FINANCE 45O EXAM 3

disadvantages

problem with mutually exclusive investments

INDEPENDENT PROJECT

CF OF 1 PROJECT ARE UNAFFECTED BY THE ACCEPTANCE OF THE OTHER

Which one of the following statements is correct? A. The net present value is a measure of profits expressed in today's dollars. B. The net present value is positive when the required return exceeds the internal rate of return. C. If the initial cost of a project is increased, the net present value of that projects will also increase. D. If the internal rate of return equals the required return, the net present value will equal zero. E. Net present value is equal to an investment's cash inflows discounted to today's dollars

D. If the internal rate of return equals the required return, the net present value will equal zero.

SCENARIO ANALYSIS

-EXAMINES SEVERAL POSSIBLE SOLUTIONS -PROVIDES RANGE OF OUTCOMES KEY: CHANGING ALL THE NUMBERS AT THE SAME TIME -SUGGEST WE NEED TO BE CAREFUL ABOUT OUR ESTIMATIONS

Capital Budgeting

-focus on asset side of BS

option to abandon

ASSUME RUNS TO COMPLETION EX: ADDS VALUE AT THE DECISION POINT IN PROJECT

Which one of the following indicates that a project should be rejected? Assume the cash flows are normal, i.e., the initial cash flow is negative. A. Average accounting return that exceeds the requirement B. Payback period that is shorter than the requirement period C. Positive net present value D. Profitability Index less than 1.0 E. Internal rate of return that exceeds the required return

D. Profitability Index less than 1.0

1. David is analyzing a proposed project to determine how changes in the sales quantity would affect the project's net present value. What type of analysis is being conducted? A. Sensitivity analysis B. Erosion planning C. Scenario analysis D. Benefit-cost analysis

Sensitivity analysis

geometric average

what was your average compound return per year?

mutually exclusive example

you can apply to a bunch of colleges but in the end you can only choose one

option to expand

•DOING BETTER THEN WE THOUGHT EX: EXPAND TO SELL IN ANOTHER COUNTRY, ADDS VALUE

NPV GRAPH

-RATE OF RETURN IS WHERE YOU HAVE A NPV OF 0 -SLOPE OF LINE INDICATED SENSITIVITY OF NPV TO THE DISCOUNT RATE

HOLDING PERIOD RETURN

-RETURNS USUALLY IMPLIES THAT YOU SELL BUT YOU DONT ACTUALLY HAVE TO SELL, YOU CAN SEE WHAT IT COULD BE

payback period

-accept the project if the payback period is less then some preset limit/ arbitrary cut off -doesn't use all cash flows -good for small projects, dont have to put in alot of effort -good for health care industry, you buy alot of big equipment but it becomes obsulte very quickly

HISTORICAL AVERAGE RETURN

-simple, or arithmetic average -best guess for any one year

Northern Companies has three separate divisions. Each year, the company determines the amount it can afford to spend in total for capital expenditures and then allocates one-third of that amount to each division. This allocation process is called: A. Soft rationing B. Hard rationing C. Opportunity cost allocation D. Divisional separation E. Strategic planning

A. Soft rationing

Sarah is considering three mutually exclusive options for the additional space she plans to add to her specialty women's store. The cost of the expansion will be $148,000. She can use this additional space to add children's clothing, an exclusive department, of a home décor section. She estimates the present value of the cash inflows from these projects are $168,000 for children's clothing, $138,000 for exclusive gifts, and $171,000 for decorator items. Which option(s), if any, should she accept? A. None of these options B. Children's clothing only C. Decorator items only D. Children's clothing and decorator items only E. All of the above

C. Decorator items only

1. Scenario analysis: A. Determines the impact a $1 change in sales has on a project's internal rate of return. B. Determines which variable has the greatest impact on a project's net present value. C. Helps determine the reasonable range of expectations for a project's anticipated outcome. D. Evaluates a project's net present value while sensitivity analysis evaluates a project's internal rate of return. E. Determines the absolute worst and absolute best outcome that could ever occur.

C. Helps determine the reasonable range of expectations for a project's anticipated outcome.

1. The internal rate of return is unreliable as an indicator of whether or not an investment should be accepted given which of the following? A. One of the time periods within the investment period has a cash flow equal to zero. B. The initial cash flow is negative. C. The investment has cash inflows that occur after the required payback period. D. The investment is mutually exclusive with another investment of a different size. E. The cash flows are conventional.

