FIN 300 Lecture Notes - Lecture 5: Cash Flow, Discount Window, Arbitrage

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5 Mar 2021

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Cost-benefit analysis: the first step in decision making is to identify the costs and benefits of a decision, quantifying these costs and benefits, aka looking at the cash value a firm has. A competitive market is a market where a good can be bought and sold at the same price. The valuation principle: the value of a commodity or an assets to a firm or its investors is determined by its competitive market price. The benefits and costs of a decision should be evaluated using those market prices. When value of benefits > costs, the decision made will increase the market value of the firm. Provides the basis for decision making; applying this principle to decisions regarding costs and benefits. We cant have 2 diff competitive market prices for the same good because then the good will be set at 2 different values. Law of one price: in competitive markets, the same goods must have the same price.

Related Questions

Amongst corporations, sole proprietorships and partnerships, approximately what percentage of revenues are generated by corporations?

50%

42%

33%

82%

Question 2

What should be the financial goal of any firm?

attracting and acquiring capital and investing it

maximization of the ownersâ wealth

offering quality products at fair prices

quality customer service

Question 3
4 pts
Which of the following statement(s) is \ are true regarding the corporate management team?

In a corporation, ownership and direct control are typically separate.

Board of Directors is elected by shareholders and has ultimate decision-making authority

The Chief Executive Officer (CEO) â the Board typically delegates day-to-day decision making to the CEO.

All of the above

Question 4
4 pts
When calculating the present value of either a future single sum or a future annuity, it involves a process called discounting. The applicable interest rate to perform the discounting function is usually called the

yield to maturity

compound interest rate

discount rate

none of the above

Question 5
4 pts
_________________ are used to present additional information about items included in the financial statements and to present additional financial information.

stock certificates

Notes to financial statements

Preferred stocks

Convertible securities
Question 6
4 pts
What should be the financial goal of any firm?

maximization of the ownersâ wealth

attracting and acquiring capital and investing it

offering quality products at fair prices

quality customer service

Question 7
4 pts
A competitive market is one in which a _____ numbers of producers compete with each other to satisfy the wants and needs of a _____ number of consumers.

Large, small

Small, small

Large, large

Small, large

Question 8
4 pts
The Valuation Principle is an analysis between the value of the ______ of a financial alternative and the value of its ______.

revenues, income

benefits, costs

expenses, costs

Question 9
4 pts
The Net Present Value rule implies that we should compare a projectâs net present value (NPV) to___________. (zero \ future value \ the past).

Zero

Future Value

The Past

An Estimate

Question 10
4 pts
The internal rate of return (IRR) rule will _______ agree with the Net Present Value rule on a given investment project.

always

never

sometimes

none of the above

Question 11
5 pts
The law of one price exists due to arbitrage opportunities. If the price of a security, commodity or asset is different in two different markets, then an arbitrageur will ______ the asset in the more expensive market and ________ it where prices are lower.

sell, purchase

purchase, sell

purchase, purchase

sell, sell

Question 12
5 pts
Approaching every problem using a timeline is a(n) ________ idea because timelines identify events in a transaction or investment which might otherwise be easily overlooked.

good

bad

indifferent

unrealistic

Question 13
5 pts
The present value (PV) of a stream of cash flows is the _______ the present values of each individual cash flow

difference between

product of

sum of

same as

Question 14
5 pts
As the number of periods increases, present value (increases\decreases\stays the same).

increases

decreases

stays the same

is unrelated

Question 15
5 pts
When a constant cash flow will occur at regular intervals for a finite number of periods of time, it is called a(n) __________.

annuity

perpetuity

interest payment

principle payment

Question 16
5 pts
When a constant cash flow will occur at regular intervals forever, it is called a(n) ___________.

annuity

perpetuity

interest payment

principle payment

Question 17
5 pts
The NPV measures the ______ change in shareholder wealth that arises from undertaking a project.

consistent

dollar

annual

semi-annual

Question 18
5 pts
When calculating the present value of either a future single sum or a future annuity, the applicable interest rate is usually called the _______ rate

compounding

inverted

market

discount

Question 19
5 pts
To endow a perpetuity is the same as calculating the present value (PV) of a perpetuity. Say you want to endow an annual graduation party at your alma mater. You want the event to be a memorable one, so you budget $30,000 per year forever for the party. If the university earns 8% per year on its investments, and if the first party is in one yearâs time, how much will you need to donate to endow the party?
The formula for PV of a perpetuity = C\r; = $30,000 \ 0.08; =

$3,750

$37,500

$375,000

$3,750,000

Question 20
5 pts
With an Ordinary Annuity, payments are required at the ________ of each period. An example of this is bonds which usually pay coupon payments at the end of every six months until the bond's maturity date.

beginning

middle

end

payments are not required

Question 21
5 pts
Sales of securities that the seller does not own is called a:

stop-loss order

short sale

limit order

maintenance margin

Question 22
5 pts
What is the name of the market where money market securities, bonds, and mortgages are originated and traded?

debt securities market

foreign exchange market

derivative securities market

equity securities market

Question 23
5 pts
If an investor feels the price of a stock will decline in the future, which trade should the investor undertake?

market order

buy on margin

limit order

short sale

Question 24
5 pts
For risk averse investors, how much return is expected for taking on more risk?

lower

equal

zero

higher

Question 25
5 pts
A ___________________ is a highly regulated document which details the issuers operations and finances and must be provided to each buyer of a newly issued security.

