FIN 310 Exam 2 Review

Gordon Growth Model Formula

D1 = D0 (1+g)^1

Dt = Dt-1 (1+g)^1 = D0 (1+g)^t

P0 = D1/(r-g)

r = (D1/P0) + g

FCF (Free Cash Flow) formula

EBIT - Taxes + Depreciation - CapEx - ΔNWC

NPV (Net Present Value) formula

CF0 + CF1/(1+r) + CF2/(1+r)² + CF3/(1+r)³ + … + CFt/(1+r)^t

CAPM

(E(rM) - rF) / βM

E(ri) = RF + βi(E[rM] - rF) = rF + βiRPM

WACC (Weighted Average Cost of Capital) formula

D/V (1-Tc)rD + (Pfd/V)rPfd + (E/V)rE

If any, which of the following does NOT have the potential to increase the net present value of a proposed investment?

A. The ability to immediately shut down a project should the project become unprofitable

B. The ability to wait until the economy improves before making the investment

C. The option to increase production beyond that initially projected

D. All of the above have the potential to increase the NPV of a proposed investment

D. All of the above have the potential to increase the NPV of a proposed investment

Which of the following statements is FALSE?

A. Over the long run, investments in small-company stocks have had the largest return but also the most risk, when compared with large-company stocks, bonds, and T-Bills.

B. The average return is always less than the geometric return.

C. Investors who hold bonds instead of stocks over long horizons can be rational and relatively averse to risk.

D. Unlike the capital gains yield, the dividend yield can never be negative.

B. The average return is always less than the geometric return.

Which of the following should not be included in the analysis of a proposed investment?

A. The current market value of an existing building to be used in the project.

B. The amount paid 4 years ago for an existing building to be used in the project.

C. The expected after-tax salvage value at the end of a project of an existing building to be used in the project.

D. The net working capital balance remaining at the end of the project.

B. The amount paid 4 years ago for an existing building to be used in the project.

Fill in the blanks: Standard deviation measures ______ risk, while beta measures ______ risk.

A. Asset-specific; market-wide

B. Market-wide; total

C. Total; market-wide

D. Total; asset-specific

C. Total; market-wide

Which one of the following statements is TRUE?

A. The risk-free rate of return has a risk premium of 1.0.

B. The reward for bearing risk is called the standard deviation.

C. Risks and expected return are inversely related.

D. The higher the expected rate of return, the wider the distribution of returns

D. The higher the expected rate of return, the wider the distribution of returns

Which of the following statements is FALSE?

A. The cost to a firm for capital funding equals the expected return to the providers of those funds

B. WACC is affected by market conditions including interest rates, tax rates, and the market risk premium

C. A firm’s cost of capital depends primarily on the source of the funds, not the use

D. A firm's WACC reflects the average risk of the existing projects undertaken by the firm

C. A firm’s cost of capital depends primarily on the source of the funds, not the use

Which of the following statements is TRUE?

A. By investing in varied and numerous assets, an investor can virtually eliminate all asset-specific risks in her portfolio, both easily and cheaply.

B. It is possible, but not very easy, for an investor to control market-wide risks in his portfolio and increases in these market-wide risks are costly because they reduce expected returns.

C. The most important characteristic in determining the expected return of a well-diversified portfolio is the total variance risks of the individual assets in the portfolio.

D. When a portfolio has a positive investment in every one of its assets, its standard deviation cannot be less than that on every asset in the portfolio

A. By investing in varied and numerous assets, an investor can virtually eliminate all asset-specific risks in her portfolio, both easily and cheaply

Newly issued securities are sold to investors in which one of the following markets?

A. Proxy

B. Inside

C. Secondary

D. Primary

D. Primary

Which of the following statements is TRUE?

A. The Gordon Growth Model assumes constant dividend growth but implies that stock prices grow at a different rate.

B. A stock’s price is the present value of its future cash flows, namely, its expected capital gains and dividends.

C. Brokers buy and sell securities from their own inventory, while dealers bring buyers and sellers together to complete transactions.

D. Holders of common stock have greater voting rights in corporate decisions than holders of preferred stock, but they have less voting rights than creditors of the corporation

B. A stock’s price is the present value of its future cash flows, namely, its expected capital gains and dividends

Which of the following statements is FALSE?

A. The internal rate of return is defined as the discount rate which results in a zero net present value for the project.

B. The primary advantage to payback analysis is that it biases companies to invest in long-term projects that require large current expenditures on research and development.

C. The average accounting return ignores cash flows is most similar to computing the return on assets (ROA).

D. The profitability index reflects the value created per dollar invested.

B. The primary advantage to payback analysis is that it biases companies to invest in long-term projects that require large current expenditures on research and development.

A firm uses its weighted average cost of capital to evaluate the proposed projects for all of its varying divisions. By doing so, the firm:

A. Automatically gives preferential treatment in the allocation of funds to its riskiest division

B. Encourages the division managers to only recommend their most conservative projects

C. Maintains the current risk level and capital structure of the firm

D. Automatically maximizes the total value created for its shareholders

A. Automatically gives preferential treatment in the allocation of funds to its riskiest division

unsystematic risk

unique or asset-specific risks; factors that affect a limited number of assets (ex: labor strikes, part shortages)

systematic risk

market-wide risks; factors that affect a large number of assets (ex: changes in GDP, inflation, interest rates)

Efficient Market Hypothesis

market knows equal information, no one knows more or less

Average Accounting Return

based on Net Income and Book Value; = Avg. Net Income/Avg. Book Value

brokers

a connecting point

dealers

sell something they own

New Product Line Equation

Rev from new product line + Synergies - Erosion

Average Arithmetic Return

= (r1+r2+…+rT)/T; sum of returns over each period divided by number of periods

Volatility

also called Standard Deviation; σ = √Variance

Geometric Return

[(1+r1)(1+r2)…(1+rT)]^1/T - 1; always less than Average Return

Payback Period

From information, Calculate Owed value from Y0, Y1, Y2 …YT; If owed value only takes partial year, divide Owed Value by total Value paid in that year (ex: Y3: 200/500 = 0.4 year)

Total Return Index

Geometric return, exclude bringing equation to the Power of T and exclude subtracting by 1; OR (1 - Geometric Return)^T; dollar value