Finance Fundamentals Midterm 2 Textbook Quiz
What are the four financial statements that all public companies must produce?
1. balance sheets 2. income statements 3. cash flow statements 4. statements of shareholder's equity
Explain why choosing the option with the highest NPV is not always correct when the options have different lives.
1. the required life of the project is important in choosing the projects with different lives 2. the replacement cost of the project
What is the role of an auditor?
A neutral third party, which corporations are required to hire, that checks a firm's annual financial statements to ensure they are prepared according to GAAP, and provides evidence to support the reliability of the information.
What is dilution?
An increase in the total number of shares that will divide a fixed amount of earnings.
If depreciation expense is not a cash flow, why do we have to subtract it and add it back? Why not just ignore it?
Because it reduces tax liability by reducing taxable earnings. Since taxes are considered cash out flows, depreciation also affects the firm's cash flow. We add it back to incremental earning to recognize the fact that we still have the cash flows associated with it.
If a bond's yield to maturity does not change, how does its cash price change between coupon payments?
Between coupon payments, the prices of all bonds rise at a rate equal to the yield to maturityas the remaining cash flows of the bonds become closer. But as each coupon is paid,the price of a bond drops by the amount of the coupon.
Why does a firm's net income not correspond to cash earned?
First, there are non-cash entries on the income statement, such as depreciation and amortization. Second, certain uses, such as the purchase of a building or expenditures on inventory, and sources of cash, such as the collection of accounts receivable, are not reported on the income statement.
Explain the NPV rule for stand-alone projects.
In the case of a stand-alone project, the alternatives we are considering are to accept or reject a project. The NPV rule then implies that we should compare the project's NPV to zero (the NPV of rejecting the project and doing nothing). Thus, we should accept the project if its NPV is positive.
Where do off-balance sheet transactions appear in a firm's financial statements?
Management is also required to disclose any off-balance sheet transactions, which are transactions or arrangements that can have a material impact on the firm's future performance yet do not appear on the balance sheet. For example, if a firm has made guarantees that it will compensate a buyer for losses related to an asset purchased from the firm, these guarantees represent a potential future liability for the firm that must be disclosed as part of the MD&A.
Explain why picking the project with the highest NPV might not be optimal when you evaluate projects with different resource requirements.
NPV does not take into account resource constraints so the Profitability Index which takes into consideration both NPV and resources consumed would be the best way to determine the value created.
Why do real options increase the NPV of a project?
Real options are not an obligation by a right. A project accepts only if it has a positive and higher NPV. Investment in project delays, expands, or drops if the NPV is not increased. If there is a greater flexibility in the project, then it is possible to increase the NPV of the project. A decision maker has the option to choose the most attractive investment once the new information has been learned, and hence adds value to the investment opportunity.
What is a share of stock and what are dividends?
Share of Stock: a fractional ownership in business and the holders of these shares of stock are called "stockholders" or "shareholders." These shares of stock are traded in the stock market. The ownership gives the shareholder the right to dividends and rights to vote an election of directors, mergers & acquisitions an other major events. Dividends: a cash of inflow to the shareholder. The corporation returns a part of the earnings to the shareholder in the form of dividends. The shareholders receive dividends in proportion to the number of shares they own. Dividends are calculated as a percentage on the face value of the share. It is not compulsory for the corporation to pay dividends but corporations prefer or try to maintain a steady dividend payout ratio to its earnings, year on year.
How will the yield to maturity of a bond vary with the bond's risk of default?
The bond's expected return is less than the YTM if there is a risk of default.
What do we need in order to value a coupon bond?
The cash flows that will occur and the interest rate used to discount those cash flows
What are the components of the statement of cash flows?
The firm's statement of cash flows utilizes the information from the income statement and balance sheet to determine how much cash the firm has generated, and how that cash has been allocated, during a set period.
What is the NPV decision rule? How is it related to the Valuation Principle?
The net present value rule is the idea that company managers and investors should only invest in projects or engage in transactions that have a positive net present value(NPV). They should avoid investing in projects that have a negative net present value. Valuation Principle implies that we should undertake projects with a positive NPV because undertaking those projects increases wealth.
What is capital budgeting, and what is its goal?
