Ch. 6-7: Making Investment Decisions w. the NPV-Rule & Risk/Return

Question 1

Separate investment and financing decisions: investment projects are assumed to be all equity-financed: i.e., we do not take interest expenses and repayment of principal into account. The financing part is incorporated into the cost of capital rather than FCF

True/ False

Answer 1

True

Question 2

If investment choices impact future opportunities, choosing between competing projects with the NPV rule becomes more difficult. Which of the following is/are not main problem(s)?
A) The investment timing problem
B) the choice between long- and short-lived equipment
C) The replacement problem
D) The cost of excess capacity
E) The cost of capital problem

Answer 2

False: E) The cost of capital problem

Question 3

What is the equivalent annual cost?
Explain/define

Answer 3

The equivalent annual cost is the annual cash flow sufficient to recover a capital investment (incl. the cost of capital for that investment) over the economic life of the investment.

Question 4

Choosing between long- and short-lived equipment: select the asset with the lowest equivalent annual cost (fair rental charge).

True/ False

Answer 4

True:

Calculating the equivalent annual cost allows for better comparability between machines with different life-spans. The decision rule is to choose the asset with the lowest equivalent annual cost

Question 5

Geometric average return (GAR) is defined as:
A) the simple average of periodic returns
B) compounded return with annual rate

Answer 5

B) compounded return with annual rate

Question 6

Arithmetic average return (GAR) is defined as:
A) the simple average of periodic returns
B) compounded return with annual rate

Answer 6

A) the simple average of periodic returns

Question 7

What is the equity risk premium?

Answer 7

The equity risk premium measures the excess return from investing in equities rather than risk-free asset

Question 8

The annualized rate of return is when the annual returns takes into account compounding. This is also the:

Arithmetic mean/ geometric mean

Answer 8

Geometric mean

The arithmetic mean return is the average annual, which is not annualized

Question 9

An individual stock is exposed to two kinds of risks - which?

Answer 9

1) Idiosyncratic (unsystematic risk)/ specific/diversifiable risk

2) Market risk (systematic)/ undiversifiable risk

Question 10

Market risk (systematic risk), affect stocks individually and can be eliminated by holding a well-diversified portfolio

True/ False

Answer 10

False:

Market risk: affects all stocks and cannot be eliminated by diversification

It is undiversifiable

Question 11

Specific risk/ unsystematic risk/ idiosyncratic risk affects individual stocks or small groups of stocks, and can be eliminated by holding a well-diversified portfolio

True/ False

Answer 11

True

Question 12

Market risk is measured by:

Answer 12

Beta

Question 13

How is the beta of a portfolio calculated?

Answer 13

Weighted average of betas of the stocks in the portfolio

Question 14

β>1: the security is more/less volatile than the broader market

β<1: the security is more/less volatile than the broader market

Answer 14

β>1: the security is more volatile than the broader market
β<1: the security is less volatile than the broader market

Question 15

When investors have access to well-functioning capital markets, there are large benefits from firm diversification

True/ False

Answer 15

False:

When investors have access to well-functioning capital markets, there are no benefits to firms from diversification.
Essentially, it is the belief that it is cheaper for investors to diversify themselves than it is for firms to diversify through its operations.

Question 16

When using the NPV rule to choose among projects, how should the choice be made if the investments will not affect future opportunities? (Simple case)

Answer 16

Choosing between mutually exclusive projects that DO NOT AFFECT FUTURE OPPORTUNITIES

Calculate the NPV of each project, and choose the highest NPV project

Question 17

Using the NPV rule, when projects are mutually exclusive AND any investment will affect future opportunities, choosing between competing project is is more/less difficult

Answer 17

More difficult

Question 18

Four main challenges exist for choosing among projects that affect future opportunities. Which of the following is NOT one?
A) The investment timing problem
B) The choice between long-and short-lived equipment
C) The cost of excess capacity
D) The wait and see problem
E) The replacement problem

Answer 18

D) The wait and see problem

Question 19

The challenge of deciding whether to invest in an asset now or wait since today’s investment is competing with possible future investments - this problem is referred to as?

Answer 19

The investment timing problem

Question 20

The challenge of whether the firm should save money today by installing cheaper
machinery that will not last as long or to choose the longer-lasting more expensive machine is referred to as which problem?

Answer 20

The choice between long-and short-lived equipment

Question 21

The challenge of whether the firm should replace existing machinery now or wait and use the machine to delay investment in more modern equipment - this problem is referred to as?

Answer 21

The replacement problem

Question 22

The challenge of deciding the cost of using equipment that is temporarily not
needed - this problem is referred to as:
A) The replacement problem
B) The choice between long-and short-lived equipment
C) excess capacity problem
D) investment timing problem

Answer 22

C) excess capacity problem