D. The investment is mutually exclusive with another investment of a different size.

HOW DO WE MEASURE RISK?

STD DEVIATION, THE MORE IT DEVIATES THE HIGHER THE MEAN (STD DEV)

MIRR

-CONTROLS PROBLEMS WITH IRR -MODIFIES CFS TO MAKE SURE THERE IS ONLY ONE CHANGE OF SIGN

payback period advantages

-EASY TO UNDERSTAND - ADJUSTS FOR UNCERTAINTY OF LATER CASH FLOWS - BIASED TOWARDS LIQUIDITY

misconceptions about EMH

-EMH doesnt mean that you can't make money DOES MEAN: -prices are fair -all info is reflect in prices, no bias -doesnt protect you from wrong choices if you dont diversify

REINVESTMENT RATE ASSUMPTION

-IRR ASSUMES REINVESTMENT AT IRR -NPV ASSUMES REINVESTMENT AT THE FIRM'S WEIGHTED AVERAGE COST OF CAPITAL/ OPP COST -NPV IS MORE REALISTIC -NPV SHOULD ALWAYS BE USE TO CHOOSE BETWEEN MUTALLY EXCLUSIVE AND INDEPENDENT PROJECT

NON CONVENTIONAL AND CONVENTIONAL PROJECTS

-MOST PROJECTS ARE -MORE CHANGES OF SIGN THE MORE IRR YOU HAVE -NON CONVENTIONAL YOU DONT WANT TO USE IRR

NPV ESTIMATES

-ONLY ESTIMATES - FORECASTING RISK: THE MORE SENSITIVE THE GREATER THE RISK - BE ABLE TO SAY WHY THE PROJECT CREATES VALUE EX: IS IT A PROJECT THAT IS NOT ON THE MARKET YET?

IRR ADVANTAGES

-PREFFERED BY EXECUTIVES -IF HIGH ENOUGH YOU DONT NEED TO ESTIMATE RR -CONSIDERS ALL CFS -CONSIDERS TVM -PROVIDES INDICATION OF RISK

soft rationing

-THE LIMITED RESOURCES ARE TEMPORARY AND OFTEN SELF IMPOSED EX: COMPANY DOESN'T HAVE THE $ RIGHT NOW BUT THEY THINK THEY WILL IN THE FUTURE - PI is useful helps see which gives you the most return

normal distribution

-bell shaped curve -completely described by the variance and the mean -tend to cluster around the mean

NPV

-gain in shareholder's wealth -rarely 0 npv projects, not gong to add value and not going to take away so you are indifferent -directly related to the value of the firm

MACRS DEP

-higher dep earlier = higher cash flows

AAR

-requires target cut off -doesnt use cash flows, uses accounting info -higher return is better then lower -doesnt like arbitrury cut off -easiest to calc, least preffered method

sensitivity analysis

-shows changes in input variable affect on NPV and IRR - each variable is fixed except for one -answers what if questions

two reasons why npv profiles cross

-size -timing differences

The corner market has decided to expand its retail store by building on a vacant lot it currently owns. This lot was purchased four years ago at a cost of $299,000, which the firm paid in cash. To date, the firm has spent another $38,000 on land improvements, all of which was also paid in cash. Today, the lot has a market value of $329,000. What value should be included in the analysis of the expansion project for the cost of the land? A. The sum of the cash paid to date for both the lot and the improvements. B. The original purchase price only C. The current market value of the land plus the cash paid for the improvements. D. The current market value of the land. E. Zero, because the land and the improvements were previously purchased with cash.

D. The current market value of the land.

Fred works for Apple. If he can make a excess profit from his knowledge of new products the company releases what can we say about market efficiency?

