Fin3403 Test 3

Front 1

In the context of capital budgeting, what is an opportunity cost?

Back 1

In this context, an opportunity cost refers to the value of an asset or other input that will be used in a
project. The relevant cost is what the asset or input is actually worth today, not, for example, what it
cost to acquire.

Front 2

Given the choice, would a firm prefer to use MACRS depreciation or straight line, why?

Back 2

For tax purposes, a firm would choose MACRS because it provides for larger depreciation
deductions earlier. These larger deductions reduce taxes, but have no other cash consequences.
Notice that the choice between MACRS and straight-line is purely a time value issue; the total
depreciation is the same, only the timing differs.

Front 3

In our cap budgeting examples, we assumed that a firm would recoer all the workin capital it invested in a project. Is this a reasonable assumption? Why might it not be valid?

Back 3

It’s probably only a mild over-simplification. Current liabilities will all be paid, presumably. The
cash portion of current assets will be retrieved. Some receivables won’t be collected, and some
inventory will not be sold, of course. Counterbalancing these losses is the fact that inventory sold
above cost (and not replaced at the end of the project’s life) acts to increase working capital. These
effects tend to offset one another.

Front 4

Suppose a fin manager is quoted as saying, "our firm used the stand alone principle. Because we treat projects like minifirms in our evaluation process, we include financing costs b/c they are relevant at the firm level." evaluate

Back 4

Management’s discretion to set the firm’s capital structure is applicable at the firm level. Since any
one particular project could be financed entirely with equity, another project could be financed with
debt, and the firm’s overall capital structure remains unchanged, financing costs are not relevant in
the analysis of a project’s incremental cash flows according to the stand-alone principle.

Front 5

"When evaluating projects, we're concerned with the only relevant incremental aftertax cash flows. Therefore, bc depreciation is a noncash expense, we should ignore its effects when evaluating projects." Evaluate

Back 5

The EAC approach is appropriate when comparing mutually exclusive projects with different lives
that will be replaced when they wear out. This type of analysis is necessary so that the projects have
a common life span over which they can be compared; in effect, each project is assumed to exist
over an infinite horizon of N-year repeating projects. Assuming that this type of analysis is valid
implies that the project cash flows remain the same forever, thus ignoring the possible effects of,
among other things: (1) inflation, (2) changing economic conditions, (3) the increasing unreliability
of cash flow estimates that occur far into the future, and (4) the possible effects of future technology
improvement that could alter the project cash flows.

Front 6

A major college textbook publisher as an exisiting fin text book. the publisher is debating whether to produce an essentialized version, meaning shorter and lower priced. what are some of the considerations that should come into play?

Back 6

Depreciation is a non-cash expense, but it is tax-deductible on the income statement. Thus
depreciation causes taxes paid, an actual cash outflow, to be reduced by an amount equal to the
depreciation tax shield tcD. A reduction in taxes that would otherwise be paid is the same thing as a
cash inflow, so the effects of the depreciation tax shield must be added in to get the total incremental
aftertax cash flows.

Front 7

Porsche's decision to enter the SUV market with the Cayenne was a response to the succes of other high priced SUVs such as the Mercedes M class. Vehicles in this class had generated years of high profits. The Cayenne certainly spiced up the market, and Porsche subsequently introuced the Cayenne Turbo S, which goes real fast. It's $112,000

Some analysts thought they entered the suv mkt too late and that the introduction of the Cayenne would damage porsche's reputation as a maker of high performance vehicles .

a) in evaluating the Cayenne, would you consider the possible damage to porsche's reputation erosion?

b) porsche was one of the last to enter the suv mkt. Why would one company decide to proceed with a product when other comaapnies, at least initially, decide not to enter the mkt?

c) in evaluating the cayenne, what do you think porsche needs to assume regarding the substantial profit margins that exist in this mkt? Is it likely they will be maintained as the mkt becomes more competitive, or will porsche be able to maintain the profit margin beccause of its image and the performance of the cayenne?

Back 7

1) There are two particularly important considerations. The first is erosion. Will the essentialized book
simply displace copies of the existing book that would have otherwise been sold? This is of special
concern given the lower price. The second consideration is competition. Will other publishers step in
and produce such a product? If so, then any erosion is much less relevant. A particular concern to
B-176 SOLUTIONS
book publishers (and producers of a variety of other product types) is that the publisher only makes
money from the sale of new books. Thus, it is important to examine whether the new book would
displace sales of used books (good from the publisher’s perspective) or new books (not good). The
concern arises any time there is an active market for used product.

porsche

a) Definitely. The damage to Porsche’s reputation is definitely a factor the company needed to
consider. If the reputation was damaged, the company would have lost sales of its existing car lines.

b) One company may be able to produce at lower incremental cost or market better. Also, of course,
one of the two may have made a mistake!

c) Porsche would recognize that the outsized profits would dwindle as more product comes to market
and competition becomes more intense.

