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FSM
Finance Skills for Managers Unit 5
| Question | Answer |
|---|---|
| What does Net Present Value (NPV) measure? | The value a project adds today, calculated as the present value of future cash inflows minus the investment cost. |
| What is the NPV decision rule? | NPV > 0 → Accept the project NPV < 0 → Reject the project |
| What is one key advantage of NPV? | It accounts for the time value of money by discounting future cash flows. |
| How does NPV incorporate risk? | Through the discount rate, which reflects the project's risk and cost of capital. |
| What does a positive NPV indicate? | The project is expected to create value for the firm. |
| What is one limitation of NPV related to risk? | It's sensitive to the discount rate, which can be hard to estimate accurately. |
| Why might NPV be problematic when comparing projects? | It may favor larger projects even if smaller ones have higher returns per dollar invested. |
| Example: A power plant has an initial cost of $5M and an NPV of $3.38 at 11% discount rate. What concerns should be raised? | Whether the cash flow estimates are realistic, all risks are accounted for, and if market conditions are stable. |
| What are the main strengths of NPV? | Reflects time value of money, considers total cash flows, adjusts for project-specific risk. |
| What’s the key takeaway about using NPV? | NPV is a powerful tool but should be used alongside strategic and qualitative judgment. |
| What is the Internal Rate of Return (IRR)? | The discount rate that makes the Net Present Value (NPV) of a project equal to zero. |
| What is the IRR decision rule? | IRR > Cost of Capital → Accept IRR < Cost of Capital → Reject IRR = Cost of Capital → Indifferent |
| What is a key advantage of IRR over NPV? | It doesn’t require knowledge of the cost of capital to calculate. |
| How does IRR handle the time value of money? | It discounts future cash flows, just like NPV. |
| Why is IRR easy to communicate? | Because it's expressed as a percentage return on investment. |
| What is one major weakness of IRR? | It doesn't measure the dollar value added to the firm. |
| Why can IRR be misleading when comparing projects? | It can favor smaller projects with higher percentage returns over larger ones that create more value. |
| Why is IRR unsuitable for mutually exclusive projects? | It cannot identify which project adds more value when only one can be chosen. |
| What assumption does IRR make about reinvestment? | That all future cash flows are reinvested at the IRR itself, which may not be realistic. |
| Why might a project have multiple IRRs? | When the project has unconventional cash flows (i.e., cash flow signs change more than once). |
| Example: A project has an IRR of 15%, and the cost of capital is 11%. Accept or reject? | Accept — the IRR exceeds the cost of capital. |
| NPV vs. IRR — which is more reliable for comparing projects? | NPV is more reliable, especially for mutually exclusive or unequal-duration projects. |
| Suppose Alice is trying to explain to her friend, who knows nothing about the time value of money, why she should invest in Alice’s new company. Which method of valuation should Alice use to convince her friend to invest? | Internal rate of return (IRR) |
| Which NPV value indicates that the IRR has been reached? | $0.00 |
| Why is the IRR a poor valuation method for a project with unconventional cash flows? | There are multiple sign changes in the calculation resulting in multiple IRRs, and it is impossible to tell which IRR is the correct one. |
| A company called Bobby’s Books is considering purchasing a new bookbinding machine. The company calculates the hurdle rate of the project to be 9% and the IRR to be 11%. Should the company purchase the bookbinding machine? | Yes, because the IRR exceeds the cost of capital. |
| What is the formula for the Profitability Index (PI)? | PI= Present Value of Future Cash Flows/Initial Investment |
| What does a PI greater than 1 indicate? | The project creates value and should be accepted. |
| What does a PI less than 1 mean? | The project destroys value and should be rejected. |
| What does a PI equal to 1 signify? | The project breaks even—no value is created or lost. |
| What are the main advantages of the PI method? | Considers time value of money Accounts for risk via the discount rate Includes all future cash flows Indicates value creation Useful for ranking projects when capital is limited |
| What is a key disadvantage of the PI method? | Requires estimating the cost of capital, which can be difficult. |
| Why isn’t PI ideal for mutually exclusive projects? | Because it may favor smaller projects with higher ratios rather than larger projects that generate more absolute value. |
| In a capital-constrained environment, how does PI help? | It helps rank projects by return per dollar invested, maximizing value within limited capital. |
| How is PI different from NPV? | NPV shows total dollar value added. PI shows value per dollar invested (a ratio). |
