Module 4 Flashcards
the number of years needed to recover the initial cash outlay of a capital budgeting project
Payback Period
If the payback period is SHORTER than the firms guidelines for pay back, do you accept or reject
Accept
selection of projects with the highest ________ will maximize the increase in shareholder wealth, the goal of the firm
Net Present Value (NPV)
equal to the present value of all future cash flows less the investments initial outlay
If positive accept
If negative reject
Net Present Value
Considered to be the most theoretically correct criterion for evaluating capital budgeting projects
Net Present Value
the ratio of the present value of the future cash flows to the initial outlay
Same acceptance/rejection decision as NPV
Profitability Index (PI)
present value of the future cash flows to the initial outlay
Gives the same accept/reject decision as NPV
Profitability Index (PI)
helpful in ranking various projects because it lets investors quantify the value created per each investment unit. 1.0 is logically the lowest acceptable measure on the index, as any value lower than that number would indicate that the project’s present value (PV) is less than the initial investment.
Profitability Index
Based solely on the estimated cash flows and is INDEPENDENT of required rate of return or other interest rates
Internal Rate of Return (IRR)
the rate that makes the present value of future cash flows equal to the initial cost of their investment.
Internal Rate of Return (IRR)
Underlying assumption of ________ is that the projects cash flows are reinvested at the projects _________
Internal Rate of Return (IRR)
cost of capital and _____________ are the same
Internal Rate of Return (IRR)
NPV=0, IRR=Required rate of return, then the PV of future cash flows exactly equals the initial outlay. PI also equals 1
Relationship between IRR, NPV, and PI
________ has a flaw, there is potential for multiple internal rates of return if the cashflows are not normal
Internal Rate of Return
The discount rate which causes the PV of a projects terminal value to equal the PV of costs. Found by compounding inflows at the cost of capital (RRR) assumes cashflows are reinvested at the RRR
MIRR
Cash Flows are compressed (earned earlier than expected, the NPV increases (improves) as to all other analysis metrics (same with increase in cash flows)
If a projects salvage value or other cash flows increase that increases expected cash flows making the projects NPV and other metrics more favorable
If the same cash flows are expected to be earned over a longer time period, NPV will decline.
If the salvage value or other cash flows decrease NPV will decline
how cash flow amounts timing changes affect NPV IRR PI & payback would all change
If the Required Rate of Return increases, the present value of future cash flows will ________ and NPV and PI will _________
decrease
decrease
refers to the potential variability in future cash flows
the wider rage of possible future events that can occur the greater the risk
returns on common stock are _______ than returns from investing in a bank savings account
Risk
The ______ the holding period, the less volatility in returns- especially for common stocks.
longer
volatility
in a one year holding period, ______ are risky compared to _______.
Stocks
Bonds
Over a one year holding period, _______ are risky compared to ______ and TBills, but over a __________ period, stocks become _________ risky compared to other investments.
stocks
bonds
longer
less
a measure of how much the individual returns on the stock move with the overall market price “market risk”
beta
a measure of how much the individual returns on the stock deviate from the expected value or the mean
standard deviation
the weighted average of the POSSIBLE cash flows outcomes such as that the weights are the probabilities of the occurrence of the carious states of the economy
Expected Cash Flow
group of investments held together, strive for diversification, characterized by included investments & the amount invested in each security
Portfolio concept
the release of information not previously available , they have 2 parts the expected part and the surprise part
announcements
discounted information to estimate the expected return, the surprise news influences the unexpected return
parts of company news and announcements
theory states that share prices reflect all information. stocks trade at their fair market value on exchanges.
investors benefit from investing in a low-cost, passive portfolio.
Opponents of this theory believe that it is possible to beat the market and that stocks can deviate from their fair market values.
Efficient Market Hypothesis
IF 2 stocks are perfectly _________ correlated diversification has ___________ on risk
Positively
no effect
IF 2 stocks are perfectly _____________ correlated the portfolio is perfectly diversified
Negatively
measures how closely the returns on two different stocks align
Correlation between assets
if Beta is ________ the stock is expected to move in the same direction as the market
positive
if Beta is __________ the stock is expected to decline in value if the market goes up and have a positive return if the market goes down
negative
the statistical measure of market volatility, measuring how widely prices are dispersed from the average price. If prices trade in a narrow trading range, the return is a low value that indicates low volatility. If prices swing wildly up and down, returns are a high value that indicates high volatility.
Standard Deviation
the point with __________ is that over time the unexpected increases and decreases in stock price over the short term due to “unexpected news” cancel out in the long term
Unexpected returns
when positive it adds value to the frim
NPV
the amount of change a proposed project will have on the value of the frim
NPV
equal to zero, that means that the present value of future cash flows (discounted at the
appropriate cost of capital) is exactly equal to the initial outflows (initial outlay). This also means that the discount rate
is exactly equal to the project’s IRR or internal rate of return.
When NPV is equal to ZERO
generally considered to be the “gold standard” for capital budgeting analysis, which,
by definition, is for long term projects.
NPV
gives us the amount by which firm value changes
NPV
gives no indication of the change in firm value.
IRR
simplicity and it provides additional information to firms about fund availability for reinvestment.
Managers may rely on it more for short term and/or lower initial outlay projects
Payback Period
two key drawbacks to the use of the ___________, the time value of money is ignored and all cash flows after are ignored.
Negatives of using the payback period
near term cash flows will result in higher or lower NPV and IRR (all else equal)
Higher
The ________ the period until receipt of cash flows, the lower the NPV and the IRR
Longer
what would happen to the NPV if the initial investment in fixed assets increased?
NPV would decrease
what would happen to NPV if we had a higher salvage value at the end of the project?
It would increase
If the IRR= the RRR “discount rate” for the project, the NPV will be
ZERO- this is the relationship between NPV and IRR
If the NPV is positive, the project will be accepted or rejected?
Accepted
If the IRR is greater than the RRR/discount rate, the project will be accept or reject?
Accept
If the IRR is less than the discount rate, that means NPV is Negative or positive
Negative
What would happen to the IRR if the discount rate was increased or decreased?
NOTHING the IRR is independent of the RRR. However, the accept or reject decision could change.
If cash flows are condensed overtime would the IRR increase or decrease
would NPV increase or decrease
Increase
Increase
shows how many dollars of return a project returns for every $1
Profitability index
True/ False
Firms would not impose a required return of less than $1 as this rule would accept a negative NPV project
True
Beta for the overall market is 1.0
True or False
True
A Beta of 1.3 means that this particular “risky” asset is 1.3 times as volatile or reactive to systematic (market wide) risk as the “average risky asset”
True or False
True
risk/return or relative riskiness
a way to compare relative risk and return between different investments
a lower CV is preferred for those who are risk adverse
Coefficient variation
amount of return you expect from a stock based on the risk
estimated return for a stock is LESS than ______ you reject the stock
estimated return for a stock is more than _______ you buy the stock
Required Rate of Return
The ___________ is the additional return an investor will receive (or expects to receive) from holding a risky market portfolio instead of risk-free assets.
Market Risk Premium
non-diversifiable risk. This risk is the fluctuation of returns caused by macroeconomic factors that affect all risky assets.
Systematic (Market) Risk
risk is the risk that something goes wrong on for a company or industry such as mismanagement, labor strikes, production of undesirable products,
Non Systematic (Unique) Risk
