Fin3403 Test 2

Front 1

Is it true that a U.S. Treasury security is risk free?

Back 1

No. As interest rates fluctuate, the value of a Treasury security will fluctuate. Long-term Treasury
securities have substantial interest rate risk.

Front 2

Which has a greater interest rate risk, a 30 yr T bond or a 30 yr BB corporate bond?

Back 2

All else the same, the Treasury security will have lower coupons because of its lower default risk, so
it will have greater interest rate risk.

Front 3

With regard to bid and ask prices ona T bond, is it possible for the bid price to be higher? Why/ not?

Back 3

No. If the bid price were higher than the ask price, the implication would be that a dealer was willing
to sell a bond and immediately buy it back at a higher price. How many such transactions would you
like to do?

Front 4

Tres. bid and ask quotes are sometimes given in terms of yields, so there would be a bid yield and an ask yield, Which do you think would be larger? Explain

Back 4

Prices and yields move in opposite directions. Since the bid price must be lower, the bid yield must
be higher.

Front 5

A company is contemplating a long term b nd issue. It is debating whether to include a call provision. What are the benefits to the company from including a call provision? Costs? How do these answers change for a put provision?

Back 5

There are two benefits. First, the company can take advantage of interest rate declines by calling in
an issue and replacing it with a lower coupon issue. Second, a company might wish to eliminate a
covenant for some reason. Calling the issue does this. The cost to the company is a higher coupon. A
put provision is desirable from an investor’s standpoint, so it helps the company by reducing the
coupon rate on the bond. The cost to the company is that it may have to buy back the bond at an
unattractive price.

Front 6

How does a bond issuer decide on the appropriate coupon rate to set on its bonds? Explain the diff btw coupon rate and req. return on a bond

Back 6

bond issuers look at outstanding bonds of similar maturity and risk. The yields on such bonds are
used to establish the coupon rate necessary for a particular issue to initially sell for par value. Bond
issuers also simply ask potential purchasers what coupon rate would be necessary to attract them.
The coupon rate is fixed and simply determines what the bond’s coupon payments will be. The
required return is what investors actually demand on the issue, and it will fluctuate through time. The
coupon rate and required return are equal only if the bond sells for exactly at par.

Front 7

Are there any circumstances under which an investor might be more concerned about the nominal return on an investment than real return?

Back 7

Yes. Some investors have obligations that are denominated in dollars; i.e., they are nominal. Their
primary concern is that an investment provide the needed nominal dollar amounts. Pension funds, for
example, often must plan for pension payments many years in the future. If those payments are fixed
in dollar terms, then it is the nominal return on an investment that is important.

Front 8

Companies pay rating agencies to rate their bonds, and the costs can be substantial. However, companies are not required to have their bonds rated; Why do they do it?

Back 8

Companies pay to have their bonds rated simply because unrated bonds can be difficult to sell; many
large investors are prohibited from investing in unrated issues.

Front 9

U.S. T bonds are not rated. Why? Often, junk bonds are not rated, Why?

Back 9

Treasury bonds have no credit risk since it is backed by the U.S. government, so a rating is not
necessary. Junk bonds often are not rated because there would be no point in an issuer paying a
rating agency to assign its bonds a low rating (it’s like paying someone to kick you!).

Front 10

What is the diff btw the term structure of interest raates and the yield curve

Back 10

The term structure is based on pure discount bonds. The yield curve is based on coupon-bearing
issues.

Front 11

Looking back at the crossover bonds we discussed in the chapter, why do you think split ratings such as these occur?

Back 11

Bond ratings have a subjective factor to them. Split ratings reflect a difference of opinion among
credit agencies.

Front 12

Why is it that municipal bonds are not taxed at the federal level but are taxable across state lines? Why are T bonds not taxable at the state level

Back 12

As a general constitutional principle, the federal government cannot tax the states without their
consent if doing so would interfere with state government functions. At one time, this principle was
thought to provide for the tax-exempt status of municipal interest payments. However, modern court
rulings make it clear that Congress can revoke the municipal exemption, so the only basis now
appears to be historical precedent. The fact that the states and the federal government do not tax each
other’s securities is referred to as “reciprocal immunity.”

