Principles of Finance: Chapters 10-12
Reinvestment assumption with IRR
All inflows from a given investment can be reinvested at the Internal Rate of Return (IRR) and may be unrealistic to assume that reinvestment can occur at a equally high rate.
Net Present Value (NPV)
Discounting back the inflows over the life of the investment to determine whether they equal or exceed the required investment.
Each category that assets are classified into are referred to as what?
Modified Accelerated Cost Recovery System (MACRS) category.
To apply the NPV profile, what following aspects need to be considered?
NPV at a zero discount rate, NPV as determined by a normal discount rate (such as cost of capital), and IRR for the project.
Which method used for evaluating capital expenditures is not conceptually sound?
Payback method.
Risk-free rate of return combines what two factors?
Real rate of return and inflation premiuim
Internal rate of return (IRR)
Requires the determination of the yield on an investment that equates the cash outflows (cost) of an investment with subsequent cash inflows.
The value of a share of common stock may be interpreted by the shareholders as what?
The present value of an expected stream of future dividends.
In bond valuation, cash flows are discounted at what?
Y, yield to maturity.
Preferred stock has what two things?
a fixed dividend payment and no binding contractual obligation of interest on debt.
Efficient use of capital in the past results in what?
a lower required rate of return for investors.
Risk premiuim
a premium associated with the special risks of a given investment (typically 2-6%).
Inflation premiuim
a premium to compensate for the eroding effect of inflation on the value of the dollar (in the last two decades it has been about 2-4%).
Dividend valuation model
a stock valuation model based on future expected dividends.
NPV Profile
allows you to graphically portray the net present value of a project at different discount rates.
A bond provides what?
an annuity stream of interest payments and a principal payment at maturity.
The use of debt beyond a reasonable point may cause what?
an increase in the firm's financial risk and thereby drive up the costs of all sources of financing.
Financial capital consists of what?
bonds, preferred stock, and common equity.
Of primary interest, what are the two types of risk?
business risk and financial risk.
Elective Expensing
businesses can write-off certain tangible properties in the purchased year for up to $250,000 under the 2008 Economic Stimulus Act.
In capital budgeting decisions, the emphasis is on what rather than earnings?
cash flows.
The longer the time to maturity, the greater the impact on what?
changes in yield.
Modified Internal Rate of Return (MIRR)
combines reinvestment assumption of the NPV method with the IRR method.
Payback Method
computes the time required to recoup the initial investment.
Retained earnings belong to who?
current stockholders.
A firm has to balance between what and what to achieve its minimum cost of capital?
debt and equity
The valuation of a financial asset is based on what?
determining the present value of future cash flows.
What are some shortcomings of the payback method?
does not consider Time Value of Money, and ignores cash-flows after the cutoff period.
The ultimate value of any holding rests with the distribution of what?
earnings in the form of dividend payments.
What are some advantages of the payback method?
easy to understand, emphasizes liquidity, useful in industries characterized by dynamic technological developments.
For a project to be accepted under NPV, a project must what?
equal or exceed cost of capital.
What are some reasons for capital rationing?
fear of too much growth and hesitation to use external sources of financing.
Supernormal growth
growth experienced by firms in an emerging industry.
Perpetuity
has no maturity date.
Investors are willing to accept what for high risk?
high return.
If the dividend yield is low, the growth rate must be what?
high to provide the necessary return.
Why is preferred stock valued in the market without any principal payment?
it has no ending life.
Investors are willing to accept low return for what?
low risk.
Reinvestment assumption with NPV
makes the more conservative assumption that each inflow can be reinvested at the cost of capital or discount rate and allows for certain consistency as inflows from each project are assumed to have the same investment opportunity.
How many categories are assets classified into to determine allowable depreciation?
nine.
The dividend valuation model is generally applied to what three different circumstances?
no growth in dividends, constant growth in dividends, and variable growth in dividends.
Is risk premium the same for different investments?
no.
If there is a tax loss, it can be written off against what?
other income for the corporation.
Retained earnings can either be what or what?
paid out to the current stockholders in the form of dividends or reinvested in the firm.
