Finance Test 2
Terms in this set (208)
What is a bond?
fixed income instrument that is a loan made by an investor to a borrower (typically corporate or governmental) like an I.O.U. between the lender and borrower that includes the details of the loan and its payments
Bonds are used by companies, municipalities, states, and sovereign governments to do what?
to finance projects and operations
What is a big disadvantage that companies deal with when borrowing from a bank?
it can be restrictive and more expensive than selling debt on the open market through a bond issue
What is the general opinion many CFO's have in regards to a major disadvantage of bank lenders?
they offer restrictive debt covenants that banks place on direct corporate loans
What are lendors of last resort?
What are covenants?
rules placed on debt help stabilize corporate performance and reduce risk that bank is exposed to when it gives a large loan to a company therefore protecting the bank's interests
Who writes covenants in a bank? What are covenants based on?
based on what analysts have determined to be risks to that company's performance
List 3 common unrestrictive covenants faced by companies?
1. they can't issue any more debt until the bank loan is completely paid off
2. they can't participate in any share offerings until the bank loan is paid off
3. they can't acquire any companies until the bank loan is paid off
Describe an example of a restrictive covenant.
the interest rate on the debt increases if the CEO quits of earnings per share drop in a given time period
Do borrowing companies or banks benefit from covenants?
Who is more concerned with debt repayment: banks or bond holders?
What is a corporate bond?
a bond issued by a corporation as a way to borrow money for a predetermined time for specified interest rate
In most cases, what is a corporate bond par value?
What is face value?
The amount the company (borrower) will repay the lender (you) once the bond matures
What is the maturity of a bond?
the life of the bond
What is a coupon?
periodic interest payments in exchange for using your money
What are the three important factors to consider before buying a bond?
1. The issuer
2. The interest or coupon you will receive
3. The maturity date or day when the company must repay your principal
Why do corporate bonds offer a slightly higher yield?
Because they carry a higher default risk than government bonds
What is capital appreciation?
An increase in the price of assets
Are bonds are good source of capital appreciation?
Why are corporate bonds useful for tax-deferred retirement savings accounts?
They allow you to avoid taxes on the semi-annual interest payments
True OR False: Purchasing bonds from well-established and profitable companies is less risky than purchasing from firms in financial trouble.
What are junk bonds?
Bonds from companies with less-than-investment-grade (Ba and below) ratings
Name 2 strengths of corporate bonds.
1. Many corporate bonds offer a higher rate of return then government bonds for only slightly more risk
2. The risk of losing your principal is very low if you only buy bonds in well-established companies with a good track record
Name two weakness of corporate bonds.
1. Fixed interest payments are taxed at the same rate as income
2. Corporate bonds offer little protection against inflation as the interest payments are a fixed amount until maturity
What are the maturities of short, intermediate and long-term bonds?
Short: less than 5 years
Intermediate: 5-12 years
Long: more than 12 years
Do corporate or government bonds have a higher risk of defaulting ?
Corporate bonds, and therefore have higher yields
What is a convertible bond (CV)?
a bond that can be converted to common stock at the bondholder's option
How does a company minimize negative investor interpretation of its corporate actions?
Issuing convertible bonds (instead of stock which can sometimes lead investors to think the stock is overvalued) by issuing convertible bonds you are giving investors an option to convert debt to equity for a company
Why do convertible bonds have lower rates of return than regular ones?
As it allows for the value of the option to trade the bond into stock
What is a callable bond?
Also known as "redeemable bonds" can be redeemed by the issuer prior to maturity and the bond holder must pay the bond owner a premium for doing this
What is the main cause of a call regarding callable bonds?
A decline in interest rates (if interest rates have declined since the company first issues the bonds it may want to refinance at a lower rate) cause a company to take the current bonds off and reissue new, lower interest bonds to save money
What are term bonds?
Bonds from the same issue that share the same maturity date (bonds that mature all at the same time)
What is a call feature or a "provision"?
