Brainscape's Knowledge GenomeTM

Browse over 1 million classes created by top students, professors, publishers, and experts.


See full index

BEC - Wiley > Module 43: Financial Risk Management and Capital Budgeting > Flashcards

Module 43: Financial Risk Management and Capital Budgeting Flashcards

1
Q

What type of relationship does risk and return have?

A

Inverse relationship

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
2
Q

Avoidable costs

A

Costs that will not continue to be incurred if a particular course of action is taken

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
3
Q

Cash flow hedge

A

A hedge of the variability in the cash flows of a recognized asset or liability or of a forecasted transaction that is attributable to a particular risk

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
4
Q

Committed costs

A

Costs related to the company’s basic commitment to open its doors (e.g., depreciation, property taxes, management salaries, etc.)

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
5
Q

Credit (default) risk

A

The risk that a firm will default on payment of interest or principal of a debt

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
6
Q

Currency swaps

A

Forward-based contracts in which two parties agree to exchange an obligation to pay cash flows in one currency for an obligation to pay in another currency

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
7
Q

Differential (incremental) cost

A

The difference in cost between two alternative courses of action

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
8
Q

Discretionary costs

A

Fixed costs whose level is set by current management decisions (e.g. advertising, research and development)

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
9
Q

Fair value hedge

A

A hedge of the changes in fair value of a recognized asset or liability, or of an unrecognized firm commitment

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
10
Q

Forwards

A

Negotiated contracts to purchase and sell a specific quantity of a financial instrument, foreign currency, or commodity at a price specified at the origination of the contract, with delivery and payment at a specified future date

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
11
Q

Futures

A

Forward-based standardized contracts to take delivery of a specified financial instrument, foreign currency, or commodity at a specified future date or during a specified period generally at the then market price

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
12
Q

Interest rate risk

A

The risk that the value of a debt instrument will decline due to an increase in prevailing interest rates

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
13
Q

Interest rate swaps

A

Forward-based contracts in which two parties agree to swap streams of payments over a specified period of time. These contracts are often used to trade variable-rate instruments for fixed-rate instruments

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
14
Q

Internal rate of return method

A

Uses the rate of return that equates investment with future cash flows to evaluate investment alternatives

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
15
Q

Market risk

A

The risk that the value of a debt instrument will decline due to a decline in the aggregate value of all assets in the economy

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
16
Q

Net present value method

A

Uses the present value of future cash flows to evaluate investment alternatives

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
17
Q

Opportunity cost

A

Maximum income or savings (benefit) foregone by rejecting an alternative

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
18
Q

Options

A

An instrument that allows, but does not require, the holder to buy (call) or sell (put) a specific or standard commodity or financial instrument, at a specified price during a specified period of time or at a specified date

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
19
Q

Outlay cost

A

Case disbursement associated with a specific project

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
20
Q

Payback method

A

Evaluates investment alternatives based on the length of time until the investment is recaptured

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
21
Q

Relevant costs

A

Future costs that will change as a result of a specific decision

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
22
Q

Sensitivity analysis

A

Exploring the importance of various assumptions to forecasted results

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
23
Q

Sunk (unavoidable) costs

A

Committed costs that are not avoidable and are therefore irrelevant to future decisions

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
24
Q

Swaption

A

Option of a swap that provides the holder with the right to enter into a swap at a specified future date with specified terms

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
25
Q

Systematic risk

A

The risk related to market factors which cannot be diversified away

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
26
Q

Unsystematic risk

A

Risk that exists for one particular investment or a group of like investments. This risk can be diversified away

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
27
Q

Equity risk premium

A

Real return minus risk-free real return

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
28
Q

Risk averse

A

Compensated for taking risk

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
29
Q

Risk-neutral

A

Investors that prefer investments with higher returns whether or not they have risk; disregard risk

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
30
Q

Risk-seeking investors

A

Investors that prefer to take risks and would invest in a higher-risk investment despite the fact that a lower-risk investment might have the same return

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
31
Q

Return on a single asset

A

Investment return is total gain or loss on an investment for a period of time

Change in asset’s value (either gain or loss) plus any cash distributions (e.g. cash flow, interest, dividends)

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
32
Q

Investment return equation

A

Rt+1 = Pt+1 - Pt + CFt+1 / Pt

Rt+1 = investment return from time t tp t+1
Pt+1 = asset's price (market value) at t+1
Pt = asset's price (market value) at t 
CFt+1 = cash flow received from the asset from t to t+1

This formula measures return on an ex post basis (after the fact) - does not consider risk

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
33
Q

How should investors evaluate investments?