Front 13

What are the implications for bond investors of the lack of transparency in the bond market?

Back 13

Lack of transparency means that a buyer or seller can’t see recent transactions, so it is much harder
to determine what the best bid and ask prices are at any point in time.

Front 14

All T bonds are relatively liquid, but some are more liquid than others. Which are the most and least liquid?

Back 14

One measure of liquidity is the bid-ask spread. Liquid instruments have relatively small spreads.
Looking at Figure 7.4, the bellwether bond has a spread of one tick; it is one of the most liquid of all
investments. Generally, liquidity declines after a bond is issued. Some older bonds, including some
of the callable issues, have spreads as wide as six ticks.

Front 15

A controversy erupted regarding bond rating agencies when some agencies began to provide unsolicited bond ratings. Why do you think this is is controversial?

Back 15

Companies charge that bond rating agencies are pressuring them to pay for bond ratings. When a
company pays for a rating, it has the opportunity to make its case for a particular rating. With an
unsolicited rating, the company has no input.

Front 16

The 100 yr bonds have something in common with junk bonds. Critics charge that in both cases the issuers are really selling equity in disguise. What are the issues here? Why would a company want to sell equity in disguise?

Back 16

A 100-year bond looks like a share of preferred stock. In particular, it is a loan with a life that almost
certainly exceeds the life of the lender, assuming that the lender is an individual. With a junk bond,
the credit risk can be so high that the borrower is almost certain to default, meaning that the creditors
are very likely to end up as part owners of the business. In both cases, the “equity in disguise” has a
significant tax advantage.

Front 17

Why does the value of a share of stock depend on dividends?

Back 17

The value of any investment depends on the present value of its cash flows; i.e., what investors will
actually receive. The cash flows from a share of stock are the dividends.

Front 18

A substantial percentage of the companies listed on the NYSE and NASDAQ don't pay dividends, but investors are nonetheless willing to buy shares in them. How is this possible?

Back 18

Investors believe the company will eventually start paying dividends (or be sold to another
company).

Front 19

Under what circumstances might a company not pay dividends?

Back 19

In general, companies that need the cash will often forgo dividends since dividends are a cash
expense. Young, growing companies with profitable investment opportunities are one example;
another example is a company in financial distress. This question is examined in depth in a later
chapter.

Front 20

Under what two assumptions can we use the div growth model presented in the chapter to determine the value of a share of stock?

Back 20

The general method for valuing a share of stock is to find the present value of all expected future
dividends. The dividend growth model presented in the text is only valid (i) if dividends are expected
to occur forever, that is, the stock provides dividends in perpetuity, and (ii) if a constant growth rate
of dividends occurs forever. A violation of the first assumption might be a company that is expected
to cease operations and dissolve itself some finite number of years from now. The stock of such a
company would be valued by applying the general method of valuation explained in this chapter. A
violation of the second assumption might be a start-up firm that isn’t currently paying any dividends,
but is expected to eventually start making dividend payments some number of years from now. This
stock would also be valued by the general dividend valuation method explained in this chapter.

Front 21

Suppose a company has a preferred stock issue anda common stock issue. Both have just paid a $2 div. Which do you think will have a higher price, a share of pref or com?

Back 21

The common stock probably has a higher price because the dividend can grow, whereas it is fixed on
the preferred. However, the preferred is less risky because of the dividend and liquidation
preference, so it is possible the preferred could be worth more, depending on the circumstances.

Front 22

Based on the div growth model, what are the two components of a total return on a share of stock? Which do you think is typically larger?

Back 22

The two components are the dividend yield and the capital gains yield. For most companies, the
capital gains yield is larger. This is easy to see for companies that pay no dividends. For companies
that do pay dividends, the dividend yields are rarely over five percent and are often much less.

Front 23

In the context of the div growth model, is it true that the growth rate in divs and the growth rate in the price of the stock are identical?

Back 23

Yes. If the dividend grows at a steady rate, so does the stock price. In other words, the dividend
growth rate and the capital gains yield are the same.