Front 8

What is forecasting risk? In general, would the degree of forecasting risk be greater for a new product or a cost-cutting proposal? Why?

Back 8

Forecasting risk is the risk that a poor decision is made because of errors in projected cash flows.
The danger is greatest with a new product because the cash flows are probably harder to predict.

Front 9

What is the essential diff btw sensitivity analysis and scenario analysis?

Back 9

With a sensitivity analysis, one variable is examined over a broad range of values. With a scenario
analysis, all variables are examined for a limited range of values.

Front 10

A coworker claims that looking at all this marginal this and incremental that is justa bunch of nonsense, saying, "Listen, if our avg revenue doesn't exceed or avg cost, then we will have a negative cash flow, and we'll go broke!" How do you respond?

Back 10

It is true that if average revenue is less than average cost, the firm is losing money. This much of the
statement is therefore correct. At the margin, however, accepting a project with marginal revenue in
excess of its marginal cost clearly acts to increase operating cash flow.

Front 11

At one time at least, many Japanese companies had a "no-layoff" policy (so did IBM). What are the implications of such a policy for the degree of operating leverage a company faces?

Back 11

It makes wages and salaries a fixed cost, driving up operating leverage.

Front 12

Airlines offer an example of an industry in which the degree of operating leverage is fairly high. Why?

Back 12

Fixed costs are relatively high because airlines are relatively capital intensive (and airplanes are
expensive). Skilled employees such as pilots and mechanics mean relatively high wages which,
because of union agreements, are relatively fixed. Maintenance expenses are significant and
relatively fixed as well.

Front 13

As a shareholder ofa firm that is contemplating a new project, would you be more concerned with the acg break even point, the cash break even pt, or the financial break even point? Why?

Back 13

From the shareholder perspective, the financial break-even point is the most important. A project can
exceed the accounting and cash break-even points but still be below the financial break-even point.
This causes a reduction in shareholder (your) wealth.

Front 14

Assume a firm is considering a new project that requires an initial investment and has equal sales and costs over its life. Will the project reach the acg, cash, or fin break even point first? Which will it reach next? Last? Will this ordering always apply?

Back 14

The project will reach the cash break-even first, the accounting break-even next and finally the
financial break-even. For a project with an initial investment and sales after, this ordering will
always apply. The cash break-even is achieved first since it excludes depreciation. The accounting
break-even is next since it includes depreciation. Finally, the financial break-even, which includes
the time value of money, is achieved.

Front 15

How are soft rationing and hard rationing different? What are the implications if a firm is experiencing soft rationing? Hard rationing?

Back 15

Soft capital rationing implies that the firm as a whole isn’t short of capital, but the division or project
does not have the necessary capital. The implication is that the firm is passing up positive NPV
projects. With hard capital rationing the firm is unable to raise capital for a project under any
circumstances. Probably the most common reason for hard capital rationing is financial distress,
meaning bankruptcy is a possibility.

Front 16

Going all the way back to chapter 1, recall that we say partnerships and proprietorships can face difficulties when it comes to raising capital. In the context of this chapter, the implication is that small businesses will generally face what problem?

Back 16

The implication is that they will face hard capital rationing.

Front 17

Given that ViroPharma was up by over 469% for 2005, why didn't all investors hold?

Back 17

They all wish they had! Since they didn’t, it must have been the case that the stellar performance was
not foreseeable, at least not by most.

Front 18

Given that Majesco entertainment was down by almost 92% in '05, why did some investors hold the stock? Why didn't they sell out before the price declined so sharply?

Back 18

As in the previous question, it’s easy to see after the fact that the investment was terrible, but it
probably wasn’t so easy ahead of time.

Front 19

We have seen that over long periods, stock investments have tended to substantially outperform bond investments. However, it is common to observer investors with long horizons holding entirely
bonds. Are such investors irrational?

Back 19

No, stocks are riskier. Some investors are highly risk averse, and the extra possible return doesn’t
attract them relative to the extra risk.

Front 20

Explain why a characteristic of an efficient market is that investments in that market have zero NPVs.