A

Ex ante basis (before the fact)

Use expected returns and estimates of risk

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
34
Q

Arithmetic average return

A

Computer by simply adding the historical returns for a number of periods and dividing by number of periods

Used for short holding periods

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
35
Q

Geometric average return

A

Depicts compound annual return earned by an investor who bought the asset and held it for the number of historical periods examined. If returns vary through time, geometric return will always fall below the arithmetic average.

Used for longer holding periods

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
36
Q

Normal distribution

A

Pattern of historical returns of large numbers (bell curve shaped)

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
37
Q

Normal distribution

A

About 95% of returns will fall within the range created by expected return +/- two standard deviations

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
38
Q

Subjective estimates of risk

A

When management does not have significant historical data on returns to calculate the mean and variance

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
39
Q

Expected returns of a portfolio

A

E(Rp) = w1E(R1) + w2E(R2) + w3E(R3) …

E(Rp) = expected return on the portfolio 
w1,2,3 = weight of each of the assets 
E(R1,2,3) = expected return of each of the assets
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
40
Q

What does the variance of portfolio returns depends on (3 factors)

A
  1. Percentage of the portfolio invested in each asset (the weight)
  2. Variance of returns of each individual asset
  3. Covariance among the returns of assets in the portfolio
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
41
Q

Covariance

A

Captures the degree to which the asset returns move together over time
If the individual assets move together, little benefit to holding portfolio

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
42
Q

What do portfolios allow investors to do?

A

Diversify away unsystematic risk

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
43
Q

What are examples of systematic risk

A

Fluctuations in GDP, inflation, interest rates

Cannot be diversified away

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
44
Q

What does the variance of an individual investment capture?

A

Total risk of the investment, both systematic and unsystematic)

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
45
Q

Standardized measure to estimate an investment’s systematic risk

A

Beta

Beta = Bi = covariance of investment’s returns with returns of overall portfolio / portfolio’s variance

Measures how the value of the investment moves with changes in the value of the total portfolio

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
46
Q

Risk preference function

A

Describes the investor’s trade-off between risk and return

Falling on the line is an efficient portfolio

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
47
Q

What does interest represent?

A

Cost of borrowing funds

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
48
Q

What are the two parts of credit/default risk?

A
  1. Individual firm’s creditworthiness (or risk of default)

2. Sector risk - risk related to economic conditions in firm’s economic sector

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
49
Q

Interest rate risk

A

Risk that the value of the loan or bond will decline due to an increase in interest rates

Systematic risk

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
50
Q

Market risk

A

Risk that the value of the loan or bond will decline due to a decline in the aggregate value of all the assets in the economy

Systematic risk

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
51
Q

What type of risk is credit risk?

A

Unsystematic risk; unique to particular loan or investment

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
52
Q

Stated interest rate

A

Contractual rate charged by the lender

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
53
Q

Effective annual rate

A

True annual return to the lender

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
54
Q

Why do the effective annual rate and stated interest rate differ?

A

Interest is compounded more often than annually

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
55
Q

What is the formula for calculating the effective annual rate from the stated rate?

A

EAR = (1 + r/m)^4 -1

r = stated interest rate 
m = compounding frequency
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
56
Q

Term structure of interest rates

A

Describes the relationship between long-and short-term rates

Important in determining whether to use long-term fixed or variable rate financing

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
57
Q

How are term structure of interest rates depicted?

A

A yield curve

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
58
Q

Normal yield curve

A

Upward sloping curve in which short-term rates are less than intermediate-term rates which are less than long-term rates

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
59
Q

Inverted (abnormal) yield curve

A

A downward-sloping curve in which short-term rates are greater than intermediate-term rates which are greater than long-term rates

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
60
Q

Flat yield curve

A

Curve in which short-term, intermediate-term and long-term rates all about the same

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
61
Q

Humped yield curve

A

A curve in which intermediate-term rates are higher than both short-term and long-term rates

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
62
Q

Why are long-term rates usually higher?

