Exam 4 (Chapters 8 and 10) Flashcards
the process of planning and managing firms long term financial investments
Capital Budgeting
What are the 4 different types of Projects?
- Expansion
- Improvements of efficiency
- Recalls or Replacements
- Government Mandated
What are the 3 Capital Budgeting Methods?
Payback, NPV, and IRR
Time required for an investment to generate cash flows, to recover initial costs
Payback
what is another terms for Payback?
“Get your bait back” method
What are the advantages of payback?
Easiest
Adjust cash flows
Biased towards liquidity
What are the disadvantages of payback?
Ignores TVM
Requires an arbitrary cutoff point
Ignores cash flows beyond cutoff date
Biased against long term projects
what is the rule regarding payback?
accept on the project if the payback is less than the project cutoff
the difference between a projects market value and its cost
NPV
What is the rule of NPV?
accept projects with a positive NPV
reject projects with a negative NPV
what are the advantages of NPV?
Most reliable capital budgeting method
Provides a direct measure of investor contributions
DOES consider TVM
What are the disadvantages of NPV?
the growth rate is arbitrary
the discount rate (interest rate) that makes NPV of an investment zero
Internal Rate of Return (IRR)
the point at which you make nothing
Break even point
What is the rule of IRR?
accept project if the IRR that we calculate is the same or greater than the return investors require
What are the advantages of IRR?
investors prefer to speak %
what are the disadvantages of IRR?
often lead to inaccurate investment decisions
if you take on one investment, you cannot take on any other
mutually exclusive projects
as the level of risk increases, so does the potential for higher returns and greater losses. invested money renders higher profits only if subject to the possibility of being lost
Risk and Return
an investor’s preference toward risk
risk tolerance
what happened in 2008 for the stock market?
record lows since the great depression
who were the biggest winners during the Great Recession
Emergent Bio Solutions, and Mexico Energy
who were the biggest losers during the Great Recession?
AIG and Fannie Mae/Freddie Mac
Who were the biggest winners in 2014?
RadNet and Achillon Pharmaceutical
Who were the biggest losers of 2014?
TransOcean and Avon Products
the smallest 20% of companies listed on the NYSE, also measured by total market value of outstanding stock
Small-company stocks
standard & poors 500 index, composed of the 500 largest companies, in terms of total market value of outstanding stock
Large-company stock
high-quality corporate bonds with 20 year to maturity
Long-term Corporate Bonds
US government bonds with 20 years to maturity
Long-term US Government Bonds
one month maturity
US Treasury Bills
sum of actual returns divided by number of terms
Average Returns
the average squared difference between the actual return and the average return
Variance
the positive square root of the variance
standard deviation
a symmetric, bell-shaped frequency curve that is completely defined by its average and standard deviations (most commonly 2 positive and 3 negative deviations)
Normal Distribution
history suggests that the market value of securities fluctuations widely from year to year due to info available to investors
Capital market efficiency
what is the percent chance of stock falling within 1 deviation?
68%
what is the percent chance of stock falling within 2 deviation?
95%
what is the percent chance of stock falling within 3 deviation?
99%
the hypothesis that well-organised markets, such as New York Stock Exchange are efficient
Efficient Market Hypothesis (EMH)
the price of stock instantaneously adjusts to reflect new info
efficient market reaction
the price partially adjusts to the new information slowly, usually over a period of 8 days
delayed reation
the price over-adjusts and subsequently corrects itself
Over-reaction and correction
all info of every kind is reflected in stock prices
strong form efficient
all public info is reflected in stock prices
semi-strong form efficient
stock prices reflect a company’s own past prices
weak form efficient
what does history tell us about the stock market?
prices generally do respond very well to new info
future prices are difficult to predict based on publicly available info
if mis-priced stocks do exist, there is not an obvious way to identify them in advance
