Finance Test 3

Stock with dividends but behave like a level or growing perpetuity If you estimate the price of a stock at time t=n you should not include in your valuation Dn. This divided belongs to the previous owner.
Super normal growth stocks one that significantly outperforms the market and provides investors with returns that are well above average
Stock prices and required rates of return have negative/inverse relationship. While stock prices and dividends, growth rates have a positive relationship.
Common Stock shares entitling their holder to dividends that vary in amount and may even be missed, depending on the fortunes of the company.
preferred stock stock that entitles the holder to a fixed dividend, whose payment takes priority over that of common-stock dividends.
cumulative voting a system of voting in an election in which each voter is allowed as many votes as there are candidates and may give all to one candidate or varying numbers to several.
Straight voting Allows shareholder to cast all of the shareholder’s votes for each candidate for the board of directors.
Proxy voting is a particularly important practice with respect to corporations; in the United States, investment advisers often vote proxies on behalf of their client accounts.
Proxy the authority to represent someone else, esp. in voting.
Classes of shares Types of listed company stock that are differentiated by the level of voting rights shareholders receive. For example, a listed company might have two share classes, or classes of stock, designated as Class A and Class B
Dividends cash or stock a sum of money paid regularly (typically quarterly) by a company to its shareholders out of its profits (or reserves).
primary market is the part of the capital market that deals with issuing of new securities. Companies, governments or public sector institutions can obtain funds through the sale of a new stock or bond issues through primary market. They are facilitated by underwriting groups, which consist of investment banks that will set a beginning price range for a given security and then oversee its sale directly to investors.
Secondary market A market where investors purchase securities or assets from other investors, rather than from issuing companies themselves.
Dealer a person or business that buys and sells goods.
Broker a person who buys and sells goods or assets for others.
Specialist a person who concentrates primarily on a particular subject or activity; a person highly skilled in a specific and restricted field.
Bid the price that a dealer or other prospective buyer is prepared to pay for securities or other assets.
Ask is the lowest price a seller of a stock is willing to accept for a share of that given stock. the price the dealer is asking to sell the security.
inside quotes is the prices at which at which market order will be executed. If it is a sell order, a market order will be executed at the inside bid price. For a buy order, it will be executed at the inside ask price. highest bid, lowest ask.
Bid Ask Spread =Ask-Bid
Net Present Value NPV the value in the present of a sum of money, in contrast to some future value it will have when it has been invested at compound interest. When you reach different decisions using different criteria, the best rule to rely on is NPV.
Internal Rate of Return IRR a rate of return used in capital budgeting to measure and compare the profitability of investments. It is also called the discounted cash flow rate of return
Payback financial return or reward, esp. profit equal to the initial outlay of an investment.
Profitability Index PI is the ratio of payoff to investment of a proposed project. It is a useful tool for ranking projects because it allows you to quantify the amount of value created per unit of investment.
Crossover rate The return at which two alternative projects have the same net present value.
Mutual exclusive projects are where the under taking of one excludes the other. Only one project can be accepted. Accept only the project with the highest NPV.
Independent Projects are where more than one project can be accepted. Accept all projects with positive NPV.
IRR assumes that all cash flows are reinvested at the IRR. major disadvantage. IRR is intuitively appealing because we like to think in term of return. Advantage
IRR reduces the need to come up with an exact estimate of the rate of return In most cases for the range of required rate of return less than the IRR. The project will have positive NPV and for required rates of return > IRR the project will have negative NPVs
Problems arise with IRR for 3 reasons -When dealing with mutually exclusive projects.-Timing of cash flows. Do big cash flows occur at the beginning or end of the project.-The projects have unconventional cash flows and therefore there are more than one IRR solution
In a stream of cash flows is caregorized as conventional if sign change occurs only once. – + + + + + + A stream of cash flows is characterized as unconventional is its cash flows change sign more than once. – + + + –
When there are conflicts always rely on Net present value
Decision rules -No required rate of return, mutually exclusive, accept the project with the highest IRR.-When r is given, independent projects, accept all with r < IRR. Mutually exclusive, accept only the highest IRR, if the required rate of return is less than its IRR.
Crossover rates are the rates that causes the NPV profiles of 2 projects to be the same because they have the same NPV, you are indifferent between these 2 projects at this this required rate of return.
If a problem asks at what rate of return you will be indifferent between 2 projects, it asks for the crossover rate. if the crossover < highest IRR
For required rates of return < crossover rate, choose the project with the smallest IRR because its the project with the highest NPV If the required rate of return = crossover rate, then you are indifferent between the two because they have the same NPV
If the required rate of return > crossover rate, choose the project with the highest IRR. this project also has the highest IRR Crossover rates are very useful when evaluating mutually exclusive projects
Payback Rules Are where the under taking of one excludes the other. If you are not given a cut off date and you are considering several projects, choose the project with the shortest payback period. If you’re given a cut off date and your projects are independent, accept all projects with payback periods < the cut off period. Mutually exclusive, accept only the project with the smallest payback period if that period is also less than the cutoff period.
