Concepts (CH 2): Discounted Cash Flow Applications

Question 1

present value of expected cash inflows associated with the project less the present value of the project’s expected cash outflows, discounted at the appropriate cost of capital

Answer 1

net present value (NPV)

Question 2

rate of return that equates the PV of an investment’s expected benefits (inflows) with the PV of its costs (outflows)

Answer 2

IRR

Question 3

if a project has a positive NPV, this amount goes to the firm’s shareholders

Answer 3

NPV DECISION RULE

Question 4

1. positive NPV = ___________
   - will increase shareholder wealth
2. negative NPV =________
   - will decrease shareholder wealth
3. 2 projects mutually exclusive = ____________

Answer 4

accept project; reject project; accept project with higher positive NPV

Question 5

analyzing an investment using this method provides the analyst with a result in terms of a rate of return

Answer 5

IRR DECISION RULE

Question 6

IRR decision rules:

Answer 6

1. IRR greater than firm/investor’s required rate of return = accept
2. IRR less than the firm/investor’s required rate of return = reject

Question 7

when the acceptance or rejection of one project does not affect the acceptance or rejection of another, the two projects are considered as independent projects

Answer 7

Independent projects

Question 8

when only one of the two projects may be accepted

Answer 8

Mutually exclusive projects

Question 9

the NPV and IRR methods can give conflicting project rankings and can happen when:

Answer 9

• the projects’ initial costs are of
  different sizes
• the timing of the cash flow is
  different

Question 10

• can be any period of time
• maybe a matter of days or as long as several years

Answer 10

holding period

Question 11

the percentage change in the value of an investment over the period it is held

Answer 11

holding period return

Question 12

• applies the concept of IRR to
  investment portfolios
• defined as the internal rate of return on
  a portfolio, taking into account all cash inflows and outflows

Answer 12

MONEY-WEIGHTED RATE OF RETURN

Question 13

beginning value of the account and all deposits into the account

Answer 13

inflow

Question 14

ending value and withdrawals from the account.

Answer 14

outflow

Question 15

• measures compound growth
• rate at which $1 compounds over a
  specified performance horizon
• the process of averaging a set of values
  over time

Answer 15

TIME-WEIGHTED RATE OF RETURN

Question 16

are quoted based on the face value of the instrument instead of the purchase price

Answer 16

BANK DISCOUNT YIELD (BYD)

Question 17

yield quoted on a bank discount basis is not representative of the return earned by an investor for the following reasons:

Answer 17

1. bank discount yield (BDY) annualizes using simple interest and ignores the effect of compound interest
2. BDY is based on the face value of the bond, not its purchase price (investment returns should be evaluated relative to the amount invested)
3. BDY is annualized based on a 360-day year instead of 365

Question 18

total return an investor earns between the purchase date and the sale or maturity date

Answer 18

HOLDING PERIOD YIELD (HPY)

Question 19

annualized value based on a 365-year that accounts for
compound interest

Answer 19

EFFECTIVE ANNUAL YIELD (EAY)

Question 20

• equal to the annualized holding period
  yield, assuming a 360-day year
• using this makes the quoted yield on t- bill comparable to yield quotes for interest-bearing money market instrument that pay interest on 360-day
  basis

Answer 20

MONEY MARKET YIELD (or CD equivalent yield)

Question 21

• 2 x the semiannual discount rate
• stems from the fact that yield on US bonds are quoted twice the semiannual rate, bc the coupon interest is paid in
  two semiannual payments

Answer 21

Bond equivalent yield