FIN 357 Exam 2 - SI
break even analysis in finance
*EAC + FC(1-t) - depreciation*t/p-v*1-t number of units that cause NPV of a project to be 0
total risk
systematic risk + unsystematic risk
When the stock being valued does not pay dividends,
the dividend growth model can still be used.
the more volatile a return is
the greater the return is expected to be
normal distribution
the market does not have
expected return
the return that the market expects a stock to earn over the next period which is based on growth projections
allocated costs
- only be viewed as a cash outflow of a project if it is an incremental cost of the project - cost that is associated with some part of our company but not specific to our project
Owners of most common stock have right to:
- vote for the board of directors - share proportionally in dividends paid - share proportionally in assets remaining after liabilities have been paid in a liquidation - vote on stockholder matters of greater importance such as a merger
Which of the following are expected cash flows to investors in stocks?
1. Capital gains
NASDAQ has which of these features?
1. Computer network of securities dealers
What information do we need to determine the value of stock using the zero-growth model?
1. Discount rate
Once cash flows have been estimated, which of the following investment criteria can be applied to them?
1. IRR
According to Graham and Harvey's 1999 survey of 392 CFOs, which of the following two capital budgeting methods are most used by firms in the United States?
1. Internal rate of return
Which of the following are features of common stock?
1. It generally has voting rights.
Which of the following are reasons why NPV is considered a superior capital budgeting technique?
1. NPV considers all the cash flows.
Preferred stock has preference over common stock in the _____.
1. distribution of corporate assets
The possibility that errors in projected cash flows will lead to incorrect decisions is known as _____.
1. estimation risk
The IRR rule can lead to bad decisions when _____ or _____.
1. projects are mutually exclusive
A 10-year, 5% coupon bond is priced at $1,121.56. Interest is paid semi-annually. What is the bond's current yield?
4.46%
What is a sunk cost?
A cost incurred in the past that is irrelevant to the capital investment decision process.
____ budgeting is the decision-making process for accepting and rejecting projects.
Capital
As an investor in the bond market, why should you be concerned about changes in interest rates?
Changes in interest rates cause changes in bond prices.
What is a bond's current yield?
Current yield = Annual coupon payment/Current price
Which capital budgeting decision method finds the present value of each cash flow before calculating a payback period?
Discounted payback period
____ cash flows come about as a direct consequence of taking a project under consideration.
Incremental
correlation of -1
two securities move perfectly opposite of each other
correlation of 1
two securities move perfectly togther
In a competitive market, positive NPV projects are:
uncommon
debenture bonds are
unsecured bonds
Which one of the following is the most important source of risk from owning bonds?
Market interest rate fluctuations
When to reject a project?
NPV < 0
T-bills have a coupon?
No, zero
tax shield approach
OCF = (Sales - Costs)(1-t) + (Depreciation X T) depreciation tax shield: depreciation * tax rate --> depreciation saves us how much with taxes
What is the equation for estimating operating cash flows using the top-down approach?
OCF = Sales - Costs - Taxes
The formula for valuing a constant growth stock is _____.
P0 = D1/(R − g)
Which of the following are true about variable costs?
The variable cost per unit may remain constant as the number of units produced increases.
True or false: Ultimately, we are more interested in cash flow than accounting income.
True
According to the average accounting return rule, a project is acceptable if its average accounting return exceeds _____.
a target average accounting return
Capital Corp is considering a project whose internal rate of return is 14%. If Capital's required return is 14%, the project's NPV is:
zero
basic IRR rule
accept the project is the IRR is greater than the discount rate, reject the project if IRR is less than the discount rate
A project should be __________ if its NPV is greater than zero.
accepted
coupon payments are an
annuity
which average is overly optimistic for long horizons?
arithmetic average
variance & standard deviation
assess the risk of a security's return
homogenous expectations
assumes that all investors would hold the same portfolio
To be considered good, projected cash flows should _____ actual cash flows.
be close to
Opportunity costs are ____.
benefits lost due to taking on a particular project
Broker
brings buyers and sellers together, but does not maintain an inventory; make the commission for bringing buyers and sellers together; get paid a commission
A person who brings buyers and sellers together is called a(n) ______.
broker
Capital ______ is the decision-making process for accepting and rejecting projects.
