Econ 340 Exam 1

Front 1

What is Finance?

Back 1

deals with the valuation of risky cash flows spread throughout time

Front 2

Corporate Finance

Back 2

firm-level decisions about investing in projects and financing those investments

Front 3

Investments

Back 3

individuals deciding which financial assets to invest in

Front 4

What long-term investment should a firm take on?

Back 4

Capital Budgeting (Investment decision) deals with NPV

Front 5

How should the firm raise funds to select investments?

Back 5

Capital Structure (financing decision); deals with debt to equity (borrow (bonds) vs. Equity)

Front 6

How should short-term assets be managed and financed?

Back 6

Working capital management; WC= CA-CL

Front 7

What are the 5 characteristics of corporation?

Back 7

1) owned by unlimited number of shareholders

2) Transfer of ownership generally simple

3) Separation of ownership and control

4) Limited Liability

5) Taxed at the corporation level (double taxation)

Front 8

What are 3 advantages of a corporation?

Back 8

1) Firm size is large, which allows the firm to raise money

2) expertise, professional management

3) Limited Liability reduces shareholder risk

Front 9

What are 3 disadvantages of a corporation?

Back 9

1) Shareholder's Rights

2) Conflict of interest (agency problem with shareholders and managers)

3) Shareholders vs. Bondholders; bondholders are more conservative

Front 10

Contingency claims that deal with debt

Back 10

promise by the borrowing firm to repay a fixed dollar amount by a certain date

Front 11

Senior claim on CF

Back 11

debt holders get paid first

Front 12

Shareholder's claim

Back 12

residual amount that remains after the debt holder are paid

Front 13

What are advantages of debt?

Back 13

1) bonds are less ricky than stock

2) Interest expense is tax deductible

Front 14

Agency Problem

Back 14

arise when one person is hired to perform a task on behalf of another

Front 15

Who is the principal and who is the agent in the Stockholder vs. Manager relationship?

Back 15

Stockholder is the principal and the manager is the agent

Front 16

What is the main source of conflict in the stockholder vs. manager relationship?

Back 16

separation of ownership and control

Front 17

In a stockholder vs. Manager relationship what is interest?

Back 17

Stockholders want to maximize share price, focus on long-term horizon, and are well diversified

Managers want to maximize compensation and perks, focus on shorter horizon, and minimize personal risk because they are less diversified

Front 18

Agency Costs

Back 18

managers do no attempt to maximize stockholder value; stockholders incur costs to monitor and influence.

Front 19

Who is the agent and the principal in a stockholder vs. bondholder relationship?

Back 19

Stockholder is the agent the bondholder is the principal

Front 20

What is the main source of conflict in a stockholder vs. bondholder relationship?

Back 20

limited liability of corporation

Front 21

What are the interests of each in a stockholder vs. bondholder relationship?

Back 21

stockholders want to maximize stock prices; bondholders what to minimize risk and maximize the likelihood of payment

Front 22

What are the 4 internal governance mechanisms?

Back 22

1) Annual meeting and proxy vote

2) Board monitoring

3) Incentive Compensation

4) Threat of firing

Front 23

What are the 3 external governance mechanisms?

Back 23

1) the market of corporate control

2) debt Discipline

3) Regulations

Front 24

Proxy vote

Back 24

a proxy enables shareholders to vote for any matters that come before the board at the annual meeting

Front 25

What does dual classes of shares do?

Back 25

creates anti-governance

Front 26

What are 4 advantages to board of directors?

Back 26

1) elected by shareholders (in theory)

2) Protect shareholder interest (in theory)

3) Monitor management: hire and fir senior executive, choose compensation structure

4) Independent board members (not employees) and board quality

Front 27

What are 5 problems with board of directors?

Back 27

1) Spend limited time on fiduciary duties

2) Directors often nominated by the management

3) CEO often chairs the board

4) directors may lack expertise

5) Many directors are CEOS of other firms (good for expertise; bad for other interest/ busy)

Front 28

What do incentive compensation do?

Back 28

align interest between managers and shareholders

Front 29

What are negatives of incentive compensation?

Back 29

under-diversification problem; earnings and stock price manipulation

Front 30

What are advantages of debt discipline?

Back 30

1) forces manager to work hard to meet debt obligation

2) reduces free cash flow problem

Front 31

What is a disadvantage of debt discipline?

Back 31

makes managers too conservative

Front 32

Sarbanes-Oxley Act

Back 32

the overall intense of SOX was to improve the accuracy of information given to both board and management of shareholders

Front 33

When it comes to Time Valuation of money what do you do when you are moving forward in time?

Back 33

divide

Front 34

When it comes to Time Valuation of Money what do you do when you are moving backward in time?

Back 34

multiple

Front 35

What type of cash flow is a preferred stock?

Back 35

perpetutity

Front 36

What does NPV assume?

Back 36

all CF can be reinvested at the discount rate

Front 37

Internal Rate if Retrun

Back 37

the discount rate that makes a project's NPV=0

Front 38

r>IRR

Back 38

NPV= negative

Front 39

r<IRR

Back 39

NPV= Positive

Front 40

What dies "hurdles" mean?

Back 40

the IRR is greater than r so you should accept

Front 41

higher r= ?

Back 41

lower NPV

Front 42

What are advantages of IRR?

