BUSI 408 Final Exam Review
Advantages:
-explicitly adjusts for systematic risk
-applicable to all companies, as long as we can estimate beta
Disadvantages:
Advantages and Disadvantages of SML
-have to estimate the expected market risk premium, which varies over time
-have to estimate beta, which varies over time
-we are using information from the past to predict the future, which is not alw
reliable
Advantage: easy to understand/use
Disadvantage:
Advantages/Disadvantages of Dividend -only applicable to companies currently paying dividends
Growth Model -not applicable if dividends aren't growing at a reasonably constant rate
-extremely sensitive to estimated growth rate
-does not explicitly consider risk
, BUSI 408 Final Exam Review
accept the project if the AAR is greater than a pre-specified number
advantages:
-easy to calculate
-needed info will usually be available since detailed accounting data is typica
available internally (within organizations)
Average Accounting Return
disadvantages:
-not a true rate of return since time value of money is ignored
-uses an arbitrary cutoff rate
-based on accounting net income and book values, not cash flows and mark
values (lots of accounting assumptions go into calculating NI)
-could use loopholes to make project look profitable
Business Aid is funded by a group of venture capital
wealthy investors for the sole purpose of
providing funding for individuals and
small firms that are trying to convert their
new ideas into viable products. What is
this type of funding called?
Capital structure decision the right mix of debt and equity
-uses risk free rate, market risk premium, and systematic risk of asset
CAPM or SML (security market line
B<1- means equity is considered less risky than the market
approach)
B>1- means equity is considered more risky than the market
, BUSI 408 Final Exam Review
1. Account for time value of money? --> YES
2. Account for risk of cash flows? --> NO (IRR does not discount cash flows u
the required rate of return, which accounts for risk)
Decision Criteria Test: IRR
3. Provide an indication about the increase in shareholder value?
-yes if IRR>required rate of return
-but could have multiple IRR rates
A positive NPV means that the project is expected to add value to the firm an
therefore increase the wealth of the owners (shareholders)
-NPV is a direct measure of how this project will help us achieve this goal
Decision Rule Summary
-risk of project is accounted for through the discount rate
-if NPV is positive, accept the project
-pick highest NPV
NPV (net present value)
Internal rate of return (IRR)
Discount Cash Flow Analyses
Profitability index (PI)
-NPV helps us pick the project that maximizes shareholder value
Advantages:
-explicitly adjusts for systematic risk
-applicable to all companies, as long as we can estimate beta
Disadvantages:
Advantages and Disadvantages of SML
-have to estimate the expected market risk premium, which varies over time
-have to estimate beta, which varies over time
-we are using information from the past to predict the future, which is not alw
reliable
Advantage: easy to understand/use
Disadvantage:
Advantages/Disadvantages of Dividend -only applicable to companies currently paying dividends
Growth Model -not applicable if dividends aren't growing at a reasonably constant rate
-extremely sensitive to estimated growth rate
-does not explicitly consider risk
, BUSI 408 Final Exam Review
accept the project if the AAR is greater than a pre-specified number
advantages:
-easy to calculate
-needed info will usually be available since detailed accounting data is typica
available internally (within organizations)
Average Accounting Return
disadvantages:
-not a true rate of return since time value of money is ignored
-uses an arbitrary cutoff rate
-based on accounting net income and book values, not cash flows and mark
values (lots of accounting assumptions go into calculating NI)
-could use loopholes to make project look profitable
Business Aid is funded by a group of venture capital
wealthy investors for the sole purpose of
providing funding for individuals and
small firms that are trying to convert their
new ideas into viable products. What is
this type of funding called?
Capital structure decision the right mix of debt and equity
-uses risk free rate, market risk premium, and systematic risk of asset
CAPM or SML (security market line
B<1- means equity is considered less risky than the market
approach)
B>1- means equity is considered more risky than the market
, BUSI 408 Final Exam Review
1. Account for time value of money? --> YES
2. Account for risk of cash flows? --> NO (IRR does not discount cash flows u
the required rate of return, which accounts for risk)
Decision Criteria Test: IRR
3. Provide an indication about the increase in shareholder value?
-yes if IRR>required rate of return
-but could have multiple IRR rates
A positive NPV means that the project is expected to add value to the firm an
therefore increase the wealth of the owners (shareholders)
-NPV is a direct measure of how this project will help us achieve this goal
Decision Rule Summary
-risk of project is accounted for through the discount rate
-if NPV is positive, accept the project
-pick highest NPV
NPV (net present value)
Internal rate of return (IRR)
Discount Cash Flow Analyses
Profitability index (PI)
-NPV helps us pick the project that maximizes shareholder value
