Finance Exam 2

What is an annuity?

Finite series of equal payments that occur at regular intervals

What is an ordinary annuity?

If the first payment occurs as the end of the period

What is an annuity due?

If the first payment occurs at the beginning of the period

What is perpetuity?

Infinite series of equal payments

What is the perpetuity equation?

PV = C / r

If you borrow money today, what do you need to compute?

Present value

What is an annuity in which the cash flows continue forever?

Perpuity

What is perpetuity formula?

PV = C / r

What is annual percentage rate?

Annual rate that is quoted by law

What does APR (annual percentage rate) equal?

Period rate x number of periods in year

What does period rate equal?

APR / number of periods per year

What should you never divide?

The EAR by the number of periods per year because it will not give you the period rate

What is the apr if the monthly rate is .5%?

.5(12)=6%

What is the apr if the semiannual rate is .5%?

.5(2) = 1%

What is the monthly rate if the APR is 12% with monthly compounding?

12 / 12 = 1%

What is the Effective Annual Rate (EAR)?

The actual rate paid (or received) after accounting compounding that occurs during the year

If you want to compare two alternative investments with different compounding periods, what do you need to do?

Compute the EAR and use that for comparison

What is the quoted rate?

APR

What is m?

The number of compounding periods per year

what do you always need to make sure of?

The interest rate and time period match

if you are looking at annual periods, what do you need?

Annual rate

If you are looking at monthly periods, what do you need?

Monthly rate

If you have an APR based on monthly compounding, what must you do?

Use monthly periods for lump sums or adjust the interest rate appropriately if you have payments other than monthly

What is pure discount?

The borrower receives money today and repays a lump sum at some point in the future

What is an interest only loan?

The borrower pays interest each period and pay back the entire original loan amount at some point in the future

What is an amortized loan?

The borrower pays back parts of the loan amount over time

What are annuity equations?

What Is the present value formula?

What is EAR formula?

What is APR example?

What is capital budgeting?

The process of planning for purchases of assets whose returns are expected to continue beyond a year

What is capital expenditure?

A cash outlay expected to generate a flow of future cash benefits for more than a year

When do you expand output?

Until marginal revenue equals marginal costs

What do you invest in?

The most profitable projects first

When do you continue accepting projects?

As long as the rate of return exceeds the marginal cost of capital (MCC)

What is an independent project?

Acceptance or rejection has no effect on other projects

What are mutually exclusive projects?

Acceptance of one automatically rejects the others

What are contingent projects?

Acceptance is dependent upon the selection of another

What do we need to ask ourselves when evaluating decision criteria?

Does the decision rule adjust for the time value of money?

Does the decision rule adjust for risk?

Does the decision rule provide information whether we are creating value for the firm?

What is net present value?

The difference between the market value of a project and its costs

How much value is created from undertaking an investment?

1. Estimate the expected future cash flows

2. Estimate the required return for projects of this risk level

3. Find the present value of the cash flows and subtract the initial investment

If the NPV is greater than zero, then what?

We accept the project

What does a positive NPV mean?

That the project is expected to add value to the firm and will increase the wealth of the owners

Since our goal is to increase owner wealth, then what is NPV?

A direct measure of how well this project will meet our goal

What is NPV formula?

What is the decision criteria test for NPV?

Does the NPV rule account for time value of money?

Does the NPV rule account for the risk of cash flows?

Does the NPV rule provide an indication about the increase in value?

Should we consider the NPV rule for or primary decision criteria?

What is payback period?

How long it takes to get the initial cost back in a nominal sense

What is payback period computation?

Estimate the cash flows

Subtract the future cash flows from the initial cost until the initial investment has been recovered

What is the decision rule?

Accept if the payback period is less than some present limit

What are advantages of payback?

Easy to understand

adjusts for uncertainty of later cash flows

Biased towards liquidity

What are disadvantages of payback?

Ignores the time value of money

Requires an arbitrary cutoff point

Ignores cash flows beyond the cutoff date

Biased against long term projects, such as research and development, and new projects

What is the most important alternative to NPV?

Internal rate of return

When is internal rate of return often used?

In practice and is intuitively appealing

What is based entirely on the estimated cash flows and is independent of interest rates found elsewhere?

Internal rate of return