Final

Question 1

Capital Budgeting Decision

Answer 1

what fixed assets should we buy?
capital budgeting=stragetic assest allocation
the most fundamental decison a business can make concerns its product line.
what services will we offer? sell?
what markets to compete in?
new products?
to answer the question, must commit its scarce and valuable capital to certain types of asset

Question 2

Net Present Value (NPV)

Answer 2

The difference between an investments market value and its cost. NPV is a measure of how much value is created or added today by undertaking an investment.

Question 3

Payback Period Rule

Answer 3

The amount of time required for an investment to generate cash flows sufficient enough to recover its initial cost. An investment is acceptable if its calculated payback period is less than some prespecified number of years. Often used by large and sophisticated companies when they are making relatively minor decisions. A “break even” measure.

Question 4

Discounted Payback Period

Answer 4

Length of time until the sum of the discounted cash flows is equal to the initial investment. An investment is acceptable if its discounted payback is less than some prespecified number of years.

Question 5

Average Accounting Return

Answer 5

An investments average net income divided by its average book value. A project is acceptable if its average accounting return exceeds a target average accounting return

Question 6

Internal Rate of Return (discounted cash flow return)

Answer 6

The discount rate that makes the NPV of an investment zero. An investment is acceptable if the IRR exceeds the required return. It should be rejected otherwise.

Question 7

Profitability Index

Answer 7

The present value of an investments future cash flows divided by its initial cost, Also called the benefit-cost ratio. Will be bigger than 1 if NPV is positive, less than 1 is NPV negative.

Question 8

Relevant Cash Flow

Answer 8

A change in the firms overall future cash flow that comes about as a direct consequence of the decision to take that project.

Question 9

Incremental Cash Flow

Answer 9

The difference between a firm’s future cash flows with a project and those without the project. The incremental cash flows for project evaluation consist of any and all changes in the firm’s future cash flows that are a direct consequence of taking the project.

Question 10

Standalone Basis

Answer 10

The assumption that evaluation of a project may be based on the projects incremental cash flows

Question 11

Sunk cost

Answer 11

A cost that has already been incurred and cannot be removed and therefore should not be considered in an investment decision. In another way, a firm will have to pay this cost no matter what.

Question 12

Side Effects

Answer 12

The cash flows of a new project that come at the expense of a firms existing projects.

Question 13

Pro Forma Financial Statements

Answer 13

Financial Statements projecting futures years operations

Question 14

Forecasting Risk

Answer 14

The possibility that errors in projected cash flows will lead to incorrect decisions. Also known as estimation risk.

Question 15

Scenario Analysis

Answer 15

The determination of what happens to NPV estimates when we ask what-if questions

Question 16

Sensitivity Analysis

Answer 16

Investigation of what happens to NPV when only one variable is changed.

Question 17

Simulation Analysis

Answer 17

A combination of scenario and sensitivity analysis.

Question 18

Variable Costs

Answer 18

Costs that change when the quantity of output changes

Question 19

Fixed Costs

Answer 19

Costs that do not change when the quantity of output changes during a particular time period.

Question 20

Marginal Cost (Incremental Cost)

Answer 20

The change in costs that occurs when there is a small change in output.

Question 21

Operating Leverage

Answer 21

The degree to which a firm or project relies on fixed costs

Question 22

Degree of operating leverage

Answer 22

The % change in operating cash flow relative to the % change in quantity sold.

Question 23

Capital Rationing

Answer 23

The situation that exists if a firm has positive NPV projects but cannot find the necessary financing

Question 24

Soft Rationing

Answer 24

The situation that occurs when units in a business are allocated a certain amount of financing for capital budgeting

Question 25

Hard Rationing

Answer 25

The situation that occurs when a business cannot raise financing for a project under any circumstances.

Question 26

Return on Investment (ROI)

Answer 26

If you buy an asset of any sort, your gain or loss from that investment is called ROI.

Question 27

Roger Ibbotson and Rex Sinquefield

Answer 27

conducted a famous set of studies dealing with rates of return in the U.S. financial markets. They presented year-to-year historical rates of return on five important types of financial investments. Large company stocks, small company stocks, long term corporate bonds, long term U.S. government bonds, and U.S. treasury bills.

Question 28

Government can always raise

Answer 28

taxes to pay its bills, the debt represented by T-bills is virtually free of any default risk over its short life. We call the rate of return on such debt the risk-free return, and we will use it as a kind of benchmark.

Question 29

Variance

Answer 29

The average squared difference between the actual return and the average return.

Question 30

Standard Deviation

Answer 30

The positive square root of the variance

Question 31

Bell Curve

Answer 31

A symmetric, bell-shaped frequency distribution that is completely defined by its mean and standard deviation.

Question 32

What does capital market history say about market efficiency?

Answer 32

Prices appear to respond rapidly to new information, future prices in short run are difficult to predict, and if mispriced stocks exist, there is no obvious means to identify them.

Question 33

Portfolio Weight

Answer 33

The % of a portfolios total value that is invested in a particular asset.

Question 34

Systematic Risk

Answer 34

A risk that influences a large number of assets. Also called market risk

Question 35

Unsystematic Risk

Answer 35

A risk that affects at most a small number of assets. Also called unique or asset-specific risk.

Question 36

Principle of diversification

Answer 36

Spreading an investment across a number of assets will eliminate some, but not all, of that risk.

Question 37

Systematic Risk Principle

Answer 37

The expected return on a risky asset depends only on that assets systematic risk.

Question 38

Beta Coefficient

Answer 38

The amount of systematic risk present in an asset relative to that in an average asset.

Question 39

Security Market Line

Answer 39

A positively sloped straight line displaying the relationship between expected return and beta.

Question 40

Capital Asset Pricing Model (CAPM)

Answer 40

The equation of the SML showing the relationship between expected return and beta.