Problem questions B3

Question 1

1. What is normal yield curve?
2. What is Inverted (abnormal) yield curve?
3. What is Flat yield curve?
4. What is humped yield curve?

Answer 1

1. Normal yield curve = an upward sloping curve in which Short-term interest rate < intermediate term rate< LT rates.
2. Inverted yield curve= a downward-sloping curve in which ST rate >intermediate-term rate> LT rates.
3. Flat yield curve - curve in which all ST, inter, LT are all the same.
4. Humped yield curve - a curve in which intermediate term rate > both ST and LT rates.

Question 2

What is economic rate of return on Common stock?

Answer 2

It is measured by the return to investor both in appreciation and in dividends.

= (dividends + change in price)/ begin price

Question 3

What is the excess present value index (or profitability index)?

Answer 3

the ratio of PV cash in­flows to the initial cost of a project. it’s used when there is a limit on funds available for capital investments. Assuming other factors are equal, allocating funds to those projects with the highest excess present value indexes.

PV after-tax net CF/ Initial cash invested = Excess PV index

( net PV is calculated using the minimum required rate of return. )

Question 4

What is disadvanatge of IRR as a method of evaluating investment?

Answer 4

it has limitations when evaluating mutually exclusive investments. (comparing investements of different lives and different CF patterns.)

NPV assumes that cash inflows from the investment project can be reinvested at the cost of capital while IRR assumes that cash flows from each project can be reinvested at the IRR for that particular project. This underlying assumption is considered to be a weakness of the IRR technique.

Question 5

How salvage value is different between NPV method and Payback method?

Answer 5

Salvage value is included in the calculation of NPV, however,

it is ignored in the calculation of payback period.