The process of analyzing projects and investment opportunities and deciding which ones to accept. The goal is to invest its current funds most efficiently in long term activities in anticipation of flow of future benefits over a series of years.
Under what conditions will the IRR rule lead to the same decision as the NPV rule?
There are two conditions in which the NPV and IRR There is no set way to modify project cash flows to produce an MIRR. Two other approaches that each solve the multiple IRR problem are: 1. Discount all the negative cash flows to time 0 and leave the positive cash flows alone. 2. Leave the initial cash flow alone and compound all the remaining cash flows to the final period of the project. In this approach, you are implicitly reinvesting all the cash flows from the project at your compound rate until the project is complete. Again, in either case, if you use the project's cost of capital as your discount and compounding rate, you will not alter the NPV of the project at that discount rate. Furthermore, a decision to accept or reject the project based on the modified IRR will be the same as the one based on the NPV decision rule.
What are some key differences between preferred and common stock?
They key differences are as follows: 1. PS has no control rights. Where CS gives the rights to the holder to vote an election of directors, mergers and acquisitions and other major events 2. PS holders have a preference over CS holders in payment of dividends and during liquidation. 3. PS somewhat have characteristics like bond which is perpetual in nature. The PS holder gets a fixed percentage as return and the holder is aware of the expected cash flow. Whereas CS receive dividends from whatever excess cash the corporation has and the board decides to distribute. 4. PS can be "non-cumulative" or "cumulative." Any missed dividends of a non-cumulative PS do not accumulate whereas any unpaid dividends for a cumulative PS are carried forward. The CS holders are not paid any dividend until the corporation has paid all the unpaid dividends of the cumulative PS. There is no distinction for CS.
What information do the notes to financial statements provide?
They often provide information specific to a firm's subsidiaries or its separate product lines. They show the details of the firm's stock-based compensation plans for employees and the different types of debt the firm has outstanding. Details of acquisitions, spin-offs, leases, taxes, and risk management activities are also given. The information provided in the notes is often very important to a full interpretation of the firm's financial statements.
Why does an increase in net working capital represent a cash outflow?
We care about net working capital because it reflects a short-term investment that ties up cash flow that could be used elsewhere. For example, when a firm holds a lot of unsold inventory or has a lot of outstanding receivables, cash flow is tied up in the form of inventory or in the form of credit extended to customers. It is costly for the firm to tie up that cash flow because it delays the time until the cash flow is available for reinvestment or distribution to shareholders. Since we know that money has time value, we cannot ignore this delay in our forecasts for the project. Thus, whenever net working capital increases, reflecting additional investment in working capital, it represents a reduction in cash flow that year.
Why doesn't the NPV decision rule depend on the investor's preferences?
We don't need to know anything about the investor's preferences to reach this conclusion. As long as we have correctly captured all the cash flows of a project and applied the appropriate discount rate, we can determine whether the project makes us wealthier. Being wealthier increases our options and makes us better off, whatever our preferences are.
Why would you want to know the yield to maturity of a bond?
Yield to maturity can be quite useful for estimating whether buying a bond is a good investment.
What is sensitivity analysis?
an important took for evaluating the effect of uncertainty in estimates. It breakdowns the NVP calculations into constituent assumptions and it specifies in what way the NPV changes as the underlying assumptions change.
What does a high debt-to-equity ratio tell you?
assesses a firm's leverage that we calculate by dividing the total amount of short- and long-term debt (including current maturities) by the total stockholders' equity
Why do we focus only on incremental revenues and costs, rather than all revenues and costs of the firm?
because we are concerned with evaluating how the investment in a project will change the cash flows of the firm
Explain why it is advantageous for a firm to use the most accelerated depreciation schedule possible for tax purposes.
depreciation adds definitely to a firm's cash flow by its tax shield, so it is advantageous for a firm to use the most accelerated depreciation schedule possible for tax purposes because by doing so the tax savings of the firm will increase at the same present value of the firm also increase
Explain why it is advantageous for a firm to use the most accelerated depreciation schedule possible for tax purposes.
depreciation adds definitely to a firm's cash flow by its tax shield, so it is advantageous for a firm to use the most accelerated depreciation schedule possible for tax purposes because by doing this, the tax savings of the firm will increase at the same present value of the firm also increase.
