Module 43: Financial Risk Management and Capital Budgeting Flashcards

Question

Systematic risk

Answer 1

The risk related to market factors which cannot be diversified away

Answer 2

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

Answer 3

Real return minus risk-free real return

Answer 4

Compensated for taking risk

Answer 5

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

Answer 6

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

Answer 7

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)

Answer 8

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

Answer 9

Ex ante basis (before the fact) Use expected returns and estimates of risk

Answer 10

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

Answer 11

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

Answer 12

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

Answer 13

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

Answer 14

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

Answer 15

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 ```

Answer 16

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

Answer 17

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

Answer 18

Diversify away unsystematic risk

Answer 19

Fluctuations in GDP, inflation, interest rates Cannot be diversified away

Answer 20

Total risk of the investment, both systematic and unsystematic)

Answer 21

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

Answer 22

Describes the investor's trade-off between risk and return Falling on the line is an efficient portfolio

Answer 23

Cost of borrowing funds

Answer 24

1. Individual firm's creditworthiness (or risk of default) | 2. Sector risk - risk related to economic conditions in firm's economic sector

Answer 25

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

Answer 26

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

Answer 27

Unsystematic risk; unique to particular loan or investment

Answer 28

Contractual rate charged by the lender

Answer 29

True annual return to the lender

Answer 30

Interest is compounded more often than annually

Answer 31

EAR = (1 + r/m)^4 -1 ``` r = stated interest rate m = compounding frequency ```

Answer 32

Describes the relationship between long-and short-term rates Important in determining whether to use long-term fixed or variable rate financing

Answer 33

A yield curve

Answer 34

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

Answer 35

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

Answer 36

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

Answer 37

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

Answer 38

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

Answer 39

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

Answer 40

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

Answer 41

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

Answer 42

Intermediate-term securities

Answer 43

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

Answer 44

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

Answer 45

Market is expecting ST rates to fall

Answer 46

Market is indicating a belief that inflation will decline

Answer 47

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

Answer 48

- Options - Forwards - Futures - Currency swaps - Interest rate swaps - Swaption

Answer 49

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)

Answer 50

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

Answer 51

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

Answer 52

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

Answer 53

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

Answer 54

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

Answer 55

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

Answer 56

- Commercial banks - Insurance companies - Pension funds - Savings and loan associations - Mutual funds - Finance companies - Investment bankers - Money market funds - Credit unions

Answer 57

Other party to the contract or agreement

Answer 58

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

Answer 59

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

Answer 60

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

Answer 61

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

Answer 62

As an investment to speculate on price changes in various markets

Answer 63

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

Answer 64

Statement of Financial Accounting Standards 133 (SFAS 133)

Answer 65

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

Answer 66

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

Answer 67

- 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

Answer 68

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

Answer 69

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

Answer 70

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

Answer 71

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

Answer 72

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

Answer 73

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

Answer 74

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

Answer 75

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

Answer 76

London Interbank Offered Rate

Answer 77

- 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

Answer 78

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

Answer 79

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

Answer 80

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

Answer 81

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"

Answer 82

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

Answer 83

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.

Answer 84

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

Answer 85

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

Answer 86

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

Answer 87

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

Answer 88

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

Answer 89

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)).

Answer 90

Multiply the ordinary annuity factor times (1+i)

Answer 91

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)

Answer 92

Basic formula: FV or PV = TVMF x Amount

Answer 93

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

Answer 94

1. Time 2. Interest rate 3. Payment

Answer 95

1. Time | 2. Interest rate

Answer 96

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

Answer 97

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

Answer 98

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.

Answer 99

The bond will sell for the maturity value

Answer 100

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

Answer 101

$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 2. 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

Answer 102

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

Answer 103

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

Answer 104

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

Answer 105

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

Answer 106

Mgmt chooses the projects that best meet the criteria established

Answer 107

Mgmt decides on the best source of funding for the project

Answer 108

Mgmt undertakes the project and monitors the performance of the investment

Answer 109

Using discounted cash flow techniques

Answer 110

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

Answer 111

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

Answer 112

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

Answer 113

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

Answer 114

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

Answer 115

Difference in cost between two alternatives

Answer 116

Maximum income or savings foregone by rejecting an alternative

Answer 117

Cash disbursement associated with a specific project

Answer 118

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

Answer 119

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.

Answer 120

Depreciation does not consume cash

Answer 121

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

Answer 122

- 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

Answer 123

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

Answer 124

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

Answer 125

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

Answer 126

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

Answer 127

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

Answer 128

- 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

Answer 129

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

Answer 130

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

Answer 131

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

Answer 132

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

Answer 133

PV of future net cash inflows / initial investment X 100

Answer 134

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

Answer 135

Net present value methods

Answer 136

- 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

Answer 137

- 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

Answer 138

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

Answer 139

PV (investment today) / Cash flows

Answer 140

- NPV > 0; IRR > Discount rate - NPV = 0; IRR = Discount - NPV

Answer 141

- 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

Answer 142

- 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

Answer 143

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

Answer 144

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

Answer 145

Net present value works better than internal rate of return

Answer 146

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

Answer 147

- 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

Answer 148

- 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

Answer 149

Tax basis (initial cost - tax depreciation taken) -Tax gain or loss will generate tax inflow or outflow

Answer 150

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

Answer 151

Cash flows are not known with certainty

Answer 152

Provide mathematical way of expressing uncertainty about the outcomes

Answer 153

Set of all possible outcomes from an investment with a probability assigned to each outcome Can be discrete or continuous

Answer 154

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

Answer 155

Theoretically defines an infinite number of possible outcomes E.g. normal distribution (bell-shaped curve)

Answer 156

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

Answer 157

1. 00 = 68.3% 1. 64 = 90.0% 1. 96 = 95.0% 2. 00 = 95.4% 2. 57 = 99.0%

Answer 158

k^ = summation kipi ``` k^ = expected value of the returns k = returns from various possible outcomes p = probabilities assigned to possible outcomes ```

Answer 159

Summation (k^-k)^2pi

Answer 160

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

Answer 161

The greater the risk

Answer 162

Size depends on the size of investment

Answer 163

Coefficient of variation

Answer 164

Standard deviation / expected return Measure of risk that is normalized for the size of the investment

Answer 165

Using different discount rates for proposals with different levels of risk

Answer 166

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

Answer 167

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

Answer 168

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

Answer 169

Visual representation of decision points and potential decisions

Answer 170

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

Answer 171

Mgmt may receive an option to expand the investment

Answer 172

Management almost always has an option to abandon a project

Answer 173

Management may receive other investment opportunities when investing in the project

Answer 174

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

Answer 175

Mgmt will often compare the two alternatives using discounted cash flow

Answer 176

- 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

Answer 177

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)

Answer 178

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

Module 43: Financial Risk Management and Capital Budgeting Flashcards

(203 cards)