Used in term bonds, is an agreement that bond issuers make with buyers called the "indenture", which is the schedule and the price of redemptions, plus the maturity dates
What is a serial bond?
A bond which has various maturity schedules at regular intervals until the issue is retired (matured)
What is an amortized bond?
A financial certificate that has been reduced in value for records on accounting statements but is treated as an asset, with the discount amount being amortized to interest expense over the life of the bond
What is a bond that has been issued at a discount?
The bond is offered for sale below its par value (face value)
What are the two ways a discount of a bond can be treated?
1. As an expense
2. Amortized as an asset
What is an adjustment bond?
Given to bond holders of an outstanding bond issue prior to the restructuring, the debt obligation is consolidated and transferred from the outstanding bond issue to the adjustment bond (aka: the recapitalization of the company's outstanding debt obligations)
What 2 terms can be adjusted when a company is trying to recapitalize its outstanding debt obligations? (Meaning it can meet its obligations)
1. Interest rates
2. Lengths to maturity
If a company is near bankruptcy and requires protection from creditors and cannot make payments on its debt obligations what will happen to the company? How much money will creditors receive?
The company will be liquidated and the company's value will be spread among the creditors, the creditors only receive a fraction of their original loans and will have to work with the company to potentially receive more
What is a junk bond?
A "high yield" bond or "speculative bond" rated BB or lower because of its high default risk and offer interest rates 3 to 4 times higher than safer government issues
What is the fundamental principle of bond valuation?
That the bond's value is equal to the present value of its expected future cash flows
What are the three steps in bond valuation process?
1. Estimate expected cash flows
2. Determine the appropriate interest rate(s) that should be used to discount the cash flows
3. Calculate the present value of the expected cash flows found in step 1 by using the interest rate(s) determined in step 2
What is the minimum interest rate that an investor should accept?
The yield for a risk-free bond like a treasury bond
What is the treasury security most often used and why?
"On-the-run" issue as it reflects the latest yields and is most liquid
What is the rate or yield required for non-treasury (corporate bonds)?
On-the-run government security rate plus a premium that accounts for the additional risks that come with non-treasury bonds
What is the best way to handle maturities of corporate bonds?
Use the maturity that matches each of the individual cash flows rather than using the final maturity date of the issue
Suppose a Corporate Triple A rated bond is currently selling at a quote of 102.60 and suppose this bond has 5 years to maturity and the coupon rate is 2.7%. What is the rate of return of the bond to an investor? The investor requires 2.5%
PV= -$1026, FV = $1,000, PMT = $27, n=5, CPT I/Y = 2.146% therefore since the bond will yield a return of only 2.146% and required return of the investor is 2.5% the investor would not buy this bond at the current quote
What would a 0 coupon with maturity of 3 years and maturity value of $1,000 discounted at 7% give us?
FV = $1,000, I/Y = 7, n = 3, CPT PV = $816.29
What will happen as a bon'd coupon rate is below the yield required by the market?
The bond will trade below its par value or at a discount
Why would a bond trade below par value or at a discount?
Because investors will not buy this bond at par when other issues are offering higher coupon rates
As yields increase what happens to bond prices? What do investors typically do when bond prices fall?
They fall, investors purchase bonds
What is a bond rating?
A grade given to a bond that indicates its credit quality and ability to pay a bond's principal and interest in a timely fashion
Name the letter ratings given to bonds with the highest grade, junk or lowest grade?
Highest grade: AAA
Lowest "junk bond" grades: C or D
What does the bond rating system help investors determine?
A company's credit risk (like a report cards for a company's credit rating)
What are blue chip firms?
Safer investments as they are firms with high rating
If a company falls below a certain credit rating what happens to their grade?
Their grade changes from investment quality to junk status
Are bonds considered riskier than stocks?