budgeting
growth rate
businesses grow by making investments in projects, equipments. If the amount we invested was the same as our depreciation, then earnings would remain the same. g = retention ratio * ROE * sustainable growth rate * based on assumptions: we assume return on reinvestment of future retained earnings is equal to the firms past ROE
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
mutually exclusive projects
cannot both be accepted, one or another must be chosen, pick project with highest NPV
T-notes & T-bonds are traded on
capital markets
real cash flow
cash flows purchasing power must be discounted at the real rate
portfolio
combination of securities
portfolio
combination of securities * want a high expected return & low standard deviation of return
A zero-growth model for stock valuation is distinguished by a ____.
constant dividend amount
The _____ yield is the bond's annual coupon divided by its price.
current
efficient frontier
curve from MV to supertech
Including a sinking fund in the indenture agreement will __________ the investors' required rate of return
decrease
When interest rates in the market rise, we can expect the price of bonds to ____.
decrease
mortgage bonds are secured with collateral, what happens to risk and rate
decrease risk, decrease rate
sinking fund, what happens to risk and rate
decrease risk, decrease rate
variance of a portfolio
depends on both the variances of the individual securities & covariance btw the two securities
An NYSE member who acts as a dealer in particular stocks is called a ____ market maker.
designated
How to calculate standard deviation
deviation - expected return^2 * probability , add them together for variance, sq root for SD
Incremental cash flows come about as a(n) ________ consequence of taking a project under consideration.
direct
When the coupon rate is less than the prevailing market (or YTM or required rate of return) for similar bonds, the bond will sell at a
discount
an increase in market interest rates will cause the price of an outstanding bond to sell at
discount
discount rate
discount rate on a risky project is the return that one can expect to earn on a financial asset of comparable risk - opportunity cost
Total dollar return
dividend income + capital gain * change in price + coupon payment * doesnt tell us a lot, dont know what you invested V your return
Common stock as no special preference either in receiving ____ or in bankruptcy.
dividends
stocks can provide two kinds of cash flows
dividends and sales price when sell the stock
problems with average accounting return
does not use actual financial cash flows - uses accounting numbers does not consider the timing of cash flows and ignores the time value of money uses an arbitrary return target
if the interest rate for all investments of equivalent risk goes up, the rate at which you can sell your used bond goes
down
which average is overly pessimistic for short horizons?
geometric average
the greater the term to maturity, the
greater the interest rate risk
YTM
is the annual return earned if you buy the bond @ today's price and hold it till maturity
beta of a portfolio
is the weighted average of the beta of the individual investments in the portfolio
principal is a
lump sum
what rate do you use to calculate the bond's PV?
market interest rate, required rate of return, YTM
T-bills are traded on
money markets
A share of common stock is (less/more) difficult to value in practice than a bond.
more
With nonconventional cash flows, there is a possibility that more than one discount rate will make the NPV of an investment zero. This is called the ____ rates of return problem.
multiple
synergy
new project increases the cash flows of an existing project
can coupon interest rate change?
no
can systematic risk be eliminated by diversification?
no, doesnt go away no matter what
real rate
nominal rate - inflation rate
When voting for the board of directors, the number of votes a shareholder is entitled to is generally determined as follows:
one vote per share held
independent project
one whose acceptance or rejections is independent of the acceptance or rejection of other projects
real options
option to abandon a project half way through and model that three different options *market value = NPV + Options * like when items do a bunch of stuff and are not specialized
when current market interest rates equal the bond's coupon rate, the bond sells at
par
expected return on a security
risk free rate + beta of the security * difference btw expected return on market & risk free rate
Corporate managers care about the break-even point because it indicates the level to which _____ can fall before a project will start losing money.
sales
In simulation analysis, a combination of _____ analysis and _____ analysis is used.
scenario; sensitivity
T-notes & T-bonds have coupons that are
semi-annual
Multiple choice question.
sensitivity analysis
A zero-growth stock pays a dividend of $2 per share and has a discount rate of 10%. What will the stock's price be?
$20.00
Legolas Inc. paid an annual dividend of $1.25 per share yesterday. You expect the dividend to grow, indefinitely, at a rate of 4% per year. If similar companies provide an expected return of 8% per year, what is the most you would be willing to pay for a share of Legolas stock?
$32.50/share
A bond pays annual interest payments of $50, has a par value of $1,000, and a market price of $1,200. How is the coupon rate computed?
$50/$1,000
Broadband, Inc. has estimated preliminary cash flows for a project and found that the NPV for those cash flows is $400,000. The company now plans to perform a scenario analysis on the cash flow and NPV estimates. It will use an NPV of _____ as the base case.
