FINAN450-- Exam #3

The rules for depreciating assets for tax purposes are based upon provisions in the _________.

1986 Tax Reform Act

The formula for valuing a constant growth stock is ________.

P0 = D1/(R-g)

If Payback > Cutoff

Reject project

Sunk costs are costs that _________.

Have already occurred and are not affected by accepting or rejecting a project

The payback period can lead to incorrect decisions if it is used too literally because it______.

Ignores cash flows after the cutoff date

With cost-cutting proposals, when costs decrease, operating cash flows ________.

Increase

The _______ method differs from NPV because it evaluates a project by determining the time needed to recoup the initial investment.

Payback

A stock with dividend priority over common stock is called a _______ stock.

Preferred

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

Which of the following are reasons why it is more difficult to value common stock than it is to value bonds?

The ROR required by the market is not easily observed, common stock cash flows are not known in advance, the life of a common stock is essentially forever

Which of the following entities declared a dividend?

The board of directors

The computation of equivalent annual costs is useful when comparing projects with _______ lives.

Unequal

Stand-Alone Principal

Use any and all changes in the firm's future CFs that are a direct consequence of taking on the project

(+) NPV

Value creating, accept project

IRR > R

Value creating, accept project

(-) NPV

Value destroying, reject project

IRR < R

Value destroying, reject project

The ________ curse says that the lowest bidder is the one who underbid the most.

Winner's

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

Market Buy/Sell: Current price = $65

You buy at $65, You sell at $65

If you can forecast P/E and if you can forecast EPS

You necessarily can forecast stock price

Limit buy order: the limit price is $68, the current price is $65

You will not buy unless the prices increases to $68

Limit sell order: the limit price is $68, the current price is $65

You will not sell unless the prices increase to $68

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

The AAR is calculated by taking the average net income and dividing it by the average ________ value.

Book

Which of the following types of stock is defined by the fact that it receives no preferential treatment in respect to either dividends or bankruptcy proceedings?

Common Stock

NASDAQ has which of these features?

Computer network of securities dealers, multiple market maker system

What is net working capital?

Current assets minus current liabilities

T/F: Cash flows should always be considered on an after tax basis.

True

The two types of stock are

Common (much larger asset class) and Preferred

Which of the following are fixed costs?

Cost of equipment, rent on a production facility

A ________ is a payment by a corporation to shareholders, made in either cash or stock.

Dividend

Common stock has no special preference either in receiving _______ or in bankruptcy.

Dividends

Which of the following are expected cash flows to investors in stocks?

Dividends and Capital Gains

For investors in the stock market, dividends from stocks are fixed and guaranteed, while capital gains are variable and not guaranteed.

False

T/F: The MIRR function eliminates multiple IRRs and should replace NPV.

False

Different Depreciation Schedules

Straight line MACRS 3, 5, and 7 years

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

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

Which of the following is an example of a sunk cost?

Test marketing expenses

Three ways to make capital budgeting decisions:

-NPV - best decision rule*** -IRR -Payback

A benchmark PE ratio can be determined using:

A company's own historical PEs, the PEs of similar companies

If Payback < Cutoff

Accept project

Two Components of Req'd ROR

Dividend & Cap Gains Yield

Which of the following will decrease the net present value of a project?

Increasing the project's initial cost at time zero.

__________ cash flows come about as a direct consequence of taking a project under consideration.

Incremental

The accelerated cost ________ system is a depreciation method under US tax law for the accelerated write-off of property under various classifications.

Recovery

Which of the following are weaknesses of the payback method?

TVM principles are ignored, the cutoff date is arbitrary, cash flows received after the payback period are ignored

OCF is calculated as net income plus depreciation using the ________ approach.

Bottom-up

A person who brings buyers and sellers together is called a(n) _______.

Broker

The NYSE member who acts as a dealer in a small number of securities is called a(n) ________.

Specialist

Two ways to value stock/equity:

-CFs/DDMs -P/E Valuation

Mutually Exclusive Projects

-If you choose one project, you cannot choose another (regardless of NPV or IRR) -Firms have limited capital -Compare NPVs and choose highest -Compare IRRs and choose highest -If NPV and IRR disagree, use NPV***

Modern Stock Exchanges

-Electronic Limit Order Books (LOBs) -Computer matching mechanism -Used to match buyers and sellers

Capital Budgeting

-How a firm allocates its assets What 'projects' to take on → anything a company can spend its money on -What to produce/sell -In what markets -PPE needed -R&D needed

Problems with Payback

-Ignores time value of money -Choosing cut off -Ignores CFs past cut off date -Biased against L/T projects -Might reject value creating projects

Which CFs are to be considered when evaluating a project?

-Incremental or Relevant cash flows: -CFs that are incurred should (*only) the project be taken on -Net new CFs should the project be taken on

Examples of Stand-Alone Principal

-New revenue -New costs -Side effects -Changes in net working capital -Financing costs -Taxes -*And other things to consider -***CREATE FINANCIAL STATEMENTS

Stocks

-No maturity date/unlimited life -Dividends are paid in perpetuity and tend to grow at some growth rate (g)

NPV and IRR

-usually generate the same accept/reject decision for a single product -One exception- CFs change signs more than once -AKA non-conventional CFs- IRR won't work -If NPV and IRR disagree, use NPV***

According to the average accounting return rule, a project is acceptable if its average accounting return exceeds:

A target average accounting return

Opportunity costs are __________.