| What is the decision rule for PI? | PI > 1 → Accept PI < 1 → Reject PI = 1 → Indifferent |
| In the example with four projects, which metric is best for ranking when capital is limited? | Profitability Index (PI) |
| Which capital investment evaluation method is presented as a ratio? | Profitability index (PI) |
| How does the PI aid in interpretation of the NPV? | It gives an idea of the return generated by a project. |
| Should a firm accept a project that has a PI of 0.8? Why? | No, because the project would be generating cash inflows that are 20% short of the initial investment. |
| You calculate the PI of a project to be 1 but realize that some aspect of your calculation was incorrect and needs to be adjusted. Which adjustment to the PI estimation should cause you to reject the project? | The cost of capital was underestimated, so you adjust the cost of capital to be higher. |
| What is a bond? | A debt instrument where companies borrow money from investors and repay it with interest over time. |
| What are the key features of a bond? | Par value, coupon rate, maturity, and yield to maturity (YTM). |
| What happens to bond prices when the yield to maturity (YTM) increases? | Bond prices decrease. |
| Name three types of bonds. | Callable bonds, convertible bonds, zero-coupon bonds. |
| What does a stock represent? | Ownership in a company. |
| What are the two main types of stock? | Common stock and preferred stock. |
| What rights do common stockholders have? | Voting rights and residual claims on profits and assets. |
| What are the features of preferred stock? | Fixed dividends, no voting rights, and higher claim on assets than common stock. |
| What is capital investment? | Money spent on long-term assets to grow a business and increase shareholder wealth. |
| Give an example of a capital investment. | Building a new factory or purchasing machinery. |
| Why are bonds called "fixed-income securities"? | Because they pay regular, fixed interest payments. |
| In what order are stakeholders paid in a company liquidation? | 1. Creditors, 2. Preferred stockholders, 3. Common stockholders. |
| What determines a bond’s present value? | The discounted value of future coupon payments and face value using the required rate of return. |
| What is the key difference between stocks and bonds? | Stocks represent ownership; bonds are loans made to the company. |
| What is the role of time value of money in capital investment decisions? | It discounts future cash flows to determine if a project adds value (positive NPV). |
| What indicates a good capital investment project? | A positive Net Present Value (NPV), meaning the project adds value. |
| Why might a firm prefer to raise capital through stocks instead of bonds? | Stocks do not require the firm to repay the par value to investors. |
| An investor just purchased a bond for $973 that has a par value of $1,000. What type of bond is this? | A discount bond |
| In what way is preferred stock different from bonds? | Companies are allowed to skip payments to preferred stockholders but not to bondholders. |
| Why might a firm seek capital investment? | To purchase long-term assets for future growth |
| What is intrinsic value? | The present value of expected future cash flows from an asset. |
| When is a stock considered undervalued? | When intrinsic value > market price. |
| What are the cash flows in bond valuation? | Periodic coupon payments + face value at maturity. |
| How is a bond priced using YTM? | By discounting future cash flows using the yield to maturity. |
| What happens to bond price if YTM increases? | Bond price decreases. |
| What is the formula for valuing preferred stock? | Value = Annual Dividend ÷ Required Rate of Return. |
| What model is used to value common stock with stable dividends? | The Gordon Growth Model. |
| What is the Gordon Growth Model formula? | 𝑉 𝑐 𝑠 = 𝐷 1 𝑘 𝑐 𝑠 − 𝑔 V cs = k cs −g D 1 |
| In the Gordon Model, what does 𝐷 1 D 1 represent? | The dividend expected next year. |
| What is CAPM used for? | To estimate a stock's required return based on its market risk. |
| What is the CAPM formula? | R i =R f +β i (R m −R f ) |
| What does beta (β) measure in CAPM? | A stock's sensitivity to market movements. |
| What does a positive NPV indicate in capital budgeting? | The project adds value and should be accepted. |
| What is the decision rule for IRR? | Accept the project if IRR > Required Return. |
| When is a project acceptable using the Profitability Index (PI)? | When PI > 1. |
| What does the PI measure? | Value created per dollar invested. |
| Which valuation method is best for preferred stock? | The perpetuity formula: Dividend ÷ Required Return. |
| What makes common stock valuation more difficult than bonds? | Dividends are uncertain and there’s no maturity date. |
| Why use multiple valuation models in decision-making? | To evaluate different risk factors and asset characteristics accurately. |
| Which method should you use to calculate a bond value? | The PV function in Excel |