$400,000
holding period return
(1+r1)(1+r2)..... - 1
Benefits of NPV
* NPV uses cash flow * NPV uses all cash flows of a project * NPV discounts cash flows properly(aware and uses the time value of money) *NPV IS THE INCREASE IN THE VALUE OF THE FIRM FROM THE PROJECT
covariance
* a statistic that measures the interrelationship between two securities * measure variability of individual stocks
sensitivity analysis
* examines how sensitive a particular NPV calculation is to changes in the underlying assumptions of the project * way to determine how closely actual numbers will be to the planned numbers * all variables are calculated as the expected case, only variable that changes is the specific variable being tested
cases of discounted cash flow analysis
* setting the bid price * evaluating equipment options w/different lives * the general decision to replace
the top-down approach
* start at the top of the income statement with sales and work down to net cash flows subtracting costs, taxes and other expenses - leave out noncash items * sales - costs - taxes
opportunity/feasible set
* can create different portfolios of our two stocks by varying percentage of each stocks that will be held * if it is on the line the correlation is 1 * curve allows us to select the risk/return tradeoff that best suits us.
value of stock is equal to
* discounted present value of all future dividends which also means : discounted present value of the sum of next periods dividends plus next periods stock price
2008: financial crisis
* dont try to time the market - markets always eventually recover * stocks were down * market gained in 2009 by 65% * global phenomenon: no economy unscathed * S&P decreased by 37% *485/500 stocks were down * bonds benefitted, long term bonds increased by 20%
Straight voting
* each shareholder gets votes equaling the number of shares they own and must vote in each election position * only way to guarantee seat is to own 50% + 1 of the shares * vote one at a time * each shareholder gets their percentage of holding in votes for EACH election
capital asset pricing model
* expected return on a security is a linearly related to its beta
the equivalent annual cost method
* find NPV * create an annuity to determine the average annual cost over the life of each machine * costs on a per year basis
Payback Period Method
* how long it takes for a project to bring in enough cash flows to break even or pay itself off
correlation
* how to measure the relationship btw 2 stocks * return on individual securities are related to one another * measures variability of individual stocks
NWC
* increases over the early years of the project as expansion occurs * all working capital is assumed to be recovered at the end * increase in working capital over a year that leads to a cash outflow in that year * less liabilities more assets as time passes
examples of investments in NWC
* inventory is purchased * cash is kept in the project as a buffer against unexpected expenditures * credit sales are made, generating accounts receivable rather than cash
new york stock exchange - NYSE
* largest stock market in the world * became NYSE group in 2006 publicly owned corporation * exchange members purchase licenses * hybrid exchange: some face to face but there are also some big computers * face to face trade done by license holders * goal: generate as much liquidity as possible
Dealer
* maintains an inventory and stands ready to buy and sell at any time * willing to buy and sell at all times * when sell they are selling out of their own inventory - get a mark up * price willing to pay is the bid price/ willing to sell ask price
monte carlo simulation
* named after famous gamble center of europe * step 1: specify the basic model * step 2: specify a distribution for each variable * step 3: computer draws one outcome: generates cash flow for each year from a single outcome *step 4: computer repeats this procedure: distribution of cash flow for each year, can compute thousands * step 5: calculate NPV
three different real options
* option to expand : value if demands turn out to be higher than expected, uncertainty concerning annual cash flows * option to abandon * option to delay
holding period return
* return earned from the act of holding an asset over a given period of time - what was your return over the time frame when you held the stock * can be calculated two ways 1. multiplying rates + 1 * each year - 1 2. income + (end of period value - initial value) / initial value
decision trees
* used to sort through the variety of decisions that are usually involved with NPV project analysis * always start on the right hand side and work backwards * Expected Payoff = ( Probability of success * payoff if successful) + ( probability of failure * payoff if failure) * square means decision * circle means more information
what are some instances where the payback method makes sense?
*firms with good investment opportunities but no available cash *majority of companies use this method * most companies have rule that says if we are going to spend more than a certain amount of money must do an analysis * desirable features for managerial control *under NPV a long time may pass before one decides whether or not a decision was correct
A corporate bond's yield to maturity ____.
1. changes over time
Three special case patterns of dividend growth include _____.
