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Finance Exam 2
Terms in this set (43)
What is the expected return on a portfolio that will decline in value by 25% in a recession, will increase by 15% in normal times, and will increase by 40% during boom times if each scenario has equal likelihood?
What is the approximate variance of returns if over the last three years the investment returned 8.0%, -12.0% and 15%?
What is the beta of a three-stock portfolio including 25% of stock A with a beta of .90, 40% of stock B with a beta of 1.10 and 35% of stock C with a beta of 1.80?
If next year's dividend is forecast to be $4.00, the constant growth rate is 4%, and the discount rate is 16%, then what should be the current stock price?
An investor was expecting an 18% return on his portfolio with a beta of 1.25 before the market risk premium increased from 8% to 10%. Based on this change, what return will be expected on the portfolio?
What is the profitability index for a project costing $40,000 and returning $15,000 annually for 4 years at an opportunity cost of capital of 12%?
PI=NPV/Net Investment= 0.139
What is a firm's weighted average cos of capital if the stock has a beta of 1.45, Treasury bills yield 5% and the market portfolio offers an expect return of 14%? In addition to equity, the firm finances 35% of its assets with debt that has yield to maturity of 9%. The firm is in the 35% marginal tax bracket.
What are the pitfalls of the internal rule?
Many firms use internal rate of return instead of net present value. Internal rate of return is not suited for choosing between two or more competing proposals. Can't choose highest rate of return on mutually exclusive projects. Firms need to know whether they are lending or borrowing money. There can be multiple rates of return.
Why is it important to make the distinction between company cost of capital and project opportunity cost of capital when evaluating projects?
Because required rates of return for a project depend on the risk of a particular project, not on the risk of the firm's existing business.
What is beta and how would beta affect the weighted cost of capital. Explain.
Measure of risk of a security or portfolio compared to the market as a whole. Weighted cost of capital will increase as beta increases, because an increase in weighted cost of capital denotes a decrease in valuation and an increase in risk.
What are the benefits and costs of paying dividends for a public corporation?
Paying dividends helps increase shareholder loyalty. The cost is that the cash paid to investors cannot be used to reinvest in the growth of the company.
What is the pecking order theory of capital structure? What economic force drives the logic and practice of the pecking order theory? How well does it reflect corporate debt choices?
Pecking order theory says that firms prefer internal financing over external financing. The amount of debt a firm issues will depend on its need for external financing. Financial managers should try to maintain some financial slack. It doesn't reflect corporate debt choices very well, because capital structure decisions are on a case by case basis.
Suppose Wal-Mart is contemplating opening a store in Smoaks, SC. Preliminary analysis by Wal-Mart's staff indicates the net present value of the project is positive (there are currently no general merchandise stores in Smoaks). What issues should be considered in sensitivity and scenario analysis regarding this decision? Explain.
For sensitivity analysis Walmart would want to estimate profits/sales compared to their potential competitors, as well as different outcomes within their company. They should look at the financial outcomes if they under or over sell. For scenario analysis, Walmart would want to look at what would happen in a big competitor, like Target, showed up in Smoaks, SC. How would their performance and Target;s affect their finances? How would this affect their wages for employees, and their variable costs of production?
is the reduction in taxes attributable to depreciation.
depreciation tax shield
is the risk to shareholders resulting from the use of debt.
is current assets minus current liabilities.
refers to the time until cash flows recover the initial investment in project
refer to costs that do not depend on the level of output
refers to the expected return in excess of the risk-free return as compensation for risk.
is the extra average return from investing in long versus short-term Treasury securities.
is the average value of squared deviations from a mean. A measure of volatility.
is a measure of the investment performance of the overall market
is a strategy designed to reduce risk by spreading the portfolio across many investments.
refers to economy wide (macroeconomic) sources of risk that affect the overall stock market. Also called systematic risk.
is the theory of the relationship between risk and return that states that the expected risk premium on any such security equals tis beta times the market risk premium.
is the minimum acceptable expected rate of return on a project given its risk.
project cost of capital
relationship between expected return and beta.
security market line
is the portfolio of all assets in the economy. In practice, a broad stock market index is used to represent the market.
refers to a list of planned investment projects.
refers to the tax savings resulting from deductibility of interest payments.
interest tax shield
is an approach to capital budgeting that does not explicitly consider the time value of money.
is the analysis of the level of sales at which the project breaks even.
is the expected rate of return on portfolio of all the firm's securities, adjusted for the tax savings due to interest payments.
refers to the payment of cash by the firm to its shareholders.
is the risk in a firm's operating income. Also called business risk.
refers to the act of a firm distributing cash to stockholder by repurchasing shares
is the degree to which costs are fixed.
is the percentage change in profits given a 1% change in sales.
refers to the present value of cash flows minus investment
net present value
is the expected rate of return given up by investing in a project.
opportunity cost of capital
is the discount rate at which the NPV = 0.
internal rate of return
is the ratio of the net present value to the initial investment.
refers to a limit set on the amount of funds available for investment
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