Fin 301 Final Exam Questions with
Complete Solutions
Discount - Answer-Multiply a number by less than one.
Discount rate - Answer-A function of time and risk: discount rate=f(time, risk)
Discount factor - Answer-A function of both time and the discount rate: [discount
rate=f(time, discount)]
Present value - Answer-of an investment is the sum of the expected cash flows
multiplied by their respective discount rate.
Three-Step Approach [DCF Valuation] - Answer-1. Develop a set of expected cash
flows.
2. Estimate the discount rate and calculate the discount factors.
3. Multiply the cash flows by the discount factors and add them to determine the value
of the asset.
Decision Rule - Answer-Value > Price : Buy!
Value < Price : Sell!
Project/Venture - Answer-An investment to produce a product or provide a service that
will generate money in the future.
Cash Inflows - Answer--Additional revenues coming into the company as a result of the
project.
-Consist of dividends and increase/decrease in stock price.
Cash Outflows - Answer-Additional expenses being spent by the company as a result of
the project.
Bond - Answer--A debt instrument.
-Corporations, the US Government, and municipalities issue bonds.
-Payable from taxes from US government or the general revenues of a corporation.
Cash inflows to an investor - Answer-Bond interest payments, usually every 6 months,
and repayment of principal.
Stock - Answer-Represents ownership interest in a corporation.
Life of stock - Answer-Infinite. There is no maturity associated with a stock.
, Risk of a stock - Answer-Hard to quantify, making it difficult to determine the proper
discounting rate.
Capital budgeting - Answer--The process of planning and managing a firm's long-term
investment in projects and ventures.
-Estimating the amount, timing and risk of future cash flows.
-Starts with estimation of incremental cash flows from a project; creating a time line of
expected cash flows; and comparing the value of the cash flows to the cost of project.
Net Present Value [NPV] - Answer--The difference between the value of an investment
and its cost.
-The value of any project, venture or investment is equal to the present value of its
expected cash flows, discounted for their risk and timing.
NPV Rule - Answer-NPV, Positive : Invest!
NPV, Negative : Do not invest!
Internal Rate of Return [IRR] - Answer--The rate of return that is expected to be earned
on a project.
-The discounting rate that makes the net present value of an investment equal to zero.
IRR Rule - Answer-IRR > predetermined required rate of return : Accept!
IRR > predetermined required rate of return : Reject!
Payback Period - Answer--The length of time for the return on an investment to cover
the cost of the investment.
-Calculation involves only gross cash flows and not discounted cash flows.
Payback Rule - Answer-Payback period < Predetermined no of years : Accept!
Payback period > Predetermined no of years : Reject!
Profitability Index - Answer-Accept project with highest Profitability Index
Risk (Low --> High) - Answer-T-Bills -> Gov Bonds -> Corporate Bonds -> Low risk
Stock -> Market Portfolio -> High risk Stock
Efficient Capital Market [ECM] - Answer--Stock market is brutally efficient.
-Current stock prices reflect all publicly available information
-Stock prices react completely, correctly and almost instantaneously to incorporate the
receipt of new information
If stock market is efficient... - Answer-It would be useless to forecast future prices by
technical analysis and fundamental analysis.
Calculation of simple averages - Answer--If there is a negative percentage, biased
upwards
Complete Solutions
Discount - Answer-Multiply a number by less than one.
Discount rate - Answer-A function of time and risk: discount rate=f(time, risk)
Discount factor - Answer-A function of both time and the discount rate: [discount
rate=f(time, discount)]
Present value - Answer-of an investment is the sum of the expected cash flows
multiplied by their respective discount rate.
Three-Step Approach [DCF Valuation] - Answer-1. Develop a set of expected cash
flows.
2. Estimate the discount rate and calculate the discount factors.
3. Multiply the cash flows by the discount factors and add them to determine the value
of the asset.
Decision Rule - Answer-Value > Price : Buy!
Value < Price : Sell!
Project/Venture - Answer-An investment to produce a product or provide a service that
will generate money in the future.
Cash Inflows - Answer--Additional revenues coming into the company as a result of the
project.
-Consist of dividends and increase/decrease in stock price.
Cash Outflows - Answer-Additional expenses being spent by the company as a result of
the project.
Bond - Answer--A debt instrument.
-Corporations, the US Government, and municipalities issue bonds.
-Payable from taxes from US government or the general revenues of a corporation.
Cash inflows to an investor - Answer-Bond interest payments, usually every 6 months,
and repayment of principal.
Stock - Answer-Represents ownership interest in a corporation.
Life of stock - Answer-Infinite. There is no maturity associated with a stock.
, Risk of a stock - Answer-Hard to quantify, making it difficult to determine the proper
discounting rate.
Capital budgeting - Answer--The process of planning and managing a firm's long-term
investment in projects and ventures.
-Estimating the amount, timing and risk of future cash flows.
-Starts with estimation of incremental cash flows from a project; creating a time line of
expected cash flows; and comparing the value of the cash flows to the cost of project.
Net Present Value [NPV] - Answer--The difference between the value of an investment
and its cost.
-The value of any project, venture or investment is equal to the present value of its
expected cash flows, discounted for their risk and timing.
NPV Rule - Answer-NPV, Positive : Invest!
NPV, Negative : Do not invest!
Internal Rate of Return [IRR] - Answer--The rate of return that is expected to be earned
on a project.
-The discounting rate that makes the net present value of an investment equal to zero.
IRR Rule - Answer-IRR > predetermined required rate of return : Accept!
IRR > predetermined required rate of return : Reject!
Payback Period - Answer--The length of time for the return on an investment to cover
the cost of the investment.
-Calculation involves only gross cash flows and not discounted cash flows.
Payback Rule - Answer-Payback period < Predetermined no of years : Accept!
Payback period > Predetermined no of years : Reject!
Profitability Index - Answer-Accept project with highest Profitability Index
Risk (Low --> High) - Answer-T-Bills -> Gov Bonds -> Corporate Bonds -> Low risk
Stock -> Market Portfolio -> High risk Stock
Efficient Capital Market [ECM] - Answer--Stock market is brutally efficient.
-Current stock prices reflect all publicly available information
-Stock prices react completely, correctly and almost instantaneously to incorporate the
receipt of new information
If stock market is efficient... - Answer-It would be useless to forecast future prices by
technical analysis and fundamental analysis.
Calculation of simple averages - Answer--If there is a negative percentage, biased
upwards
