there is no tax.
14.3a: Why is the coupon rate a bad estimate of a firm's cost of debt?
The coupon rate measures what the firm's initial cost of debt. It does not estimate the current cost or yield.
13.7a: What is the fundamental relationship between risk and return in well-functioning markets?
The fundamental relationship between expected return and level of risk associated is that as the level of expected risk increases, the level of expected return also increases. The opposite is true as well. Lower levels of expected risk are associated with lower expected returns. The risk-return relationship is characterized as being a direct relationship or a positive relationship.
11.5c: What are the implications of operating leverage for the financial manager?
The implications of operating leverage for the financial manager are:- >Higher the degrees of operating leverage the greater potential danger from forecasting risk. >Another is coping with highly uncertain projects are to keep the degree of operating leverage as low as possible.