BEC Deck 4-Financial Management

Question 1

Sunk Costs:

Answer 1

The costs of resources incurred in the past; they cannot be changed by current or future decisions. Therefore, sunk costs are irrelevant to current & future decision making.

Question 2

Opportunity Costs:

Answer 2

The discounted dollar value of benefits lost from an opportunity as a result of choosing another opportunity.

Question 3

Differential (or Incremental) Costs:

Answer 3

Are those costs that are different between two or more alternatives.

Question 4

Weighted Average Cost of Capital is calculated as:

Answer 4

The required rate of return on each source of capital weighted by the proportion of total capital provided by each source, and the resulting weighted costs summed to get the total weighted average.

Question 5

Present Value of a Single Amount: Present Value now of an amount to be received (or paid) at some single future date-

Answer 5

This calculation determines the value now (at the present) of a single amount to be received at some single future date.

Question 6

Future Value of a Single Amount-Future value at some future date of a single amount invested now-

Answer 6

This calculation determines the value at some future date of a single amount invested now.

Question 7

Present Value of an Ordinary Annuity (Annuity in Arrears)-Present value now of an ordinary annuity to be received over some future time period-

Answer 7

This calculation determines the value now (at the present) of a series of equal amounts to be received (or paid) at equal intervals over some future period of time.

Question 8

Future Value of an Ordinary Annuity-Future value at some future time of an ordinary annuity invested over some future time period-

Answer 8

This calculation determines the value at some future date of a series of equal amounts to be paid (or received) at equal intervals over some future period.

Question 9

Present value of an Annuity Due (Annuity in Advance)-Present value now of an annuity due to be received over some future time period-

Answer 9

In an annuity due, the series of equal amounts is received (or paid) at the beginning of each period, whereas in an ordinary annuity the series of equal amounts is received (or paid) at the end of each period.

Question 10

Future Value of an Annuity Due-Future value at some future time of an annuity due invested over some future time period-

Answer 10

The calculation of the future value of an annuity due determines the value at some future date of a series of equal amounts to be paid (or received) at equal intervals over some future period of time with the amounts paid (or received) at the beginning of each period.

Question 11

Market Interest Rate:

Answer 11

The market rate of interest is the prevailing rate of interest paid on interest-bearing investments or charged on interest-bearing borrowings as determined by the supply & demand for funds in the market.

Question 12

Nominal (quoted) rate=

Answer 12

real risk-free (inflation-free) rate of interest + inflation premium + default risk premium + maturity premium + liquidity premium {+/- special premiums/discounts, if any}.

Question 13

Real Risk-Free Rate=

Answer 13

Constitutes the interest rate that would occur if there are no risks associated with the instrument & inflation is expected to be zero.

Question 14

Inflation risk premium-

Answer 14

Compensates for the adverse effects of expected inflation on the security. This premium is based on the average expected inflation rate over the life of the security.

Question 15

Default Risk Premium-

Answer 15

Compensates for the possibility that the issuer of debt will not pay interest and/or principal at the contracted time and/or in the contracted amount.

Question 16

Maturity Premium-

Answer 16

Compensates for the risk that the longer-term fixed-rate instruments will decline in value as a result of an increase in the market rate of interest.

Question 17

Liquidity premium (marketability premium)-

Answer 17

Compensates for the fact that some securities cannot be converted to cash on short notice at approximate fair market value.

Question 18

Stated Interest Rate (also called the nominal or quoted interest rate)-

Answer 18

Is the annual rate specified in the loan agreement or comparable contract; it does not take into account the compounding effects of frequency of payments or the effects of inflation.

Question 19

Nominal Interest Rate-

Answer 19

As contrasted with real interest rate, also refers to the rate of interest before taking into account the effects of inflation.

Question 20

Real Interest Rate-

Answer 20

As contrasted with nominal interest rate, refers to the rate of interest after taking into account the effects of inflation on the value of funds. The calculation of the real interest rate (RIR) is: RIR=Nominal Interest Rate-Inflation Rate

Question 21

Valuation Techniques hierarchy of inputs-

Answer 21

Level 1-Quoted market prices in active markets for identical assets or liabilities.
Level 2-Inputs other than those in Level 1 that are either directly or indirectly observable are used for valuing an item. Quoted prices for similar assets or liabilities of active markets.
Level 3-Inputs are unobservable and based on an entity’s assumptions. Estimates are used for valuing an item.

Question 22

Capital Asset Pricing Model (CAPM)-

Answer 22

An economic model that determines the relationship between risk & expected return & uses that measure in valuing securities, portfolios, capital projects, & other assets.

Question 23

Basic CAPM formula is-

RR=RFR + B(ERR-RFR)

Answer 23

RR=Required Rate of Return
RFR=Risk free rate of return; in the US generally measured by the rate (yield) of US Govt Bonds
B=Beta of the investment, a measure of volatility
ERR=Expected rate of return for a benchmark for the asset class (type of asset) being valued

Question 24

Beta is a measure of the systematic risk as reflected by the volatility of an investment. It is computed as-

Answer 24

Beta(B)=(Standard deviation of an asset{a}/Standard deviation of asset class benchmark{b})x Coefficient of correlation of a and b.

Question 25

Option Pricing-

Answer 25

A contract that entitles the owner (holder) to buy (call option) or sell (put option) an asset at a stated price within a specified period.

Question 26

Business Valuation-

Answer 26

The estimation of the economic value of a business entity or portion thereof.

Question 27

Business Forecasting can be divided into 2 major types based on the kinds of methods used:

Answer 27

1) Qualitative Methods

2) Quantitative Methods

Question 28

Qualitative Methods-

Answer 28

1) Are based on judgement or opinion
2) Are subjective in nature (do not use mathematical analysis)
3) Often involve development of consensus
4) Are appropriate when there is absence of relevant historical data to use for quantitative analysis
5) Are especially useful in making long term forecasts

Question 29

Quantitative Methods-

Answer 29

1) Are based on quantitative models
2) Are objective in nature
3) Rely on mathematical determinations or calculations