Bonds are not inherently safer than stocks, certain types of bonds can be just as risky, if not riskier than stocks (is: Junk Bonds which have higher yields but are riskier)
How often do rating agencies review bond ratings?
Every 6 to 12 months OR whenever the agency thinks it is necessary due to missed/delayed payments to investors, issuance of new bonds, change to issuer's underlying financial fundamentals or other broad economic developments
Who plays an integral role in the investment process and can make or break a company's success in primary and secondary bond markets?
What is a primary bond market?
Through which debt securities are issued and sold by borrowers to lendors
What is a secondary bond market?
Through which investors buy and sell previously issued debt securities among themselves
What happens in the bond market?
Debt securities are issued and traded and primarily includes government issued securities and corporate debt secuirites
What are 3 other names for the bond market?
1. Debt market
2. Credit market
3. Fixed income market
Is the stock market or bond market bigger?
What do the issuers do in a bond market?
Sell bonds or other debt instruments in the bond market to fund operations of their organizations
What are the three main issuers in bond market? Who is the biggest?
1. Government (the biggest and use it to fund the country's operations)
What are the two primary risks that must be assessed wen investing in bonds?
1. Interest rate risk
2. credit risk
What is interest rate risk associated with bonds?
The risk of changes in a bond's price due to changes in prevailing interest rates (whether short or long term interest rates)
What is credit risk associated with bonds?
The risk that the bond's issuer will not make scheduled interest and or principal payments (the probability of a negative credit event or default affects bond price)
With a higher risk of negative credit event occurring what do investors expect?
A higher interest rate investors expect for assuming that risk
What is yield to maturity?
The discount rate that can be used to make the present value of all of the bond's cash flows equal to its price (a bond's price is the sum of the present value of each cash flow where the present value of each cash flow is calculated using the same discount factor
What is the discount factor?
When a bond's yield rises or falls, what happens to its price?
Yield rises: price falls
Yield falls: price increases
Suppose a bond has 20 years to maturity, has a coupon rate of 2.5% and the bond currently sells at a quoted price of 103. What is YTD?
PV = -1,030, n = 20, PMT = $25, FV = $1,000, CPT I/Y = 2.31%
YTD = 2.31%
What has a great affect on a bond's yield?
The maturity or term in years
What does the yield curve represent in terms of U.S. Treasury bonds?
The YTM of a class of bonds
In most interest rate environments when the term to maturity is longer what does this imply about the yield of the bond?
It will be higher because the longer the period before a cash flow is received the more chance the required discount rate or yield will move higher
What is another name for the discount rate of a bond?
How does inflation affect a bond?
Inflation erodes the purchasing power of a bond's future cash flows
The higher the current rate of inflation and the higher the expected future rates of inflation means what will happen to the yield?
The yields will rise across the yield curve as investors will demand this higher yield to compensate for inflation risk
Inflation and expectations or future inflation are functions of what?
The dynamics between short-term and long-term interest rates
Who issues short term interest rates (federal funds rate) in the United States?
the (FOMC) or Federal Reserve Board's Open Market Committee
What is LIBOR?
The rate of eurodollars, LIBOR (London Interbank Offer Rate) is the rate at which London banks lend USDs to other London banks.
Why does the FOMC administer the federal funds rate?
To fulfill its dual mandate of promoting economic growth while maintains economic stability (it is not an easy task)
What control the long term interest rates on long term bonds?
Market forces like supply and demand determine equilibrium pricing for long term bonds
What happens if the bond market believes the federal funds rate was set too low? Too high?
If federal funds rate set too low: expectations of future inflation increase which means long term interest rates increase relative to short term interest rates and the yield curve gets steeper
If federal funds rate set too high: the long term interest rates decrease relative to short-term interest rates and flattening the yield curve
What is duration in the bond market?
An important bond metric which measures price changes relative to interest rate changes
What happens if market participants believe that there is higher inflation on the horizon?