Benefits lost due to taking on a particular project

Capital _______ is the decision-making process for accepting and rejecting projects.

Budgeting

The IRR rule can lead to bad decisions when _______ or _________.

Cash flows are not conventional, projects are mutually exclusive

Preferred stock has preference over common stock in the _____.

Distribution of corporate assets, payment of dividends

When developing cash flows for capital budgeting, it is _______ to overlook important items.

Easy

Stock =

Equity Ownership

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

Erosion

Interest expenses incurred on debt financing are ________ when computing cash flows from a project.

Ignored

An increase in depreciation expense will _______ cash flows from operations.

Increase

The present value of all cash flows (after the initial investment - future) is divided by the ______ to calculate profitability index.

Initial investment

Stock price reporting has increasingly moved from traditional print media to the ______ in recent years.

Internet

Investment in net working capital arises when ________.

Inventory is purchased, credit sales are made, cash is kept for unexpected expenditures

What are the advantages of the payback period method for management?

It allows lower level managers to make small decisions effectively, the payback period method is easy to use, the payback period method is ideal for short projects

Which of the following are features of common stock?

It has no special preference in bankruptcy, it generally has voting rights, it has no special preference in receiving dividends

While making capital budgeting decisions, which of the following sentences is true regarding the initial investment of net working capital?

It is expected to be recovered by the end of the project's life.

A share of common stock is _______ (more/less) difficult to value in practice than a bond.

More

Which of the following occurs in the primary market?

Newly-issued stocks are initially sold

The annual dividend yield is computed by dividing ________ annual dividend by the current stock price.

Next year's

When voting for the board of directors, the number of votes a shareholder is entitled to is usually ______ vote per share held.

One

The amount of time needed for the cash flows from an investment to pay for its initial cost is the _____ period.

Payback

This capital budgeting method allows lower management to make smaller, everyday financial decisions effectively.

Payback method

In capital budgeting, the net _______ determines the value of a project to the company.

Present value

Initial public offerings of stock occur in the ______ market.

Primary

T/F: IRR approach may lead to incorrect decisions in comparison of two mutually exclusive projects.

True

A project should be _______ if its NPV is greater than zero.

Accepted

Very often the Book Value of the equipment is zero, if BV = 0, then the equation is:

After-Tax Salvage Value = MV(1-Tc)

Someone who maintains an inventory of stocks and buys and sells those stocks is known as a _______.

Dealer

To calculate OCF using the bottom-up approach, add ________ to net income.

Depreciation

An NYSE member who executes customer buy and sell orders is called a _____ broker

Floor

Operating cash flow is a function of _________.

Depreciation, taxes, and earnings before interest and taxes

An NYSE member who acts as a dealer in particular stocks is called a ______ market maker.

Designated

Incremental cash flows come about as a(n) __________ consequence of taking a project under consideration.

Direct

Arrange the steps involved in the discounted payback period in order starting with the first step.

Discount the cash flows using the discount rate, add the discounted cash flows, accept if the discounted payback period is less than some prespecified number of years

What is the equation for estimating operating cash flows using the top-down approach?

OCF = Sales - Costs - Taxes

Limit Order

-You stipulate a limit price -Will not execute until price goes above/below limit price

Which capital budgeting decision method finds the present value of each cash flow before calculating a payback period?

Discounted payback period

If a project has multiple internal rates of return, which of the following methods should be used?

NPV, MIRR

By ignoring time value, the payback period rule may incorrectly accept projects with a ________(+/-) NPV.

Negative

Which one of the following is the equation for estimating operating cash flows using the tax shield approach?

OCF = (Sales - Costs) x (1 - Tax Rate) + Depreciation x Tax Rate

When the stock being valued does not pay dividends:

The dividend growth model can still be used

Erosion will _______ the sales of existing products.

Reduce

Opportunity costs are classified as ________ costs in project analysis.

Relevant

The first step in estimating cash flow is to determine the _________ cash flows.

Relevant

Cap Gains Yield

Return generated by capital gains *stock price goes up

Dividend Yield

Return generated by dividends

Trading of existing shares occurs in the ______ market.

Secondary

Identify which of the following is not a characteristic of a stock exchange:

Securities of Governments and Trusts are not allowed to trade in stock exchanges

Using the payback period rule will bias toward accepting which type of investment?

Short-term investment

A calculated NPV of $15,000 means that the project is expected to create a positive value for the firm and ________.

Should be accepted if there is no capital rationing constraint

The goal of many successful organizations is a(n) ______ rate of growth in dividends.

Steady

When evaluating cost-cutting proposals, how are operating cash flows affected?

The decrease in costs increases operating income, there is an additional depreciation deduction

Salvage Value vs. Book Value

Might owe taxes if over depreciated Might reduce tax bill if under depreciated

Preferred Stock

-No voting rights -Senior (to common) claims on assets and profits -Higher dividends -Fixed dividends -Senior (to common) dividends -Lower volatility (risk) -Lower L/T average returns

Market orders enter LOB and execute against limit order with the best price

-Occurs very rapidly with no human interaction -Very low latency trading

Common Stock

-Voting rights -Subordinate (to preferred) claims on assets and profits -Lower dividends -Variable dividends -Subordinate (to preferred) dividends -Higher volatility (risk) -Higher L/T average returns***

Market Order

-You agree to trade at the current quote/price -Order executes at current quote/price