Front 24

When it comes to voting in elections, what are the diffs between US political democracy and corporate democracy?

Back 24

In a corporate election, you can buy votes (by buying shares), so money can be used to influence or
even determine the outcome. Many would argue the same is true in political elections, but, in
principle at least, no one has more than one vote.

Front 25

IS it unfair or unethical for corporations to create classes of stock with unequal voting rights?

Back 25

It wouldn’t seem to be. Investors who don’t like the voting features of a particular class of stock are
under no obligation to buy it.

Front 26

Some companies, such as reader's digest, have created classes of stock with no voting rights at all. Why would investors buy?

Back 26

Investors buy such stock because they want it, recognizing that the shares have no voting power.
Presumably, investors pay a little less for such shares than they would otherwise.

Front 27

Evaluate the following: Managers should not focus on the current stock value bc doing so will lead to an overemphasis on short term profits at the expense of long term profits

Back 27

Presumably, the current stock value reflects the risk, timing and magnitude of all future cash flows,
both short-term and long-term. If this is correct, then the statement is false.

Front 28

One of the assumptions of the two stage growth model is that the divs drop immediately from the high growth rate to the perpetual growth rate. What do you think about this assumption? What happens if it is violated?

Back 28

If this assumption is violated, the two-stage dividend growth model is not valid. In other words, the
price calculated will not be correct. Depending on the stock, it may be more reasonable to assume
that the dividends fall from the high growth rate to the low perpetual growth rate over a period of
years, rather than in one year.

Front 29

If a project with conventional cash flows has a payback period less than the project's life, can you definitively state the algebraic sign of the NPV? Why/not? If you know that the discounted payback period is less than the project's life, what can you say about the NPV? explain.

Back 29

A payback period less than the project’s life means that the NPV is positive for a zero discount rate,
but nothing more definitive can be said. For discount rates greater than zero, the payback period will
still be less than the project’s life, but the NPV may be positive, zero, or negative, depending on
whether the discount rate is less than, equal to, or greater than the IRR. The discounted payback
includes the effect of the relevant discount rate. If a project’s discounted payback period is less than
the project’s life, it must be the case that NPV is positive.

Front 30

Suppose a project has conventional ccash flows and a positive NPV. What do you know about it's payback? Its discounted payback? Its profitability index? Its IRR? explain

Back 30

If a project has a positive NPV for a certain discount rate, then it will also have a positive NPV for a
zero discount rate; thus, the payback period must be less than the project life. Since discounted
payback is calculated at the same discount rate as is NPV, if NPV is positive, the discounted payback
period must be less than the project’s life. If NPV is positive, then the present value of future cash
inflows is greater than the initial investment cost; thus PI must be greater than 1. If NPV is positive
for a certain discount rate R, then it will be zero for some larger discount rate R*; thus the IRR must
be greater than the required return.

Front 31

a) describe how the payback period is calculated, and describe the info this measure provies about a sequence of cash flows. What is the payback criterion decision rule?

b) What are the problems associated with using the payback period to evaluate cash flows?

c) What are the advantages of using the payback period to evaluate cash flows? Are there any circumstances under which using payback might be appropriate?

Back 31

a. Payback period is simply the accounting break-even point of a series of cash flows. To actually
compute the payback period, it is assumed that any cash flow occurring during a given period is
realized continuously throughout the period, and not at a single point in time. The payback is
then the point in time for the series of cash flows when the initial cash outlays are fully
recovered. Given some predetermined cutoff for the payback period, the decision rule is to
accept projects that payback before this cutoff, and reject projects that take longer to payback.
b. The worst problem associated with payback period is that it ignores the time value of money. In
addition, the selection of a hurdle point for payback period is an arbitrary exercise that lacks
any steadfast rule or method. The payback period is biased towards short-term projects; it fully
ignores any cash flows that occur after the cutoff point.
c. Despite its shortcomings, payback is often used because (1) the analysis is straightforward and
simple and (2) accounting numbers and estimates are readily available. Materiality considerations
often warrant a payback analysis as sufficient; maintenance projects are another example
where the detailed analysis of other methods is often not needed. Since payback is biased
towards liquidity, it may be a useful and appropriate analysis method for short-term projects
where cash management is most important.