A

They involve more interest rate risk so require higher maturity risk premiums for long-term lending

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
63
Q

Liquidity preference (premium) theory

A

Long-term rates should be higher than short-term rates, because investors have to be offered a premium to entice them to hold less liquid and more price-sensitive securities

If interest rates increase and an investor holds a fixed-rate long-term security, the value of the security will decline

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
64
Q

Market segmentation theory

A

This theory states that treasury securities are divided into market segments by the various financial institutions investing in the market.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
65
Q

What type of securities do commercial banks prefer?

A

Short-term securities to match their short-term lending strategies

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
66
Q

What types of securities do savings and loans prefer?

A

Intermediate-term securities

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
67
Q

What types of securities do insurance companies prefer?

A

Long-term securities because of the nature of their commitments to policy holders

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
68
Q

Expectations theory

A

Explains yields on LT securities as a function of ST rates

States that LT rates reflect average of ST expected rates over the time period that the LT security will be outstanding

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
69
Q

When LT rates are lower than ST rates…

A

Market is expecting ST rates to fall

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
70
Q

How are interest rates tied to inflation rates?

A

Directly

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
71
Q

If LT rates are lower than ST rates…

A

Market is indicating a belief that inflation will decline

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
72
Q

Derivative

A

Financial instrument or contract whose value is derived from some other financial measure (underlyings, such as commodity prices, stock prices, interest rates, etc.) and includes payment provisions

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
73
Q

Examples of derivatives

A
  • Options
  • Forwards
  • Futures
  • Currency swaps
  • Interest rate swaps
  • Swaption
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
74
Q

Options

A

Allow, but do not require, the holder to buy (call) or sell (put) a specific or standard commodity of financial instrument, at a specified price during a specified period of time (American option) or a specified date (European option)

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
75
Q

Forwards

A

Negotiated contracts to purchase and sell a specified quantity of a financial instrument, foreign currency, or commodity at a price specified at origination of the contract, with delivery and payment at a specified future date

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
76
Q

Futures

A

Forward-based standardized contracts to take delivery of a specified financial instrument, foreign currency, or commodity at a specified future date or during a specified period generally at the then market price

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
77
Q

Currency swaps

A

Forward-based contracts in which two parties agree to exchange an obligation to pay cash flows in one currency for an obligation to pay in another currency

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
78
Q

Interest rate swaps

A

Forward-based contracts in which two parties agree to swap streams of payments over a specified period of time

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
79
Q

Example of interest rate swap

A

One party agrees to make payments based on a fixed rate of interest and other party agrees to make payments based on a variable rate of interest

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
80
Q

Swaption

A

Option of swap that provides the holder with the right to enter into a swap at a specified future date with specified terms, or to extend or terminate the life of an existing swap. Characteristics of an option and an interest rate swap

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
81
Q

Examples of financial intermediaries

A
  • Commercial banks
  • Insurance companies
  • Pension funds
  • Savings and loan associations
  • Mutual funds
  • Finance companies
  • Investment bankers
  • Money market funds
  • Credit unions
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
82
Q

Counterparty

A

Other party to the contract or agreement

83
Q

Credit risk in using derivative

A

Risk of loss as a result of the counterparty to a derivative agreement failing to meet its obligation

84
Q

Market risk in using derivative

A

The risk of loss from adverse changes in market factors that affect the fair value of a derivative, such as interest rates, foreign exchange rates, and market indexes for equity securities

85
Q

Basis risk in using derivative

A

Risk of loss from ineffective hedging activities

Difference between fair value (or cash flows) of the hedged item and the fair value (or cash flows) of the hedging derivative

Entity is subject to the risk that FVs (or cash flows) will change so that the hedge will no longer be effective

86
Q

Legal risk in using derivative

A

Risk of loss from a legal or regulatory action that invalidates or otherwise precludes performance by one of both parties to the derivative agreement