1. constant growth
how to calculate correlation & covariance
1. multiply the deviations from expected return together 2. multiply by the associated probability 3. add together gives covariance 4. covariance / Asd* Bsd = correlation * the sign of correlation between two variables must be the same as that of the covariance between two variables
Suppose Price per Unit is $6, variable cost per unit is $2, fixed costs are $400 and the depreciation allowance per year is $500. The relationship between operating cash flow (OCF) and sales volume (Q) can be expressed as:
OCF = −400 + 4*Q
Profitability Index
PV of cash flows after initial investment / initial investment accept project is the profitability index > 1 application of profitability index: * independent project * mutually exclusive projects: has scale problem: use incremental * capital rationing: the case when the firm does not have enough capital to fund all positive NPV projects: rank them according to the ratio of present value to initial investment
EPS
Payout(dividend) + Retained Earnings - can be retained by a company or it can be paid out to the shareholders as a dividend
Which of the following statements is true in the context of comparing accounting profit and present value break-even point?
Present value is superior to accounting profit because it adjusts for time value and considers the depreciation tax shield effect.
PE Ratio
Price per share / EPS * assumed similiar firms have similiar PE ratios * equity ratio Three things PE is affected by: * related to growth opportunities * PE ratio is negatively related to firms discount rate & risk * more conservative accounting principles have higher PE ratio
Preferred Stocks
have priority in bankruptcy and dividends, usually have no voting rights * usually owned by company * get a stated value * seen as a debt besides in tax purposes * sometimes convertible to common stock and callable
A firm with higher operating leverage will have (low/high) fixed costs relative to a firm with low operating leverage.
high
lower rated bonds have
higher rates of return
geometric return
holding period method ^(1/n) -1 what was your actual return each year on average, compounded annually over a particular period?
standard error
how much can we have in out historical average of 7.2% of equity risk premium * we can be % confident that our estimate of the US equity risk premium from historical data is in the range of 2SE's
Interest expenses incurred on debt financing are ______ when computing cash flows from a project.
ignored
The payback period can lead to incorrect decisions if it is used too literally because it ____.
ignores cash flows after the cutoff date
An increase in depreciation expense will ____ cash flows from operations.
increase
call provisions, what happens to risk and rate
increase risk, increase rate
The price of a bond is found by discounting the bond's future cash flows using the
market rate/required rate of return/YTM
By ignoring time value, the payback period rule may incorrectly accept projects with a (positive/negative) NPV.
negative
There is a(n) ______ relationship between market interest rates and bond values.
negative
Accounts receivable and accounts payable are not an issue with project cash flow estimation unless changes in ______________ are overlooked.
net working capital
diversification effect
occurs when the correlation between two securities is below 1; no diversification effect is correlation = 1; diversification effect rises as correlation declines;
The amount of time needed for the cash flows from an investment to pay for its initial cost is the _____ period.
payback
market portfolio
portfolio everyone holds, S&P 500 is often considered it but the wilshire 5000 can also be considered * perfectly diversified by having eliminated all unsystematic risk
Hobbit inc. issued bonds with an annual coupon rate of 5%. The prevailing market rate for similar bonds is 4%. Investors will pay a
premium
When the coupon rate is more than the prevailing market rate (or YTM or required rate of return) for similar bonds, the bond will sell at a
premium
Erosion will ______ the sales of existing products.
reduce
West Corporation estimated cash flows for a project, evaluated those cash flows using NPV, and determined that the project was acceptable. Unfortunately West Corporation lost money on the project. This may have been avoided had they assessed the ______ of the cash flow estimates.
reliability
When the term structure of interest rates is downward sloping, ____.
short-term rates are higher than long-term rates
Discounted Payback Period Method
start with each cash flow but discount each of them back to 0 * first discount cash flows * then ask how long it takes for the discounted cash flows to equal the initial investment * as long as the cash flows are positive, the discounted payback period will never be smaller than the payback period because discounting reduces the value of the cash flows
Payback Period Rule
states that all projects must be paid back before a particular cutoff date - arbitrary - up to management to select
How to fix inflation?
stop expectation of inflation, raise interest rate, people stopped spending money
With ____ voting, the directors are elected one at a time and the only way to guarantee a seat is to own 50 percent plus one share.
straight
security market line
straight line connecting the risk free rate and the return on a stock if its beta = 1, at 1 will have the return of the market
incremental irr
subtract the smaller project from the larger project then find the IRR of difference if the irr of difference is greater than the discount rate, accept the larger project
The payback period rule ______ a project if it has a payback period that is less than or equal to a particular cutoff date.
suggests accepting
preemptive right
the right to share proportionally in any new stock sold - company that wishes to sell stock must first offer it to the existing stockholders
A firm will start generating profits when ___.
the total number of units sold exceeds the accounting break-even point
unsystematic risk
unique or asset specific risk - news surprises that only affect a small number of companies
average risk free rate
use fisher equation
modified accelerated cost recovery system ( MACRS)
use tax code - getting more depreciation earlier in the life of the project; good for a company because of the time value
value additivity
value of the firm is merely the sum of the values of different project division, or other entities within the firm
Enterprise Value Ratio
EV/EBITDA
Which of the following entities declares a dividend?
