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Terms in this set (57)
What does it mean if an investment has an NPV of 0?
An NPV of 0 means that you are earning what you require on the investment. Positive NPV signals wealth creation.
Explain why all stocks should have a zero NPV in an efficient market.
The efficient market hypothesis believes that stocks without an NPV of 0 will be exploited away because of its extraordinary profit. Investors should be expected to receive a normal rate of return and have an NPV of 0.
A firm's WACC is 10%. Would the company ever consider a capital investment with an expected return of 8%? Explain.
Not normally, but if it is out of the scope of "normal business", and they are willing to take a lower return, they could accept the 8% return.
Normally, the investment wouldn't be considered because the weighted average cost of capital exceeds the expected return.
If you have all your money invested in T-Bills earning 2%, then you take some of that money to invest in a high-beta stock, is 2% your required return on that stock.
No. T-bills are risk free investments so you don't require as high of a return. Your required return on a high beta stock needs to be higher to account for higher risk.
A firm has excess cash that it temporarily invests in Treasury Bills yielding 3%. If the company's WACC is 10%, is this investment producing a negative NPV? What is the NPV?
No, the NPV would be 0 because an NPV of 0 is appropriate for that level of risk (T-Bills are risk free).
If treasury bills are yielding 3%, could there be any situation where an informed investor would invest in an asset that has an expected return of 0%?
No, the investor should invest in the T-bills instead because they are risk free and produce a return of 3%. The other investment is not risk free and produces 0 returns.
Leverage increases risk of financial distress. So, if a company borrows money - shouldn't the value of the firm go down due to the higher risk?
The more leverage a company has, the more potential for profitability. However, this potential for profitability also makes the company riskier. The value can go up but so does the risk.
Is it appropriate for a company to match capital investment projects with the specific sources of capital used to finance them?
No - Financing decisions are always independent of investing decisions.
If Target acquired Neiman Marcus and used their own WACC to value the deal, what is the consequence?
- Target likely has a lower Beta stock. Neiman Marcus is in a different industry and likely has a higher Beta. If Target uses their WACC to value the deal, then the value will be perceived as higher due to the neglect of Neiman Marcus's true risk.
According to the EMH, it is improbable that investors be able to consistently beat the market. Why?
The Equity Market Hypothesis states that predicting the market should be impossible because changes in the market are associated with changes in expectations, news, surprises. The value of the market is already as precisely predicted as it can be with all available information being exploited.
Why do bond prices go down when interest rates go up?
If interest rates go up, bonds must remain competitive and provide a yield to maturity that is better than other alternatives.
If a business can borrow all the money it needs for a capital investment project at 8% interest, is 8% the appropriate cost of capital for that project?
No, the WACC has more contributing factors such as the cost of equity and cost of preferred equity. The formula is more involved than simply the interest rate.
The Cost of Capital depends on the risk of the project, not the source of the money. Explain.
What matters is how you use the money - not where it comes from. The source of money is just one variable in the WACC formula; D/E ratios and tax rates matter more than the source of money.
What is the unsystematic risk and how it can be eliminated?
Unsystematic risk is stock-specific risk, meaning risk that can affect a single stock price but not the entire market.
Unsystematic risk is also known as diversifiable risk which means it can be reduced or eliminated through diversification of a portfolio, by buying various securities or equities.
It reflects specific risks to certain industries and companies (only affecting them).
How does Beta differ from standard deviation as a measure of risk?
Beta is a systematic risk measure that compares stocks relative to the market as a result of economic movements.
Standard deviation is the measure of total risk and variability regardless of the sources (market and non-market).
What does NPV represent?
NPV represents wealth creation; the gains you acquire above your required return on investment.
It is also the difference between its worth and the cost to acquire it. The present value of all future cash flows of a project.
Explain systematic risk and how to measure it.
Systematic risk is market risk which affects all investments across the economy. Total market risk is measured through Beta.
Explain what causes financial leverage.
Financial leverage is caused by fixed costs related to borrowing money = interest in the costing structure. When sales increase, variable costs increase but fixed ones do not and that creates the leverage effect.
If Boeing's reward-to-risk ratio exceeds the market risk premium, what are the implications?
If their risk to reward ratio is higher than the market risk premium that means their stock is valued too low and you should invest now. The stock lays above the SML.
How does APR differ from EAR?
APR does not account for compound interest but EAR does. APR could be compounded periodically, but EAR is compounded on a yearly basis.
What causes stock prices to fluctuate day-to-day?
Unexpected news in the media changes people's expectations and predictions which affect their investing decisions and therefore the stock prices.
Explain the concept of financial risk.
Risk is the chances of having an unexpected or negative outcome in an investment (the potential for financial loss). The only reason investors would take on a financial risk is if the potential reward outweighs the risk.
If interest expense is a cash disbursement, why is it excluded from Operating Cash Flow?
Interest and taxes are excluded from Operating Cash Flow because the Operating Cash Flow is the cash generated from normal business operations. The interest and tax is not an operating expense because they are indirect expenses and already built into the net income.
Since depreciation is a non-cash expense, does it have an effect on NPV and IRR?
Although depreciation is a non-cash expense, non-cash expenses are added back to real FCF's.
Depreciation also serves as a tax deduction.
The IRR is lower if the NPV is higher.
Is leverage a good thing? Discuss.
Leverage is the process of borrowing capital to make an investment (debt), with the expectation that the profits made from the investment will be greater than the interest on your debt/loan.
By leveraging your company, you increase the amount of debt financing, which increases fixed interest expenses (interest does not change with EBIT). However, leverage amplifies the variability of income and leads to lots of risk if the company is unable to service debt.