87
Q

Speculation

A

As an investment to speculate on price changes in various markets

88
Q

Hedging

A

To mitigate a business risk that is faced by a firm. Protects the entity against the risk of adverse changes in the FV or CF of assets, liabilities, or future transactions. Defensive strategy

89
Q

Financial statement effects of derivative transactions governed by who

A

Statement of Financial Accounting Standards 133 (SFAS 133)

90
Q

Fair value hedge

A

Hedge of the changes in the FV of a recognized asset or liability, or of an unrecognized firm commitment, that are attributable to a particular risk

91
Q

Cash flow hedge

A

A hedge of the variability in the CF of a recognized asset or liability, or of a forecasted transaction, that is attributable to a particular risk

92
Q

Foreign currency hedges

A
  • FV hedge of an unrecognized firm commitment or a recognized asset or liability valued in a foreign currency (a foreign currency fair value hedge)
  • A CF hedge of a forecasted transaction, an unrecognized firm commitment, the forecasted functional-currency-equivalent cash flows associated with a recognized asset or liability, or a forecasted intercompany transaction
  • Hedge of a net investment in a foreign operation
93
Q

What does SFAS 133 require an entity to do about derivatives?

A

Report all derivatives as assets and liabilities in the statement of financial position, measured at fair value

94
Q

Accounting for a FV hedge

A

Change in the FV of a derivative designated and qualifying as a FV hedge is recognized in earnings and is offset by the portion of the change in the FV of the hedged asset or liability that is attributable to the risk being hedged

If hedge is completely effective, change in the derivative’s FV will equal change in hedge item’s fair value = no effect on earnings

If hedge is not completely effective, earnings will be increased or decreased for the difference between the changes in the FV of the derivative and hedged item

95
Q

Accounting for CF hedge

A

Effective portion of the change in the FV of a derivative designated and qualifying as a CF hedge is reported in other comprehensive income and the ineffective portion is reported in earnings

96
Q

How are derivatives valued?

A

Valued on financial statements at FV, which is the current market price of the derivative

Quoted market prices in active markets are the best source of fair value and may be used for many derivatives

97
Q

Black-Scholes option-pricing model

A

Mathematical model for estimating the price of stock options, using the following five variables

  1. Time to expiration of the option
  2. Exercise or strike price
  3. Risk-free interest rate
  4. Price of the underlying stock
  5. Volatility of the price of the underlying stock

Other methods include: Monte-Carlo simulation and binomial trees

98
Q

Zero-coupon method

A

Used to determine the fair value of interest rate swaps

Present value model in which the net settlements from the swap are estimated and discounted back to their current value

Key variables:

  • Estimated net settlement cash flows
  • Timing of the cash flows as specified by contract
  • Discount rate
99
Q

Example of agreement to swap payments on fixed-rate liability for a variable rate

A

If interest rates decline, the firm will receive a net positive cash flow from the swap because the amount received on the fixed rate will be greater than the amount due on the variable rate; opposite is true if rates increase

Zero coupon method estimates future cash flows by calculating the net settlement that would be required if future interest rates are equal to the rates implied by the current yield curve; amount is discounted to determine the current fair value of the swap for financial reporting purposes

100
Q

Short position

A

When a firm is committed to sell something it does not own

101
Q

LIBOR rate

A

London Interbank Offered Rate

102
Q

Example: Firm entered into a $20,000,000, 10 year noncallable debt agreement

A
  • Variable interest payments tied to LIBOR rate (4.5%)
  • Firm enters into an interest rate swap to pay 7% fixed interest for the remaining term of loan instead of variable LIBOR rate
  • Financial statement effects of this transaction would be recognition of a 7% fixed rate of interest over the life of the loan as opposed to the variable rate
103
Q

Example: short position and futures

A

Firm carries ~$200k in ST financing at variable interest rates and management concerned about current instability of ST interest rates.
Mgmt decides to see on futures market $200k in Treasury notes to be delivered one year from today
Sale gives firm a short position
If interest rates rise, the firm will pay more interest on its ST debt but it will also experience a gain on the futures contract because the price of Treasury notes will decline
Near end of contract, firm purchases Treasury note contracts to close its short position
If hedge was completely effective, $20k gain on futures contracts will offset the increase in interest expense experienced by the firm due to increase in ST interest rates
Gain on the contracts would be used to reduce interest expense in operating income

