Brainscape's Knowledge GenomeTM


Top Flashcards (Certified)
All Flashcards

EC333 FINANCE > LECTURE 3 > Flashcards

LECTURE 3 Flashcards

(48 cards)

Start Studying
1
Q

3 limitations to NPV

A
  1. Sensitive to choice of ROR
  2. Cash flows predicted
  3. Unstable environments decrease power of rule
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
2
Q

If ROR is wrongly estimated, how does this affect NPV rule?

A 
Overestimated = reject good projects
Underestimated = accept bad projects
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
3
Q

3 benefits of NPV

A
  1. Uses cash flows, not earnings
  2. Uses ALL cash flows
  3. Discount cash flows = incorporates time value of money
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
4
Q

Difference between cash flows and accounting flow/earnings

A

cash flows = considers money when it actually comes into your account
Accounting flow = also considers sales made even if the money hasn’t been received yet.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
5
Q

How to calculate internal rate of return

A

IRR = the discount rate that makes NPV=0

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
6
Q

IRR rule

A

Accept if IRR > r which is the opportunity cost of capital

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
7
Q

How do YTM and IRR relate?

A

They’re mathematically equivalent

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
8
Q

4 limitations of IRR

A
  1. Doesn’t differentiate between borrowing & lending to finance a project
  2. Some projects have -VE cash flows at end = double IRR
  3. Misleading if mutually exclusive projects with different cash flow & initial investment
  4. If > 1 opp cost in different years - which to use?
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
9
Q

What kind of relationship between IRR and NPV is not acceptable?

A

A +VE one - they should be inversely related.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
10
Q

Payback period =

A

the number of years required to compensate the initial cost of the investment by accumulating cash inflow of the project or savings.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
11
Q

Payback rule

A

Accept project is payback period <= cutoff period (time limit for reimbursement).

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
12
Q

Payback rule in formulas

A

Sum Ci >= I0 after t years (cut-off) = accept

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
13
Q

5 limitations of payback rule

A
  1. Does not use all cash flows
  2. Doesn’t consider time value of money
  3. Doesn’t consider project’s life
  4. Cannot use if multi period investments
  5. Doesn’t account for shareholders’ expected ROR
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
14
Q

4 steps to book ROR/average account return rule

A
  1. Average net income - sum over project’s life divided by number of years.
  2. Average investment - initial investment + account for depreciation
  3. AAR = average net income / average investment
  4. AAR >= target return = accept
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
15
Q

1 benefit of AAR

A

simple return based measure that accounts for expected ROR of shareholders.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
16
Q

3 limitations to AAR

A
  1. Does not use cash flows
  2. Does not discount - no time value of money
  3. Arbitrary target ROR
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
17
Q

Profitability index

A

reformatted version of NPV

NPV/cost = PV/cost > 1

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
18
Q

Net cash flow =

A

Cash flow from capital investment and disposal
+ operating cash flow
+ cash flow from changes in working capitals

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
19
Q

how do we calculate operating cash flow?

A

Revenue - expenses - taxes

or after-tax profit + depreciation

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
20
Q

Working capital ratio =

Study These Flashcards
A

current assets / current liabilities

21
Q

Working capital measures…

Study These Flashcards
A

the SR liquid assets a firm has to pay for unexpected expenses or even planned SR obligations.

22
Q

Problem if working capital ratio < 1

Study These Flashcards
A

Current assets < Current liabilities - may run into trouble

23
Q

Why is a persistently high working capital ratio also bad?

Study These Flashcards
A

Suggests CFO doesn’t know how to use assets to create more value for shareholders

24
Q

NPV must estimate cash flow on an…basis

What does this mean?

Study These Flashcards
A

INCREMENTAL basis - consider additional cash flows after project accepted and anything that impacts cash flow.

25
Does NPV need to consider sunk costs?
NO - already happen in the past and cannot be changed by accepting or rejecting a project.
26
Should NPV calculations consider inflation? How do we do this?
YES Either: discount nominal cash flows by nominal rate OR: discount real cash flows by real rate Should give the same value.
27
Do financing decisions need to be considered by NPV?
NO - project's cash flow doesn't depend on how it's financed. Do NOT consider borrowings as a cash outflow from each year - treat as if fully equity financed.
28
When CAN we measure risk?
When the total number of outcomes (sample space) is known we can calculate probability distribution.
29
2 ways to calculate risk using probability
1. Use historical data | 2. Use a theoretical model which assigns the same probability to equally likely events
30
Fundamental uncertainty when...
We do NOT know the sample space | No historical data or any scientific ground to use probability theory.
31
Law of large numbers
Estimates of population parameters using a sample tend towards true population values as n-->infinity.
32
How do we measure risk?
Calculate variance/SD of returns
33
ASSUMPTION WHEN CALCULATING RISK
RETUNS = NORMALLY DISTRIBUTED
34
Even if returns are not normally distributed, when can still use the mean-variance framework as long as...
The 2 projects comparing have the same distribution of returns.
35
2 types of risk
1. Diversifiable/unsystematic | 2. Market/systematic/non-diversifiable
36
How does diversification affect risk?
Leads to reduced risk associated with any specific asst. Moves risk of unique asset towards market risk.
37
Minimum risk =
market risk - affected by state of whole economy
38
How do the variance of an individual asset and portfolio compare?
variance individual asset > variance portfolio if -1 <= p < 1 Variances are EQUAL if p=1 - perfect +VE linear association
39
As the number of assets increases, what does the variance of the portfolio depend on?
N increases = portfolio variance increasingly dependent on covariance and less dependent on individual variances
40
The risk of a well-diversified portfolio depends on...
The overall market risk of securities included in the portfolio
41
Beta measures...
market risk of a security - sensitivity to market movements
42
beta > 1 means
Security amplifies market movements.
43
beta < 1 means
security's return move in same direction as market bu slower
44
beta = 1
represents market portfolio
45
Weights in a portfolio for long and short positions
Long position: w > 0 - can be > 1 if other asset < 1 Short position: w < 0 ws must always sum to 1.
46
Long position means...
Buy a stock and sell it in the future - hope to benefit from price rise.
47
Short position means...
Sell a stock you do not own then buy it back in the future - hope to benefit from price fall.
48
What may short selling mean for comparison of individuals and portfolio volatility?
Portfolio volatility > individual

EC333 FINANCE (9 decks)

Brainscape helps you reach your goals faster, through stronger study habits.
© 2025 Bold Learning Solutions. Terms and Conditions