The board of directors
Why does a bond's value fluctuate over time?
The coupon rate and par value are fixed, while market interest rates change
True or false: Cumulative voting means board members are elected one at a time, with each shareholder casting his or her allotted votes for each seat on the board.
false
if sell stock at end of year/ total cash if stock is sold
initial investment + total dollar return
expected return on portfolio
is weighted average of returns of the individual investments in the portfolio
What makes a high P/E ratio more likely
low-risk stocks
arithmetic return
normal average what was your return in an average year? - doesn't help deciding in the future
The IRR rule can lead to bad decisions when cash flows are _____ or projects are mutually exclusive.
not conventional
A stock with dividend priority over tis called a ____ stock.
preferred
a decrease in market interest rates will cause the price of an outstanding bond to sell at
premium
Net ____ value is a measure of how much value is created or added today by undertaking an investment.
present
In capital budgeting, the net ______ determines the value of a project to the company.
present value
average return
sum of returns/number of returns past annual returns on the stock market
Investment firms that are active participants in stocks assigned to them are called ____ liquidity providers.
supplemental
Using the top-down approach, OCF is calculated by subtracting costs and ____ from sales.
taxes
If you own corporate bonds, you will be concerned about interest rate risk as it affects ____.
the market price of the bonds
unexpected return
the returns which are uncertain that come from unexpected news about a company such as: * GDP, unemployement * good or bad news *company announcement
if the correlation of investments in portfolio is less than 1
the standard deviation will be less than weighted average of the SD of the individual securities
When evaluating cost-cutting proposals, how are operating cash flows affected?
1. The decrease in costs increases operating income.
Which of the following institutions issue bonds that are traded in the bond market?
1. The federal government
Which of the following are reasons why it is more difficult to value common stock than it is to value bonds?
1. The life of a common stock is essentially forever.
Which of these are required to calculate the current value of a bond?
1. Time remaining to maturity
Which of the following are fixed costs?
1. rent on a production facility
Constant growth of stock
Po = Div / R - g Dividend grows at a rate of G Div is the dividend at the end of the first period * same as a growing perpetuity
Value of stock at zero growth
Po = Div/r
In evaluating capital projects, the decisions using the NPV method and the IRR method may disagree under which of the following circumstances?
The projects being evaluated are mutually exclusive
T-notes & T-bonds interest is
an interest only loan
Ibbotson Chart
asset classes, type of assets, invest $ in each of them, what will they be worth today? * large company common stock: 2nd highest return over time * small company common stocks: give highest return over time / also gives you the highest risk *long term corporate bonds * long term government bonds * US treasury bills * riskier if the line is spiky and moves up&down - the more risked I am asked to take the better the return there needs to be
A firm will start generating positive accounting profits _____.
beyond the break-even sales point
The AAR is calculated by taking the average net income and dividing it by the average ____ value.
book
investing on margin
borrowing money to invest
incremental profitability index
if mutually exclusive, subtract smaller project cash flows from the larger project cash flow to get incremental cash flows
Including a call provision in the indenture agreement will __________ the investors' required rate of return
increase
With cost-cutting proposals, when costs decrease, operating cash flows (decrease/increase).
increase
A humped term structure of interest rates indicates that interest rates are expected to _____ as the time to maturity increases.
increase and then decline
debenture bonds, what happens to risk and rate
increase risk, increase rate
As a practical matter, it is easier to (decrease/increase) operating leverage than it is to (decrease/increase) it.
increase; decrease
When interest rates in the market fall, bond values are likely to increase because the present value of the bond's remaining cash flows ____.
increases
The present value of all cash flows (after the initial investment) is divided by the ______ to calculate the profitability index.
initial investment
separation principle
investors decisions consist of two separate steps: * estimating expected return, variance, covariance and calculating the efficient set of risky assets is completed. Then determination of which risky portfolio will be held is made * the investor now determines how much riskless asset to ad to the portfolio
In general, a corporate bond's coupon rate ____,
is fixed until the bond matures
The federal government can raise money from financial markets to finance its deficits by ___.