| You are evaluating a common stock. What is a key assumption for this evaluation? | The growth rate is assumed to stay the same forever. |
| What is the name for the process of evaluating and planning for purchases of long-term assets? | Capital budgeting |
| Why is it important to have an accurate, carefully calculated required rate of return as part of the NPV? | An inaccurate required rate estimate could cause a firm to reject good projects or accept bad projects. |
| A potential project to expand the size of an apartment complex will cost $100,000. Its calculated net present value is $5,000. Given this information, which statement is correct? | The project should be accepted because it has a positive NPV. |
| What are the three essential features of an effective capital budgeting method? | It must include all cash flows, account for time value of money, and incorporate the cost of capital. |
| Why is the time value of money important in capital budgeting? | Because a dollar today is worth more than a dollar in the future. |
| What does the cost of capital represent in project evaluation? | The required rate of return reflecting the project’s risk. |
| What is the most reliable capital budgeting tool? | Net Present Value (NPV). |
| What does NPV measure? | The actual dollar value a project adds to the firm. |
| When can IRR be misleading? | When cash flows are irregular or projects are mutually exclusive. |
| What does the Profitability Index (PI) measure? | Value created per dollar invested. |
| When is PI most useful? | When capital is limited and you must choose among several projects. |
| In the chocolate factory example, which project was the best and why? | Project B, because it had the highest NPV, adding the most value. |
| In capital-constrained situations, which metric should you prioritize? | Profitability Index (PI). |
| Why use NPV over IRR when comparing mutually exclusive projects? | NPV directly measures total value added; IRR can favor smaller or faster-paying projects. |
| What is the capital budgeting decision rule for NPV? | Accept projects with NPV > 0. |
| What is the decision rule for IRR? | Accept if IRR > cost of capital. |
| What is the decision rule for PI? | Accept if PI > 1. |
| What should a company do to maximize total value when capital is limited? | Use PI to rank projects and choose the combination with the highest total NPV within the budget. |
| Why is it important to consider all relevant cash flows in an ideal evaluation method for capital investment? | Without considering every cash flow of a potential project, you do not know how the project will enhance the value of a firm. |
| Talia is comparing four mutually exclusive projects. In order to choose the best project to optimize the goal of the firm, which capital budgeting method should Talia use? | Net present value (NPV) |
| Alphabet Co. has $50,000 to spend on capital investment projects for the next year. It will do as many projects as it has cash for. Alphabet Co. calculates the potential incremental cash flows and costs of the projects as well as the NPV, IRR, and PI for | It should choose the projects with the highest PIs until all capital has been used. |
| What is the time value of money (TVM)? | The concept that money received today is worth more than the same amount received in the future due to inflation, risk, and opportunity cost. |
| Why does timing matter in capital budgeting? | Earlier returns are more valuable—they reduce risk, preserve purchasing power, and allow for reinvestment. |
| What are the three key factors that reduce the value of future money? | Inflation, risk, and opportunity cost. |
| What is the main purpose of using TVM in capital budgeting? | To determine whether a project adds value in today’s dollars by comparing the present value of benefits to costs. |
| Which TVM tools are commonly used in capital budgeting? | Net Present Value (NPV), Internal Rate of Return (IRR), and discounting future cash flows. |
| In the ABC Company case study, why is the 5-year project preferred over the 10-year one, despite the same return? | It delivers returns earlier, reducing risk and allowing earlier reinvestment. |
| What does a positive NPV indicate? | The project’s present value of benefits exceeds its cost—so it adds value and should be accepted. |
| How does Amazon’s Prime Air Drone Project illustrate the use of TVM? | Amazon used forecasting, NPV, and IRR to reassess project value as new info emerged, despite delays. |
| What is the role of the discount rate in TVM analysis? | It adjusts future cash flows for risk and opportunity cost to calculate present value. |
| What are the key steps in applying TVM to capital investments? | 1. Forecast inflows/outflows 2. Discount to present value 3. Compare to initial cost |
| How does TVM help in comparing different capital projects? | It standardizes future cash flows to today’s value, allowing fair comparison regardless of timing or size. |
| What does TVM help companies decide? | Whether a project will maximize shareholder value and is worth pursuing now. |