Interest rates and bond yields will rise and prices will decrease to compensate for the loss of the purchasing power of future cash flows
Bonds with the longest cash flows see what happen their yields?
Their yields rise and prices fall the most
True or false: Interest rates, bond yields (prices) and inflation expectations have a correlation to each other?
True or false: Changes in short term interest rates have less of an effect on short term bonds than long term bonds, and changes in long term interest rates have less of an effect on long term bonds but not short term bonds
False (as short term interest rates affect short term bonds more and long term interest rates affect long term bonds more)
What is convexity in regards to bonds?
What is the key to understanding how a change in interest rates will affect a certain bond's price and yield?
To see where on the yield curve the bond lies (the short or long end) and to understand the dynamics between short and long term interest rates
What are valuation methods?
Ways to value a stock
What are the two basic categories of stock?
Common and preferred stock
What are three other names for stock?
Shares, securities, equity
What is common stock?
Ownership in part of a company whereby you are entitled to a portion of the company's profits and any voting rights attached to the stock
What is the typical way companies pay out profits?
Through dividends (the more shares you own, the larger the portion of the company and profits you own
Over the long term which investment has better returns at a reasonable risk?
What is a penny stock?
If an investor uses a margin what can they increase in terms of a stock? Is this recommended for beginners or experts?
Their leverage in a stock
Recommended for experts
What is the most common method for buying stocks?
To use a brokerage (either full service or discount) which sometimes require a minimum of $500 to open an account
What are Dividend reinvestment plans (DRIPS)?
What are direct investment plans (DIPS)?
What do DRIPS and DIPS allow investors to do?
Purchase stock directly from individual companies for a minimal cost
What are the strengths of common stock?
Very easy to buy and sell due to the Internet allowing us to find reliable information on public companies
How many companies in North America offer common stock?
What are the weaknesses of common stock?
1. Your original investment is not guaranteed
2. There is a risk that the stock you invest in will decline in value and you may lose your entire principal
3. Your stock is only as good as the company in which you invest
What are the three main uses of common stock?
1. Capital appreciation
What are preferred stocks?
Which type of investment acts like combination between stocks and bonds, share many characteristic with debt instruments and are often called hybrid securities?
Describe how preferred stocks work.
They are issued with a fixed par value and pay dividends based on a percentage of that par at a fixed rate
What is market value?
true value; the price at which the assets, liabilities, or equity can actually be bought or sold
What would be true being that the market value of preferred stock is sensitive to changes in interest rates?
That if interest rates rise the value of the preferred shares would need to fall to offer investors a better rate
If rates fall the opposite would hold true
Why do preferred stocks have an unlimited life?
Because they have no fixed maturity date (although they may be called by the issuer after a certain date because securities may be paying higher rates than what the market is currently offering OR price may be at a premium to par to enhance the preferred initial marketability)
What is seniority?
Do preferred stocks or bonds have more seniority?
What is seniority of preferred stock applied to?
1. The distribution of corporate earnings (as dividends)
2. The liquidation of proceeds in case of bankrupcy
What are convertible bonds?
Convertible bonds are convertible into common stock of the debtor at the option of the bondholder.
Can preferred stock be converted into common stock?
Oftentimes they can
Why is it a benefit to convert preferred stocks to common stock?
Gives investors flexibility allowing them to lock in the fixed return from the preferred dividends and potentially participate in the capital appreciation of the common stock
How are preferred stock rated?
By major credit rating companies such as Standard & Poor's and Moody's
Why is the rating for preferred stocks one or two tiers below that of the same company's bonds?
Because preferred dividends do not carry the same guarantees as interest payments from bonds and they are junior to all creditors
What does the term junior refer to?
What is preferred stock and what are bond? Meaning are they equity or debt?
Preferred stock is equity while bonds are debt
Are debt or equity instruments more senior?
Debt instruments along with most creditors
What is an indenture?
the written agreement between the corporation and the lender detailing the terms of the debt issue
Do preferred stocks pay dividend? What kind?
