Finance 450 Exam 3 Concepts

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The capital gains yield =

(Pt+1 - Pt)/Pt

capital gains yield=

(ending price - beginning price) / beginning price

Among the three main sources of cash flow, which source of cash flow is the most important and also the most difficult to forecast?

The operating cash flows from net sales over the life of the project

True or false: The operating cash flows of a project include erosion effects

True

True or false: To prepare proforma financial statements, estimates of quantities such as unit sales, selling price per unit, variable cost per unit, and total fixed costs are required.

True

Which one of the following statements is correct? Assume cash flows are conventional.

When the internal rate of return is greater than the required return, the net present value is positive.

The internal rate of return is a function of ____.

a project's cash flows

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

a target average accounting return

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

The geometric rate of return takes ______ into account.

compounding

Normally, the excess rate of return is ___.

positive

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

relevant

If the IRR is greater than the _______ ________, we should accept the project.

required return

Which of the following is a disadvantage of the payback period rule?

requires an arbitrary cutoff point

The arithmetic average rate of return measures the ____.

return in an average year over a given period

If a study of a firm's financial information will not lead to gains in the market, then the market must be at least _____ efficient.

semi-strong form

____________ analysis is useful in pinpointing variables that deserve the most attention.

sensitivity

To investigate the impact on NPV of a change in one variable, you would employ ________.

sensitivity analysis

Dan is a chemist for ABC, a major drug manufacturer. Dan cannot earn excess profits on ABC stock based on the knowledge he has related to his experiments if the financial markets are:

strong form efficient

The discounted (DCF) valuation estimates

the NPV as the difference between the present value of the future cash flows and the cost of the investment.

capital gains yield

the capital gain during a given year divided by the beginning price

Scenario Analysis

the determination of what happens to NPV estimates when we ask what-if questions (change multiple variables)

When calculating NPV, the present value of the nth cash flow is found by dividing the nth cash flow by 1 plus ______ rate raised to the nth power.

the discount

The higher the risk,

the higher the return

Capital rationing exists when a company has identified positive NPV projects but cannot (or will not) find:

the necessary financing

Which of the following are ways to make money by investing in stocks?

-capital gains -dividends

In general, NPV is ___.

-equal to zero when the discount rate equals the IRR -negative for discount rates above the IRR -positive for discount rates below the IRR

We underestimate NPV because of the option(s) to ______.

-expand -abandon -wait

The internal rate of return is unreliable as an indicator of whether or not an investment should be accepted given which one of the following?

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

True or false: The value of managerial options is taken into account when performing conventional NPV analysis.

false

Roger Ibbotson and Rex Sinquefield presented year-to-year historical rates of return on _____ types of financial investments

five, 5

The profitability index is calculated by dividing the PV of the _________ cash inflows by the initial investment.

future

If we find that our estimated NPV is sensitive to a variable that is difficult to forecast, then the degree of forecasting risk is _____.

high

What is the primary concern of the payback period rule?

how long it will take to recover your initial investment

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

ignored

An efficient market is one in which any change in available information will be reflected in the company's stock price ___.

immediately

Dividends are the ______ component of the total return from investing in a stock.

income

Total Dollar Return

income from investment (dividends) + capital gain (loss) due to change in price

Synergy will _____ the sales of existing products

increase

The stand-alone principle assumes that evaluation of a project may be based on the project's ________________ cash flows.

incremental

An efficient market is one that fully reflects all available ______.

information

Stock prices fluctuate from day to day because of:

information flow

The capital gains yield can be found by finding the difference between the ending stock price and the initial stock price and dividing it by the:

initial stock price

If the dispersion of returns on a particular security is very spread out from the security's mean return, the security ____.

is highly risky

Which of the following is a disadvantage of the Profitability Index?

it cannot rank mutually exclusive projects

The payback period can lead to foolish decisions if it is used too literally because:

it ignores cash flows after the cutoff date

The profitability index rule for an independent project states that, if a project has a positive NPV, then the present value of the future cash flows must be _________ than the initial investment.