Back 20

On average, the only return that is earned is the required return—investors buy assets with returns in
excess of the required return (positive NPV), bidding up the price and thus causing the return to fall
to the required return (zero NPV); investors sell assets with returns less than the required return
(negative NPV), driving the price lower and thus causing the return to rise to the required return
(zero NPV).

Front 21

A stock market analyst is able to identify mispriced stocks by comparing the avg price for the last 10 days to the avg price for the last 60 days. If this is true, what do you know about the mkt?

Back 21

The market is not weak form efficient.

Front 22

If a mkt is semistrong form efficient, is it also weak form efficient? Explain.

Back 22

Yes, historical information is also public information; weak form efficiency is a subset of semistrong
form efficiency.

Front 23

What are the implications of the efficient mkts hypothesis for investors who buy and sell stocks in an attempt to "beat the market"?

Back 23

Ignoring trading costs, on average, such investors merely earn what the market offers; the trades all
have zero NPV. If trading costs exist, then these investors lose by the amount of the costs.

Front 24

Critically evaluate the following statement: Playing the stock market is like gambling. Such speculative investing has no social value other than the pleasure people get from this form of gambling.

Back 24

Unlike gambling, the stock market is a positive sum game; everybody can win. Also, speculators
provide liquidity to markets and thus help to promote efficiency.

Front 25

Several celebrated investors and stock pickers frequently mentioned in the financial press have recorded huge returns on their investments over the past two decades. Is the success of these particular investors an invalidation of the EMH? Explain

Back 25

The EMH only says, within the bounds of increasingly strong assumptions about the information
processing of investors, that assets are fairly priced. An implication of this is that, on average, the
typical market participant cannot earn excessive profits from a particular trading strategy. However,
that does not mean that a few particular investors cannot outperform the market over a particular
investment horizon. Certain investors who do well for a period of time get a lot of attention from the
financial press, but the scores of investors who do not do well over the same period of time generally
get considerably less attention from the financial press.

Front 26

For each of the following scenarios, discuss whether profit opportunities exist from trading in the stock of the firm under the conditions that 1) the market is not weak form efficient, 2) the market is weak form efficient, 3) the mkt is semistrong form but not strong form efficient, and 4) the mkt is strong form efficient

a) the stock price has risen steadily each day for the past 30 days

b) the fin statements for a company were released 3 days ago, and you believed you've uncovered anomalies in the company's inventory and cost control reporting techniques that are causing the firm's true liquidity strength to be understated.

c) you observer that the senior managers of a company have been buying a lot of the company's stock on the open market over the past week.

Back 26

a. If the market is not weak form efficient, then this information could be acted on and a profit
earned from following the price trend. Under (2), (3), and (4), this information is fully
impounded in the current price and no abnormal profit opportunity exists.
B-220 SOLUTIONS
b. Under (2), if the market is not semi-strong form efficient, then this information could be used to
buy the stock “cheap” before the rest of the market discovers the financial statement anomaly.
Since (2) is stronger than (1), both imply that a profit opportunity exists; under (3) and (4), this
information is fully impounded in the current price and no profit opportunity exists.
c. Under (3), if the market is not strong form efficient, then this information could be used as a
profitable trading strategy, by noting the buying activity of the insiders as a signal that the stock
is underpriced or that good news is imminent. Since (1) and (2) are weaker than (3), all three
imply that a profit opportunity exists. Note that this assumes the individual who sees the insider
trading is the only one who sees the trading. If the information about the trades made by
company management is public information, it will be discounted in the stock price and no
profit opportunity exists. Under (4), this information does not signal any profit opportunity for
traders; any pertinent information the manager-insiders may have is fully reflected in the
current share price.

Front 27

In broad terms, why is some risk diversifiable? Why are some risks nondiversifiable? does it follow that an investor can control the level of unsystematic risk in a portfolio, but not the level of systematic risk?

Back 27

Some of the risk in holding any asset is unique to the asset in question. By investing in a variety of
assets, this unique portion of the total risk can be eliminated at little cost. On the other hand, there
are some risks that affect all investments. This portion of the total risk of an asset cannot be
costlessly eliminated. In other words, systematic risk can be controlled, but only by a costly
reduction in expected returns.

Front 28

Suppose the govt announces that based on a just completed survey the growth rate in the economy is likely to be 2% in the coming year, as compared to 5% for the past year. Will security prices increase, decrease, or stay the same following this announcement? Does it make any difference whether the 2% figure was anticipated by the mkt? Explain.