What determines the value of an economic asset?
The present value of all cash flows.
Why would investors demand a return of an investment that has no risk?
Otherwise, they would have no incentive to invest in it and losing opportunity costs of investing elsewhere.
Why does the present value of a future cash flow declines as the required return increases?
The present value of cash flows decline as the required return increases because if you can earn a higher return then you don't need to invest as much and your alternatives have improved.
As required return increases, variability of returns increases, and the likelihood of receiving that future goes down.
Explain why historical information should be useless in predicting the stock market.
The stock market is unpredictable and does not follow trends. According to the Efficient Market Hypothesis, the historical data that is relevant and available has already been worked into the pricing of the stocks (all relevant and available information is already reflected in current stock prices).
If Apple announced record earnings and its stock price didn't go up in response, how could that be explained?
- Was already priced in
- Did not meet expectations that were higher
- Offset by other negative news such as declining forecasted margins
If your financial advisor claims to have beaten the market for 10 years straight, what do you think?
It is very unlikely to have predicted the market for 10 years in a row. Investors should not consistently be able to earn "excess" return based on skill.
If WalMart was considering the acquisition of a generic drug manufacturer, should it use its corporate WACC to value the deal? Explain.
Since this is related to existing core business operations that they already conduct, they know the risk and can use their own Weighted Average Cost of Capital.
Is it ever appropriate for a company to accept a capital investment that provides a NPV of 0?
Yes, but you are accepting a risk for no reward. You only accept if it is a necessary project.
The book says "all stocks in an efficient market are zero NPV investments". Why should this be true?
In an efficient market an NPV should be 0 and fall on the SML line. Extraordinary profits will be exploited and run out - returning to efficiency.
If borrowing increases the risk of a company, does it WACC increase with more leverage?
Yes, it has to account for the increased risk. With more leverage comes more debt, so the debt/equity ratio increases. Additional, higher levels of debt will increase the Cost of Equity.
Do the NPV and IRR decision rules ever conflict?
When the NPV and IRR rules give conflicting results (a result of nonconventional cash flows or mutually exclusive projects), trust the NPV decision because the IRR is unreliable.
What's wrong with Payback Period as decision criteria?
The payback period does not take Time Value of Money into consideration and it also doesn't take future cash flows after the payback period into consideration.
If two companies valued the same capital project, should the resulting NPV's be the same?
The valuations could be different depending on the risk profiles of the companies.
Explain what it meant by market efficiency.
An efficient market is when all stocks and investments are valued fairly and fall on the SML. The returns of investments are appropriate for the levels of risk.
Does the Efficient Market Hypothesis imply pricing perfection? Do stock market bubbles disprove the Efficient Market Hypothesis?
Efficient Market Hypothesis says that the stock market is unpredictable so it is impossible to achieve perfection. In the long run, all gains will be exploited under Efficient Market Hypothesis. Market bubbles are only visible in hindsight.
What is Beta? How is it related to the expected return?
Beta is the measure of variability of a stock in relation to the market. As risk goes up, expected return goes up.
A company cannot spend its Net Income. Explain why.
The net income could consist of non-cash assets. Due to accrual accounting, net income could be made of receivables.
Is it always correct to reject a capital project that has an IRR less than its WACC?
The IRR may be wrong, such as in cases of nonconsecutive cash flows, so do not reject immediately. Always double check.
If Google does not pay a dividend, why is it stock worth over $1,000 per share?
They could be reinvesting their dividend to improve their earnings and save the dividend for later.
Why invest in a portfolio of stocks instead of just one?
You invest in a portfolio of stocks to diversify and eliminate your unsystematic risk.
Explain what's meant by the term "Time Value of Money".
The concept of time value of money means that over time, the value of money changes. A dollar today is greater in value than that of a dollar a year from now. Investing that dollar will make it grow, with interest rates and returns.
Explain why WACC would effect a firm's stock price.
Stockholder's money is being affected by investment decisions of a company so if the WACC goes up, the stock price goes down. If the Weighted Average Cost of Capital goes down, the stock price will go up.
What effect does borrowing have on a firm's Weighted Average Cost of Capital?
The weight of debt will be increased because debt is a component of WACC. The cost of equity will also increase as greater leverage results in higher levels of risk and greater demands for returns.
What does the Security Market Line represent?
The Security Market Line is the different returns associated with corresponding levels of risk.
Discuss what diversification does and how it works.
Diversification is the process of investing in a portfolio, or assortment, of stock to reduce unsystematic risk. Pairing inverse companies together so the change is steady.
A company is buying a warehouse and has arranged a loan to finance it. It calculated this project's NPV using the loan's interest rate to discount the cash flows.
You use the Weighted Average Cost of Capital to determine what investors want as a return.
If payback period equals a project's life, what does that imply about its IRR and NPV?
...
If NPV and IRR give you conflicting decisions, which do you side with?
You will go with the Net Present Value.
You are reviewing a capital investment proposal with multiple cash outflows. What are the implications?
Your IRR is going to be inaccurate.
When discussing a capital investment, what is meant by "conventional project"?
A conventional project starts with a cash outflow and then has constant cash inflows.
Explain why a capital investment's NPV profile may not be downard sloping to the right.
If the return is lower than the weighted average cost of capital.
If you invested $1,000 and three years later you got $1,000 back. What could the annual arithmetic average return be other than zero? What about the mean geometric return? Why?
Arithmetic return will be 0. the geometric return can be anything depending on the rates.
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