larger

The primary risk in estimation errors is the potential to __________.

make incorrect capital budgeting decisions

The normal distribution is completely described by the _______ and ________.

mean, standard deviation/variance

The project cash flow equals the project operating cash flow _____________ project change in NWC minus project capital spending.

minus

The discounted cash flow valuation shows that higher cash flows earlier in a project's life are ______ valuable than higher cash flows later on.

more

If a firm is evaluating two possible projects, both of which require the use of the same production facilities, and taking one project means that we cannot take the other, these projects would be considered _______________.

mutually exclusive

Accounts receivable and accounts payable are included in project cash flow estimation as part of changes in ______________.

net working capital

Which type of stock price adjustment time path occurs when there is a bubble (price run up) in the path followed by a decline after the market receives information about the stock?

overreaction and correction

The ______ method evaluates a project by determining the time needed to recoup the initial investment.

payback

The __________ is best suited for decisions on relatively small, minor projects while ______ is more appropriate for large complex projects.

payback period, NPV

If you use a geometric average to project short-run wealth levels, your results will most likely be _______ .

pessimistic

The NPV is ______ if the required return is less than the IRR, and it is ______ if the required return is greater than the IRR.

positive; negative

Given a level of investment in net working capital, that same investment must be ____________ at some time in the future.

recovered

Erosion will ______ the sales of existing products.

reduce

According to the basic IRR rule, we should:

reject a project if the IRR is less than the required return

The average risk premium on long-term government bonds for the period 1926-2014 was equal to:

the rate of return on the bonds minus the T-bill rate.

risk-free rate

the rate of return that can be earned with certainty

depreciation tax shield

the tax saving that results from the depreciation deduction (calculated as depreciation multiplied by the corporate tax rate)

In a competitive market, positive NPV projects are:

uncommon

In order to analyze the risk of a project's NPV estimate, we should establish ___________ for each important estimate variable.

upper and lower bounds

The square of the standard deviation is equal to the ____.

variance

The basic approach to evaluating cash flow and NPV estimates involves asking:

what-if quesitons

The IRR is the discount rate that makes NPV equal to ______.

zero

The Average Accounting Return is defined as:

average net Income/average book value

The risk premium can be interpreted as a reward for

bearing risk

A disadvantage of the AAR is that it is based on

book values, not market values.

When a company declares a dividend, shareholders generally receive ____.

cash

the geometric average return is the average ____________ return earned per year over a multiyear period.

compound

Managerial options are taken into consideration in ___________ planning.

contingency

The Profitability Index is also called the __________ ratio.

cost-benefit

Net Working Capital=

current assets - current liabilities

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

direct

total return percentage

dividend yield+capital gains yield

The total dollar return on a stock is the sum of the ____ and the _____.

dividends, capital gains

The ______ rate of return is the difference between the rate of return on a risky asset and the risk-free rate of return.

excess

The basic NPV investment rule is:

-If the NPV is equal to zero, acceptance or rejection of the project is a matter of indifference. -Accept a project if the NPV is greater than zero -Reject a project if its NPV is less than zero

Which of the following are reasons why NPV is considered a superior capital budgeting technique?

-It considers the riskiness of the project. -It properly chooses among mutually exclusive projects -It considers time value of money. -It considers all the cash flows.

Operating cash flow is a function of:

-Taxes -Earnings Before Interest and Taxes (EBIT) -Depreciation

A manager has estimated a positive NPV for a project. What could drive this result?

-The cash flow estimations are inaccurate. -The project is a good investment. -Overly optimistic management

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

-The payback period method is ideal for minor projects. -It allows lower level managers to make small decisions effectively. -The payback period method is easy to use.

If a new project requires an investment in net working capital when it is launched, then at the end of the project, NWC will be

100% reversed

The probability of a return being within ± one standard deviation of the mean in a normal distribution is approximately ___ percent.

