Main exam

Question 1

What are the three most common securities issued?

Answer 1

• Common stock (shares/equity)
• Preferred stock (sometimes convertible)
• Bonds

Question 2

What is the valuation principle?

Answer 2

The value of an asset to the firm or its investors is determined by its competitive market price.

Question 3

What are the three important rules that allow us to compare or combine values?

Answer 3

1. Only possible at the same point in time
2. Moving cash forward in time
3. Moving cash flows back in time

Question 4

What happens if g > r in a growing perpetuity?

Answer 4

The sum is infinite

Question 5

What is the EAR?

Answer 5

The rate indicates the actual amount of interest that will be earned at the end of one year

Question 6

What is the APR?

Answer 6

Indicates the amount of simple interest earned in one year; interest earned without the effect of compounding

Question 7

What are nominal interest rates?

Answer 7

Indicate the rate at which your money will grow if invested for a certain period.

Question 8

What is the real interest rate?

Answer 8

The rate of growth of purchasing power, after adjusting nominal interest rate for inflation

Question 9

What is the opportunity cost of capital?

Answer 9

The best available expected return offered in the market on an investment of comparable risk and term to the cash flow being discounted

Question 10

What can be said about the difference between the cost of capital and the IRR?

Answer 10

It is the maximum estimation error in the cost of capital that can exist without altering the original decision

Question 11

What does the IRR rule state?

Answer 11

Take any investment opportunity where the IRR exceeds the opportunity cost of capital.

Question 12

What is the only condition that guarantees that the IRR rule is correct for stand-aloe projects?

Answer 12

If all of the project’s negative cash flows precede its positive cash flows

Question 13

What are pitfalls of the IRR rule?

Answer 13

1. Delayed investments (borrow to invest later = prefer low rate)
2. Multiple IRRs; generally as many as the number of sign changes
3. Non-existent IRR

Question 14

What are some pitfalls of the Payback rule?

Answer 14

• ignores the project’s cost of capital and the time value of money
• ignores cash flows after the payback period
• relies on an ad hoc decision criterion about the number of years to require for the payback period

Question 15

What are factors that affect that IRRs of mutually exclusive investments can’t be compared?

Answer 15

• Differences in scale
• Differences in timing of cash flows
• Differences in risk

Question 16

What are incremental earnings?

Answer 16

The amount by which the firm’s earnings are expected to change as a result of the investment decision

Question 17

Are interest expenses a part of incremental earnings?

Answer 17

No, since we want to evaluate the project on its own, separate from the financing decision

Question 18

How are taxes calculated?

Answer 18

Income tax = EBIT x t

Question 19

What is the unlevered net income?

Answer 19

= EBIT * (1-t)

= (Revenues - Costs - Depreciation) * (1-t)

Question 20

What are indirect effect on incremental earnings?

Answer 20

• Opportunity costs

- project externalities (cannibalization)

Question 21

What are sunk costs that should not be taken into account in capital budgeting?

Answer 21

• Fixed overhead expenses
• Past R&D expenditures
• Unavoidable competitive effects

Question 22

What are free cash flows?

Answer 22

The incremental effect of a project on the firm’s available cash, separate from any financing decisions

Question 23

What is Net Working Capital?

Answer 23

Cash + Inventory + Receivables - Payables

= Current assets - current liabilities

Question 24

How do we calculate the free cash flows?

Answer 24

FCF = Unlevered net income + depreciation - CapEx - change in NWC

Question 25

What is an arbitrage opportunity?

Answer 25

Any situation in which it is possible to make a profit without taking any risk or making any investment

Question 26

What is the difference between financial investments and real investments?

Answer 26

• Financial: involve only reallocation of rights to existing cash flows
• Real: create new cash flows or destroy existing ones

Question 27

What is the yield to maturity of a bond?

Answer 27

The IRR of a bond investment. The YTM of a bond is the single discount rate (quoted as an APR) that sets the present value of the promised bond payments equal to the current market price of the bond.

Question 28

What is a spot rate?

Answer 28

Spot rate = risk-free interest rate = YTM

Question 29

What is implied by par, premium and discount price of a bond?

Answer 29

Par: CPN rate = YTM

Premium: CPN rate > YTM

Discount: CPN rate < YTM

Question 30

What is the default/credit spread?

Answer 30

The difference between the yields of corporate bonds and Treasury yields

Question 31

What is a forward interest rate?

Answer 31

An interest rate that we can guarantee today for a loan or investment that will occur in the future

Question 32

What are some limitations of the YTM?

Answer 32

• Can only be calculated after we know a bond’s price

- Can only be applied to a single bond