Front 32

a) describe how the discounted payback period is calculated, and describe the info this measure provides about a sequence of cash flows. What is the discounted payback criterion decision rule?

b) What are the problems associated with using the discounted payback period to evaluate cash flows?

c) What conceptual advantage does the discounted payback method have over the regular payback method? Can the disc. payback ever be longer than the reg. payback?

Back 32

a. The discounted payback is calculated the same as is regular payback, with the exception that
each cash flow in the series is first converted to its present value. Thus discounted payback
provides a measure of financial/economic break-even because of this discounting, just as
regular payback provides a measure of accounting break-even because it does not discount the
cash flows. Given some predetermined cutoff for the discounted payback period, the decision
rule is to accept projects whose discounted cash flows payback before this cutoff period, and to
reject all other projects.
B-152 SOLUTIONS
b. The primary disadvantage to using the discounted payback method is that it ignores all cash
flows that occur after the cutoff date, thus biasing this criterion towards short-term projects. As
a result, the method may reject projects that in fact have positive NPVs, or it may accept
projects with large future cash outlays resulting in negative NPVs. In addition, the selection of
a cutoff point is again an arbitrary exercise.
c. Discounted payback is an improvement on regular payback because it takes into account the
time value of money. For conventional cash flows and strictly positive discount rates, the
discounted payback will always be greater than the regular payback period.

Front 33

a) Describe how the avg acg return is usually calculated, and describe the info this measure provides about a sequence of cash flows. What is the AAR criterion decision rule?

b) What are the probs associated with using the AAR to evaluate a project's cash flows? What underlying feature of AAR is most troubling to you from a financial perspective? Does the AAR have any redeeming qualities?

Back 33

a. The average accounting return is interpreted as an average measure of the accounting performance
of a project over time, computed as some average profit measure attributable to the
project divided by some average balance sheet value for the project. This text computes AAR
as average net income with respect to average (total) book value. Given some predetermined
cutoff for AAR, the decision rule is to accept projects with an AAR in excess of the target
measure, and reject all other projects.
b. AAR is not a measure of cash flows and market value, but a measure of financial statement
accounts that often bear little resemblance to the relevant value of a project. In addition, the
selection of a cutoff is arbitrary, and the time value of money is ignored. For a financial
manager, both the reliance on accounting numbers rather than relevant market data and the
exclusion of time value of money considerations are troubling. Despite these problems, AAR
continues to be used in practice because (1) the accounting information is usually available, (2)
analysts often use accounting ratios to analyze firm performance, and (3) managerial
compensation is often tied to the attainment of certain target accounting ratio goals.

Front 34

a) Describe how NPV is calculated, and describe the info this measure provides about a sequence of cash flows. What is the NPV criterion decision rule?

b) Why is NPV considered a superior method of evaluating the cash flows from a project? Suppose the NPV for a project's cash flows is computed to be $2500. What does this number represent with respect to the firm's shareholders?

Back 34

a. NPV is simply the present value of a project’s cash flows. NPV specifically measures, after
considering the time value of money, the net increase or decrease in firm wealth due to the
project. The decision rule is to accept projects that have a positive NPV, and reject projects
with a negative NPV.
b. NPV is superior to the other methods of analysis presented in the text because it has no serious
flaws. The method unambiguously ranks mutually exclusive projects, and can differentiate
between projects of different scale and time horizon. The only drawback to NPV is that it relies
on cash flow and discount rate values that are often estimates and not certain, but this is a
problem shared by the other performance criteria as well. A project with NPV = $2,500 implies
that the total shareholder wealth of the firm will increase by $2,500 if the project is accepted.

Front 35

a) Describe how the IRR is calculated, and describe the info this measure provides about a series of cash flows. What is the IRR decision rule?

b) What is the relationship between IRR and NPV? Are there any situations in which you might prefer one method over the other?

c) Despite it's shortcomings in some situations, why do most fin. managers use IRR along with NPV when evaluating projects? Can you think of a situation in which IRR might be a more appropriate measure to use the NPV?

