EXAM TWO

Question 1

What is a stock?

Answer 1

A stock represents fractional ownership in a company, meaning if you own one share, you own a small part of the company.

Question 2

What is the difference between common shares and owner’s shares?

Answer 2

Common shares are available to the public, while owner’s shares are typically held by the company’s founders and often carry higher voting rights.

Question 3

What is common stock?

Answer 3

Common stock is publicly traded and represents ownership in a company. Shareholders may have voting rights and the potential to receive dividends.

Question 4

What is a dividend?

Answer 4

A dividend is a distribution of a company’s earnings to its shareholders. A firm is not required to pay dividends.

Question 5

What is the IPO?

Answer 5

An Initial Public Offering (IPO) is when a company issues stock for the first time, selling it in the primary market, generally to investment banks.

Question 6

What is the secondary market?

Answer 6

The secondary market is where individuals trade stocks with each other. The company does not receive any money from these transactions.

Question 7

What is the difference between NYSE and NASDAQ?

Answer 7

NYSE has a centralized location and uses Designated Market Makers (DMM) to facilitate trades, while NASDAQ operates without a central location and uses multiple dealers.

Question 8

How do stockholders receive cash from their investments?

Answer 8

Stockholders receive cash through dividends paid by the company or by selling their shares. The return is the dividend yield and the capital gains yield.

Question 9

What are the types of stock dividend growth models?

Answer 9

The types include constant dividend (perpetuity), constant dividend growth (Gordon Growth Model), and supernormal growth (growth that becomes constant after a few years).

Question 10

What are dual-class shares?

Answer 10

Dual-class shares are a type of equity with different voting rights. Typically, one class has superior voting rights, while the other class has limited or no voting rights.

Question 11

Why do shareholders vote for the board of directors?

Answer 11

Shareholders vote for the board of directors to have a say in the company’s management and decision-making. The board represents the interests of the shareholders

Question 12

How do shareholders vote for the board of directors?

Answer 12

Shareholders vote during annual meetings or special meetings. Typically, each share represents one vote, and the candidates with the most votes are elected to the board.

Question 13

Why is capital budgeting important?

Answer 13

Capital budgeting helps businesses make critical decisions about investments, such as launching new products or entering new markets, which can significantly impact their growth and financial future.

Question 14

What are cash inflows and outflows in a project?

Answer 14

Cash inflows are positive amounts representing revenue from a project, while cash outflows are negative amounts representing the costs incurred to start the project.

Question 15

What is the payback period?

Answer 15

The payback period measures how long it takes to recover the initial investment from the project’s cash inflows. Accept the project if the payback period is less than a preset limit.

Question 16

What are the advantages of the payback period method?

Answer 16

It’s easy to understand, adjusts for uncertainty in later cash flows, and is biased towards liquidity, which is advantageous for small businesses.

Question 17

What are the disadvantages of the payback period method?

Answer 17

It ignores the time value of money, requires an arbitrary cutoff point, and ignores cash flows beyond the cutoff, making it biased against long-term projects

Question 18

What is the discounted payback period?

Answer 18

The discounted payback period accounts for the time value of money by calculating the present value of future cash flows. The project is accepted if it pays back within a specified time

Question 19

What are the advantages of the discounted payback method?

Answer 19

It includes the time value of money, is easy to understand, and doesn’t accept negative NPV investments. It’s also biased towards liquidity, useful for small businesses.

Question 20

What are the disadvantages of the discounted payback method?

Answer 20

It may reject positive NPV investments, requires an arbitrary cutoff point, and ignores cash flows beyond the cutoff, similar to the payback method.

Question 21

What is Net Present Value (NPV)?

Answer 21

NPV is the difference between the market value of a project and its cost. It shows how much value the project will add to the company. A positive NPV means the project will increase shareholder wealth

Question 22

What is the NPV decision rule?

Answer 22

Accept a project if the NPV is positive. A positive NPV means the project will increase the value of the firm

Question 23

What is Internal Rate of Return (IRR)?

Answer 23

IRR is the rate at which the NPV of a project equals zero. If the IRR is higher than the required return, the project should be accepted.

Question 24

What is the IRR decision rule?

Answer 24

Accept the project if the IRR is greater than the required return

Question 25

What are the advantages of IRR?

Answer 25

IRR is intuitive and easy to communicate, especially for non-financial audiences. It also provides a simple method for assessing the profitability of a project.

Question 26

When might there be conflicts between NPV and IRR?

Answer 26

Conflicts can arise in cases of non-conventional cash flows, mutually exclusive projects, or when the timing and size of cash flows differ significantly.

Question 27

What is a non-conventional cash flow?

Answer 27

Non-conventional cash flows occur when cash flows change sign more than once, making IRR difficult to calculate and sometimes resulting in multiple IRRs.

Question 28

What is the NPV profile?

Answer 28

The NPV profile plots the NPV of a project against various discount rates, helping to visualize the project’s sensitivity to changes in the required return.

Question 29

What are mutually exclusive projects?

Answer 29

Mutually exclusive projects are those where selecting one project means rejecting the other. The decision is based on choosing the project with the higher NPV or IRR.

Question 30

What should you do when NPV and IRR provide conflicting decisions?

Answer 30

Always use NPV as the decision rule, especially when there are non-conventional cash flows or mutually exclusive projects, as NPV directly measures value added to the firm

Question 31

What does the crossover point in mutually exclusive projects mean?

Answer 31

The crossover point is the discount rate at which the NPVs of two mutually exclusive projects are equal. It’s crucial for determining which project to choose based on varying rates.

Question 32

How does IRR relate to non-conventional cash flows in decision-making?

Answer 32

When cash flows change signs more than once, there may be multiple IRRs. In such cases, it’s important to look at the NPV profile to make the right decision.