Acc depreciation sum of all annual depreciation up to and including year t.
pro forma financial statements A Latin term meaning “for the sake of form”. In the investing world, it describes a method of calculating financial results in order to emphasize either current or projected figures.
incremental cash flows is the additional operating cash flow that an organization receives from taking on a new project. A positive incremental cash flow means that the company’s cash flow will increase with the acceptance of the project.
sunk costs is money that has already been spent and cannot be recovered. Sunk costs are also called retrospective costs. Logic dictates that because sunk costs will not change — no matter what actions are taken — they should not play a role in decision-making.
opportunity cost the loss of potential gain from other alternatives when one alternative is chosen.
erosion costs The gradual redirection of funds from profitable segments or projects within a business to new projects and areas. Although managers almost always consider money flowing into new projects as investments in long-term growth, the short-term effect is a slow erosion of cash flow.
Scenario Analysis is a process to ascertain and analyze possible events that can take place in the future.
sensitivity analysis is the study of how the uncertainty in the output of a mathematical model or system (numerical or otherwise) can be apportioned to different sources of uncertainty in its inputs.
managerial options Management flexibility to make future decisions that affect a project’s expected cash flows, life, or future acceptance.
contingency planning a process that prepares an organization to respond coherently to an unplanned event. The contingency plan can be also used as an alternative for action if expected results fail to materialize. A contingency plan is sometimes referred to as “Plan B.”
capital rationing The act of placing restrictions on the amount of new investments or projects undertaken by a company. This is accomplished by imposing a higher cost of capital for investment consideration or by setting a ceiling on the specific sections of the budget.
with common stock, not even the promised cash flows are known in advance the life of the investment is essentially forever, since common stock has no maturity.
there is no way to easily observe the rate of return that the market requires. no matter what the stock price is, the present value is essentially zero if we push the sale of the stock far enough away
The price of the stock today is equal to the present value of all of the future dividends the dividend is always the same, so the stock can be viewed as an ordinary perpetuity
an asset with cash flows that grow at a constant rate forever is called a growing perpetuity dividend growth model is a model that determines the current price of a stock as its dividend next period divided by the discount rate less the divided growth rate.
dividend yield is a stock’s expected cash dividend divided by its current price capital gains yield is the dividend growth rate or the rate at which the value of an investment grows
A broker is an agent who: brings buyers and sellers together.
What is the market called that allows shareholders to resell their shares to other investors? Secondary
Which one of the following will increase the current value of a stock? Increase in the capital gains yield
An agent who buys and sells securities from inventory is called a: dealer
Which one of the following types of securities has no priority in a bankruptcy proceeding? Common stock
Dividends are best defined as: cash or stock payments to shareholders.
Which one of the following generally pays a fixed dividend, receives first priority in dividend payment, and maintains the right to a dividend payment, even if that payment is deferred? Cumulative preferred
What is the name given to the model that computes the present value of a stock by dividing next year’s annual dividend amount by the difference between the discount rate and the rate of change in the annual dividend amount? Dividend growth model
The net present value of an investment represents the difference between the investment’s: cost and its market value.
Which one of the following indicates that a project is expected to create value for its owners? Positive net present value
The internal rate of return is unreliable as an indicator of whether or not an investment should be accepted given which one of the following? The investment is mutually exclusive with another investment under consideration.
Which one of the following statements is correct? The payback period ignores the time value of money.
The payback period is the length of time it takes an investment to generate sufficient cash flows to enable the project to: recoup its initial cost.
Which one of the following is generally considered to be the best form of analysis if you have to select a single method to analyze a variety of investment opportunities? Net present value
You were recently hired by a firm as a project analyst. The owner of the firm is unfamiliar with financial analysis and wants to know only what the expected dollar return is per dollar spent on a given project. Which financial method of analysis will provide the information that the owner requests? Profitability index
The payback method of analysis ignores which one of the following? Time value of money
Both Projects A and B are acceptable as independent projects. However, the selection of either one of these projects eliminates the option of selecting the other project. Which one of the following terms best describes the relationship between Project A and Project B? Mutually exclusive
Which one of the following indicates that a project is definitely acceptable? Profitability index greater than 1.0
Which one of the following terms is most commonly used to describe the cash flows of a new project that are simply an offset of reduced cash flows for a current project? Erosion
The opportunities that a manager has to modify a project once it has started are called: managerial options.
Which one of the following terms refers to the best option that was foregone when a particular investment is selected? Opportunity cost
Which one of the following principles refers to the assumption that a project will be evaluated based on its incremental cash flows? Stand-alone principle
A cost that should be ignored when evaluating a project because that cost has already been incurred and cannot be recouped is referred to as which type of cost? Sunk
The Blackwell Group is unable to obtain financing for any new projects under any circumstances. Which term best applies to this situation? Hard rationing
A pro forma financial statement is a financial statement that: projects future years’ operations.
Marcos Enterprises has three separate divisions. The firm allocates each division $1.5 million per year for capital purchases. Which one of the following terms applies to this allocation process? Soft rationing
Jamie is analyzing the estimated net present value of a project under various what if scenarios. The type of analysis that Jamie is doing is best described as: scenario analysis.
Any changes to a firm’s projected future cash flows that are caused by adding a new project are referred to as which one of the following? Incremental cash flows
The amount by which a firm’s tax bill is reduced as a result of the depreciation expense is referred to as the depreciation: tax shield.
Kyle Electric has three positive net present value opportunities. Unfortunately, the firm has not been able to find financing for any of these projects. Which one of the following terms best describes the firm’s situation? Capital rationing
Mark is analyzing a proposed project to determine how changes in the variable costs per unit would affect the project’s net present value. What type of analysis is Mark conducting? Sensitivity analysis

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