APRIL ROZE L.

NUDO
BS- IV

FINANCIAL MANAGEMENT 2
QUIZ-S FINALS 2

1. Discounted payback has a more severe bias – discounted cash flows will be smaller, making
it even harder for a project to pass the payback hurdle.
2. Discounted payback has a more severe bias – discounted cash flows will be smaller, making
it even harder for a project to pass the payback hurdle.
3. If the firm consistently uses a “too high” discount rate, then it will reject good project that
would add to shareholder value.
4. -
5. Any method can be manipulated. It would be hard to argue that accounting numbers can’tbe
manipulated after all the accounting scandals, starting with Enron in late 2001. Managers
should have incentives to provide the most accurate information possible.
6. If a company makes consistent NPV investments for projects that are greater than zero
(NPV > $0) then the firm’s overall value rises which in turn increases the stock price.
TheNPV relays the expected return investment of a project within a predetermined amount
oftime so if they only choose projects that meet these criteria then they are investing in
projects only that they know should make them money.
7. a. A firm that consistently earns returns higher than its opportunity cost of capital is adding
value to the firm, and its stock price should increase.
b. For the project returning 18%, as long as it returns enough to compensate for the risk of
the project, it is adding value and shareholders will be happy about the decision to accept
the project.
8. The IRR suffers from several problems. The IRR is not well suited to ranking projects with
very different scales or projects with very different cash flow timing patterns. The IRR
method can also yield no solution or multiple solutions that are hard to interpret. Despite
the flaws, the IRR method enjoys widespread use because in most investment situations it
generates reliable accept/reject recommendations and it is easy to interpret intuitively.
9. The NPV is the most appropriate capital budgeting method because it yields correct
accept/reject situations and correct project rankings. Nevertheless, it is somewhat less
intuitive than the IRR. In projects with cash flow stream that switch signs, the IRR method
can yield multiple solutions. In those cases, it is difficult for a firm to know whether to
accept or reject a project based upon its IRR.
10. The NPV is calculated by discounting all of a project’s cash flows to the present. The IRR is
calculated by finding the discount rate which equates the NPV to zero. The profitability
index is the ratio of the present value of a project’s cash flows (excluding the initial cash
outflow) divided by the initial cash outflow. All three methods lead to the same
accept/reject decision when evaluating a single project, but IRR and PI have problems when
ranking projects. NPV generally overcomes these problems.
11. IRR, NPV, and PI can lead to different decisions when they are used to rank projects or to
select between mutually exclusive projects. IRR and PI methods are not well suited to
 evaluating projects which vary in scale. The NPV method yields correct project rankings no
matter what the scale of the project.
12. The investment bank deals with large investors, mostly institutions like mutual funds,
insurance companies, and pension funds, each time it brings new securities to market. In
contrast, the investment bank issues new securities for a corporation infrequently. The
institutional investor clients of the bank want the lowest price possible for the securities
they are buying, but the issuing firm wants a high price so that it raises more money.
Therefore, there is a natural conflict of interest between the two client groups that
investment banks serve. This makes the relationship between a corporation and its
investment bank rather tense at times.
13. No. The company raises capital when it sells securities in the primary market. Subsequent
trading determines what the price of the stock is and who owns the stock, but it does not
generate any additional cash for the company.
14. Competition makes growth largely unpredictable. High-growth industries attract new
competitors, and more competition will lead to lower growth for some or all of the firms in
the industry. Low-growth industries may see some firms exit, which could improve growth
opportunities for the firms that remain. Over time, the dynamic effects of competition make
it very difficult to predict which firms will enjoy above average or below average growth
going forward.
15. Holding an asset’s cash flows constant, if investors pay a higher price for the asset, then
their return from holding the asset will be lower. In general, asset prices are inversely
correlated with returns.
16. The par value is the face value of principal amount that a bond repays when it matures. It is
usually $1,000 for corporate bonds. The maturity date indicates when a bond’s final
payment is due, and it signals the end of the bond’s life. The coupon is the dollar amount of
interest that a bond pays over a year. The coupon rate equals the coupon divided by thepar
value. The coupon yield equals the coupon dividend by the market price of the bond. The
YTM is the discount rate that equates the present value of a bond’s cash flows to its current
market price, and it is a measure of the return that investors require on a particularbond.
The yield curve is a graph showing how interest rates vary with maturity for a group of
bonds having equal risk.
17. Risk arises for businesses when they do not know what is going to happen in the future, so
obviously there is risk attached to many business decisions and activities. Interest rate risk
arises when businesses do not know how much interest they might have to pay on the