issuing bonds
According to Graham and Harvey's 1999 survey of 392 CFOs, in addition to IRR and NPV, which were the two most widely used techniques, over half of the respondents always, or almost always, used which of the following methods?
payback method
This capital budgeting method allows lower management to make smaller, everyday financial decisions effectively.
payback method
Problems with discounted payback method
payments after the payback period are ignored arbitrary standards for payback period
T-bills interest?
pure discount loan
The first step in estimating cash flow is to determine the _________ cash flows.
relevant
why is EBITDA used in the denominator or EV/EBITDA
since EV involves debt and equity, denominator is unaffected by interest payments
The payback period method allows lower management to make (smaller/larger), everyday financial decisions effectively.
smaller
The Omega Division of Alpha Corporation has been allocated $4 million for capital spending but has identified $4.6 million in positive NPV projects. Omega's manager thinks he can convince the company to fund the additional $0.6 million dollars because Omega uses _______ rationing to control overall spending.
soft --- Soft rationing occurs when units in a business are allocated a certain amount of financing for capital budgeting.
investment of unequal lives
sometimes when NPV could give you a misleading number, if projects have unequal lives * the replacement chain * The equivalent annual cost method
The NYSE member who acts as a dealer in a small number of securities is called a(n) _____.
specialist
According to the _________ principle, once the incremental cash flows from a project have been identified, the project can be viewed as a "minifirm."
stand-alone
True or false: Equity represents an ownership interest.
true
The _____ cost is equal to the quantity of output times the cost per unit of output.
variable
expected return for a portfolio
weighted average of the returns of the individual investments in the portfolio XaE(Ra) + XbE(Rb)
The basic approach to evaluating cash flow and NPV estimates involves asking ---- -if questions.
what
Zero growth
when a stock pays the same dividend each period
staggering
where only a fraction of directorships are up for election at a particular time has two basic effects: * more difficult for a minority to elect a director when there is cumulative voting * takeover attempts less likely to be successful because it makes it more difficult to vote in a majority of new directors
When analyzing a proposed investment, we (will/won't) include interest paid or any other financing costs.
won't
can you value company without dividends?
yes, if you make projections
standard deviation of the annual return on a portfolio of 500 large common stocks
20% per year
NASDAQ
* 2nd largest stock market * not a physical exchange * tech stocks * completely computerized
break even analysis for accounting
* FC + depreciation / price - variable cost * determines the sales needed to break even on a project * losing money * depreciation understates the true costs of recovering initial investment: losing the opportunity cost of the initial investment
Two set of books
* IRS: tax books *annual report: stockholders books * income on municipal bonds ignored for tax purposes but treated as income for stockholders * have different rules
2 key differences between NASDAQ and NYSE
* NASDAQ is computer generated and has no physical location * NASDAQ has multiple market maker systems rather than a DMM system
betas
* best way to think about risk of individual securities within a diversified portfolio * best measure of risk * measures the responsiveness of a security to movements in the market portfolio * if stocks with a beta > 1 are correlated w/the market & have greater magnitudes of movement * if stocks with a beta = 1 are correlated w/the market & have a similar magnitude of movements as the market * if stocks with a beta <1 are less correlated with the market & have a smaller magnitude of movement * measure of systematic risk
the bottom-up approach
* start with accounting bottom line and add back any non cash deductions * net income + depreciation
Problems with Payback Method
* timing of cash flows within payback period is not considered * payments after the payback period are ignored * arbitrary standards for payback period
net investment
* total investment - depreciation * will be positive only if some earnings are not paid out as dividends
how to solve multiple IRR problem
* use the NPV rule instead * modified IRR: combining cash flows until only one change in sign remains: violates the spirit of IRR
Capital Asset Pricing Model (CAPM)
* used to find the expected return on different securities
average accounting return method
* uses net income generated by projects to analyze whether they will add value to a company * three steps: **determine average net income **determine average investment **divide by each other * one value more than time periods you have on net income
scenario analysis
* variant of sensitivity analysis where multiple variables are changed at one time to create different scenarios * save problem of assuming variable effects are isolated
incremental cash flows
* when valuing a firm as a whole discount cash flows not earnings * only use cash flows that are pertinent to the project * if you would have the cash flow without the project wouldn't use it * sunk costs should never be used to value a new project * consider opportunity costs
