Study Guide

Question 1

Excess cash flows can result in

Answer 1

paying dividends
reinvest in projects

Question 2

Net Present Value

Answer 2

measures the present value of all of the changes in a firm’s current and future free cash flow resulting from an investment

Question 3

Capital Budgeting decisions are

Answer 3

independent of finance decisions

Question 4

What does NPV miss?

Answer 4

misses the value of options that managers have to expand, scale back, or abandon investment projects once they are undertaken

Question 5

IRR

Answer 5

tells you the return you expect to earn each year

Question 6

Qualities of IRR (3 things)

Answer 6

1. NPV is equal to 0
2. depends only on the characteristics of cash flows
3. discount rate is not part of the equation

Question 7

IRR and NPV criteria lead to the same investment decision when

Answer 7

initial cash flow being -
followed by the rest being positive

vice versa

investment decision does not change

Question 8

Problems with IRR

Answer 8

Multiple discount rates exist
inappropriate to use IRR to choose among projects

Question 9

Payback Period

Answer 9

is the time until the sum of future cash flows equals the initial investment

“time it takes to get our money back”

Question 10

Issues Concerning Payback

Answer 10

1. Doesn’t correspond to a measure of an invt. effect on value of firm
2. Doesn’t discount cash flows
3. Benchmark payback period is arbitary
4. ignores distant cash flows

Question 11

Machinery is

Answer 11

not part of NWC since it is not long term

Question 12

What is a measure of total risk?

Answer 12

Standard Deviation

Question 13

List out the order of risk from least to highest

Answer 13

T Bills
Bonds
Large Firm Common Stocks
Small Firm Common Stocks

Question 14

Higher risk means that there is going to be a

Answer 14

higher return

Question 15

When correlation is close to 1 it is

Answer 15

getting close and similar to one another in having a linear relationship

Question 16

Systematic Risk and…

Answer 16

market
non-diversifiable

Question 17

Unsystematic Risk and…

Answer 17

firm specific
diversifiable

Question 18

When correlation goes towards -1 you get

Answer 18

lower risk and more diversification

Question 19

A stock’s Beta measures

Answer 19

its non-diversifiable, systematic, or market risk

Question 20

Example of non-diversifiable risk

Answer 20

interest rates
war
market rates

Question 21

Examples of diversifiable risk

Answer 21

death of a ceo
markets and acquisitions

• both only effect a single company

Question 22

Higher Beta indicates

Answer 22

higher market risk
the company is more affected by changes in the overall economy and therefore has higher required returns

Question 23

What type of companies sell high betas?

Answer 23

Luxury companies

Question 24

T-Bills =

Answer 24

R f

Question 25

S&P 500 =

Answer 25

R m

Question 26

Any asset that plots below the SML is

Answer 26

overpriced and has a negative NPV

Question 27

Beta vs standard deviation

Answer 27

beta measures a stock’s volatility relative to the market as a whole, while standard deviation measures the risk of individual stocks.

Question 28

Required Returns represent

Answer 28

a cost of raising capital

Question 29

firms with high risk will have

Answer 29

high WACC’s

Question 30

Tax deductibility of interest payments on debt results in

Answer 30

lowers the cost of debt for firms

Question 31

Order of Operations

Answer 31

Debt - lowest
preferred stock
common stock

Question 32

Venture Capital

Answer 32

money invested to finance a new firm

Question 33

Interest tax shield

Answer 33

increases the value of the firm

Question 34

M&M Proposition assumes

Answer 34

no taxes
no fees
fixed investment policy

capital strucutre doesn’t impact firm value

Question 35

Beta is associated with
(2 things)

Answer 35

compensated risk
which is affiliated with required rate of return

Question 36

St.Dev and risk

Answer 36

StandardDeviation involves total risk so therefore it is both systematic risk and unsystematic risk

Question 37

What decides to accept or reject IRR?

Answer 37

if irr is above market then take it

Question 38

Beta vs StDev

Answer 38

beta is compensated risk while stdev is total risk of everything