Financial Management Week 3 Flashcards
What does Cost of Equity mean within financial management?
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.
What does Internal Rate of Return mean within financial management?
The discount rate at which the projects Net Present Value equals zero
How is Economic Value measured now by future long-lived investment projects—within financial management?
Net Present Value (NPV)
How would you create value for shareholders within financial management?
Invest in projects with a positive NPV
How are stocks valued within financial management?
Stocks are valued as the present value of all future expected dividends
What are the two main influences for the Cost of Equity within financial management?
- The current level of interest rates.
- The risk of the stock.
What is CAPM within financial management?
The Capital Asset Pricing Model
What function does the CAPM provide with financial management?
It provides a practical method for estimating the Cost of Equity based upon the stocks Beta
How would you generalize the evaluation for Cost of Capital within financial management?
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
What does WACC stand for within financial management?
The Weighted Average Cost of Capital
How is the WACC useful within financial management?
The Cost of Capital is a weighted average of the Cost of Debt and the Cost of Equity
What is the main value of a firm within financial management?
The value of a firm is the present value of projected free cash flows discounted at its weighted average cost of capital
What are the steps of the Capital Investment Analysis?
- Identification
- Evaluation
- Selection
- Implementation
How does Future Value fit into financial management?
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.
How does Present Value fit into financial management?
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.
What does the Excel formula RATE help with?
Used to find the interest rate for a known Present Value, Future Value, and time period.
What does the Excel formula NPER help with?
Used to find the time periods for a known Present Value, Future Value, and interest rate.
What does the Excel formula PMT help with?
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)
What does NPV stand for within financial management?
Net Present Value
How are NPV’s used within financial management?
These values are used to measure the cash flows of long-term investments
What does it mean if an NPV is positive, negative, or zero?
- Positive projects increases shareholder value
- Negative projects reduces shareholder value
- Zero projects break even
What are Mutually Exclusive and Independent projects within financial management?
- Mutual: Can only accept A or B but not both
- Independent: Does not rely on other projects to be accepted
What do most people forget about the NPV Excel formula within financial management?
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
What does IRR stand for within financial management?
Internal Rate of Return
What does Internal Rate of Return imply for within financial management?
The discount rate for when a project reaches NPV equal to zero.
How do you compare just IRR for multiple projects?
You would pick the project that has the highest IRR, if the IRR is larger in value than the cost of capital.
What does PI stand for within financial management?
Profitability Index, or sometimes called benefit/cost ratio
How do you compare just PI for multiple projects?
You would pick the project that has the highest PI, if the PI is above one.
How do you calculate the PI?
Use the NPV and the initial Cash Flow as (NPV + CF₀) / CF₀
What are the problems with solely relying on IRR?
- Multiple IRR’s can exist
- The Scale problem
- The Timing problem
What does the Crossover Rate of two projects mean within financial management?
It is the point where both project’s NPV and Discount Rate are the same.
What does PP stand for within financial management?
Payback Period
How is PP used within financial management?
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.
What is the discounted payback period formula?
Full year until present value is recovered + (unrecovered PV at start of recovery year/ PV of CF in recovery year)