Seven classes of depreciable property
*3 year class *5 year class * 7 year class *10 year class *15 year class *20 year class * real property: non residential and residential
risk premium
*average real return - average risk real free rate * the additional return resulting from the riskiness of common stocks difference between risky and risk free are excess return on the risky asset
Cumulative Voting
*each shareholder gets votes equaling *all directors are elected at one * if there are 4 positions, then the top 4 vote getters win spots * can put all your votes in one position * permit minority participation * if there are N directors up for election, then 1/(N+1) percent of stock + 1 share will guarantee you a seat
internal rate of return
*interest rate that would make a project have a 0 NPV - way to figure out if its NPV is + or not *most commonly used by companies *provides a single number summarizing the merits of a project - does not depend on interest rates * number is intrinsic to project * only depends on cash flow
percentage returns
*total dollar return/initial price * how much return do we get for each dollar? * using the yields dividend yield & capital gains yield * formula for it but hard to write out * can determine how much you would profit on any amount when have return percentage * better approach
How to compare mutually exclusive projects
- compare NPVs of two choices - calculate the incremental NPV from taking the larger project - compare the incremental IRR to the discount rate
reasons to use IRR
- having a single rate of return seems to aid people in discussing and thinking about projects - most companies that use IRR do understand its flaws and take them into account
According to Graham and Harvey's 1999 survey of 392 CFOs, which of the following two capital budgeting methods are most used by firms in the United States?
1. Net present value
When the U.S. government wants to borrow money for the long-term (more than one year) it issues:
1. Treasury bonds
The U.S. government borrows money by issuing:
1. Treasury bonds.
Which three of the following are common shapes for the term structure of interest rates?
1. Upward sloping
What is a corporate bond's yield to maturity (YTM)?
1. YTM is the prevailing market interest rate for bonds with similar features.
A benchmark PE ratio can be determined using:
1. a company's own historical PEs
Investment in net working capital arises when ___.
1. cash is kept for unexpected expenditures
3. it will never cost the firm more than calculated in the cash flow analysis
1. should be accepted if there is no capital rationing constraint
What is the coupon rate on a bond that has a par value of $1,000, a market value of $1,100, and a coupon interest payment of $100 per year?
10%
In terms of time to maturity, U.S. Treasury notes and bonds have initial maturities ranging from ___ years.
2 to 30
Assume your marginal income tax rate on all income is 33% and that you own a corporate bond that yields 6% per year. What annual rate would you need to earn on the municipal bond to ensure that you earn the same after-tax income as on the corporate bond?
4.02%
Suppose Bob owns 20 shares and Vikki owns 30 shares in Good Company, and there are five members of the board of directors. Under which voting arrangement can Bob assure himself of a board member that represents his interests?
Cumulative voting
Capital Gains Yield
Div/ Po + g * rate at which the value of the investment grows * determination of r highly dependent on determination of g * doesn't work well when firm is currently paying no dividends * if estimate of g is equal to or above R there is a problem
Dividend Yield
Dividend price/ initial price of the stock * conceptually similiar to current yield on bond
Which one of the following is true about dividend growth patterns?
Dividends may grow at a constant rate.
Which of the following equations correctly relates OCF to sales volume?
OCF = (P − v) × Q − FC
License Holders
entitled to buy or sell on the exchange three different types: DMMs: specialists, act as dealers in particular stocks, maintain two-sided market Floor Brokers: execute trade for customers - employees of Merrill lynch SLPs: investment firms who agree to be active participants in stocks assigned to them - one sided market; trade purely for their own accounts, dont operate on the floor
coupon payment =
face value * coupon rate / m
For investors in the stock market, dividends from stocks are fixed and guaranteed, while capital gains are variable and not guaranteed.
false
True or false: A bond's value is not affected by changes in the market rate of interest.
false
True or false: The MIRR function eliminates multiple IRRs and should replace NPV.
false
Municipal Gov bonds are exempt from
federal income taxes
The ____ break-even is the sales level that results in a zero NPV.
financial
Coupon rate is
fixed, can never change
An NYSE member who executes customer buy and sell orders is called a ____ broker.
floor
order flow
flow of customers orders to buy and sell shares; business of NYSE is to attract and process this
Proxy
grant of authority by a shareholder to someone else to vote his/her shares ; they represent you * if shareholders upset with management, can give outside group the proxy to replace management - proxy fight
the lower the coupon rate, the
greater the interest rate risk
What has the greatest impact on P/E ratios?