STRONG BECAUSE IT IS PRIVATE INFORMATION. IF HE CAN MAKE MONEY FROM HIS PRIVATE KNOWLEDGE THE MARKET IS NOT STRONG FOR EFFICIENT

MUTUALLY EXCLUSIVE PROJECT

THE ACCEPTANCE OF ONE PROJECT PRECLUDES THE ACCEPTING OF THE OTHER EX: WHEN BUYING A CAR YOU CAN LOOK AT MULTIPLE BUT YOU CAN ONLY CHOOSE ONE

Hard rationing

THE RESOURCES WILL NEVER BE AVAILABLE FOR THE PROJECT EX: COMPANY THAT IS IN FINACIAL DISTRESS, COMPANY HAS A GREAT PROJECT BUT NOONE WANTS TO BUY STOCK BECAUSE OF THEIR DISTRESS

IRR

•Most important alternative to NPV •Widely used in practice •Intuitively appealing •Based entirely on the estimated cash flows •Independent of interest rates (REALLY GOOD FEATURE) -DISCOUNT RATE THAT MAKES NPV EQUAL TO 0

PBP Disadvantages

- IGNORES TIME VALUE OF MONEY - REQUIRES AN ARBITRARY CUT OFF POINT - IGNORES CASH FLOWS BEYOND THE CUT OFF DATE - BIASED AGAINST LONG-TERM PROJECTS

IRR DISADVANTAGES

-CAN PRODUCE MULTIPLE ANSWERS -CANT RANK MUTUALLY EXCLUSIVE PROJECTS RELIABLY -REINVESTMENT ASSUMPTION IS FLAWED

PI ADVANTAGES

-close to npv -easy to understand

problems with scenario analysis

-considers only a few possible outcomes -assumes all bad values go together and all good values go together -focuses on stand alone risk

disadvantages sensitivity analysis

-doesnt take into account probability -ignores relationships among variables

advantages aar

-easy to calc -info is usually available

risk premium

-excess return on a risky asset over the risk free rate -reward for bearing risk

advantages sensitivity analysis

-identifies dangerous variable -provides break even info

disadvantages of sensitivity and scenario analysis

-neither provide a decision rule -ignores diversification -biggest limitation is not having a probability

disadvantages aar

-not a true rate of return -time value of money is ignored -usually arbitrary benchmark is the cut off rate

risk free rate

-rate of return on riskless investment -treasury bills

strategic options

ASSUME IF YOU HAVE A NEGATIVE NPV PROJECT IN THE LONG RUN IT COULD GIVE YOU A FOOT IN THE MARKET

1. Sensitivity analysis: A. Looks at the most reasonably optimistic and pessimistic results for a project. B. Helps identify the variable within a project that presents the greatest forecasting risk. C. is used for projects that cannot be analyzed by scenario analysis because the cash flows are unconventional. D. Is generally conducted prior to scenario analysis just to determine if the range of potential outcomes is acceptable. E. Illustrates how an increase in operating cash flow caused by changing both the revenue and the costs simultaneously will change the net present value for a project.

B. Helps identify the variable within a project that presents the greatest forecasting risk.

1. The opportunities that a manager has to modify a project once the project has started are called: A. Sensitivity choices. B. Managerial Options C. Scenario Adjustments D. Restructuring Options. E. Erosion Control Measures.

B. Managerial Options

Which one of the following statements is correct? A. The internal rate of return is the most reliable method of analysis for any type of investment decision. B. The payback method is biased toward short-term projects. C. The modified internal rate of return is most useful when projects are mutually exclusive. D. The average accounting return is the most difficult method of analysis to compute. E. The net present value method is applicable only if a project has conventional cash flows.

B. The payback method is biased toward short-term projects.

1. The modified internal rate of return is specifically designed to address the problems associated with: A. Mutually exclusive projects. B. Unconventional cash flows. C. Long-term projects. D. Negative net present values. E. Crossover points.

B. Unconventional cash flows.

Which one of the following methods of analysis does not use cash flows? A. Profitability index B. Payback C. Average accounting Return D. Modified internal rate of return E. Internal rate of return

C. Average accounting Return

1. Which one of the following terms refers to the best option that was foregone when a particular investment is selected? A. Side effect B. Erosion C. Sunk Cost D. Opportunity Cost

D. Opportunity Cost

1. If a project with conventional cash flows has a profitability index of 1.0, the project will: A. Never pay back. B. Have a negative net present value. C. Have a negative internal rate of return. D. Produce more cash inflows than outflows in today's dollars. E. Have an internal rate of return that equals the required return.

