Financial Management Week 3

Question 1

What does Cost of Equity mean within financial management?

Answer 1

Return equity investors expect to earn by holding shares in a company. The expected return for gone by equity investors in the next best equal risk opportunity.

Question 2

What does Internal Rate of Return mean within financial management?

Answer 2

The discount rate at which the projects Net Present Value equals zero

Question 3

How is Economic Value measured now by future long-lived investment projects—within financial management?

Answer 3

Net Present Value (NPV)

Question 4

How would you create value for shareholders within financial management?

Answer 4

Invest in projects with a positive NPV

Question 5

How are stocks valued within financial management?

Answer 5

Stocks are valued as the present value of all future expected dividends

Question 6

What are the two main influences for the Cost of Equity within financial management?

Answer 6

1. The current level of interest rates.
2. The risk of the stock.

Question 7

What is CAPM within financial management?

Answer 7

The Capital Asset Pricing Model

Question 8

What function does the CAPM provide with financial management?

Answer 8

It provides a practical method for estimating the Cost of Equity based upon the stocks Beta

Question 9

How would you generalize the evaluation for Cost of Capital within financial management?

Answer 9

The cost of capital is the rate of return the corporation must earn on its invested capital, in order to compensate for the time value of money and risk

Question 10

What does WACC stand for within financial management?

Answer 10

The Weighted Average Cost of Capital

Question 11

How is the WACC useful within financial management?

Answer 11

The Cost of Capital is a weighted average of the Cost of Debt and the Cost of Equity

Question 12

What is the main value of a firm within financial management?

Answer 12

The value of a firm is the present value of projected free cash flows discounted at its weighted average cost of capital

Question 13

What are the steps of the Capital Investment Analysis?

Answer 13

1. Identification
2. Evaluation
3. Selection
4. Implementation

Question 14

How does Future Value fit into financial management?

Answer 14

A strategy to think about how money will accrue with interest. Use the Excel formula to use a Present Value and an interest to calculate it.

Question 15

How does Present Value fit into financial management?

Answer 15

A strategy to think about how money will accrue with interest. Use the Excel formula to use a Future Value and an interest to calculate it.

Question 16

What does the Excel formula RATE help with?

Answer 16

Used to find the interest rate for a known Present Value, Future Value, and time period.

Question 17

What does the Excel formula NPER help with?

Answer 17

Used to find the time periods for a known Present Value, Future Value, and interest rate.

Question 18

What does the Excel formula PMT help with?

Answer 18

Used to find the payment (for each time period) for a known interest rate, initial cash value, and payment period length. (Think: get the monthly payment for a 100k loan for car, with 5% interest over 48 months)

Question 19

What does NPV stand for within financial management?

Answer 19

Net Present Value

Question 20

How are NPV’s used within financial management?

Answer 20

These values are used to measure the cash flows of long-term investments

Question 21

What does it mean if an NPV is positive, negative, or zero?

Answer 21

• Positive projects increases shareholder value
• Negative projects reduces shareholder value
• Zero projects break even

Question 22

What are Mutually Exclusive and Independent projects within financial management?

Answer 22

• Mutual: Can only accept A or B but not both
• Independent: Does not rely on other projects to be accepted

Question 23

What do most people forget about the NPV Excel formula within financial management?

Answer 23

You need to add the initial cash flow to the NPV formula in Excel since that formula only calculates the benefits. NPV(r, CF₀, CF₁, CF₂) + CF₀

Question 24

What does IRR stand for within financial management?

Answer 24

Internal Rate of Return

Question 25

What does Internal Rate of Return imply for within financial management?

Answer 25

The discount rate for when a project reaches NPV equal to zero.

Question 26

How do you compare just IRR for multiple projects?

Answer 26

You would pick the project that has the highest IRR, if the IRR is larger in value than the cost of capital.

Question 27

What does PI stand for within financial management?

Answer 27

Profitability Index, or sometimes called benefit/cost ratio

Question 28

How do you compare just PI for multiple projects?

Answer 28

You would pick the project that has the highest PI, if the PI is above one.

Question 29

How do you calculate the PI?

Answer 29

Use the NPV and the initial Cash Flow as (NPV + CF₀) / CF₀

Question 30

What are the problems with solely relying on IRR?

Answer 30

• Multiple IRR’s can exist
• The Scale problem
• The Timing problem

Question 31

What does the Crossover Rate of two projects mean within financial management?

Answer 31

It is the point where both project’s NPV and Discount Rate are the same.

Question 32

What does PP stand for within financial management?

Answer 32

Payback Period

Question 33

How is PP used within financial management?

Answer 33

Payback periods are used to calculate how soon a project will result in zero NPV. In other words, how many time periods until a project breaks even.

Question 34

What is the discounted payback period formula?

Answer 34

Full year until present value is recovered + (unrecovered PV at start of recovery year/ PV of CF in recovery year)