68

How does the timing and the size of cash flows affect the payback method? Assume the project does pay back within the project's lifetime.

An increase in the size of the first cash inflow will decrease the payback period, all else held constant.

If discount rate is infinite, NPV=

CF0

The pro forma income statements for a proposed investment should include all of the following except:

Changes in Net Working Capital

Dividend Yield Formula

D1/P0, dividend amount/beg. stock price

True or false: In calculating cash flows, you should consider all financing costs.

False

What is an important drawback of traditional NPV analysis?

It ignores managerial options in investment decisions.

Generally speaking, payback is best used to evaluate which type of projects?

Low-cost, short-term

Which of the following techniques will provide the most consistently correct result?

NPV

Graham and Harveys' survey: 2 most popular capital budgeting methods

NPV and IRR

The discounted (DCF) valuation estimates the

NPV as the difference between the present value of the future cash flows and the cost of the investment.

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

NPV or MIRR

_______ is a measure of how much value is created or added by undertaking an investment.

Net Present Value

The Tax Shield Approach:

OCF = (Sales - Costs) x (1-TC) + Depreciation x TC

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

OCF = (Sales - Costs) × (1 - Tax rate) + Depreciation × Tax rate

Which one of the following indicators offers the best assurance that a project will produce value for its owners?

Positive NPV

You were recently hired by a firm as a project analyst. The owner of the firm is unfamiliar with financial analysis and wants to know only what the expected dollar return is per dollar spent on a given project. Which financial method of analysis will provide the information that the owner requests?

Profitability index

Which of the following is an example of an opportunity cost?

Rental income likely to be lost by using a vacant building for an upcoming project

Side effects from investing in a project refer to cash flows from:

-beneficial spillover effects -erosion effects

Which of the following are considered relevant cash flows?

-Cash flows from beneficial spillover effects -Cash flows from external costs -Cash flows from erosion effects

Identify the three main sources of cash flows over the life of a typical project.

-Cash outflows from investment in plant and equipment at the inception of the project -Net cash flows from salvage value at the end of the project -Net cash flows from sales and expenses over the life of the project

Which of the following are components of project cash flow?

-Change in net working capital -Operating cash flow -Capital spending

lowest historical risk premium to highest historical risk premium:

-Treasury Bills -Long-term Gov Bonds -Large-company stocks -Small-company stocks

Cash flows used in project estimation should always reflect:

-after-tax cash flows -cash flows when they occur

Percentage returns are more convenient than dollar returns because they:

-apply to any amount invested -allow comparison against other investments

Which of the following is true relative to capital rationing?

-hard rationing implies the firm is unable to raise funds for projects -soft rationing is typically internal in that the firm allocates funds to divisions for capital projects

The goals of risk analysis in capital budgeting include:

-identifying critical components -assessing the degree of financing risk

Though depreciation is a non-cash expense, it is important to capital budgeting for these reasons:

-it determines the book value of assets which affects net salvage value -it determines taxes owed on fixed assets when they are sold -it affects a firm's annual tax liability

Which of the following present problems when using the IRR method?

-mutually exclusive projects -non-conventional cash flows

An option on a real asset rather than a financial asset is known as a:

-real option -managerial option

capital gains yield

The percentage change in the price of a stock over a period of time

Profitability Index (PI)

The present value of an investment's future cash flows divided by its initial cost. (PV/initial cost)

True or false: A project with non-conventional cash flows will produce two or more IRRs.

True

True or false: The measure of average accounting profit is in the numerator of the average accounting return (AAR) formula.

True

The PI rule for an independent project is to ______ the project if the PI is greater than 1.

accept

Based on the average accounting return rule, a project is _____ if its average accounting return exceeds a target average accounting return.

acceptable

The payback period rule ______ a project if it has a payback period that is less than or equal to a particular cutoff date.

accepts

Cash flows should always be considered on a(n) _______________ basis.

after-tax

In an efficient market ______ investments have a _____ NPV.

all, zero

A positive capital gain on a stock results from ___.

an increase in price


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