FNAN 522 Exam 2 2021 with complete complete solution

State the basic valuation model - V = CF1/(1+R)^1 + CF2 / (1 + R)^2 + ... + CFn / (1 + R)^n in the basic valuation model, if risk is high, i will be - large legal document that spells out the rights of bond holders - bond indenture corporate IOUs - bonds unsecured bonds with no liens - debentures the face value of a bond which the holder receives at maturity - par value what is the valuation model of preferred stock? - VP = D0 / rps d0 = last dividend rps = required return hybrid stock - part debt and part equity - preferred stock state the gordon model formula for common stock constant growth - p0 = d1 / (rs - g) p0 = value or price of a common stock d1 = next dividend (D0 * (1 + g)) rs = required return for p0 g = growth rate in dividends state the capital asset pricing model formula - Rs = Rf + b(rM - Rf) Rs = a stock's expected return Rf = the current risk-free rate (T-Bonds) b = the stock's beta rM = the market's required return idea that describes the behavior of a capital market--states that the market is efficient and that it is therefore difficult to "beat the market" - efficient market hypothesis securities are generally in __________ - equilibrium the idea that, since people are involved in financial decision making, it is not a perfect science - behavioral finance what is the formula to calculate a stock's value based on its book value - Po = book value of CS / # shares what is the formula to calculate a stock's value based on the liquidation model? - Po = (liquidation of assets - liabilities - preferred stock) / # of shares what is the formula to calculate a stock's value based on P/E multiples? - P/E = price per share / EPS a systematic process to evaluate long-term (capital) business investments - capital budgeting an investment opportunity with a PV greater than its cost will ___ the value of the firm - increase what are the steps in the capital budgeting process? - idea test the idea to make sure it confirms to the firm's goals and strategies appoint a capital budgeting team and have them determine assumptions and gather data gather required data prepare the cash flow worksheet apply capital budgeting techniques to the cash flow worksheet make a decision implement follow-up (compare actual to predicted cash flows and investigate variances) length of time it takes to recover an initial investment using based on cash flows or discounted cash flows - payback period discount of all expected cash flows by the appropriate discount rate minus the initial investment - net present value theoretically, what is the best capital budgeting technique? - Net present value based on NPV, which projects should be accepted - if the NPV is = 0 based on payback period, which projects should be accepted - if the payback period is less than the required payback period discount rate that makes the present value of the cash inflows equal to the initial investment - IRR - internal rate of return based on IRR, which projects should be accepted - projects whose return exceeds the required return present value of cash flows divided by the initial investment - profitability index based on the profitability index, which projects should be accepted? - Projects whose PI exceeds the required return uses the required rate of returns to adjust expected cash flows - modified IRR What is the format of capital budgeting - initial investment operating cash flows terminal cash flows in capital budgeting, ______ are relevant and not profits - cash flows what is the most important and difficult step in capital budgeting - estimating cash flows change in cash flow attributable to a project - incremental cash flow expenses that have already occurred and will not change due to acceptance or rejection of a project - sunk costs costs that require a sacrifice of a benefit - opportunity costs effects of outside forces that may impact the success of a project - externalities where cost may be understated or inflows overstated - cash flow bias a technique which indicates how much the NPV or IRR will change in response to a given change in a single input variable, all else being equal - sensitivity analysis considers both the sensitivity of NPV to changes in Key inputs and also the range of likely variables values - scenario analysis represent the percentage of estimated cash flow that investors would be satisfied to receive for certain rather than the cash flows that may be possible for each year given a proposed investment - certainty equivalents (CE) rate of return that must be earned on a given project to compensate the firm's owners adequately - Risk-adjusted discount rate list the RADRs and risk classes - I - below average risk - RADR 8% II - average risk - RADR 12% III - above-average risk - RADR 14% IV - high risk - RADR 20% Between CE and RADR, which is preferred in practice? - CEs are preferred because they separately adjust for risk and time They first eliminate risk from the cash flows, then discount the certain cash flows at a risk-free rate an approach that allows the use of probability and abandonment - decision tree analysis what is the project selection criteria using payback period - if PBP is = required PBP, accept the project what is the project selection criteria using NPV? - if NPV = 0, accept project what is the project selection criteria using IRR? - if IRR is larger than required return (cost of capital), accept project what is the project selection criteria using profitability index - if PI = required return, accept project what is the project selection criteria using modified IRR? - if MIRR = cost of capital, accept project what are the components of cost of capital for most firms? - permanent financing portion of short-term notes all long-term debt all preferred stock all common stock what is specifically excluded from cost of capital calculations? - non interest-bearing liabilities -- accounts payable and accruals how is cost of capital measured with respect to taxes? - it is measured on an after-tax basis what are the 2 ways a firm can raise common equity? - retaining earnings issuing new common stock the risk everyone assumes when investing in a market - systematic risk or nondiversifiable risk Company- or industry-specific hazard that is inherent in each investment - unsystematic risk or diversifiable risk - can be reduced by diversification a measure of the risk arising from exposure to general market movements as opposed to idiosyncratic factors - beta A model that describes the relationship between risk and expected return and that is used in the pricing of risky securities - capital asset pricing model (CAPM) A line formed using regression analysis that summarizes a particular security or portfolio's systematic risk and rate of return Same as the characteristic line - security market line (SML) A description of an investor who, when faced with two investments with a similar expected return (but different risks), will prefer the one with the lower risk - risk aversion the future value of an annuity due is always _____ than the future value of an otherwise identical ordinary annuity - more a level periodic cash flow where the cash flow occurs at the end of each period - annuity a level periodic cash flow where the cash flow occurs at the beginning of each period - annuity due long-term debt instrument used by business and government to raise large sums of money, generally from a diverse group of lenders - bond a special form of ownership having a fixed periodic dividend that must be paid prior to payment of any common stock dividends - preferred stock units of ownership (equity) in a corporation - common stock constant-growth model used in dividend valuation - Gordon model combining negatively correlated assets to reduce risk - diversification chance of financial loss, or variability of returns associated with a given asset - risk