Finance

Question 1

Internal Rate of Return.

Answer 1

The Internal Rate of Return (IRR) for a project is the discount rate at which its
NPV is precisely zero. A project that requires upfront investment and then generates returns in the future
has a positive NPV precisely when its IRR exceeds its cost of capital. But IRR should be used with care.
The standard rule that investment should occur precisely when IRR exceeds CoC is reversed for projects
that generate positive income followed by costs; for more complicated projects whose cash flows change
signs several times the rule is ambiguous, because such projects have multiple IRRs. Moreover, a higher
IRR does not mean a hgher NPV: all else equal, longer-dated projects with the same NPV have lower IRRs.
So it is easy to be misled by IRR figures; the safest approach is to base investment decisions on NPV figures

Question 2

Modigliani Miller Propositions

Answer 2

The first Modigliani Miller (MM) Proposition states that, in a Modigliani
Miller world (q.v.), the way that a corporation’s value is unaffected by its capital structure
; the second
MM Proposition says that the corporate cost of capital is unaffected by capital structure. It is wrong to
interpret the MM propositions as saying that capital structure is irrelevant in the real world; rather, you
should interpret them as statements about under what circumstances capital structure is important

Question 3

Modigliani Miller World.

Answer 3

A Modigliani Miller world is one in which markets are complete, everyone
has the same information about the quality of investments, there are no bankruptcy costs, there is no tax,
there are no agency effects (in other words, managers always work in the interests of shareholders), there is
perfect competition, and there are no costs of issuing securities. Of course, this is not the real world (q.v.).
The Modigliani Miller world is a useful theoretical idea, which helps us to think about financing patterns in
the real world.

Question 4

Pro-cyclical

Answer 4

The performance of a procyclical business reflects the performance of the broad economy:
procyclical businesses do well when the economy booms, and do badly when the economy shrinks. Procyclical
businesses have higher betas.

Question 5

Real Interest Rate

Answer 5

The real interest rate measures the increase in spending powers that lenders earn by
delaying their consumption. If there were no inflation, the real interst rate would be the same as the nominal
interest rate.

Question 6

Real Option

Answer 6

A real option is the ability to delay a decision in capital budgeting. For example, business
expansion decisions are real options; market entry decisions are frequently real options. Real options are
valuable, because they allow decision makers to acquire more information before reaching a conclusion

Question 7

Two Fund Separation.

Answer 7

Two fund separation obtains when investors choose to split their wealth between
(long or short) positions in just two investments.