Risk Mgmt and Capital Budgeting

Question 1

What is a financial intermediary?

Answer 1

Commercial bank, mutual fund, investment banker

Question 2

What is sensitivity analysis

Answer 2

A technique that explores the importance of variables by manipulating variables one at a time to determine their importance to the forecast - it explores the importance of assumptions underlying a forecast

Question 3

What is scenario analysis

Answer 3

It is a technique that explores the effect of simultaneous changes in a group of variables

Question 4

What are decision trees

Answer 4

A technique that recognizes the multiple decisions that are involved in implementing a project

Question 5

What is the real options technique

Answer 5

Views an investment as purchasing an option

Question 6

What is the formula for the economic rate of return on common stock

Answer 6

( Dividends + change in price ) / beginning price

Return on stock is measured by the return to the investor both in appreciation and dividends.

Question 7

Simple earnings per share

Answer 7

(Net income - preferred dividend) / common shares outstanding

Question 8

Price earnings ratio

Answer 8

Market price per share / earnings per share

Question 9

Dividend rate on a share of stock

Answer 9

Dividends per share / market price per share

Question 10

What is internal rate of return aka time adjusted rate of return method

Answer 10

It is the cost of capital % at which the NPV profile crosses the horizontal axis. If it crosses the horizontal axis at a higher cost of capital %, it has a higher IRR.
Depending on the cost of capital %, it will have a higher or lower NPV.
IRR adjusts for time value of money, profitability of a project, intuitive, BUT it has limitations when evaluating mutually exclusive investments.
IRR does not explicitly consider risk.
Project cost / annual cash inflow = PV of ordinary annuity factor of IRR%
REMEMBER THIS FORMULA!
Inflow X pv of $1 due at end of N periods = outflow
Investment = TVMF X Cash flows

Question 11

What are hedging strategies for a variable short term loan where mgmt is concerned with volatility of short term rates?

Answer 11

Purchase a short position in the Treasury bills futures market
Enter into an interest rate swap
Enter into a forward contract to sell Treasury bonds in the future

Question 12

How is payback period calculated

Answer 12

Evaluates investments on the basis of the length of time until the initial investment is returned. If annual cash flows are constant, it is: initial investment / annual cash flow
Payback method ignores profitability! It only determines how many periods it will take to recover the initial investment. It does not consider the time value of money.
It would consider the salvage value of old equipment.

Question 13

What are the differences between rates

Answer 13

Inflation = nominal rate - risk free rate
Risk of borrower = nominal rate - stated rate
Risk free rate = basic charge for funds
Frequency of compounding = effective - stated rate

Question 14

Yield curve

Answer 14

A normal yield curve is one in which short term rates are lower than intermediate term rates which are lower than long term rates - it is upward sloping.
If it is the other way around, it is an inverted yield curve.
Humped or flat curves are not normal.

Question 15

What are derivative risks

Answer 15

Market risk - possible loss due to adverse market changes
Legal risk - possible loss from legal/regulatory action
Basis risk - risk of loss from ineffective hedging activities
Credit risk - as a result of counterparty to agreement failing to meet obligation
Exchange rate risk - risk of fluctuations in relative value of foreign currencies
Expropriation and sovereign risks - possibility that a country might seize a foreign investment
Multinational beta - risk of individual investment relative to multinational market as a whole

Question 16

Difference between NPV and IRR

Answer 16

IRR uses rate of return at which PV of cash flows will equal the investment outlay. It assumes that cash flows received are reinvested to earn the same IRR (rate earned on the investment).

NPV uses a discount rate which is the minimum rate of return desired. It assumes that all cash flows received are reinvested at this minimum rate of return.
NPV is best at considering profitability.
Note that NPV considers cash flows, thus amortization would not impact, but taxes paid on inflow less amortization would be considered!

Question 17

Financial decision making

Answer 17

All capital budgeting decisions are based on predictions of future income or cash flows.
The accounting rate of return does not consider the time value of money.
Opportunity cost is a hypothetical cost and is not recorded as an expense.

Question 18

When will a loan have the lowest effective annual % rate if the nominal rate is the same?

Answer 18

For a given nominal rate, the least frequent compounding is associated with the lowest effective annual % cost. The term of the loan is NOT relevant.

