Fin Test 3: Non Quan

Question 1

Relationship between interest rates and bonds

Answer 1

When interest rates rise, prices of existing bonds tend to fall

-inverse relationship (one goes up, while other goes down)

Question 2

Bonds selling at par, premium, or discount

Answer 2

-Par Bond: currently trades at its face value
-Premium Bond: trading above it face value or costs more than the face amount on the bond

-Discount Bond: a bond that is issued for less than its par- or face- value

Question 3

Value

Answer 3

-equals to present value of future CFs

Question 4

Weight component costs of capital (WACC) according to optimal capital structure

Answer 4

carrying effects on the market capitalization rates for debt and equity allow the firm to lowers its cost of capital by the use of leverage (debt)

Question 5

Why can’t debt financing be used to provide all the capital of the firm?

Answer 5

Equity Increases

Question 6

Relationship between use of debt and type of industry

Answer 6

D/E ratios vary across industries because some industries are more capital intensive than others.

Question 7

Why is firm’s cost of debt lower than the yield on its bonds?

Answer 7

in bankruptcy, bondholders are paid before shareholders as the firm’s assets are liquidated.

Question 8

What does a firm’s Beta in CAPM measure?

Answer 8

systematic risk and expected ROA

Question 9

Yield-to-maturity on bonds

Answer 9

-equals to firm’s pre-tax cost of debt

Question 10

Why is cost of new common stock higher than the cost of retained earnings?

Answer 10

floation costs and common stock is risker

Question 11

What are capital budgeting decision rules for IRR and NPV?

Answer 11

project should be pursued if IRR is greater than the min required rate of return

Question 12

What relationship does the Security Market Line in CAPM show?

Answer 12

the different levels of risk and marketable securities

Question 13

What is relationship between bond price and yield-to-maturity?

Answer 13

-inverse

-bond price ^ yield -^

Question 14

Define the CAPM model

Answer 14

describes the relationship between systematic risk and expected return on assets

Question 15

What does a Beta of less than, equal to, or greater than 1 mean?

Answer 15

= 1, means security price tends to move with the market
> means security price tends to be more volatile
< means security price tends to be less volatile

Question 16

What are the IRR and NPV reinvestment rate assumptions?

Answer 16

IRR has no reinvestment rate assumptions; meaning the reinvestment rate will not change the outcome of the project
NPV- the company will reinvest cash inflows at the IRRs rate of return for the lifetime of the project

Question 17

If an investment has a positive, 0, or negative NPV, for each case relate IRR to the cost
of capital.

Answer 17

0= IRR= Discount rate
NPV (-) IRR is below discount rate
NPV(+) IRR above discount rate

Question 18

What are the weaknesses and strengths of the Payback method?

Answer 18

weakness- ignores TVM, and cash flows after the payback period
strengths- easy to do and compare to other projects gives cash payback period as well

Question 19

What doe and NPV profile show?

Answer 19

graph that shows the discount rate and the npv of the investment

Question 20

Why is NPV more conservative than the IRR in selecting investment projects?

Answer 20

assumes that cash flows are reinvested at the firms weighted avg. cost of capital

Question 21

What does “risk averse” mean?

Answer 21

when an investor chooses the preservation of capital over the potential for a higher than average return

Question 22

As cost of capital increases or decreases, how is project acceptance affected?

Answer 22

capital increases- more likely to accept project because of higher NPV
Capital decreases- less likely to accept project, lower NPV

Question 23

When projects are mutually exclusive, what does this mean?

Answer 23

when you have to pick only one project

Question 24

Explain what “correlation” means

Answer 24

measures the degree to which two securities mover in relation to one another

Question 25

How do you calculate the weighted average cost of capital?

Answer 25

need to compute the cost of debt, preferred stock, and common equity

Question 26

With respect to a stock’s beta, what are ”aggressive” and “defensive” stocks?

Answer 26

aggressive- high beta values
defensive- low beta values

Question 27

What are book value and market value weights in calculating WACC? Which is better?

Answer 27

derived from the stated values of individual components of the capital structure is stable over time, because book value weights don’t depend on market prices; easy to determine because values are already given on balance sheet
Market weight values are superior to book values they are reflection of the effect of current decisions on the firms future book values-past decisions

Question 28

What is Optimal Capital Structure?

Answer 28

the best mix of debt and equity financing that maximizes a company’s market value while minimizing its cost of capital.

Question 29

What is the coefficient of variation?

Answer 29

the mix of debt preferred stock and common equity that minimizes the weighted cost of the firms employed capital

Question 30

What are IRR and NPV decision rules?

Answer 30

IRR and NPV have two different uses within capital budgeting. IRR is useful when comparing multiple projects against each other or in situations where it is difficult to determine a discount rate. NPV is better in situations where there are varying directions of cash flow over time or multiple discount rates.

Question 31

What is Cash Flow for an investment project equal to?

Answer 31

IRR- project should be accepted if, IRR is greater than the min. Required rate of return\ discount rate
NPV- Project should be accepted if NPV is positive; reject if negative

Question 32

How does diversification affect unsystematic or diversifiable risk?

Answer 32

it reduces risk, almost non-existent when capital markets are efficient and investors are well diversified.

Question 33

Define NPV

Answer 33

Net Present Value

Question 34

What is the Profitability Index (PI)?

Answer 34

a measure of a project’s or investment’s attractiveness.

Question 35

Define the IRR?

Answer 35

present value of future cash inflows, mirrors the present value of all cash outflows

Question 36

Which capital budgeting techniques consider the time value of money and which do not?

Answer 36

-payback period doesn’t

-NPV does

Question 37

Which capital budgeting techniques consider the time value of money and which do not?

Answer 37

Considered- NPV, profitability index, IRR
not- payback and average accounting rate of return