104
Q

Future value (FV) of an amount

A

Future value of an amount is the amount that will be available at some point in the future if an amount is deposited today and earns compound interest for “n” periods

E.g. savings deposits

105
Q

Example of future value of an amount

A

Deposited $100 today at 10%

[100 + (100 x 10%)] = $110 at end of first year
[100 + (110 x 10%)] = $121 at end of second year

106
Q

Present value of a future amount

A

The present value of a future amount is the amount you would pay now for an amount to be received n periods in the future given an interest rate of “i”

107
Q

Example of PV of a future amount

A

Money you would lend today for a noninterest-bearing note receivable in the future

Lending money at 10%, lend $100 for a $110 note due in one year or for a $121 note due in two years

108
Q

Trick for PV v. FV

A

PV of $1 is the inverse of the FV of $1

E.g. The future value of $1 at 10% in five years is 1.611. Thus, the PV of $1 in 5 years would be 1.00 / 1.611 = 6.21

Conversely, the FV of $1 is found by dividing the PV of $1 into 1.00. 1.00 / 6.21 = 1.611.

109
Q

Compounding

A

When interest is compounded more than once a year, 2 extra steps are needed:

  1. Multiply “n” by the # of times interest is compounded annually. Gives you total number of interest periods
  2. Divide “i” by # of times interest is compounded annually. Gives you appropriate interest rate for each interest period
110
Q

Example of compounding

A

if 10% was compounded semiannually, the amount of $100 at the end of one year would be $110.25 [(1.05)^2].

111
Q

Future value of an ordinary annuity

A

Amount available “n” periods in the future as a result of the deposit of an amount (A) at the end of every period 1 through “n”

E.g. bond sinking fund; deposit is made at the end of the first period and earns compound interest for n-1 periods (not during the first period)

Next to the last payment earns one period’s interest; n-(n-1) = 1; last payment earns no interest, because it is deposited at the end of the last (nth) period

112
Q

Present value of an ordinary annuity

A

Value today, given a discount rate, of a series of future payments

E.g. capitalization of lease payments by either lessors or lessees

Payments “1” through “n” are assumed to be made at the end of years “1” through “n” and are discounted back to the present

113
Q

Distinguishing a future value of an annuity from a present value of an annuity

A

Distinguished by determining whether the total dollar amount in the problem comes at the beginning (e.g. cost of equipment acquired for leasing) or at the end (e.g. amount needed to retire bonds) of the series of payments

PV of annuity = beginning
FV of annuity = end

114
Q

Annuities due

A

E.g. payments might be made at the beginning of each of the five years instead of at the end of each year (aka annuity in advance in contrast to an ordinary annuity (annuity in arrears)).

115
Q

How to convert either a FV of an ordinary annuity or PV of an ordinary annuity factor to an annuity due factor

A

Multiply the ordinary annuity factor times (1+i)

116
Q

Interest rates

A

Usually given in problems

Made up of 2 components:

  1. Expected inflation/deflation rate (affects relative value of the currency)
  2. Inflation adjusted return for the particular investment (determined by risk of the investment)
117
Q

TVMF Applications

A

Basic formula:

FV or PV = TVMF x Amount

118
Q

If an annuity is involved, what is the amount?

A

Periodic payment or deposit; if not, it is a single sum

119
Q

What three variables determines an FV or PV?

A
  1. Time
  2. Interest rate
  3. Payment
120
Q

What two variables determines TVMF?

A
  1. Time

2. Interest rate

121
Q

Bonds

A

Provide for periodic fixed interest payments at a coupon (contract) rate of interest

122
Q

Bonds: What happens if the market rate exceeds the coupon rate of a bond?

A

Book value will be less than the maturity value. Difference (discount) will make up for the coupon rate being below the market rate

123
Q

Bonds: What happens if the coupon rate exceeds the market rate?

A

Bond will sell for more than maturity value to bring the effective rate to the market rate. Difference (premium) will make up for the coupon rate being above the market rate.

