Chapter 7 Flashcards
what does the discount rate reflect?
annual return we could earn over that time period
what is an effective annual rate for interest rates mean?
indicates the actual amount of interest that will be earned at the end of one year
what is an annual percentage rate?
indicates the amount of simple interest earned in one year, or amount of interest earned without the effect of compounding
can you use the APR as a discount rate?
no
why cant you use the APR as a discount rate?
APR does not reflect the true amount you will earn over one year
what is continuous compounding?
when we compound interest every instant
what are amortizing loans?
each money you pay interest on the loan plus some part of the loan balance
what is the term structure of interest?
relationship between investment term or horizon and interest rates
when we plot the term structure of interest on a graph we get?
yield curve
what is the fed funds rate?
rate at which banks can borrow cash reserves on an overnight basis
what does the APR display?
does not include the effect of compounding and understates the amount of interest that will be received if interest compounds more than once a year
to compute the actual amount of interest earned in one year, what do we convert?
APR to EAR, which includes the effect of compounding and provides a measure of the amount of interest that will actually be earned over a year
what are amortizing loans?
each months payment includes the interest that accrues that month along with some part of the loan balance
what is an amortization table?
displays the reduction in interest payments and principal over time
what do nominal interest rates display in relation to loans and interest?
indicate actual rate at which interest will accrue
what does the real interest rate display with relation to purchasing power?
rate of growth of purchasing power that would result at investing at a nominal rate
what is the credit spread?
difference between the interest rate on a loan and the treasury rate
what is the cost of capital?
discount rate to evaluate cash flows; also called opportunity cost
what is the cost of capital?
best available expected return offered din the market on investments with comparable risk and terms to cash flow being discounted
what is the difference between an EAR and APR Quote?
AP is rate that interest earns in one year before effects of compounding. EAR is rate that the amount of interest actual earns with compounding. APR is not as accurate as EAR
Why can’t the APR be used as a discount rate?
APR does not reflect the true amount you will earn one year, so t cant be use
how can you compute the outstanding balance on a loan?
constructing amortization table or by finding PV of remaining payments
hat is an amortizing loan?
loan in which each month you pay interest on the loan plus part of the loan principal, or amount borrowed. each payment s the same, and loan is fully repaid with final payment. loan balance declines over time, interest portion of payment declines over time while principal payment portion increases
how do investors expectations of future short term interest rates affect the shape of the current yield curve?
tends to vary with investors expectations of future economic growth and interest rates. tends to be inverted prior to recessions and to be steep coming out of a recession
How do you compare alternative investments against each-other?
compute the free cash flow associated with each alternative and then choose whichever ha the highest NPV
what complications can arise when estimating projects free cash flow?
non-cash charges, alternative depreciation methods, liquidation or continuation values, and tax loss carry forwards
non cash items that appear as part of incremental earnings should or should not be included in projects FCF?
not included
what should be included in projects FCF?
only actual cash revenues or expenses
is it in the firms best interest to use the most or least accelerated method of depreciation that’s allowable for tax purposes?
most accelerated method; because depreciation contributes positively to firms cash flow from tax shield
if we use most accelerated method of depreciation with FCF, what does this do?
accelerate tax savings and increase PV.
how does MACRS work?
most accelerate deprecation method allowed by IRS. categorize assets according to recovery period and then table assigns fraction of the purchase price that the firm can recover each year
when an asset is liquidated, how is it taxed?
any gain on sale is taxed. difference between sale price and book value. book value is assets original cost less amount t has already been depreciated for tax purposes.
do you adjust the projects FCF to account for after tax cash flow that results from an asset sale?
yes: after tax cash flow from asset sale = sale price - (txrate x gain on sale)
what is the terminal o continuation value of a project?
indefinite time horizon: market value of free cash flow from the project at all future dates. you add this to your shorter term calculation
what are tax loss carry-backs?
from last two years to offset taxable income in current year
what are tax loss carry-forwards?
use losses in current year to reduce taxable income for up to 20 years in the future
what is sensitivity analysis?
shows how NPV caries when changing one variable
what is scenario analysis?
considers effect on NPV of changing multiple project variables together
What is break even analysis?
studying how far a variable can be changed until projects NPV is 0
how do we forecast unlevered net income?
interest and other financing related expenses are excluded from the forecasted income statements to determine a projects unlevered net income
should we include sunk costs in the cash flows of a project? why or why not?
we should not include sun costs because they must be paid regardless of whether or not the firm decides to proceed with project. sunk costs are not incremental with respect to current decision
explain why you must include the opportunity cost of using a resource as an incremental cost of a project:
because that resource can be used in the next best alternative way. mistake to assume that the resource is free
what adjustments must you make to a projects unlevered net income to determine its free cash flows?
must add depreciation back (because non cash expense) and subtract capital spending and change in working capital
what is depreciation tax shield?
reduction in tax expense from ability to deduct deprecation expense before determining taxable income
how do you choose between mutually exclusive capital budgeting decisions?
make best decision by first computing free cash flows and NPV of each alternative then choosing alternative with highest NPV
when choosing between alternatives, what cash flows can be ignored?
components of free cash flow that are the same in each alternative can be ignored
explain when it is advantageous for a firm to use the most accelerated depreciation schedule possible for tax purposes?
because depreciation contributes positively to firms cash flow through tax shield. if company uses most accelerated method, they accelerate their tax savings and increase PV
what is continuation or terminal value of project?
estimated value of remaining CF beyond forecast horizon of project Amount represents market value (as of last forecast period) of FCF from project at all future dates
what is sensitivity analysis?
breaks NPV into component assumptions and shows how NPV varies as underlying assumptions change. allows us to explore impact errors in NPV estimates of project
how does scenario analysis differ from sensitivity analysis?
sensitivity changes one parameter at a time. scenario analysis changes multiple parameters at a time