borrowings, either already made or planned, or how much interest they might earn on
deposits, either already made or planned. The borrowers fear that interest rate risk will
arise as this will increase expense. If interest rates will rise, future price will fall, so it’s
better to sell future contracts now and buy later to obtain lower price. The gain on future
can be used to offset the lower interest earned.
18. Loan covenants in a debt agreement are promises made to the bank that certain activities will or
will not be carried out. Often referred to as the returns of the contract. Loan covenant establish
benchmarks metrics that can ensure a company stays healthy. However, if the requirements are
too stringent, too sensitive or too difficult to meet, they can put the same in a stranglehold.
19. The loan period for a long-term debt exceeds 12 months. The length of the term
corresponds to the perceived value of the item. A car loan, for instance, would not receive
financing over a 20-year period. Collateral Long-term debt is secured by some form of
collateral. An example of this would be a mortgage on a building, a loan on construction
equipment or a loan on a piece of land. If the borrower defaults, the holder of the loan
receives the property and can dispose of it in such a way as to allow the holder to recoup
some of the money owed by the borrower. The interest rate for a long-term debt is
relatively low and remains fixed for the duration of the loan. The reason for this is because
the loan is secured by an asset, unlike unsecured loans, which tend to have a higher interest
rate. A business with a lot of long-term debt is considered risky. Long-term debt is
calculated into the company's debt-to-equity ratio, which is the difference between its long-
term debt, also known as its liabilities, and stockholder's equity. If the debt-to-equity ratio is
low, analysts may consider that a good risk for investors.
20. Term loan is a loan made by a financial institution to a company. It last at least a year and
generally last 5-12 years. Balloon payment occurs when the loan requires small
intermediate payments and a final large payment at the maturity of loan. Collateral refers to
the assets that back up a loan, assets that the lender can repossess if the firm defaults on the
loan. stock purchase warrants are generally used as sweeteners to a risky loan agreement,
allowing lender to purchase stock and therefore share in the upside potential if the firm
does well.
21. A debenture is a type of debt instrument that is not secured by physical assets or collateral.
Debentures are backed only by the general creditworthiness and reputation of the issuer.
Both corporations and governments frequently issue this type of bond to secure capital.
Like other types of bonds, debentures are documented in an indenture. Debentures are the
most common form of long-term loans that can be taken out by a corporation. These loans
are repayable on a fixed date and pay a fixed rate of interest. A company normally makes
these interest payments prior to paying out dividends to its shareholders, similar to most
debt instruments. In relation to other types of loans and debt instruments, debentures are
advantageous in that they carry a lower interest rate and have a repayment date that is far
in the future.
22. The sinking fund reduces default risk by requiring that the issuer retire the bonds over
time, not at maturity. However, because the issue can be called at par to satisfy the
sinking fund requirement, the disadvantages of a callable issue apply.
23. A trustee is a person who takes responsibility for managing money or assets that have been
set aside in a trust for the benefit of someone else. A bond trustee is a company designated
by the issuer as the custodian of funds and official representative of bondholders. The
trustee plays a vital role in investor protection with the aim of operating in the best interest
of the investors rather than the issuer (although the trustee’s expenses are paid by the
issuer). The Trustee is generally indemnified against all liabilities of the issuer and all
actions and proceedings undertaken, except in the case of a breach of the deed or a fraud.
24. A callable bond pays an investor a higher coupon than a non-callable bond. The issuer has
flexibility in payment amount and loan length when borrowing money from an investor.
Issuing a bond lets a corporation borrow at a lower interest rate than a bank loan, saving
the company money. Callable bonds also come with one big advantage for investors. They
are less in demand due to the lack of a guarantee of receiving interest payments for the full
term, so issuers must pay higher interest rates to persuade people to invest in them.
 Normally, when an investor wants a bond at a higher interest rate, they must pay a bond
premium, meaning that they pay more than the face value for the bond. With a callable
bond, however, the investor can receive higher interest payments without a bond premium.
Callable bonds do not always get called; many of them pay interest for the full term, and the
investor reaps the benefits of higher interest for the entire duration.
25. A credit rating is a useful tool not only for the investor, but also for the entities looking for
investors. An investment-grade rating can put a security, company or country on the global
radar, attracting foreign money and boosting a nation's economy. Ratings can be assigned to
short-term and long-term debt obligations as well as securities, loan, preferred stock and
insurance companies. Long-term credit ratings tend to be more indicative of a country's
investment surroundings and or a company's ability to honor its debt responsibilities.