124
Q

Bonds: What happens if the coupon rate equals the market rate?

A

The bond will sell for the maturity value

125
Q

What is the market value of a bond?

A

Equal to the maturity value and interest payments discounted to the present

126
Q

Bond Valuation Example

A

$10K in bonds; semi-annual interest at 6% coupon rate, maturing in 6 years, and market rate of 5%

Find PV of maturity value; PV of $1 factor. Discount $10k back 12 periods at 2 1/2% interest (Factor = .7436)

$10k x .7436 = $7,436

  1. Find the PV of the annuity of 12 $300 interest payments. Use PV of an ordinary annuity of $1 factor for 12 periods at 2 1/2 % interest (Factor = 10.26)

$300 x 10.26 = $3,078

Today’s value of bond: $10,514

127
Q

Capital budgeting

A

Technique to evaluate and control LT investments. There are six stages

128
Q

Capital budgeting stage 1: Identification stage

A

Management determines the type of capital projects that are necessary to achieve mgmt’s objectives and strategies

129
Q

Capital budgeting stage 2: Search stage

A

Mgmt attempts to identify alternative capital investments that will achieve mgmt’s objectives

130
Q

Capital budgeting stage 3: Information-acquisition stage

A

Mgmt attempts to revaluate the various investments in terms of their costs and benefits

131
Q

Capital budgeting stage 4: Selection stage

A

Mgmt chooses the projects that best meet the criteria established

132
Q

Capital budgeting stage 5: financing stage

A

Mgmt decides on the best source of funding for the project

133
Q

Capital budgeting stage 6: implementation and control stage

A

Mgmt undertakes the project and monitors the performance of the investment

134
Q

How are capital budgeting alternatives typically evaluated?

A

Using discounted cash flow techniques

135
Q

Sunk, past or unavoidable costs

A

Committed costs that are not avoidable and therefore irrelevant to the decision process

136
Q

Avoidable costs

A

Costs that will not continue to be incurred if a department or product is terminated

137
Q

Committed costs

A

Arise from a company’s basic commitment to open its doors and engage in business (depreciation, property taxes, management salaries)

138
Q

Discretionary costs

A

Fixed costs whose level is set by current management decisions (e.g. advertising, R&D)

139
Q

Relevant costs

A

Future costs that will change as a result of a specific decision

140
Q

Differential (incremental) cost

A

Difference in cost between two alternatives

141
Q

Opportunity cost

A

Maximum income or savings foregone by rejecting an alternative

142
Q

Outlay (out of pocket) cost

A

Cash disbursement associated with a specific project

143
Q

Examples of capital budgeting models

A
  1. Payback or discounted payback
  2. Accounting rate of return
  3. Net present value
  4. Excess present value index
  5. Internal (time-adjusted) rate of return
144
Q

Capital budgeting mode: payback method

A

Evaluates investments on the length of time until recapture (return) of the investment

E.g. if a $10K investment were to return a cash flow of $2.5k a year for 8 years, the payback period is 4 years.

145
Q

Depreciation and cash flow

A

Depreciation does not consume cash

146
Q

Payback example (computed after income taxes)

A

8 year life with no salvage value and a 404 income tax rate:

Cash flow: $2,500 x (1-40%) = $1,500
Tax savings from depreciation: $1,250 x 40% = $500
Cash flow after tax: $1,500 + $500 = $2,000
$10,000 / $2,000 = 5 years

147
Q

What are the limitations of the payback method?

A
  • Ignores total project profitability and has little or no connection to maximization of shareholder value
  • Method is not really effective in taking into account the time value of money
148
Q

Discounted payback method

A

Essentially the same as the payback method except that in calculating the payback period, cash flows are first discounted to their present value

149
Q

Disadvantages of discounted payback method

A

-Ignores any cash flows after the cutoff period and therefore does not consider total project profitability

150
Q

Accounting rate of return (ARR)

A

Computes an approximate rate of return which ignores the time value of money

151
Q

Accounting rate of return (ARR) formula

A

ARR = Annual net income / average (or initial) investment

152
Q

Example of accounting rate of return (ARR)

A

(cash flow - depreciation) / (average or initial investment)

153
Q

What are the limitations of the accounting rate of return?