Back 28

If the market expected the growth rate in the coming year to be 2 percent, then there would be no
change in security prices if this expectation had been fully anticipated and priced. However, if the
market had been expecting a growth rate other than 2 percent and the expectation was incorporated
into security prices, then the government’s announcement would most likely cause security prices in
general to change; prices would drop if the anticipated growth rate had been more than 2 percent,
and prices would rise if the anticipated growth rate had been less than 2 percent.

Front 29

Classify the following events as mostly systematic or mostly unsystematic. Is the distinction clear in every case?

a) short term interest rates increase unexpectedly

b) the interest rate a company pays on its short term debt borrowing is increased by its banks.

c) oil prices unexpectedly decline.

d) an oil tanker rupture, creating a large oil spill,

e) a manufacturer loses a multimillion-dollar product liability suit.

f) a supreme court decision substantially broadens producer liability for injuries suffered by product users.

Back 29

a. systematic
b. unsystematic
c. both; probably mostly systematic
d. unsystematic
e. unsystematic
f. systematic

Front 30

Indicate whether the following events might cause stocks in general to change price, and whether they might cause Big Widget Corp.'s stock to change price:

a) the govt announces that inflation unexpectedly jumped by 2% last month

b) big widget's quarterly earnings report, just issued, generally fell in line with analysts' expectations

c) the govt reports that economic growth last year was 3%, which generally agreed with most economists' forecasts

d) the directors of big widget die in a plane crash

e) congress approves changes to the tax code that will increase the top marginal corporate tax rate. The legislation had been debated for the previous six months.

Back 30

a. a change in systematic risk has occurred; market prices in general will most likely decline.
b. no change in unsystematic risk; company price will most likely stay constant.
c. no change in systematic risk; market prices in general will most likely stay constant.
d. a change in unsystematic risk has occurred; company price will most likely decline.
e. no change in systematic risk; market prices in general will most likely stay constant.

Front 31

If a portfolio has a positive investment in every asset, can the expected return on the portfolio be greater than that on every asset in the portfolio? Can it be less than that on every asset in the portfolio? If you answer yes to one or both of these questions, give an example to support your answers.

Back 31

No to both questions. The portfolio expected return is a weighted average of the asset returns, so it
must be less than the largest asset return and greater than the smallest asset return.

Front 32

True or false: the most important characteristic in determining the expected return of a well-diversified portfolio is the variance of the individual assets in the portfolio. Explain

Back 32

false. The variance of the individual assets is a measure of the total risk. The variance on a welldiversified
portfolio is a function of systematic risk only.

Front 33

If a portfolio has a positive investment in every asset, can the standard deviation on the portfolio be less than that on every asset in the portfolio? What about the portfolio beta?

Back 33

Yes, the standard deviation can be less than that of every asset in the portfolio. However, βp cannot
be less than the smallest beta because βp is a weighted average of the individual asset betas.

Front 34

Is it possible that a risky asset could have a beta of zero? Explain. Based on the CAPM, what is the expected return on such an asset? Is it possible that a risky asset could have a negative beta? What does the CAPM predict about the expected return on such an asset? Can you give an explanation for your answer?

Back 34

Yes. It is possible, in theory, to construct a zero beta portfolio of risky assets whose return would be
equal to the risk-free rate. It is also possible to have a negative beta; the return would be less than the
risk-free rate. A negative beta asset would carry a negative risk premium because of its value as a
diversification instrument.

Front 35

In recent years, it has been common for companies to experience significant stock price changes in reaction to announcements of massive layoffs. Critics charge that such events encourage companies to fire longtime employees and that Wall Street is cheering them on. Do you agree or disagree?

Back 35

Such layoffs generally occur in the context of corporate restructurings. To the extent that the market
views a restructuring as value-creating, stock prices will rise. So, it’s not layoffs per se that are being
cheered on. Nonetheless, Wall Street does encourage corporations to takes actions to create value,
even if such actions involve layoffs.

Front 36

As indicated by a number of examples in this chapter, earnings announcements by companies are closely followed by, and frequently result in, share price revisions. Two issues should come to mind. First, earnings announcements concern past periods. If the market values stocks based on expectations of the future, why are numbers summarizing past performance relevant? Second, these announcements concern accounting earnings. Going back to ch 2, such earnings may have little to do with cash flow - so again, why are they relevant?

Back 36

Earnings contain information about recent sales and costs. This information is useful for projecting
future growth rates and cash flows. Thus, unexpectedly low earnings often lead market participants
to reduce estimates of future growth rates and cash flows; price drops are the result. The reverse is
often true for unexpectedly high earnings.