How do you apply the payback rule?
1. Calculate the amount of time it takes to pay back the initial investment, called the payback period. 2. Accept the project if the payback period is less than a pre-specified length of time—usually a few years. 3. Reject the project if the payback period is greater than that prespecified length of time. PAYBACK PERIOD: The amount of time until the cash flows from a project offset the initial investment. The time it takes to pay back the initial investment.
Why do interest rates and bond prices move in opposite directions?
A higher yield to maturity means that investors demand a higher return for investing. They apply a higher discount rate to the bond's remaining cash flows, reducing their present value and hence the bond's price. The reverse holds when interest rates fall. Investors then demand a lower yield to maturity, reducing the discount rate applied to the bond's cash flows and raising the price. Therefore, as interest rates and bond yields rise, bond prices will fall, and vice versa, so that interest rates and bond prices always move in the opposite direction.
How are the periodic coupon payments on a bond determined?
CPN=(Coupon Rate × Face Value) / Number of Coupon Payments per Year
What do a firm's earnings measure?
Net Income- The last or "bottom" line of a firm's income statement that is a measure of the firm's income over a given period of time.
What types of cash flows does a bond buyer receive?
The coupon payments and the par value at maturity
What are real options?
The right to make a particular business decision, such as a capital investment.
Why is computing a project's effect on the firm's earnings insufficient for capital budgeting?
earnings are not actual cash flows
What is the relationship between a bond's price and its yield to maturity?
A bond's price moves inversely with its YTM. An increase in YTM decreases the priceand a decrease in YTM increases the price of a bond.
What is a junk bond?
Bonds in one of the bottom five categories of creditworthiness (below investment grade) that have a high risk of default.
What is depreciation designed to capture?
Depreciation is used in accounting to try to match the expense of an asset to the income that the asset helps the company earn. indicates how much of an asset's value has been used up.
How can you interpret the difference between the cost of capital and the IRR?
In general, the difference between the cost of capital and the IRR tells us the amount of estimation error in the cost of capital estimate that can exist without altering the original decision.
What does the profitability index tell you?
Measures the NPV per unit of resource consumed.
What is the most reliable way to choose between mutually exclusive projects?
When you are comparing mutually exclusive projects of different scale, however, you need to know the dollar impact on value—the NPV. Choosing largest IRR can lead to mistakes!
The book value of a company's assets usually does not equal the market value of those assets. What are some reasons for this difference?
many of the firm's valuable assets are not captured on the balance sheet (quality of management team and marketplace reputation). Furthermore, successful firms are often able to borrow in excess of the book value of their assets because creditors recognize the market value of the assets is far higher than the book value.
What cash flows does a company pay to investors holding its coupon bonds?
the cash flows consist of the interest payments during the bond's life plus the amount borrowed (the par value)
How are operating expenses and capital expenditures treated differently when calculating incremental earnings?
the costs spent for day to day operations of the firm are known as operating expenses whereas investment in capital assets is known as capital expenditure While calculating incremental earnings, the operating expenses are directly listed as costs, whereas capital expenditures are not directly listed as expenses. Instead, the firm deducts a fraction of cost of these items each as a depreciation.
What are real options?
the right but NOT obligation to make particular business decision. You are not obligated to take the action and action can take place only in certain cases when it increases the NPV of the project.
Should we include sunk costs in the cash flows of a project? Why or why not?
No because they will be paid irrespective of choice whether or not you continue with the project. sunk cost: any unrecoverable cost for which the firm is now liable.
For mutually exclusive projects, explain why picking one project over another because it has a larger IRR can lead to mistakes.
Problems arise when the mutually exclusive investments have differences in scale (require different initial investments) and when they have different cash flow patterns. If a project has a positive NPV, then if we can double its size, its NPV will double: By the Valuation Principle, doubling the cash flows of an investment opportunity must make it worth twice as much. However, the IRR rule does not have this property—it is unaffected by the scale of the investment opportunity because the IRR measures the average return of the investment. Thus, the IRR rule cannot be used to compare projects of different scales Note that the IRR is unaffected by the scale. The IRR is a measure of the average return, which can be valuable information. When you are comparing mutually exclusive projects of different scale, however, you need to know the dollar impact on value—the NPV.