E. Have an internal rate of return that equals the required return.

36. Which of the following is specifically designed to compute the rate of return on a project that has a multiple negative cash flows that are interrupted by one or more positive cash flows? A. Average accounting return B. Profitability index C. Internal rate of return D. indexed rate of return E. Modified internal rate of return

E. Modified internal rate of return

1. Which one of the following is generally considered to be the best form of analysis if you have to select a single method to analyze a variety of investment opportunities? A. Payback B. Profitability index C. Accounting rate of return D. Internal rate of return E. Net present value

E. Net present value

1. Ed owns a store that sells men's clothes. Each of the answer options represents an item related to a planned store expansion. Each of these items should be included in the expansion analysis with the exception of the cost: A. Of the property insurance premium increase. B. Of the exterior landscaping that will be required once the expansion is complete. C. Of the additional sales person that will be required. D. Of the inventory required to fill the additional retail space. E. Of the blueprints that have been drawn of the expansion area.

E. Of the blueprints that have been drawn of the expansion area.

DO WE CONSIDER THE US MARKET EFFICENT AT ANY LEVEL?

GENERALLY WE CONSIDER MARKET EFFICENT

Does the AAR rule provide an indication about the increase in value?

GIVES RETURN MEASURE BUT IT IS AN ACCOUTING RETURN NOT THE REAL TRUE RETURN

WHATS INCORPORATED IN PRICES IN A EFFICENT MARKET?

HOW QUICKLY AND ACCURATLY INFORMATION IS

IF YOU ARE LOOKING AT ONE PROJECT ON ITS OWN...

IRR AND NPV WILL BE CONSISTENT

DOES IRR Provide an indication about the increase in value?

IT IS A PERCENTAGE, IN A PERCENTAGE INCREASE SO YES

DO WE WANT OUR PROJECTS TO HAVE A HIGH OR LOW PAYBACK PERIOD?

LOW, QUICKER IT PAYS BACK BETTER THE PROJECT IS, REALLY GOOD WHEN YOU HAVE A OBSOLETE PROJECT (HOSPITAL EQUPMENT)

CONSUMER PRICE INDEX

MEASURES INFLATION

MIRR VS IRR

MIRR correctly assumes reinvestment at opportunity cost = WACC MIRR avoids the multiple IRR problem Managers like rate of return comparisons, and MIRR is better for this than IRR

TREASURY BILLS

NEVER NEGATIVE ALWAYS POSITIVE

Sarah has been tracking stock prices and found a pattern that consistently provides profits above the market index. What does this tell us about market efficiency?

NOT EVEN WEAK FORM EFFICENT SO ALSO NOT STRONG FORM OR SEMI STRONG FORM

WHAT IS THE INFORMATION SET WE TALKED ABOUT FOR WEAK FOR EFFICENCY?

PASS PRICE AND VOLUME DATA

TREASURY BONDS

PLENTY OF POSITIVES BUT SOME NEGATIVES

option to wait

PUT IT ON THE BACK BURNER UNTIL IT IS PROFITABLE EX: MAYBE THE MARKET ISNT READY FOR THE PROJECT YET, BUT SOMETHING COULD CHANGE

IF WE WANT TO CALC A RISK PREMIUM WHAT DO WE SUBRTRACT FROM OUR RETURNS?

RISK FREE RATE

contingency plan

SAYING WHAT IF SOMETHING HAPPENS HOW CAN WE CHANGE OUR PARTICULAR PROJECT EX: WHAT IF WE WANT TO CHANGE SOMETHING UP TO MAKE PROJECT BETTEr

DOES IRR Account for the risk of the cash flows?

WE DON'T USE RISK ADJUSTED IN CALC BUT COMPARE IT TO RISK

DOES IRR Permit project ranking?

YES BUT IT DOESN'T ALWAYS GET IT RIGHT

DOES IRR Account for the time value of money?

YES, EFFECTIVELY DISCOUNT CASH FLOWS

stand alone principle

analyze project in isolation, focus on incremental CFS, treat projects like they are mini projects on their own

1. Assuming markets are (only) weak form efficient, investors can make excess profits from______ information? a)Price and volume b)Public c)Private

b and c

Does the AAR rule account for the risk of the cash flows?

no

Does the AAR rule account for the time value of money?

no

Should we consider the AAR rule for our primary decision criteria?

no we only consider because managers love % figures

capital rationing

occurs when a firm or division has limited resources

Dep effects...

ocf and cf when you sell an asset

risk

the more clustered around the mean the lower the risk, the wider the distribution the higher the risk

markets are ____ when it comes to stocks

volatile, very risky

arithmetic average

what is your return in an average year?