## 15 terms · bec cpa

### a. Monte Carlo Technique

This technique is often used in simulation to generate the individual values for a random variable. The performance of a quantitative model under uncertainty may be investigated by randomly selecting values for each of the variables in the model (based on the probability distribution of each variable) and then calculating the value of the solution. If this process is performed a large number of times, the distribution of results from the model will be obtained.

### Capital Asset Pricing Model (CAPM)

This method is derived from the use of portfolio theory. It assumes that all assets are held in a portfolio. Each asset has variability in its returns. Some of this variability is caused by movements in the market as a whole, and some is specific to each firm. In a portfolio, each security's specific variability is eliminated through diversification, and the only relevant risk is the market component. The more sensitive an asset's rate of return is to changes in the market's rate of return, the riskier the asset

### Real Options

a. Real (managerial or strategic) options reduce the risk of an investment project. A real option is the flexibility to affect the amounts and risk of an investment project's cash flows, to determine its duration, or to postpone its implementation.

b. The value of a real option is the difference between the project's net present value (NPV) without the option and its NPV with the option. Similarly, the worth of the project (true NPV) equals its NPV without the option plus the value of the option.

### Other real options include the following:

a) The flexibility option to vary inputs, for example, by switching fuels

b) The capacity option to vary output, for example, to respond to economic conditions by raising or lowering output or by temporarily shutting down

c) The option to enter a new geographical market, for example, in a market where NPV is apparently negative but the follow-up investment option is promising

d) The new product option, for example, the opportunity to sell a complementary or a next-generation product even though the initial product is unprofitable

### Under various return ratios, the numerator (net income) may be adjusted by

1) Subtracting preferred dividends to leave only income available to common stockholders

2) Adding back minority interest in the income of a consolidated subsidiary (when invested capital is defined to include the minority interest)

3) Adding back interest expense

4) Adding back both interest expense and taxes so that the numerator is EBIT; this results in the basic earning power ratio, which enhances comparability of firms with different capital structures and tax planning strategies

### The denominator ("equity" or "assets") may be adjusted by

1) Excluding nonoperating assets, such as investments, intangible assets, and the other asset category

2) Excluding unproductive assets, such as idle plant, intangible assets, and obsolete inventories

3) Excluding preferred stock to arrive at equity capital

4) Stating invested capital at market value

### 5) Residual Income

Residential income measures performance in dollars rather than a percentage return

net income-(avg total assets *target rate of return)

###
When determining net present value in an inflationary environment, adjustments should be made to:

A.Increase the discount rate, only.

B. Increase the estimated cash inflows and increase the discount rate.

C. Increase the estimated cash inflows but not the discount rate.

D. Decrease the estimated cash inflows and increase the discount rate.

B. Increase the estimated cash inflows and increase the discount rate.

###
Which of the following is not an example of a real option in a capital budgeting decision?

A. Abandonment.

B. Follow-up investment.

C. Option to wait and learn.

D. Risk-adjusted discount rates.

Answer (D) is correct. Real options include such factors as the ability to abandon the

project early, the opportunity for follow-up investments or ability to create new products,

the ability to base additional cash outflows on a wait-and-learn opportunity, or the option

to change capacity during the project. Risk-adjusted discount rates are not real options but

are a form of sensitivity analysis.

###
Residual income is a better measure for performance evaluation of an investment center

manager than return on investment because......

Residual income is the excess of the return on an investment over the

targeted amount (the imputed return on investment). Some enterprises prefer to measure

managerial performance in terms of the amount of residual income rather than a percentage

ROI. The principle is that the enterprise is expected to benefit from expansion as long as

residual income is earned. Using a percentage ROI approach, expansion might be rejected if it

lowered ROI in a highly profitable division even though residual income would increase. For

example, if managers are expected to earn a 15% ROI, a division with a 30% ROI might not

invest in a project offering a 25% rate of return

###
Which one of the following statements pertaining to the return on investment (ROI) as a

performance measurement is false?

When the average age of assets differs substantially across segments of a business, the use

of ROI may not be appropriate.

A.

ROI relies on financial measures that are capable of being independently verified, while

other forms of performance measures are subject to manipulation.

B.

The use of ROI may lead managers to reject capital investment projects that can be

justified by using discounted cash flow models.

C.

The use of ROI can make it undesirable for a skillful manager to take on troubleshooting

assignments such as those involving turning around unprofitable divisions.

Answer (B) is correct. Return on investment is the key performance measure in an

investment center. ROI is a rate computed by dividing a segment's income by the invested

capital. ROI is therefore subject to the numerous possible manipulations of the income

and investment amounts. For example, a manager may choose not to invest in a project

that will yield less than the desired rate of return, or (s)he may defer necessary expenses.

###
What term represents the residual income that remains after the cost of all

capital, including equity capital, has been deducted?

Economic value-added is based on the assumption that the

measured firms have no debt or financial assets. This assumption is made to improve the

comparability of EVA calculations between firms. EVA equals net operating profit before

interest and taxes, minus an amount of taxes calculated based on the assumption of no

debt or financial assets [NOPAT - (Capital × Weighted-Average Cost of Capital)]. Thus,

EVA includes all capital costs in the calculation.

### A firm earning a profit can increase its return on investment by

ROI equals income divided by invested capital. If a company is already

profitable, increasing sales and expenses by the same percentage will increase ROI. For

example, if a company has sales of $100 and expenses of $80, its net income is $20. Given

invested capital of $100, ROI is 20% ($20 ÷ $100). If sales and expenses both increase 10% to

$110 and $88, respectively, net income increases to $22. ROI will then be 22% ($22 ÷ $100).

###
One approach to measuring divisional performance is return on investment. Return on

investment is expressed as operating income

ROI is calculated by dividing income by invested capital. It is a

key performance measure of an investment center. Invested capital may be defined in

various ways, such as shareholders' equity, total assets available, or total assets employed

(which excludes assets that are idle). Total assets available is the measure that assumes

the manager will use all assets without regard to financing.

###
The segment margin of an investment center after deducting the imputed interest on the assets

used by the investment center is known as

Residual income is the excess of the amount of return on investment

(ROI) over a targeted amount equal to an imputed interest charge on invested capital. The rate

used to impute the interest is usually the weighted-average cost of capital. The advantage of

using residual income rather than percentage ROI is that the former emphasizes maximizing an

amount instead of a percentage. Managers are encouraged to accept projects with returns

exceeding the cost of capital even if the investments reduce the percentage ROI.