Yes, they pay fixed dividends for the life of the stock BUT they must be declared by the company's board of directors
Why doesn't the same array of guarantees exist for holders of preferred stock in comparison to bond holders in terms of dividends?
Because bonds are issued with the protection of an indenture
If a company were to have a cash problem what could the board of directors do? What makes bonds different?
They could decide to withhold preferred dividends
With bonds, the trust indenture exists and prevents companies from taking the same action on bonds
What are preferred dividends paid from and what are bonds paid from? Which one is more expensive for the issuing company?
Preferred dividends are paid from the company's after tax profits
Bond interest is paid before taxes
It is more expensive for the issuing company to issue and pay dividends on preferred stocks
What is current yield?
How do you calculate the current yield of a preferred stock?
The annual dividend/ the current price it is trading at
In the market, are the yields on preferred stocks higher or lower than those of bonds?
Higher due to higher risks for investors
Describe the volatility of preferred stocks and how to differs from that of bonds?
Preferred stocks are interest rate sensitive but are not as price sensitive to interest rate changes as bonds (prices do reflect the general market factors that affect their issuers to a greater degree than the same issuer's bonds)
Which information is easier to gather about a company: preferred shares or bonds? What does this imply?
It implies that preferred shares are easier to trade and more liquid
Why do low par values of preferred shares make investing easier in comparison to investing in bonds?
Because bonds with par values of around $1000 often have minimum purchase amounts (ie: 5 bonds)
How are payments received with both common and preferred stocks?
They are equity instruments that pay dividends from the company's after-tax profit
How are fixed dividends allocated in preferred vs. common stock?
Companies issuing preferred stocks have more of an obligation to pay fixed dividends than companies issuing common stock
If common stock exists, the dividends are only paid after all obligations to preferred stockholders have been satisfied
Where does preferred stock lose its luster in comparison to common stock?
In regards to appreciation: when a company celebrates great success the higher volatility of common stock means investors holding common stock will have a higher return, BUT preferred stockholders will have a lower return due to the lower volatility of this type of investment
How does voting differ in common vs. preferred stock?
Whereas common stock is often called voting equity, preferred stocks usually have no voting rights
What are voting rights in investing?
What are the 5 basic types of preferred stock? Describe each.
1. Cumulative: most preferred stock is cumulative meaning that if a company withholds part or all of the expected dividends these are considered dividends in arrears and must be paid before any other dividends
2. Callable: the majority of preferred shares are redeemable, giving the issuer the right to redeem the stock at a date and price specified in the prospectus
3. Convertible: the timing for conversion and the conversion price specific to the individual issue will be laid out in the preferred stock's prospectus
4.Participating: preferred stock has a fixed dividend rate and if the company issues participating preferred stocks, those stocks gain the potential to earn more than their stated rate (the formula for participation is found in the prospectus and most preferred stocks are non-participating)
5.Adjustable-Rate Preferred Stock: pay dividends based on several factors stipulated by the company (these dividends are keyed to yields in the U.S. government issues, providing against adverse interest rate markets)
What are ARPs?
What is a prospectus?
What is preferred stock that does not carry the cumulative feature called?
Straight or non-cumulative
Why would a company choose to issue preferred stocks?
1. Flexibility of payments: preferred dividends may be suspended in case of corporate cash problems
2. Easier to market: the majority of preferred stock is bought and held by institutions which may make it easier to market at the initial public offering
Why to do institutions invest in preferred stock?
Because IRS rules allow U.S. corporations that pay corporate income taxes to exclude 70% of the dividend income they receive from their taxable income (known as dividend received deduction)
Why do institutions hold the highest amount of preferred stock?
Because they get dividend received deductions (aka: favorable tax treatment)
What is typically the tax rate for individual investors of preferred stock? Is it better than paying the ordinary rate on interest received from corporate bonds?