Question 19

Standard deviation

Answer 19

Square root of the variance

Question 20

Expected value

Answer 20

Uses probabilities as weights in determining the probability of outcome. Each possible outcome is multiplied by an appropriate weight. Summed to get expected value

Question 21

Coefficient of variation

Answer 21

=Standard deviation of returns / expected value amount

Question 22

Objective function

Answer 22

Decision model which quantifies a goal

Question 23

When would the IRR of a proposed asset purchase decrease?

Answer 23

An event that would decrease IRR would have to either decrease or extend the cash flows from, or increase the initial cost of, the investment.
A decrease in tax credits would increase the initial cost of investment.
An increase in related working capital
Lengthening the payback period
Using straight line instead of accelerated as there would be more tax expense in earlier years, decreasing rate of return

Question 24

Calculate payback

initial cost 500k, life 10 years, annual cash flows 200k, salvage value 100k

Answer 24

Initial cost of investment / annual net cash inflows = 2.5 years
Salvage value of new machine does NOT impact initial cost

Question 25

What are the stages in capital budgeting

Answer 25

Identification
Search
Info acquisition
Selection
Financing
Implementation and control

Question 26

How is relative risk calculated? Find investment with lowest relative level of risk
1 - expected return of 16% and std dev of 10%
2- 20% and std dev of 11%

Answer 26

Relative risk is the ratio of the std dev of the return to the expected return. Investment 2 has the least .550 (11/20).

Question 27

What is the preferred method of calculating expected return for a long term investment? geo or arithmetic

Answer 27

geometric average depicts the compound annual returns earned by the investor

Question 28

What is beta

Answer 28

Beta is the measure of systematic risk of the investment. If >1, then the investment’s systematic risk is higher than that of the market portfolio.
An investment with a low return and high positive beta should be removed. Positive beta indicates that its return is highly correlated with the return of the portfolio, increasing the risk of portfolio,

Question 29

How do you know which stock is riskier?

Given A with expected return of 20% and 15% std dev and B with 10% and 9%.

Answer 29

The coefficient of variation for B is higher. This provides a measure of the relative variability of investments calculated by std dev/expected return.
Note a higher std dev does not mean riskier, nor does a higher return.

Question 30

Who impacts what term maturities? Commercial banks, savings institutions, life insurance companies, and individual investors

Answer 30

Commercial banks - short term
, savings institutions - intermediate term
, life insurance companies - long term due to nature of their commitments to policyholders
, and individual investors - no significant impact on market

Question 31

How is effective annual interest on loan calculated? 1 year of 100k at 8% compounded quarterly

Answer 31

EAR = (1+ stated rate / compounding frequency) to the power of compounding frequency - 1
= (1+ .08/4) ^4 -1
= 8.24%

Question 32

If company has large amount of variable rate financing due in one year and is concerned about increases in short term rates, how would they hedge?

Answer 32

Selling Treasury notes in the futures market will hedged increase in short term interest rates. If interest rates increase, the value of the Treasury notes will decline, resulting in a gain to the company. If the hedge is effective, the gain will offset the increase in the company’s interest costs.
Note that buying an option to purchase treasury bonds would hedge a decline in interest rates.
Note selling options is not effective as it allows the purchaser the option and not the obligation to purchase.

Question 33

Interest rate swap

Answer 33

Involves an exchange of cash flows, usually the exchange of fixed cash flows for variable cash flows. The underlying assets are not relevant. Two companies exchange their debt servicing obligations on some amount of debt principal. The actual exchange of funds is the net pmt from the party owing the greater amount for the period.

Zero coupon method is used to determine the fair value of interest rate swaps and includes variables of discount rate, timing of cash flows, estimated net settlement cash flows

Question 34

Selling at premium

Answer 34

Means that the market rate is LESS than the coupon rate

Premium means that the sale price is higher than the bond value.

Question 35

IRR question: what is the annual savings needed to make investment realize a 12% yield?
Cost 50k, Residual at 5 year end 10k, PV of annuity of 1 at 12% for 5 years is 3.6 and pv of 1 due in 5 years at 12% is 0.57

Answer 35

TVMF X Cashflows = PV(investment today)
3.60CF + (.57 X 10k) = 50k
CF = 12,306
If the annual savings equals 12,306 the PV of the cash inflows will equal the cash outflows

Question 36

How is receivable recorded that has an unreasonably low stated interest rate? Given 10k note with 3% annual for 5 years. Future value of $1 due in 5 years at 3% is 1.1593 and PV of $1 due in 5 years at 8% is .680

Answer 36

It is recorded at its present value. The receivable will result in a lump sum collection of 11,593 (10k x 1.1593) so its PV is 7883 (11593 X .680).