A
  • Results are effected by the depreciation method used
  • ARR makes no adjustment for project risk
  • ARR makes no adjustment for the time value of money
154
Q

Net present value (NPV)

A

discounted cash flow method which calculates the PV of the future cash flows of a project and compares this with the investment outlay required to implement the project

155
Q

What is the formula of the net present value?

A

NPV = (PV of future cash flows) - (Required investment)

156
Q

What does the calculation of the present value of the future cash flows?

A

Requires the selection of a discount rate (aka target or hurdle rate)

Use minimum rate of return that management is willing to accept on capital investment projects

Rate used should be no less than the cost of capital - the rate management currently must pay to obtain funds

157
Q

Excess present value (profitability) index

A

Computes the ratio of the PV of the cash inflows to the initial cost of a project

Used to implement the net present value method when there is a limit on funds available

158
Q

Formula for the excess present value index

A

PV of future net cash inflows / initial investment

X

100

159
Q

If the excess PV index is equal to or greater than 100%

A

Project will generate a return equal to or greater than the required rate of return

160
Q

What is the most widely accepted methods of evaluating a capital expenditure?

A

Net present value methods

161
Q

Advantages of net present value methods

A
  • Presents results in dollars which are easily understood
  • Adjusts for the time value of money
  • Considers the total profitability of the project
  • Provides a straightforward method of controlling for the risk of competing projects - higher-risk cash flows can be discounted at a higher interest rate
  • Provides a direct estimate of the change in shareholder wealth resulting from undertaking a project
162
Q

What are the limitations of net present value methods?

A
  • May not be considered as simple or intuitive as some other methods
  • Does not take into account the management flexibility with respect to a project - mgmt may be able to adjust the amount invested after the first year or two depending on the actual returns
163
Q

Internal (time-adjusted) rate of return (IRR)

A

Discounted cash flow method; determines the rate of discount at which the PV of the future CF will exactly equal the investment outlay

164
Q

TVMF formula

A

PV (investment today) / Cash flows

165
Q

Relationship between NPV method and the IRR method

A
  • NPV > 0; IRR > Discount rate
  • NPV = 0; IRR = Discount
  • NPV
166
Q

Advantages of the internal rate of return method

A
  • Adjusts for the time value of money
  • Hurdle rate is based on market interest rates for similar investments
  • Results tend to be a little more intuitive than the results of the net present value method
167
Q

Limitations of the internal rate of return method

A
  • Depending on the CF pattern, there may be no unique IRR for a particular project - there may be multiple
  • Occasionally, there may be no real discount rate that equates the project’s NPV to zero
  • Technique also has limitations when evaluating mutually exclusive investments
168
Q

Capital rationing

A

Deciding on one of serveral projects that are all acceptable; decide on the best project

169
Q

Net present value profile

A

Allows the portrayal of the net present value of projects at different discount rates

170
Q

What works better when a choice must be made among a group of investments?

A

Net present value works better than internal rate of return

171
Q

Example of choosing between IRR and NPV

A

Company must choose between projects C and D.

IRR on project C is 15% with life of 5 years
IRR on project D is 13% with life of 10 years
-Project C selected under IRR criteria (assumes that cash inflows can be reinvested at 15%)

If cash inflows can be reinvested at only 9%, project B may be better alternative

172
Q

Examples of relevant cash flows

A
  • Initial investment in LT tabgible or intangible assets for each investment alternative
  • Any initial investment in working capital for each investment alternative (e.g. inventories, AR)
  • Cash flow from sale of any assets being replaced
  • Differences in cash flows from operations under the alternatives
173
Q

What should be considered when determining future cash flows?

A
  • Focus on cash flows not accounting income
  • Payments for incremental income taxes should be included
  • Depreciation expense does not affect cash flows but the firm receives a tax savings (shield) from depreciation expense; reduces taxable income and therefore reduces tax payments; note that this is tax depreciation that generates the tax shield
174
Q

What happens if the tax basis is expected to be different from the disposal price?