It can be, but is best to seek competent tax advice
What are the 5 benefits of preferred stock?
1. Higher fixed income payments than bonds or common stock
2. Lower investment per share compared to bonds
3. Priority over common stocks for dividend payments and liquidation proceeds
4. Greater price stability than common stocks
5. Greater liquidity than corporate bonds of similar quality
What are the 5 disadvantages of preferred stock?
2. Lack of specific maturity date makes recovery of invested principal uncertain
3. Limited appreciation potential
4. Interest rate sensitivity
5. Lack of voting rights
Do some preferred stocks pay dividends above investment grade bonds?
What are investment grade bonds?
What is the starting point for research on a specific preferred stock?
The stock's prospectus
What are the two types of common stock valuation models?
1. Absolute valuation model
2. Relative valuation model
What is the absolute valuation model?
Attempt to find the "intrinsic" or true value of an investment based only on fundamentals (only focusing on things like dividends, cash flow and growth rate for a single company and you wouldn't worry about other companies
Give 4 examples of absolute valuation models.
1. Dividend discount model
2. Discounted cash flow model
3. Residual income models
4. Asset-based models
What is the relative valuation model?
Operate by comparing the company in question to other similar companies (involve calculating ratios like price to earnings multiple and comparing them to the multiples of other comparable firms)
In the relative valuation model, if the P/E ratio of the firm you are trying to value is lower than the P/E multiple of a comparable firm, what can be said about that company?
It is undervalued
Which method of analyzing stocks is easier? Relative valuation or absolute valuation model?
Relative valuation model
What is the dividend discount model (DDM) for common stock valuation?
Calculates the true value of a firm based on the dividends the company pays its shareholders (as dividends represent the actual cash flows going to the shareholder thus valuing the present value of those cash flows should give you the value of what the shares are worth)
Which companies are likely valued using the dividend discount model (DDM)?
Typically mature blue chip companies in well developed industries that pay stable and predictable dividends
If dividends per share and earnings per share are both increasing at a steady predictable rate, which stock valuation method is best?
dividend discount model (DDM)
What are earnings per share?
When is the discounted cash flow model (DCF) used?
Used when a company does not pay steady or any dividends and rather uses a firm's discounted future cash flows to value the business
Describe the 2 stage variation of the discounted cash flow model (DCF)? What is a requirement for this to be the method of choice?
free cash flows are forecasted for 5-10 years and then terminal value is calculated to account for all the cash flows beyond the forecast period
To use this method, the company must have predictable free cash flows that are positive (this usually cuts out small high growth firms and non-mature firms due to large capital expenditures they face
What is terminal value?
What is the comparable method when valuing common stock?
"Catch all method" It compares the stock's price multiples to a benchmark to determine if the stock is relatively undervalued or overvalued (this method does not find the intrinsic value for the stock as the previous methods)
What rationale is the basis for the comparable method for valuing common stock?
The Law of One Price which states that two similar assets should sell for similar prices
What are the types of multiples applied to the comparable method for valuing stock? Which is most popular method and why?
Price to earnings ratio (P/E), price to book (P/B), price to sales (P/S), price to cash flow (P/CF)
The most common method is P/E ratio as it focuses on the earning of a company which is one of the primary drivers of an investment's value)
What are the 3 requirements to use P/E multiple for comparisons of common stock?
1. If the the company is publicly traded because you need the price of the stock and need to know the earnings of the company
2. The company should be generating positive earnings because a comparison using a negative P/E multiple would be meaningless
3. The earning quality should be strong; earnings should not be too volatile and the accounting practices used by management should not distort the reported earnings
What is the stake in the company in regards to stocks?
The proportion to the held stocks
Preferred stock as have what type of dividends? What does this mean?
Fixed dividends meaning we can calculate the value by discounting each of these payments to the present day
Are fixed dividends guaranteed in common shares?
How do you find the value of a preferred stock?