Question 37

How is the market price of a bond issued at a discount calculated?

Answer 37

The market price of a bond issued at any amount is equal to the PV of all of its future cash flows, discounted a the current market (effective) interest rate. The market price of a bond issued at a discount is equal to the pv of both its principal and periodic future cash interest pmts at the state cash rate of interested, discounted at the current market/effective rate

Question 38

How is the accounting rate of return calculated? Given equipment for 100k that lasts 10 years, deprec st line, 20k annual savings

Answer 38

It computes an approximate rate of return which ignores the time value of money. It is calculated as expected increase in annual net income divide by initial (or average) investment in a project.
The increase in annual net income is 20k of cash flows less the annual deprec of 10k to get 10k. The ARR is 10k/ 100k investment = 10%

ARR does not consider the ACTUAL cash flows or time value of money.

Question 39

What is the profitability index (1.15)

Answer 39

It is the NPV of future cash flows divided by the amount of the initial investment. If the index is >1, then the NPV of investment is positive.

Question 40

Real options technique

Answer 40

Views an investment as purchasing an option. Would allow mgmt to justify an investment based on considerations other than expected cash flows.

Question 41

Risks for single project vs diversified

Answer 41

A diversified company can be thought of as an investment portfolio. The relevant risk for both mgmt and investors is the weighted average of project risk.
Pure play risk and project risk relates to a single project.
Note that the std dev of project risk does not adequately measure the risk of the portfolio.

Question 42

Decision making tools

Answer 42

Probability analysis - uses probabilities to calculate the expected value of each action. The expected value of an action is the weighted average of the payoffs for that action, where the weights are the probabilities of the various mutually exclusive events that may occur. It is an extension of sensitivity analysis.
Cost volume profit analysis is used to predict prodits at all levels of production in the relevant range.
Program evaluation and review technique (PERT) is used to estimate, schedule, manage a network of interdependent project activities. It is useful for managing large scale complex projects. It is the best method to determine the best course of action under uncertain conditions.
The scattergraph is a graphical approach to computing the relationship between two variables.

Question 43

Systematic and unsystematic risk

Answer 43

Systematic and unsystematic risk is captured by the variance of an investment.
Beta is the covariance of the asset’s returns with the returns of the overall portfolio. Beta measures the systematic risk of the investment.

Question 44

What would encourage a company to use short term loans to retire its 10 year bonds that have 5 years to maturity

Answer 44

If interest rates have DECLINED over the last 5 years, the loan obtained 5 years ago would have a higher interest rate than loans obtained today.

Question 45

Calculate after tax cash flows in year 2. Given 20k annual deprec for tax purposes, 5k additional investment in working capital, 100k initial investment, 30 annual cash flows before taxes, terminal value is 0, cost of capital 8%. Tax rate is 30%

Answer 45

Need to deduct the income taxes including impact from depreciation. The income taxes are (30k-20k deprec)X30% = 3k. The after tax cash flows then would be 30k - 3k taxes = 27k after tax cash flows
It does not subtract depreciation but the taxes impact from deprec.

Question 46

Multiperiod project has positive NPV. How is required rate of return?

Answer 46

If positive NPV, then the internal rate of return is greater than the require rate of return.
Note that there is not relationship to WACC.

Question 47

WACC

Answer 47

The WACC provides a measure of the cost of the funds that the company is considering investing in a project. The WACC is the most commonly compared to the IRR to evaluate whether to make an investment. Would want a IRR higher than WACC.
Note it is not Treasury rates as it does not provide an estimate of the company’s cost of funds.

Question 48

How to find the cost of new machine under ARR? Given 10 year depreciation, cash flow after tax of 3k for 10 years, 10% ARR on initial increase in required investment.

Answer 48

ARR = accounting net income / book value
BV of new machine is its cost.
The 3k does not reflect the 10% deprec.

Cost = (3k - .1cost) / cap rate of 10%
.1 cost = 3k - .1cost
cost = 15k