The term principal payment at maturity is used interchangeably with what?
par value or face value of the bond.
What are the three methods used for evaluating capital expenditures?
payback method, internal rate of return, and net present value.
The further the yield to maturity on a bond changes from the stated interest rate on the bond, the greater what effect will be?
price change effect.
What are two things firms must be sensitive to in determining the cost of common stock?
pricing and performance demands of current and future stockholders.
Depreciation is added back to what to determine the amount of cash flow generated?
profit.
What are the three factors that influences bondholders required rate of return?
real rate of return, inflation premium, and risk premium.
Business risk
relates to the inability of the firm to hold its competitive position and maintain stability and growth in its earnings.
Financial risk
relates to the inability of the firm to meet its debt obligations as they come due.
Price-earnings ratio
represents a multiplier added to current earnings to determine the value of a share of stock in the market.
The market allocates capital to companies based on what?
risk, efficiency, and expected return (are based to a large degree on past performance).
What is the cash inflow from the sale of an old asset?
sales price and related tax factors.
What are the steps that a good capital budgeting program requires?
search for and discovery of investment opportunities, collection of data, evaluation and decision making, and reevaluation and adjustment.
What is perhaps the most important of the four steps to a good capital budgeting program?
search for and discovery of investment opportunities.
Flotation cost
selling costs.
which approach is a more acceptable method: annually or semiannually?
semiannually.
In bond valuation, the value of Y (yield to maturity) is determined by what?
the bond market and represents the required rate of return for bonds of a given risk and maturity.
If there is a tax gain, it would be taxed at what?
the corporation's normal tax rate.
Cost of capital
the cost of a firm's funds.
Under NPV, the basic discount rate is usually what?
the cost of capital to the firm.
Yield to maturity indicates what?
the current cost to the corporations to issue bonds.
Required Rate of Return
the discount rate.
Price-earnings ratio is influenced by what?
the earnings and sales growth of the firm, the risk (or volatility in performance), the debt-equity structure of the firm, the dividend policy, the quality of management, and a number of other factors.
Asset Depreciation Range (ADR)
the expected physical life of the asset or class of assets.
The cost of debt is measured by what?
the interest rate, or yield, paid to bondholders.
Required rates of return are competitively determined among who?
the many companies seeking financial capital.
The market-determined required rate of return depends on what?
the market's perceived level of risk associated with the individual security.
Since preferred stock is a hybrid security, it has neither what and what?
the ownership of the privilege of common stock nor the legally enforceable provisions of debt.
Accumulated retained earnings represent what?
the past and present earnings of the firm minus previously distributed dividends.
The price of a bond is equal to what?
the present value of regular interest payments (discounted at Y) added to the present value of the principal (also discounted at Y).
One obvious supplier of common stock equity capital is what?
the purchaser of new shares of common stock.
Yield to Maturity (discount rate)
the rate of return required by bondholders.
Real rate of return
the rate of return the investor demands for giving up the current use of the funds on a noninflation-adjusted basis (typically 2-3%)
Risk-free rate of return
the rate that compensates the investor for the current use of his or her funds for the loss in purchasing power due to inflation, but not for taking risks.
The replacement decisions include several additions to the basic investment situation such as what?
the sale of the old machine and tax consequences.
To determine related tax factors, the book value of the old asset is compared with what?
the sales price to determine if there is a taxable gain or loss.
Mutually exclusive
the selection of one alternative will preclude the selection of another alternative.
MIRR is the discount rate that equates what with what?
the terminal (final) value of the inflows and the investment.
To value a financial asset, what must we know?
the value of future cash flows and the discount rate to be applied to the future cash flows to determine the current value.
If the rate of return required by a security holder changes, what will change?
the value of the financial asset.
Optimum Capital Structure
weighing capital components in accordance with our desire to achieve a minimum overall cost of capital.
Capital rationing
when management places an artificial constraint on the amount of funds that can be invested in a given period.
Can capital rationing hinder a firm from achieving maximum profitability?
yes.
Required rate of return on a bond is effectively the same concept as what?
yield to maturity.