Unit 6 Decision Making

Question 1

Capital Budgeting Criteria

Answer 1

used to evaluate investments
NPV - net present value
IRR - Internal Rate of Return
PI - Profitability Index

Question 2

NPV

Answer 2

difference between a projects present value of cash inflows and outflows
Indicates potential profit in today’s $ of a planned investment

Question 3

Advantages of NPV

Answer 3

Accounts for time value of money
Determines value added to firm
Considers risk and required return

Question 4

Disadvantages of NPV

Answer 4

Difficult to know appropriate cost of capital

Cannot be use to compare projects of different size

Question 5

IRR

Answer 5

percentage return on an investment

The rate that would make NPV equal to 0.

Question 6

Decision rule for IRR

Answer 6

If IRR > cost of capital, accept project

cost of capital = hurdle rate

Question 7

Advantages to IRR

Answer 7

Easy to interpret
Considers Time Value of Money
Doesn’t need Rate of Return

Question 8

Disadvantages of IRR

Answer 8

• Not a good indicator of value created
• Ignores mutually exclusive projects - can’t be used on its own to choose between one project or another
• Assumes Reinvestment at IRR
• Cannot Compare Projects with Different Durations
• Requires Conventional Cash Flows

Question 9

NPV decision rule

Answer 9

If NPV is positive = accept

If NPV is negative = reject

Question 10

PI

Answer 10

ratio of payoff to the investment amount

Question 11

PI decision rule

Answer 11

Accept if PI > 1

Reject if PI < 1

Question 12

Advantages of PI

Answer 12

same advantages of NPV

+ Can be used to choose between projects

Question 13

Disadvantages to PI

Answer 13

Need cost of capital

not useful for mutually exclusive projects

Question 14

Par Value

Answer 14

initial value of bond
value paid out at maturity
corporate US bonds usually $1000

Question 15

Coupon Rate

Answer 15

aka coupon yield

interest rate on the bond

Question 16

coupon

Answer 16

interest payment amount

Question 17

YTM

Answer 17

yield to maturity

actual return on a bond when bought on the marketplace

Question 18

covenants

Answer 18

affirmative - things bond issuer pledges to do to protect bondholders
Negative - things bond issues pledges not to do to protect bondholders

Question 19

Premium

Answer 19

bond selling above face value

YTM is lower than coupon rate

Question 20

Discount

Answer 20

bond selling below face value

YTM is higher than coupon rate

Question 21

Common stock

Answer 21

equity/ownership in a firm
confers voting rights
lowest claim
no maturity

Question 22

corporate governance

Answer 22

control issues involved in running a company (management tasks)

Question 23

upside potential

Answer 23

unlimited potential earnings on common stock

Question 24

preferred stock

Answer 24

aka hybrid security
some elements of equity and debt
no fixed maturity (like equity/common stock)
no voting rights
fixed payments
company may skip payments
payments must be paid before common stock dividends are paid out (cumulative)

Question 25

capital investment

Answer 25

money use used to buy long term assets loans, stocks, bonds may affect short term earnings and growth

Question 26

Intrinsic value

Answer 26

asset value determined through analysis without looking at market value add discounted future cash flows of an asset (present value of future cash flows) compare to market value to determine value

Question 27

bond valuation

Answer 27

derive YTM from coupon, face value, current value derive current value from coupon, face value, YTM use Present Value to determine value

Question 28

preferred stock valuation

Answer 28

``` perpetuity model Vps = D/kps D is dividend kps is required rate of return compare to current market value to determine if purchase is advisable ```

Question 29

common stock valuation methods

Answer 29

Gordon Growth Model | based on Dividend Discount Model - calculate present value of all future dividend cash flows

Question 30

Assumptions in Gordon Growth Model

Answer 30

Dividends paid each year | Dividends grow at constant rate forever

Question 31

GGM formula

Answer 31

Vcs = D1/(kcs-g) D1 is dividend paid next year kcs is required rate of return g is constant growth rate

Question 32

Capital Asset Pricing Model

Answer 32

Pricing for Capital Assets | linear relationships between risk and return

Question 33

beta

Answer 33

how the price of a security varies with market market has beta of 1 riskless asset has beta of 0 exaggerated reaction to market by a firm is beta > 1 muted reaction to market by a firm is beta < 1

Question 34

aggressive asset vs defensive asset

Answer 34

aggressive - beta > 1 | defensive - beta < 1

Question 35

CAPM formula

Answer 35

``` Ri = Rf + Bi(Rm - Rf) Ri is return on a security Rf is risk free rate Rm is market return Bi is beta ```

Question 36

CAPM decision rule

Answer 36

if CAPM is below expected return, asset is undervalued

Question 37

3 factors for evaluating capital investments

Answer 37

All cash flows through project's life Time value of money - evaluate costs and returns in present dollars Cost of capital (required rate of return) - incorporate risk into required rate of return

Question 38

opportunity cost

Answer 38

future investment opportunity lost due to time scope of current investment

Question 39

tax shield

Answer 39

interest expenses are paid before taxes are calculated | interest expenses reduce taxable income

Question 40

incremental cash flows

Answer 40

cash flows in or out of firm that result from accepting a project

Question 41

non-incremental cash flows

Answer 41

costs a firm would incur regardless of accepting a project

Question 42

2 guidelines when considering cash flows

Answer 42

capital budgeting occurs in CEO office, to judge impact on entire company decide what really are incremental cash flows

Question 43

Incidental cash flows

Answer 43

indirect cash flows that should be included in the project evaluation

Question 44

cannibalization

Answer 44

one product steals sales from another product in the company | may be an incidental cost

Question 45

sunk costs

Answer 45

irretrievable costs ie research development, market analysis | should not affect decisions on the future