Back 35

a. The IRR is the discount rate that causes the NPV of a series of cash flows to be identically zero.
IRR can thus be interpreted as a financial break-even rate of return; at the IRR discount rate, the
net value of the project is zero. The IRR decision rule is to accept projects with IRRs greater
than the discount rate, and to reject projects with IRRs less than the discount rate.
b. IRR is the interest rate that causes NPV for a series of cash flows to be zero. NPV is preferred
in all situations to IRR; IRR can lead to ambiguous results if there are non-conventional cash
flows, and it also ambiguously ranks some mutually exclusive projects. However, for standalone
projects with conventional cash flows, IRR and NPV are interchangeable techniques.
c. IRR is frequently used because it is easier for many financial managers and analysts to rate
performance in relative terms, such as “12%”, than in absolute terms, such as “$46,000.” IRR
may be a preferred method to NPV in situations where an appropriate discount rate is unknown
are uncertain; in this situation, IRR would provide more information about the project than
would NPV.

Front 36

a) Describe how the profitability index is calculated, and describe the info this measure provides about a series of cash flows. What is the PI decision rule?

b) What is the relationship between PI and NPV? Are there any situations in which you might prefer one method over the other?

Back 36

a. The profitability index is the present value of cash inflows relative to the project cost. As such,
it is a benefit/cost ratio, providing a measure of the relative profitability of a project. The
profitability index decision rule is to accept projects with a PI greater than one, and to reject
projects with a PI less than one.
b. PI = (NPV + cost)/cost = 1 + (NPV/cost). If a firm has a basket of positive NPV projects and is
subject to capital rationing, PI may provide a good ranking measure of the projects, indicating
the “bang for the buck” of each particular project.

Front 37

A project has perpetual cash flows of C per period, a cost of I and a req. return of R. What is the relationship btw the project's payback and its IRR? What implications does your answer have for long lived projects with relatively constant cash flows?

Back 37

For a project with future cash flows that are an annuity:
Payback = I / C
And the IRR is:
0 = – I + C / IRR
Solving the IRR equation for IRR, we get:
IRR = C / I
Notice this is just the reciprocal of the payback. So:
IRR = 1 / PB
For long-lived projects with relatively constant cash flows, the sooner the project pays back, the
greater is the IRR.

Front 38

In 2004, honda announced plans to build an automatic transmission plant in GA and expand its transmission plant in OH. Honda apparently felt that it would be better able to compete and create value with US based facilities. Other companies such as Fiji and lonza have reached similar conclusions and taken similar actions. What are some of the reasons that foreign manufacturers of diverse products might arrive at this same conclusion?

Back 38

There are a number of reasons. Two of the most important have to do with transportation costs and
exchange rates. Manufacturing in the U.S. places the finished product much closer to the point of
sale, resulting in significant savings in transportation costs. It also reduces inventories because goods
spend less time in transit. Higher labor costs tend to offset these savings to some degree, at least
compared to other possible manufacturing locations. Of great importance is the fact that
manufacturing in the U.S. means that a much higher proportion of the costs are paid in dollars. Since
sales are in dollars, the net effect is to immunize profits to a large extent against fluctuations in
exchange rates. This issue is discussed in greater detail in the chapter on international finance.

Front 39

What difficulties might come up in actual applications of the various criteria discussed? Which one would be the easiest to implement in actual applications? The most difficult?

Back 39

The single biggest difficulty, by far, is coming up with reliable cash flow estimates. Determining an
appropriate discount rate is also not a simple task. These issues are discussed in greater depth in the
next several chapters. The payback approach is probably the simplest, followed by the AAR, but
even these require revenue and cost projections. The discounted cash flow measures (discounted
payback, NPV, IRR, and profitability index) are really only slightly more difficult in practice.

Front 40

Are the capital budgeting criteria we discussed applicable for non profits? How should such entities make cap budgeting decisions? What about the govt? Should it evaluate spending proposals using these techniques?