Back 42

1) people like to look at returns

2) Comparable across projects of different sized (because it tells you the return of each dollar)

3) useful in preparing analysis for outside investors

Front 43

What are problems with IRR?

Back 43

1) Some cash flow streams can have multiple IRRs

2) reinvestment rate assumption: IRR assumes all CF are reinvested at IRR, however, reinvestment at the opportunity cost of capital is a better assumption

Front 44

What is IRR bias toward?

Back 44

smaller sized projects

Front 45

What does MIRR fix?

Back 45

1) eliminates multiple IRRs when there are negative future CF (unconventional CF)

2) Fixes the reinvestment rate problem; assuming all CF are reinvested at the opportunity cost of capital

Front 46

How do you find MIRR?

Back 46

1) Discount all negative CF to PV using the opportunity cost of capital rate

2) Compound all positive CF to FV using the opportunity cost of capital rate

3) Plug in PV (-) and FV(+) to find I/Y which will be MIRR

Front 47

What is the rule with MIRR?

Back 47

MIRR> opportunity cost of capital Accept

Front 48

What problem does IIRR fix?

Back 48

size problem; one project is larger than another

Front 49

How do you find IIRR?

Back 49

1) Take the CF form the larger project and subtract the smaller project

2) Find IRR on calculator, that will be IIRR

Front 50

What is the Rule with IIRR

Back 50

IIRR> WACC choose Large project

IIRR<WACC choose Small project

Front 51

What are advantages of the Profitability Index?

Back 51

1) May be useful when available investment funds are limited

2) Easy to understand and communicate

3) Correct decision when evaluating independent projects

Front 52

What is a problem of the profitability index?

Back 52

it does not consider the scale of investment

Front 53

Profitability Index

Back 53

means per dollar investment how much NPV is generated

Front 54

What is profitability index bias toward?

Back 54

small projects

Front 55

Payback period

Back 55

number of years to recover initial costs

Front 56

Rule for Payback period

Back 56

Payback period > t years reject

Front 57

what does discounted Payback Period do?

Back 57

discounts all the CF to PV; factors in TVM

Front 58

Soft Rationing

Back 58

Capital budgets for divisions and subdivisions of a firm for planning and control purposes. (Internal)

Front 59

Hard Rationing

Back 59

difficult or costly to raise more capital. (External, by market)

Front 60

When dealing with capital constraints what does it mean to maximize total NPV?

Back 60

do within budget and the Sum of NPV of all projects

Front 61

When do you use Least Common Multiple (LCM)?

Back 61

when projects have uneven lives and if projects can be repeated to have "common" lives

Front 62

How do you find LCM?

Back 62

1) Repeat the CF of the shorter life project to "common life" and calculate CF

2) find NPV of repeated project and compare to NPV of longer life project

Front 63

What is the rule for LCM?

Back 63

If shorter life NPV repeated is greater than longer life project's NPV, do shorter project

Front 64

How do you find EAA?

Back 64

1) Find NPV of both projects in Calculator

2) for each project, use the NPV you found as the PV in calculator and find PMT, this will be your EAA for the project

Front 65

What is the rule with EAA?

Back 65

choose the project with a larger EAA

Front 66

(Rev.- Costs- Dep)=

Back 66

EBIT (Earnings before Interest and tax)

Front 67

(Rev.- Costs- Dep.) (1-t)=

Back 67

EBIT(1-T); NOPLAT-> Net Operating Income Less Adjusted Taxes

Front 68

What are depreciation tax effects?

Back 68

it is a non-cash expense; It lowers taxable income so it generates "extra" CF

Front 69

If Working capital increases what does that mean?

Back 69

cash out flow

Front 70

Capital gain/Loss

Back 70

SV(t)-BV(t)

Front 71

Project CF= ?

Back 71

FCFF- Initial Investment + After-Tax Salvage Value

Front 72

When dealing with change in working capital, and the change is positive, what do you do when trying to find FCFF?

Back 72

subtract it

Front 73

When deal with change in working capital and the change is negative, what do you do when trying to find FCFF?

Back 73

add it

Front 74

Once you find the FCFF, how do you find the Final CF?

Back 74

1) Factor in the Initial outlay (-) at year 0 and the After-tax Salvage value in the final year (+)

2) If there are opportunity costs or externalities, factor those in as well

3) once you have the Final CF for each year, find NPV

Front 75

What is Product Cannibalization?

Back 75

when consumers of a company's product switch to another product of the company

Front 76

sensitivity Analysis

Back 76

change one variable at a time to analyze which factors affect NPV the most; isolate effe of one variable

Front 77

Scenario Analysis

Back 77

project analysis given a particular combination or assumptions; allow several variables to change, create best/worst scenario

Front 78

Break Even Analysis

Back 78

analysis of the level of sales (or other variable) at which the company breaks even

Front 79

Simulation Analysis

Back 79

estimation of the probabilities of different possible outcomes; generate NPV estimates for a wide range of scenarios

Front 80

% change in Rev./NPV

Back 80

New-old/old

Front 81

How to you find the Break Even Quantity using the accounting method

Back 81

set NI =0 and solve

Front 82

What does the accounting break even method not consider?

Back 82

initial investment

Front 83

How do you fin the Break Even quantity using Financial method?

Back 83

1) for CF add back depreciation to NI equation

2) On calculator set PV to initial investment and find PMT, this will be what you set you CF equation to

3) Solve for Q in equation