| What is opportunity cost as it relates to the time value of money? | It is the opportunity you forgo to invest in other options due to the time scope of an investment. |
| Why is the timing of cash flows an important characteristic of capital investment? | Timing of cash flows is related to the opportunity cost associated with those cash flows. |
| What is the cost of capital? | It’s the minimum return a project must earn to be acceptable; the return investors expect based on risk. |
| Why is the cost of capital important in capital budgeting? | It acts as a benchmark to decide if a project increases firm value. |
| How does risk affect the cost of capital? | Higher risk → higher required return → higher cost of capital. |
| What are the typical risk levels and returns for different capital sources? | Debt: Lower risk → Lower return Preferred Stock: Moderate risk/return Common Stock: Highest risk → Highest return |
| What is a tax shield? | The tax benefit from deductible interest on debt, which lowers the effective cost of debt. |
| Why is too much debt risky despite tax benefits? | It increases financial risk and can raise the overall cost of capital. |
| What does project-specific risk mean? | Different projects have different risk levels and may require different discount rates. |
| Costco Example – Which location requires a higher discount rate and why? | Bentonville, AR – due to strong competition (Walmart/Sam’s Club), meaning higher risk. |
| From a manager's perspective, what does the cost of capital represent? | It’s the cost of using investor funds to finance a project. |
| From an investor’s perspective, what is the cost of capital? | It’s the return they require for the risk they take. |
| In a real-world project evaluation, how is the cost of capital used? | As the discount rate to compare present value of future cash inflows against project cost. |
| What happens if the present value of a project’s cash flows exceeds its cost? | The project should be accepted—it adds value. |
| Why might each project use a different discount rate? | Because each project carries a different risk level. |
| What is the key takeaway from this lesson? | Align project evaluation with its risk-adjusted cost of capital to make value-maximizing decisions. |
| Why is there always a cost for bringing funds into a business? | A business must compensate investors for the risk that they are taking to invest in the business. |
| What is the relationship between the risk and the rate of return? | The higher the risk investors have to take on, the higher return they require. |
| How can having more debt benefit a company? | Interest expense on debts is paid before taxes are calculated. |
| Which example demonstrates a financing decision in a firm? | How a company will fund its assets and operations—namely, what proportions of debt and equity the business will use |
| What type of cash flows should be included in capital budgeting? | Only incremental, incidental, and opportunity costs—not sunk costs. |
| What are incremental cash flows? | Cash flows that occur only because a project is undertaken (e.g., new revenues, new expenses, tax changes). |
| Why do only incremental cash flows matter in investment decisions? | Because they reflect the true change in the firm’s financial position caused by the project. |
| What are incidental cash flows? | Indirect impacts of the project, like increased sales of related products or losses from cannibalization. |
| Give an example of an incidental cash flow. | A store sells tuna at a loss, but earns profit from added sales of mayo and bread. |
| What are sunk costs, and should they be included? | Past costs already incurred; do NOT include them—they’re irrelevant to future decisions. |
| Example of a sunk cost? | $3 million spent last year on market research. It’s already spent and shouldn’t affect today’s decisions. |
| What is an opportunity cost in capital investment? | The value of the next best alternative you give up when choosing a project. |
| Should opportunity costs be included in the analysis? | Yes — they represent real trade-offs. |
| Why is it important to evaluate projects from a firm-wide perspective? | To ensure decisions reflect overall impact, not just departmental effects. |
| Which of the following is not included in cash flow estimation: | A. Incremental revenues B. Shared administrative costs C. Opportunity cost of owned land D. Additional taxes from the project A: B. Shared administrative costs — they are not incremental. |
| What’s the goal of proper cash flow estimation? | To decide whether a project creates net value for the business based on relevant future-oriented cash flows. |
| What are incremental cash flows? | Any additional cash flows, whether in or out of the firm, that are created as a result of accepting a project |
| How does allocated overhead affect the selection of capital investment projects? | These cash flows are not a direct result of a specific project but are a general cost to the firm. |
