FNAN 522 FINAL EXAM STUDY GUIDE 2021/2022

Systematic risk - Also known as non-diversifiable risk, attributable to market factors that affect all firms; can't be eliminated through diversification Unsystematic risk - Also known as diversifiable risk, attributable to firm-specific, random causes; can be eliminated through diversification. Beta - Relative measure of non-diversifiable risk. An index of the degree of movement of an asset's return in response to a change in the market return CAPM(Capital Asset Pricing Model) - Describes the relationship btw the required return and the non-diversifiable risk of the firm as measured by beta. CAPM(2) - The basic theory that links risk and return for all assets SML(Security Market Line) - Depiction of the CAPM as a graph that reflects the required return in the marketplace for each level of non-diversifiable risk Risk Averse - The attitude toward risk where investors would require an increased return as compensation for an increase in risk Annuity - A stream of equal periodic cash flows over a specified time period. These cash flows can be inflows or outflows Annuity Due - An annuity for which the cash flow occurs at the beginning of each period Bond - Long-term debt instrument used by business and government to raise large sums of money, generally from a diverse group of lenders Preferred Stock - A special form of ownership having a fixed periodic dividend that must be paid prior to payment of any dividends to common stockholders Common Stock - The purest and most basic form of corporate ownership Gordon Model - Also known as the constant growth model that is widely cited in dividend valuation Diversification - Reduces risk, combines to adds assets that have a low correlation with each other Risk - A measure of uncertainty surrounding the return that an investment will earn or, more formally, the variability of returns associated with a given asset C.V.(Coefficient of variation) - A measure of relative dispersion that is useful in comparing the risks of assets with differing expected returns Payback Method - How long it takes to recover an investment NPV - The best and correct method. Most theoretical method Advantages of NPV - Answer is in dollars, shows the change in the value of the firm, reinvestment rate assumption for the cash flows is the discount rate Disadvantage of NPV - Some managers don't understand the answer or misinterpret the answer Formula for NPV - Cost of capital adjusted by the risk of the cash flows -initial investment from PV total IRR - The discount rate that makes the present value of the cash inflows equal the initial investment(similar to bond yields) Rule of IRR - If IRR is required return(cost of capital) than accept the project Advantages of IRR - Answer is is a yield of rate of return, managers like an answer as a rate of return Disadvantages of IRR - If the cf can't be reinvested at the IRR rate, the IRR calculation is incorrect IRR(fill in the blank) - With the mutually exclusive projects, the __ may give the wrong project selection.(conflict with the NPV due to the reinvestment rate assumption) Timing differences and scale effect - The 2 conditions for IRR are the _ _ and _ _ PI (Profitability Index) - the present value of cash flows divided by the initial investment(its a ratio) MIRR(Modified IRR) - Use the required rate of returns to adjust the expected cash flows Rule of MIRR - iF MIRR is equal to or larger than Cost of Capital accept the project Advantages of MIRR - Cf are reinvested at the cost of capital(better assumption), single solution when there are embedded negative cfs, MIRR is superior to IRR Disadvantages of MIRR - Conflict can still occur with NPV, if there is a scale effect, NPV is superior Cash flow bias - Cost is understated or inflows are overstated. Why? Managers may benefit if the project is undertaken or managers become attached to the project and lose their subjectivity Agency Theory - Management may have stake in project, put personal goals ahead of goals of stakeholders How do you uncover bias? - Ask why will this project increase wealth? How does it contribute to competitive advantage? What causes it to have a positive NPV? Mutually exclusive project - Project that is competing against another, so that the acceptance of one eliminates from further consideration all other projects that serve a similar function Externalities - Cannibalization and Synergy Sunk Costs - are not incremental. These are expenses that have already occurred and will not change because of the acceptance or rejection of the project. Cannibalization - When a new product may take sales from own existing products Synergy - A new product may complement other existing products and cause an increase in sales Incremental cash flow - The additional cash flows expected to result from a proposed capital expenditure Post audit - Use this as a budget to compare the actual cfs to the predicted cfs and investigate significant variances Results of a good post audit - Improves future capital budgeting analysis, improves current project's performance, and allows consideration of the abandonment of the project at the earliest point Replacement chain - When you pick new machinery over old machinery(maybe its energy efficient and will save money in the long run) Sensitivity Analysis - technique which indicates how much NPV or IRR will change in response to a given change in a single input variable, ceteris paribus Scenario Analysis - considers both the sensitivity of NPV to changes in key inputs and also the range of likely variable values Certainty Equivalent - One of the most direct and theoretically preferred approaches for risk adjustment;represents the percentage of estimated cash flow that investors would be satisfied to receive for certain rather than the cash inflows that are possible for each year RADRs(Risk-Adjsuted Discount Rates) - A more practical approach for risk adjustment involves the use of risk-adjsuted discount rates. Instead of adjusting cf inflows for risk, as the certainty equivalent approach does, this approach adjusts the discount rate Pure Play Method - Method trying to find a single product company in the same line of business as the project under consideration. Then find the firm's required return. Managerial Options - (embedded options)-many investments have the potential to lead to a number of valuable opportunities that are beyond the scope of the original proposal 1)follow up products 2)expand product markets3)opportunity to abandon project Abandonment Option - to allow abandon or to terminate a project prior to the end of it's planned life.Allows management to avoid or minimize losses on projects that turn bad or to find projects that shouldn't be held for its entire life. Abandoning often leads to a increase in NPV Flexibility Option - to incorporate flexibility into the firm's operations and facilities. It generally includes the opportunity to design the facility and production process to accept multiple inputs and to use flexibility tech. to create a variety of outputs Growth Option - to allow the development of follow-on projects, expand markets, expand or retool plants, and so on, that would not be possible without implementation of the project that is being evaluated. Growth opportunities embedded in a project often increase the NPV of the project. Timing Option - to determine when various actions with respect to a given project are taken. This option recognizes the firm's opportunity to delay acceptance of a project for one or more periods as the future may be more rewarding for the project.This option can improve the NPV. WACC(Weighted Average Cost of Capital) - Reflects the expiated average future cost of capital over the long run; found by weighting the cost of each specific type of capital by its proportion in the firm's capital structure IOS(Investment Opportunity Schedule) - The graph that plots IRRs in descending order against the total dollar investment. Nominal Interest Rate - In the international context, the stated rate charged on financing when only the MNC parent's currency is involved. Real Interest Rate - Creates equilibrium btw the supply of savings and the demand for funds;represents the most basic cost of money. Inflation Premium - The expected rate of inflation Nominal Cash flow - Always use this cash flow over the real cash flow Market Risk - Discount rate using CAPM