Take the dividend payments and calculate the sum of the present values into perpetuity
If a company pays $3 dividends every year and the required rate of return is 6% per year, how would you find the value of the stock using the dividend discount approach?
Why can corporate bonds be rewarding fixed income investments?
Because of the risk the investor must take on
With corporate bonds, is a company's credit quality important?
Yes, the higher the quality the lower the interest rate the investor receives
Why from an investor's perspective does a convertible bond have a value added component in it?
It is a bond with a stock option hidden inside thus it offers a lower rate of return in exchange for the value of the option to trade the bond into stock
Why do preferred stocks have both qualities of equity securities and have characteristics of debt instruments?
As they straddle the line between stocks and bonds (they are hybrids)
What is the net present value?
The difference between the present value of cash inflows and the present value of cash outflows
What does NPV compare?
The value of the dollar today to the value of that same dollar in the future taking inflation and returns into account
What is NPV analysis used for? What is it sensitive to?
Used in capital budgeting to assess the profitability of an investment or project
It is sensitive to the reliability of future cash inflows that an investment or project will yield
If the NPV of the prospective project is positive do we accept or reject the project?
If the NPV of a prospective project is negative do we accept or reject it? Why?
Reject as the cash flows will also be negative
If a retail clothing business wants to purchase an existing store and its future cash flows it would generate are discounted into a lump sum present value of $565,000 and the owner of the store was willing to sell his business for less than $565,000 would the purchasing company accept the offer? Why?
Yes because it presents a positive NPV investment
If a retail clothing business wants to purchase an existing store and its future cash flows it would generate are discounted into a lump sum present value of $565,000 and the owner of the store was not willing to sell his business for less than $565,000 would the purchasing company accept the offer? Why?
No as the investment would present a negative NPV
How do you determine payback decision rule?
What is the Internal rate of return (IRR)?
The discount rate often used in capital budgeting that makes net present value of all cash flows from a particular project equal zero
Does a higher the IRR (internal rate of return) mean a project will likely be accepted?
Assuming all other factors are equal among various projects, can the IRR be used to rank several prospective projects a firm is considering?
What does the profitability index do?
attempts to identify the relationship between the costs and benefits of a proposed project
How do you calculate the profitability index?
PV of future cash flows/ initial investment
A profitability index ratio of less than one vs. greater than one would mean a project would be accepted or rejected for both cases?
Less than one: project should be rejected as NPV is negative
Greater than one: project is accepted as NPV is positive
What makes the profitability ratio different from NPV calculation?
It ignores the scale of investment and provides no indication of the size of the actual cash flows
What is capital budgeting?
the process of planning for projects on assets with cash flows of a period greater than one year
What are 5 common classifications of projects that use capital budgeting?
1. Replacement decisions to maintain business (like machinery replacement)
2. Existing product or market expansion
3. New products or services
4. Regulatory safety and environmental
5. Pet projects or difficult to evaluate projects
What does it mean when a project is mutually exclusive?
Potential projects are unrelated and any combo of those projects can be accepted
What does it mean when a project is independent?
There is only one project among all possible projects that can be accepted
Why is capital budgeting important? (3 reasons)
1. Since projects approved via capital budgeting are long term, the firm becomes tied to the project and loses some of its flexibility during that period
2. When making the decision to purchase an asset, managers need to forecast the revenue over the life of that asset
3. Capital budgeting decisions define the strategic plan of the company
What is valuation analysis used for?
To evaluate the potential merits of an investment or to objectively assess the value of a business or asset
What are the most important drivers of asset prices over the long term?
Valuations using valuation analysis and cash flows
What basic question does valuation analysis answer?
What is something worth?
What are the factors that influence returns in capital markets?
1. Risk: the chance that an investment's actual return will be different than expected ( the lower the risk the lower the return and vice versus)
2. Risk return trade off: the balance between the desire for the lowest possible risk and the highest possible return
What are the two categories that investment risks are divided into?