TCU Financial Management Test 3
What is capital budgeting? ..
the process of analyzing projects and investment opportunities and deciding which ones to accept
-Long term, high dollar, investment decisions
-a year or longer
-Not immediate decisions
What are incremental earnings? ..
the amount by which a firm;s earnings are expected to change as a result of an investment decision
What is free cash flow?
the incremental effect of a project on a firm's available cash (does not include depreciation)
What is working capital management? ..
managing current assets
Steps in decision-making process: ..
1. search for investment opportunities
2. Data Collection
3. Evaluation and decision making
4. Reevaluation and adjustment
What are capital expenditures? ..
buying plant, property and equipment
Factors to consider when estimating a project's revenue and costs: ..
1. a new product typically has lower sales initially, tends to build
2. The average selling price of a product and its cost of production will generally change over time (competition tends
to drive prices down)
3. For most industries, competition tends to reduce profit margins over time
What is pro forma? ..
a statement that is not based on actual data but rather depicts a firm's financials under a given set of hypothetical
assumptions
What is the marginal corporate tax rate? ..
the tax rate a firm will pay on an incremental dollar of pre-tax income
What is the liquidation or salvage value? ..
assets that are no longer needed often have a resale value or some salvage value if the parts are sold for scrap
-when an asset is liquidated, any capital gain is taxed as income (capital gain = sales price - book value)
What are the 5 methods of ranking investment proposals? (8)
1. Net Present Value
2. Payback Method
3. Internal rate of return
(4.) Modified Internal Rate of Return
(5.) Profitability Index
For project (investment) to be accepted: (8)
1. profitability must equal or exceed cost of capital
For Mutually- exclusive projects - selecting one option precludes alternatives)
, For Non-mutually-exclusive projects - Alternatives providing return in excess of cost of capital is selected
What is Net Present Value (NPV)? (8)
the difference between the present value of a project's or investment's benefits and the present value of its cost
- finding difference between PV (discount) of inflows and PV of outflows
-"golden rule"
What is the NPV equation? (8)
PV (benefits) - PV (costs)
when finding net PV, use WACC as discount rate
NPV decision rule: (8)
T/F: In capital budgeting decisions, emphasis is on earnings rather than cash flows. ..
F: emphasis is on cash flows rather than earnings
How do you calculate the weight of a stock in a portfolio? (12)
weight = value of investment i / total value of portfolio
How do you calculate the expected return of a portfolio? (12)
E[R^p] = wAE[RA] + wBE[RB] + ....
How do you reduce risk in a portfolio?
by combining stock, aka diversification
the volatility of a portfolio is the _____________, measured as _____________, of the portfolio (12)
total risk
standard deviation
volatility (12)
measure of risk; measured through standard deviation
more volatility, more risk
the amount of risk that is eliminated depends upon the _________________________________ (12)
degree to which the stocks move together (correlation)
-when stocks do not move together, more risk (volatility) is cancelled out, making the portfolio much less risky
the more the returns tend to move together as a result of common risk
correlation is: (12)
scaled covariance
Volatility declines as the number of stocks in the equally weighted portfolio _________ (12)
grows
T/F: Systematic risk is eliminated as the portfolio grows (12)
F; it remains
By diversification, we can reduce ____________ risk to zero (12)
Unsystematic
T/F: You can't diversify away all of the unsystematic risk (12)
F; you can
What is capital budgeting? ..
the process of analyzing projects and investment opportunities and deciding which ones to accept
-Long term, high dollar, investment decisions
-a year or longer
-Not immediate decisions
What are incremental earnings? ..
the amount by which a firm;s earnings are expected to change as a result of an investment decision
What is free cash flow?
the incremental effect of a project on a firm's available cash (does not include depreciation)
What is working capital management? ..
managing current assets
Steps in decision-making process: ..
1. search for investment opportunities
2. Data Collection
3. Evaluation and decision making
4. Reevaluation and adjustment
What are capital expenditures? ..
buying plant, property and equipment
Factors to consider when estimating a project's revenue and costs: ..
1. a new product typically has lower sales initially, tends to build
2. The average selling price of a product and its cost of production will generally change over time (competition tends
to drive prices down)
3. For most industries, competition tends to reduce profit margins over time
What is pro forma? ..
a statement that is not based on actual data but rather depicts a firm's financials under a given set of hypothetical
assumptions
What is the marginal corporate tax rate? ..
the tax rate a firm will pay on an incremental dollar of pre-tax income
What is the liquidation or salvage value? ..
assets that are no longer needed often have a resale value or some salvage value if the parts are sold for scrap
-when an asset is liquidated, any capital gain is taxed as income (capital gain = sales price - book value)
What are the 5 methods of ranking investment proposals? (8)
1. Net Present Value
2. Payback Method
3. Internal rate of return
(4.) Modified Internal Rate of Return
(5.) Profitability Index
For project (investment) to be accepted: (8)
1. profitability must equal or exceed cost of capital
For Mutually- exclusive projects - selecting one option precludes alternatives)
, For Non-mutually-exclusive projects - Alternatives providing return in excess of cost of capital is selected
What is Net Present Value (NPV)? (8)
the difference between the present value of a project's or investment's benefits and the present value of its cost
- finding difference between PV (discount) of inflows and PV of outflows
-"golden rule"
What is the NPV equation? (8)
PV (benefits) - PV (costs)
when finding net PV, use WACC as discount rate
NPV decision rule: (8)
T/F: In capital budgeting decisions, emphasis is on earnings rather than cash flows. ..
F: emphasis is on cash flows rather than earnings
How do you calculate the weight of a stock in a portfolio? (12)
weight = value of investment i / total value of portfolio
How do you calculate the expected return of a portfolio? (12)
E[R^p] = wAE[RA] + wBE[RB] + ....
How do you reduce risk in a portfolio?
by combining stock, aka diversification
the volatility of a portfolio is the _____________, measured as _____________, of the portfolio (12)
total risk
standard deviation
volatility (12)
measure of risk; measured through standard deviation
more volatility, more risk
the amount of risk that is eliminated depends upon the _________________________________ (12)
degree to which the stocks move together (correlation)
-when stocks do not move together, more risk (volatility) is cancelled out, making the portfolio much less risky
the more the returns tend to move together as a result of common risk
correlation is: (12)
scaled covariance
Volatility declines as the number of stocks in the equally weighted portfolio _________ (12)
grows
T/F: Systematic risk is eliminated as the portfolio grows (12)
F; it remains
By diversification, we can reduce ____________ risk to zero (12)
Unsystematic
T/F: You can't diversify away all of the unsystematic risk (12)
F; you can
