Exam 2 review
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. What would you like to do?
NPV and IRR will generally give us the same decision; if not then go with ____
What are the exceptions to this rule?
- nonconventional cash flows (cash flow signs change more than once)
- Mutually exclusive projects
3 Advantages of IRR
- intuituvley appealing
- simple way to communicate the value of a project to comeone whoe doesnt know all the estimation details
- if its high enough, you may not need to estimate a required return
As the DR increases the NPV ___. Why?
Decreases, because we are accounting for the risk with in this reutrn
What is IRR and its decision rule?
the return that makes NPV = 0
accept the project if the IRR is greater than the required return
What is IRR based on?
The estimated cash flows and is independent of interest rates found else where
Disadvantages of AAR
- not a true rate of return
- cutoff point
- biased on book value
What is average accounting return and what is its decision rule?
avg ni / avg bv
accept the project if the AAR is greater than a preset rate
Disadvantages of discounted payback
- rejects positive NPV investments
- arbitrary cut off point
- ignores cash flows beyond cutoff point
- biased against long term projects
Advantages of disounted payback
- time value of money
- easy to understand
- doesnt accept negative estimated NPV when all future cash flows are +
- Biased towards liquidity
Does the discounted pay back include the inidcation about the increase in value, and should we consider the payback rule for decision maker?
Does the discount payback period account for the time value of money, the risk of the cash flows?
Yes because discounting was introduces and because risk is built into that
How do you compute the DISCOUNTED payback period?
What do you compare it to?
What is the decision rule?
Compute the PV of each cash flow and then determine how long it takes to pay back on a discounted basis
a spcified required period
accept the project if it pays back on a discounted basis with in a specified time
Advantages of Payback
Easy to understand, adjusts for uncertainity of later cash flows, and biased towards liquidity
Does the payback period account for the time value of moeny, the risk of the cash flows, the inidcation about the increase in value, and should we consider the payback rule for decision maker?
How do you solve for the payback period?
- 1) estimate the cash flows
- 2) subtract the furture cash flows from the inital cost until the initial investment has been recovered
What is the payback period and its decision rule?
How long does it take to get the initial cost back in nominal sense?
Accept the payback if the period is less than some preset limit
Does the NPV rule account for the Time value of money, risk of cash flows, an indication about the increase in value, and should NPV even be considered in the decision rule?
NPV can best be describes as representing...
the dollar change in the firms value resulting from undertaking the project
What happens when a firm regularly undertakes projects with positive NPVs?
The firms stock price will rise because the projects provide returns which exceeded shareholders expectations; which were the required rate of return
What is the decision rule for NPV and what does it mean?
If the NPV is positive the accept the project. This means that the project is expected to add value to the firm and will therefor increase the wealth of the owners.
The discount rate that we use for the NPV calculation is known as the ____ _____ for the assets of this risk level. Other potential synonyms are (4):
- 1) Required rate of Return
- 2) reinvestment rate
- 3) opportunity cost
- 4) cost of capital
What are the 3 steps in creating NPV?
- 1) estimate future cash flows
- 2) estimate required return
- 3) find the PV of the cash flows and subtract the initial investment
What is NPV and what does it tell us?
The difference between the market value of a project and its cost; it tells us how much value is creates from undertaking an investment
How is capital budgeting used in practice?
- Consider investment criteria when making decisions
- NPV and IRR are the most commonly used primary investment criteria
- Payback is a commonly used secondary payback criteria
Different capital budgeting decision makers
- Profitiability Index
- Payback Period
- Discounted Payback Period
Capital budgeting decision rules
- 1) Does the decision rule adjust for the time value of money?
- 2) Does the decistion rule adjust for risk?
- 3) Does the decision rule provide information on whether we are creating value for the firm?
What is the difference between a dealer and a broker? Give 1 example of each
- not a physical exchange- computer based quotation system
- electronic communication networks
- large portion on technology stocks
- buying and selling out its inventory
- profit comes from bid (dealer pays) ask (dealer sell) spread
- BrokerNYSE AMEX
- largest stock market in the world
- license holders (1,366)
- they are the go between--- brings parties together and makes a trade
What are preemptive rights?
first shot at new stock issue to maintain proportional onwership if desired
What is a discount bond and how does it relate to YTM, the coupon, and the coupon rate?
- If YTM > coupon rate, then par value > bond price
- Why? The discount bond provides yield above the coupon rate
What is a premium bond and does it relate to YTM, coupon, and coupon rate?
- If YTM < coupon rate, then par value < bonds price
- Why? Higher coupon rate causes value above par
What is preferred stock?
dividends get paid before the common stock holders, the dividends can be deferred indefinatley, most preferred dividends are cumulative meaning that any dividends that are missed but be paid, there are no voting rights
What are the different classes of common stock?
There is either A or B
A stock are shares with certain voting rights (30%)
B stock are shares with different voting rights (70%)
What is common stock?
You have voting rights, proxy voting
There are different classes of stock, share proportionally in declared diidends, and remaining assets during liquidation
What would you like to do?
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