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Finance D 76 > Unit 6 Decision Making > Flashcards

Unit 6 Decision Making Flashcards

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1
Q

Capital Budgeting Criteria

A

used to evaluate investments
NPV - net present value
IRR - Internal Rate of Return
PI - Profitability Index

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2
Q

NPV

A

difference between a projects present value of cash inflows and outflows
Indicates potential profit in today’s $ of a planned investment

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3
Q

Advantages of NPV

A

Accounts for time value of money
Determines value added to firm
Considers risk and required return

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4
Q

Disadvantages of NPV

A

Difficult to know appropriate cost of capital

Cannot be use to compare projects of different size

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5
Q

IRR

A

percentage return on an investment

The rate that would make NPV equal to 0.

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6
Q

Decision rule for IRR

A

If IRR > cost of capital, accept project

cost of capital = hurdle rate

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7
Q

Advantages to IRR

A

Easy to interpret
Considers Time Value of Money
Doesn’t need Rate of Return

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8
Q

Disadvantages of IRR

A
  • Not a good indicator of value created
  • Ignores mutually exclusive projects - can’t be used on its own to choose between one project or another
  • Assumes Reinvestment at IRR
  • Cannot Compare Projects with Different Durations
  • Requires Conventional Cash Flows
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9
Q

NPV decision rule

A

If NPV is positive = accept

If NPV is negative = reject

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10
Q

PI

A

ratio of payoff to the investment amount

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11
Q

PI decision rule

A

Accept if PI > 1

Reject if PI < 1

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12
Q

Advantages of PI

A

same advantages of NPV

+ Can be used to choose between projects

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13
Q

Disadvantages to PI

A

Need cost of capital

not useful for mutually exclusive projects

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14
Q

Par Value

A

initial value of bond
value paid out at maturity
corporate US bonds usually $1000

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15
Q

Coupon Rate

A

aka coupon yield

interest rate on the bond

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16
Q

coupon

A

interest payment amount

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17
Q

YTM

A

yield to maturity

actual return on a bond when bought on the marketplace

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18
Q

covenants

A

affirmative - things bond issuer pledges to do to protect bondholders
Negative - things bond issues pledges not to do to protect bondholders

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19
Q

Premium

A

bond selling above face value

YTM is lower than coupon rate

20
Q

Discount

A

bond selling below face value

YTM is higher than coupon rate

21
Q

Common stock

A

equity/ownership in a firm
confers voting rights
lowest claim
no maturity

22
Q

corporate governance

A

control issues involved in running a company (management tasks)

23
Q

upside potential

A

unlimited potential earnings on common stock

24
Q

preferred stock

A

aka hybrid security
some elements of equity and debt
no fixed maturity (like equity/common stock)
no voting rights
fixed payments
company may skip payments
payments must be paid before common stock dividends are paid out (cumulative)

25
Q

capital investment

A

money use used to buy long term assets
loans, stocks, bonds
may affect short term earnings and growth

26
Q

Intrinsic value

A

asset value determined through analysis without looking at market value
add discounted future cash flows of an asset (present value of future cash flows)
compare to market value to determine value

27
Q

bond valuation

A

derive YTM from coupon, face value, current value
derive current value from coupon, face value, YTM
use Present Value to determine value

28
Q

preferred stock valuation

A 
perpetuity model
Vps = D/kps
D is dividend
kps is required rate of return
compare to current market value to determine if purchase is advisable
29
Q

common stock valuation methods

A

Gordon Growth Model

based on Dividend Discount Model - calculate present value of all future dividend cash flows

30
Q

Assumptions in Gordon Growth Model

A

Dividends paid each year

Dividends grow at constant rate forever

31
Q

GGM formula

A

Vcs = D1/(kcs-g)
D1 is dividend paid next year
kcs is required rate of return
g is constant growth rate

32
Q

Capital Asset Pricing Model

A

Pricing for Capital Assets

linear relationships between risk and return

33
Q

beta

A

how the price of a security varies with market
market has beta of 1
riskless asset has beta of 0
exaggerated reaction to market by a firm is beta > 1
muted reaction to market by a firm is beta < 1

34
Q

aggressive asset vs defensive asset

A

aggressive - beta > 1

defensive - beta < 1

35
Q

CAPM formula

A 
Ri = Rf + Bi(Rm - Rf)
Ri is return on a security
Rf is risk free rate
Rm is market return
Bi is beta
36
Q

CAPM decision rule

A

if CAPM is below expected return, asset is undervalued

37
Q

3 factors for evaluating capital investments

A

All cash flows through project’s life
Time value of money - evaluate costs and returns in present dollars
Cost of capital (required rate of return) - incorporate risk into required rate of return

38
Q

opportunity cost

A

future investment opportunity lost due to time scope of current investment

39
Q

tax shield

A

interest expenses are paid before taxes are calculated

interest expenses reduce taxable income

40
Q

incremental cash flows

A

cash flows in or out of firm that result from accepting a project

41
Q

non-incremental cash flows

A

costs a firm would incur regardless of accepting a project

42
Q

2 guidelines when considering cash flows

A

capital budgeting occurs in CEO office, to judge impact on entire company
decide what really are incremental cash flows

43
Q

Incidental cash flows

A

indirect cash flows that should be included in the project evaluation

44
Q

cannibalization

A

one product steals sales from another product in the company

may be an incidental cost

45
Q

sunk costs

A

irretrievable costs ie research development, market analysis

should not affect decisions on the future

Finance D 76 (5 decks)

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