A

Tax basis (initial cost - tax depreciation taken)

-Tax gain or loss will generate tax inflow or outflow

175
Q

Recovery of any working capital investment

A

investment recovered at the end of project by liquidation of inventories, accounts receivable; generally no tax implications of this recovery because it is assumed that the cash received will be equal to the book value (tax basis) of the WC items

176
Q

Risk in capital bugeting?

A

Cash flows are not known with certainty

177
Q

Probability analysis

A

Provide mathematical way of expressing uncertainty about the outcomes

178
Q

Probability distribution

A

Set of all possible outcomes from an investment with a probability assigned to each outcome

Can be discrete or continuous

179
Q

Discrete probability distribution

A

Identifies a limited number of potential outcomes and assigns probabilities to each of the outcomes

180
Q

Continuous probability distribution

A

Theoretically defines an infinite number of possible outcomes

E.g. normal distribution (bell-shaped curve)

181
Q

Why is the normal distribution useful?

A

Approximates many real-world situations can be completely described with only two statistics; mean and standard deviation

182
Q

Distances and curve areas under the normal distribution

A
  1. 00 = 68.3%
  2. 64 = 90.0%
  3. 96 = 95.0%
  4. 00 = 95.4%
  5. 57 = 99.0%
183
Q

Expected return formula

A

k^ = summation kipi

k^ = expected value of the returns
k = returns from various possible outcomes
p = probabilities assigned to possible outcomes
184
Q

Standard deviation formula

A

Summation (k^-k)^2pi

185
Q

What does the standard deviation provide?

A

Rough estimate of how far each outcome falls away from the mean

186
Q

The larger the standard deviation..

A

The greater the risk

187
Q

What is the significant limitation of standard deviation as a measure of risk?

A

Size depends on the size of investment

188
Q

How to eliminate the size difficulty analysts have with standard deviation as a measure of risk?

A

Coefficient of variation

189
Q

Coefficient of variation formula

A

Standard deviation / expected return

Measure of risk that is normalized for the size of the investment

190
Q

Risk-adjusted discount rates

A

Using different discount rates for proposals with different levels of risk

191
Q

Sensitivity analysis

A

Management makes many assumptions before arriving at the investment’s net present value; recompute with different variables, management can determine how sensitive the net present value is to changes in each major assumption

Explore “what if” situations to determine the variables to which the outcomes are particularly sensitive

192
Q

Scenario analysis

A

More complex variation of sensitivity analysis

Instead of exploring the effects of a change in one variable, management develops a scenario that might happen if a number of related variables change

193
Q

Simulation models

A

Computer simulation software makes it possible to model the effects of even more economic conditions on the results of an investment project

194
Q

Decision trees

A

Visual representation of decision points and potential decisions

195
Q

Real options

A

Assumes that once management makes an initial investment, it has an option to take a number of future actions that will change the value of the investment

196
Q

Expansion options

A

Mgmt may receive an option to expand the investment

197
Q

Abandonment options

A

Management almost always has an option to abandon a project

198
Q

Follow-up investment options

A

Management may receive other investment opportunities when investing in the project

199
Q

Flexibility options

A

Management may be provided with the ability to take advantages of changes in economic circumstances

200
Q

Lease versus Buy

A

Mgmt will often compare the two alternatives using discounted cash flow

201
Q

Why is a lease attractive?

A
  • Tax advantages
  • Require less initial investment
  • Less formal borrowing which may be restricted by loan covenants tied to the company’s other debt
  • Certain leases do not have to be capitalized and therefore will not require recognition of debt on the company’s balance sheet
202
Q

Risk preference function

A

Illustrates the efficient frontier for portfolio investments

Any portfolio of investments that falls on the line is efficient

Highly correlated investments do nothing to diversify risk
Negatively correlated investments do reduce overall risk (investments move in opposite directions with changing economic conditions)

203
Q

Coefficient of correlation

A

Measure that is used to express the extent of the correlation between a set of investments

Value from +1 to -1

Positive is little risk reduction and negative is significant risk reduction

BEC - Wiley (5 decks)

Brainscape helps you reach your goals faster, through stronger study habits.
© 2024 Bold Learning Solutions. Terms and Conditions