chapter 3

Question 1

in order to compare costs and benefits, financial managers must evaluated them in what terms?

Answer 1

in the terms of cash today

Question 2

what is the valuation principle?

Answer 2

the value of an asset to the firm or its investors is determined by its competitive market price, the benefits and costs of a decision should be evaluated using these market prices, when the value of the benefits exceeds the value of the costs the decisions will increase the market value of the firm

Question 3

in finance does it matter when a dollar is received or disbursed?

Answer 3

yes

Question 4

is the statement true “one dollar you receive today is worse one dollar you receive one year from today”?

Answer 4

yes because you can earn interest over the year on the dollar you receive today

Question 5

what isn the time value of money?

Answer 5

the difference in value between money today and money in the future

Question 6

what is discounting?

Answer 6

the act of standardizing (exchanging) future dollars to current dollars

Question 7

what is compounding?

Answer 7

expressing today dollars interns of some future date

Question 8

what is the risk-free interest rate?

Answer 8

the interest rate at which money can be borrowed or lent without risk over that period

Question 9

what is the discount rate?

Answer 9

same as the risk free interest rate

Question 10

what is the interest rate factor?

Answer 10

(1+Rf)

Question 11

what is the net present value (NPV)?

Answer 11

the difference between the present value of the benefits and the present value of the costs of an investment to project

Question 12

what is the net present value (NPV) formula?

Answer 12

NPV= PV (benefits) - PV (costs)

Question 13

what is the NPV decision rule?

Answer 13

when making an investment decision, take the alternative with the highest NPV. choosing this alternative is equivalent to receiving its NPV in cash today

Question 14

how will a positive NPV project impact the value of the firm?

Answer 14

it will increase the value of the firm

Question 15

what is arbitrage?

Answer 15

the practice of buying and selling equivalent goods in different markets to take advantage pf a price difference

Question 16

what is an arbitrage opportunity?

Answer 16

any situation in which it is possible to make a risk-free profit at no cost is known as an arbitrage opportunity

Question 17

how will taking advantage of an arbitrage opportunity impact prices?

Answer 17

eventually it will cause the price to change and it will equal out the 2 markets

Question 18

what does risk free mean?

Answer 18

the outcome of the investment is guaranteed

Question 19

what is assumed about arbitrage opportunities in competitive markets?

Answer 19

they have already been eliminated

Question 20

if markets do not have arbitrage opportunities, then what must be true?

Answer 20

prices for equivalent goods must be the same in all markets

Question 21

what is the law of on price?

Answer 21

if equivalent investment opportunities trade simultaneously in different competitive markets, then they must trade for the same price in both markets

Question 22

what is a financial security?

Answer 22

an investment opportunity that trades in a financial market

Question 23

how can we use the law of one price to value a security?

Answer 23

if we can find an investment whose price is already known we know how to price equivalent investment

Question 24

is this statement true, “if two risk free securities have the same cash flows, then they must trade for the same price”?

Answer 24

yes, otherwise there would be an arbitrage opportunity

Question 25

what is a short sale?

Answer 25

when you borrow a security from someone who owns it and sell it today with the assumption that the price will go down, then you buy it back at a later point to return it back to the original owner

Question 26

what is the formula of the no arbitrage price of a security?

Answer 26

price= PV (of all cash flows paid by the security)

Question 27

if the price of the security is less than the value of the security, what is the arbitrage strategy?

Answer 27

borrow the amount of the value of the security, and buy the security, keep the left over and pay off the bank loan after the security matures

Question 28

if the price of the security is higher than the value of the security, what is the arbitrage strategy?

Answer 28

short sell the security for the current price, take the value amount of the security and invest it at the bank, at maturity buy back the security and get the investment at the bank and keep the left over

Question 29

how can law of on price help price a portfolio of securities?

Answer 29

since the portfolio has the same cashflows as the some of its components, you can find similar investments or portfolios that have the equivalent return

Question 30

what will investors be willing to pay more for?

Answer 30

they will pay more for a certain outcome instead of a risky outcome

Question 31

what does risk averse mean?

Answer 31

an investor prefers to have a safe income rather than a risky one of the same expected amount

Question 32

can we use the risk free interest rate to calculate the present value of a risky cash flow?

Answer 32

no

Question 33

investors must be compensated for taking risk on an investment, what do they demand?

Answer 33

an expected return that is different from that of a risk free investment

Question 34

what is the formula for the expected return of a risky investment?

Answer 34

expected gain at end of year/ initial cost

Question 35

what is the risk premium?

Answer 35

the difference between the expected return on a risky investment and the risk free rate of interest, this represents that additional return that investors expect to earn to compensate them for the securities risk

Question 36

how do you find the risk premium of a risky investment?

Answer 36

expected return - risk-free interest rate