Principles of Finance – Short Questions

Chapter 13

1. Explain what is meant by the time value of money. Why is a bird in the hand worth two (or so) in the bush? Which capital budgeting approach ignores this concept? Is it optimal?

The time value of money is a concept that some amount of money today is worth more than the same amount at a future date. It is the reason why investors prefer to receive money today rather than receiving the same amount at a later date because if invested, that amount grows over time by earning interest. It is better to receive some money today (bird in the hand) than wait for more in the future (two in the bush) because the value may decrease due to risk in economic activities, inflation, and the ability of money to earn interest today. The Payback Period technique ignores the time value of money. This method is not optimal because of this and other limitations such as failure to consider cash inflows that occur beyond the payback period, which is why it is supplemented with other evaluations like NPV.

2. Why does the payback period bias the process of asset selection toward short-lived assets?

Because it fully ignores any cash flows that occur after the cutoff point. It considers the cumulative cash flows (undiscounted) hence ignoring the time value of money. This method simply adds cash flows without regard to the timing of these flows. Again, the maximum acceptable payback period, which is the cutoff standard, is a purely subjective choice.

3. Why does the net present value method favor larger projects over smaller ones when used to choose between mutually exclusive projects? Is this a problem?

Because a larger project will have a higher NPV than a smaller one. This is a problem. It doesn’t necessarily mean the larger project is a better investment compared to the smaller project because it does not account for the investment amounts. Therefore, it is important to assess the returns from the investment in percentage terms to get an accurate picture.

4. Contrast the internal rate of return method of project evaluation and selection with the net present value method. Why might these two discounted cash flow techniques lead to conflicts in project rankings?

The internal rate of return method estimates the profitability of potential investments using a percentage value instead of the dollar amount, excluding external factors such as inflation. Unlike IRR, the net present value is calculated by estimating a company’s future cash flows related to a project and then discounting them to the present value using a discount rate that reflects the risk and desired rate of return. IRR is preferred when comparing multiple projects where it is difficult to tell the discount rate. NPV is preferred where there are varying directions of cash flow over time or with multiple discount rates. The discounted cash flow techniques lead to conflict in project rankings because of the differences in scale of investment, cash flow pattern, and project life. For instance, in mutually-exclusive projects, an NPV and IRR conflict could arise when one project has a larger NPV value but the other has a higher IRR.

6. What are mutually exclusive investment projects? What is a dependent project?

A mutually exclusive investment project is one whose acceptance impedes the consideration of one or more alternative proposals. A dependent project is one whose acceptance depends on the acceptance of one or more projects.

Chapter 15

1. Define the “overall cost of capital”.

The overall cost of capital of a firm is defined as the proportionate average of the costs of the various components of the firm’s financing.

2. Why do you want to use the overall cost of capital as an acceptance criterion for an investment?

First, because of its simplicity. Once calculated, one can evaluate projects using a single rate that remains constant unless underlying business and financial market conditions change. It avoids the problem of having to compute the individual required rate of returns for each investment proposal. The use of a single hurdle rate for all projects saves a lot of time for managers to evaluate other projects which imply that decisions can arrive at a faster pace.

3. How do you calculate the cost of capital? Explain method.

Cost of Equity = Risk-free rate + Beta * (market risk premium – risk-free rate)

Cost of debt capital = Interest rate * (1 – tax rate)

Therefore, cost of capital = Weight of equity * cost of equity + weight of debt * cost of debt

It begins with computing the costs of individual components of the firm’s financing, assigning weights to each source according to some standard, and then finding out the cost of capital.

4. Define Capital-Asset Pricing Model (CAMP). Provide examples and why is important?

The Capital Asset Pricing Model (CAPM) describes the relationship between systematic risk and expected return for assets, particularly stocks. It is important for investors, especially fund managers, because without necessarily holding any cash when the market is likely to fall, they can hold low-beta stocks instead.

5. What are the sources of value creation through capital investment decisions?

Value creation has several sources, but the most important are industry attractiveness and competitive advantage.

Chapter 17

Art Wyatt Pool Company wishes to finance a $15 million expansion program and is trying to decide between debt and external equity. Management believes that the market does not appreciate the company’s profit potential and that the common stock is undervalued. What type of security (debt or common stock) do you suppose that the company will issue to provide financing, and what will be the market’s reaction? What type of security do you think would be issued if management felt the stock was overvalued? Explain.

Answer

The company can either raise the money from debt or external equity. According to the notion of asymmetric information between investors and management, if the stock is undervalued, the company should issue the overvalued security (debt). Investors would know this management’s intention and view this as attractive which would raise the stock price. If the management feels the common stock is overvalued, it should issue common stocks which would be attractive to shareholders. On the contrary, the investors would take this as bad news, and stock prices could decline.

Chapter 18

The H. M. Hornes Company is primarily owned by several wealthy Texans. The firm earned $3,500,000 after taxes this year. With 1 million shares outstanding, earnings per share were $3.50. The stock recently has traded at $72 per share, among the current shareholders. Two dollars of this value is accounted for by investor anticipation of a cash dividend. As financial manager of H. M. Hornes, you have contemplated the alternative of repurchasing some company common stock using a tender offer at $72 per share.

a) How much common stock could the firm repurchase if this alternative were selected?

b) Ignoring taxes, which alternative should be selected?

c) Considering taxes, which alternative should be selected

Answer:

• The dividend anticipated per share is $2

Total dividend amounts to $2,000,000

Therefore, the total amount available for the buyback is $2,000,000

We can then find the number of shares that can be bought back as follows:

= $2,000,000/$72 per share = 27,777 shares (Rounded down)

• Total Profit is equivalent to $3,500,000

The total number of shares after buyback is 1,000,000-27,777 = 972,223 shares

The profit per share = 3,500,000/972,223 shares = $3.60 per share

• The dividend option is more convenient because, with the buyback option, there are more legal formalities and procedures.