Back 40

Yes, they are. Such entities generally need to allocate available capital efficiently, just as for-profits
do. However, it is frequently the case that the “revenues” from not-for-profit ventures are not
tangible. For example, charitable giving has real opportunity costs, but the benefits are generally
hard to measure. To the extent that benefits are measurable, the question of an appropriate required
return remains. Payback rules are commonly used in such cases. Finally, realistic cost/benefit
analysis along the lines indicated should definitely be used by the U.S. government and would go a
long way toward balancing the budget!

Front 41

One of the less flattering interpretations of the acronym MIRR is "meaningless internal rate of return" Why do you think this is replied to modified IRR?

Back 41

The MIRR is calculated by finding the present value of all cash outflows, the future value of all cash
inflows to the end of the project, and then calculating the IRR of the two cash flows. As a result, the
cash flows have been discounted or compounded by one interest rate (the required return), and then
the interest rate between the two remaining cash flows is calculated. As such, the MIRR is not a true
interest rate. In contrast, consider the IRR. If you take the initial investment, and calculate the future
value at the IRR, you can replicate the future cash flows of the project exactly.

Front 42

It is sometimes stated that "the net present value approach assumes reinvestment of the intermediate ccash flows at the req. return" Is this claim correct? To answer, suppose you calculate the NPV of a project in the usual way. Next, suppose the following:

a) calculate the future value (at the end of a project) of all the cash flows other than the initial outlay assuming they are not reinvested at the req. return, producing a single future value figure for the project.

b) calculate the NPV of the project using the single future value calculated in the previous step and the initial outlay. It is easy to verify that you will get the same NPV as in your original calculation only if you use the req. return as the reinvestment rate in the previous step.

Back 42

The statement is incorrect. It is true that if you calculate the future value of all intermediate cash
flows to the end of the project at the required return, then calculate the NPV of this future value and
the initial investment, you will get the same NPV. However, NPV says nothing about reinvestment
of intermediate cash flows. The NPV is the present value of the project cash flows. What is actually
done with those cash flows once they are generated is not relevant. Put differently, the value of a
project depends on the cash flows generated by the project, not on the future value of those cash
flows. The fact that the reinvestment “works” only if you use the required return as the reinvestment
rate is also irrelevant simply because reinvestment is not relevant in the first place to the value of the
project.
One caveat: Our discussion here assumes that the cash flows are truly available once they are
generated, meaning that it is up to firm management to decide what to do with the cash flows. In
certain cases, there may be a requirement that the cash flows be reinvested. For example, in
international investing, a company may be required to reinvest the cash flows in the country in
which they are generated and not “repatriate” the money. Such funds are said to be “blocked” and
reinvestment becomes relevant because the cash flows are not truly available.

Front 43

It is sometimes stated that "the IRR approach assumes reinvestment of the intermediate cash flows at the internal rate of return." Is this claim corrrect? To answer, suppose you calculate the IRR of a project in the usual way. Next suppose you do the following:

a) calculate the future value (at the end of the project) of all cash flows other than the initial outlay assuming they are reinvested at the IRR, producing a single future value figure for the project.

b) calculate the IRR of the project using the single future value calculated in the previous step and the initial outlay. It is easy to verify that you will get the same IRR as in your original calculation only if you use the IRR as the reinvestment rate in the prev. step.

Back 43

The statement is incorrect. It is true that if you calculate the future value of all intermediate cash
flows to the end of the project at the IRR, then calculate the IRR of this future value and the initial
investment, you will get the same IRR. However, as in the previous question, what is done with the
cash flows once they are generated does not affect the IRR. Consider the following example:

Project A: C0: –$100 C1: $10 C2: $110 IRR: 10%

Suppose this $100 is a deposit into a bank account. The IRR of the cash flows is 10 percent. Does
the IRR change if the Year 1 cash flow is reinvested in the account, or if it is withdrawn and spent on
pizza? No. Finally, consider the yield to maturity calculation on a bond. If you think about it, the
YTM is the IRR on the bond, but no mention of a reinvestment assumption for the bond coupons is
suggested. The reason is that reinvestment is irrelevant to the YTM calculation; in the same way,
reinvestment is irrelevant in the IRR calculation. Our caveat about blocked funds applies here as
well.