| How are non-incremental cash flows different from incidental cash flows? | Incidental cash flows are indirect cash flows that are not explicitly revenues or costs. Nevertheless, they must be included in the analysis. |
| How does cannibalization factor into capital investment decisions? | If your company is planning on launching a product, and that product is going to steal some of the sales of another of the company’s products, that loss of sales could be an incidental cost or revenue caused by the new product. |
| What would an analyst predict for a potential investment with an NPV of zero? | The project would earn exactly the rate of return required by the firm. |
| A financial analyst for the company Bobby’s Books has been asked to evaluate a potential investment using a method that considers the time value of money. Is there more than one way to do this? | Yes, the analyst could use both the NPV and the IRR. |
| If two projects are mutually exclusive, which decision-making criterion will help you make the best decision about which project to accept? | Net present value (NPV) |
| Why might a firm prefer to raise debt capital through bonds instead of stocks? | Bonds do not require a firm to give up any ownership. |
| Why is it appropriate to calculate the value of a bond in the same way that the present value of an annuity is calculated? | Bonds pay a coupon every six months, pay a constant coupon amount, and have a maturity date. |
| Why is it important to consider the cost of capital in an ideal evaluation method of capital investment? | Because cash flows for a project may be uncertain |
| What must be determined in order to compare the values of two projects with differently timed cash flows that does not need to be determined for projects with similarly timed cash flows? | Opportunity cost |
| What is the disadvantage of debt financing? | Debt financing does not actually achieve an optimal capital structure for a company. |
| How do you factor sunk costs into capital investment analysis? | For the purposes of analysis, sunk costs are irrelevant. |
| Why is NPV the most reliable method for evaluating investments? | It considers the time value of money, it tells you the dollar value that the investment will add to the firm, and it takes risk into account. |
| Suppose you are a manager at a firm. One of your financial analysts places a report on your desk of valuation calculations for some potential investment projects. When you look at the calculations later, you notice that the analyst did not indicate if she | The analyst used the IRR method. |
| You are considering a project that has a profitability index of 1. What does this mean? | The project has an internal rate of return equal to the cost of capital. |
| You just purchased a bond for $1,000 that has a par value of $1,000. What type of bond is this? | A par bond |
| Why is it appropriate to calculate the value of a preferred stock in the same way that you would find the present value of a perpetuity? | For a preferred stock, a fixed amount is paid forever to compensate the investors. |
| Why is it important to consider the time value of money in an ideal evaluation method for capital investment? | Because the value of a cash flow today is different from the value of a cash flow of the same dollar amount in 10 years |
| Which scenario correctly describes opportunity cost? | Alexandra decides to spend $50 on some new clothes instead of using that money to pay her electric bill. The opportunity cost is having the electricity turned off. |
| How does management choose between two projects that are seemingly the same? | Management can analyze the different inherent risks that change the cost of capital to the firm. |
| Which term describes the reduction in sales of a company’s own products due to the introduction of another similar product? | Cost of cannibalization |
| Which item is considered a sunk cost? | The consulting cost spent three months prior to the start of a project |
| A company is considering five projects that are not mutually exclusive. However, the company does not have enough money to do all of them. In order to prioritize projects that fit within the company’s budget, which capital budgeting method should be used? | Profitability index (PI) |
| Which scenario is an example of an opportunity cost that is not associated with cash flows? | Albert decides to stay home and study for his test instead of going to the movies. |
| Which condition indicates that an investment will add value to a company? | The present value of the benefits of the investment outweigh the present value of the costs of the investment. |
| How do corporations and purchasers of financial securities view returns? | Purchasers of financial securities look at returns as the amount of money they require in order to lend or give their money to the corporation that issued those securities. |
| What is an opportunity cost? | The loss of the ability to use an asset toward the next best project once you have invested it in another project |
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