growth opportunities
option to abandon
has value if demand turns out to be lower than expected * increases value of potential project * 50% * success 50% * if abandon
option to delay
has value if the underlying variables are changing with a favorable trend * can yield benefit if costs are falling * use discount rate and determine the year which gives the highest NPV today
index
list of stocks, can't invest directly in an index - invest in investment that invest just like index - can invest in ETF(exchange traded fund) -pick an index and spread the money out according to all the stocks in the index - the larger the stock the larger percentage of your money goes there - not equally weighted
The computation of equivalent annual costs is useful when comparing projects with unequal _____.
lives
If the term structure of interest rates is upward sloping, then ____.
long-term rates are higher than short-term rates
systematic risk
market risk - affects the market - ex: increased unemployment levels and GDP contraction - affects large number of assets
Enterprise Value
market value of equity + market value of debt - cash * the price you would have to pay if you wanted to buy a company and pay off all its debt
Primary Market
market where initial sales of securities take place- sell securities to raise money
why does the denominator of EV/EBITDA ignore depreciation and amortization?
merely reflect sunk cost of previous purchase
standard deviation of a portfolio
not the weighted average of returns of the individual investments in the portfolio * as long as correlation <1 ; the standard deviation of a portfolio of two securities is less than the weighted average of the standard deviations of individual securities
When voting for the board of directors, the number of votes a shareholder is entitled to is usually ____ vote per share held.
one
True or false: IRR approach may lead to incorrect decisions in comparison of two mutually exclusive projects.
true
True or false: Some projects, such as mines, have cash outflows followed by cash inflows, which are then followed by cash outflows, giving the project multiple rates of return.
true
True or false: When developing cash flows for capital budgeting, it is easy to overlook important items.
true
True or false: When a business does hard rationing, the firm's DCF analysis breaks down.
true --- When a business does hard rationing, the firm's DCF analysis breaks down and the best course of action is ambiguous.
Valuation Multiple
value a company by estimating the value of the firm based on the value of other comparable firms; PE ratio most commonly used multiple for valuation; if PE is 12 and company's earnings are 10 million, company is valued at 120 million
Differential Growth
when dividends grow at different rates over different periods of time
An accounting break-even point of 1,000 units means that ____.
when the firm sells 1,000 units, profits will be equal to zero
When a firm finances new investments, it may set up accounts payable with suppliers, but the balance that the firm must supply is called the investment in net ____ capital.
working
is there any advantage to the EV/EBITDA ratio over the PE ratio
yes, companies in the same industry may differ in leverage(ratio of debt to equity); leverage increases the risk of equity impacting the discount rate; impact of leverage on EV/EBITDA is less
return on any stock
* expected return * uncertain & risky
problems with internal rate of return
Problems for Both Independent and Mutually Exclusive: * investing or financing: if cash inflow comes before cash outflow then accept the project when IRR is less than the discount rate *multiple rates of return - flip flops - exhibits two changes in signs - lead to multiple IRR values - cash flow stream can with K changes in signs can have up to K sensible IRR's Problems for Mutually Exclusive Projects: *scale problem: ignores issue of scales: incremental IRR solves this *Timing problem: cash flows occur at different times
What are the two major forms of long-term debt?
Public issue and privately placed
Free Cash Flows
Revenue - expenses - taxes - net investment net investment = change in net working capital + capital expenditures - depreciation
____ analysis involves estimating the best-case, worst-case, and base-case cash flows and calculating the corresponding NPVs.
Scenario
Which of the following variables are required to calculate the value of a bond?
1. Remaining life of bond
nominal cash flows
actual dollars to be received - must be discounted at a nominal rate
equity risk premium
additional return resulting from the riskiness of common stocks
Secondary Market
after the initial shares are purchased from the issuing company, all purchases of stock are from stockholders
Multiple choice question.
aftertax
diversification
allows us to almost completely eliminate unsystematic risk - reduce riskiness from individual investments in diversifiable portfolio; only have systematic risk
financial erosion
already have a product line, if you create a new line you will reduce the sales of your other line - cause cash flow of another project to decrease
contribution margin
amount by which each additional unit contributes to after tax profit revenue - variable costs
announcement
expected part + surprise
total return
expected return + unexpected return
When to accept a project?
NPV > 0 * accepting positive NPV projects benefits the stockholders
Using the payback period rule will bias toward accepting which type of investment?
Short-term investment
4. Bonus to top management
Test marketing expenses