Prospectus

An underwriting agreement

A best efforts agreement

none of the above

Question 26
5 pts
Which of the following statements about liquidity ratios is true?

The lower the quick ratio relative to the current ratio, the safer a firm is in terms of liquidity.

The higher the current ratio, the more likely a firm is able to pay its short-term obligations.

The quick ratio is always between 0 and 1.

All the above statements are true.

Question 27
5 pts
The ability of a firm to meet its short-term debt obligations as they come due is indicated by which of the following ratios:

liquidity ratios

asset utilization ratios

financial leverage ratios

profitability ratios

Question 28
5 pts
Which one of the following financial statements reports a firmâs assets and the claims on assets?

balance sheet

income statement

statement of changes in financial position

cash flow statement

Question 29
5 pts
The extent to which assets are used to support sales is indicated by which of the following ratios:

liquidity ratios

asset utilization ratios

financial leverage ratios

profitability ratios

Question 30
5 pts
The extent to which assets are financed by borrowed funds and other liabilities is indicated by:

liquidity ratios

asset utilization ratios

financial leverage ratios

profitability ratios

Question 31
5 pts
The basic price that equates the demand for and supply of loanable funds in the financial markets is the __________:

interest rate

yield curve

term structure

cash price

none of the above

Question 32
5 pts
Federal obligations usually issued for maturities of two to ten years are called:

Treasury bonds

Treasury notes

Treasury bills

Agency issues

Question 33
5 pts
An increase in the demand for loan-able funds, holding supply constant, will cause interest rates to:

increase

decrease

stay the same

none of the above

Question 34
5 pts
As interest rates rise, the prices of existing bonds will:

rise

stay the same

fall

either a or b

Question 35
5 pts
In an inflationary period, interest rates have a tendency to:

rise

fall

stay the same

act erratically

salmonhound248

F1 Q11-15

Please show all workings/give explanations

Note: Questions 11 â 20 are based on the same mega problem. For convenience we have included the entire set of information in every question. For purposes of the questions that follow, assume that changes in working capital are negligible and capex and depreciation are of the same magnitude and therefore cancel each other. This is the assumption we made in most of the videos to focus on valuation effects of borrowing and taxes and to figure out the key differences between alternative valuation methods.

Q11. You are planning on opening a consulting firm. You have projected an EBIT of $2 million starting next year (t = 1) with a growth rate of 3% over the foreseeable future thereafter. This endeavor will require a substantial investment and you will have to convince investors to provide you the capital to do so. You will invest some of your own money, convincing other investors will of course be useful for your valuing your own investment decision. A critical piece of your analysis is figuring out the present value of the cash flows of the business. Your research has revealed the following information: similar consulting businesses equity has an average beta of 2.40 and the average debt-to-equity ratio in this industry is close to zero. The risk-free rate is 3.20% and the expected market risk premium (the average difference between the market return and the risk-free rate) is 4.50%. The corporate tax rate is 35% and interest payments on debt are tax deductible. What is the value of your company assuming that it will be all-equity financed? (Enter the nearest rounded dollar number without any $ or comma sign.)

Q12. You are planning on opening a consulting firm. You have projected an EBIT of $2 million starting next year (t = 1) with a growth rate of 3% over the foreseeable future thereafter. This endeavor will require a substantial investment and you will have to convince investors to provide you the capital to do so. You will invest some of your own money, convincing other investors will of course be useful for your valuing your own investment decision. A critical piece of your analysis is figuring out the present value of the cash flows of the business. Your research has revealed the following information: similar consulting businesses equity has an average beta of 2.40 and the average debt-to-equity ratio in this industry is close to zero. The risk-free rate is 3.20% and the expected market risk premium (the average difference between the market return and the risk-free rate) is 4.50%. The corporate tax rate is 35% and interest payments on debt are tax deductible. You decide to start the business and issue 500,000 shares to finance an all-equity firm, the price per share will be (Enter the number with up to two decimals but without any $ or comma sign):

Q13. You are planning on opening a consulting firm. You have projected an EBIT of $2 million starting next year (t = 1) with a growth rate of 3% over the foreseeable future thereafter. This endeavor will require a substantial investment and you will have to convince investors to provide you the capital to do so. You will invest some of your own money, convincing other investors will of course be useful for your valuing your own investment decision. A critical piece of your analysis is figuring out the present value of the cash flows of the business. Your research has revealed the following information: similar consulting businesses equity has an average beta of 2.40 and the average debt-to-equity ratio in this industry is close to zero. The risk-free rate is 3.20% and the expected market risk premium (the average difference between the market return and the risk-free rate) is 4.50%. The corporate tax rate is 35% and interest payments on debt are tax deductible. You decide to start the business and issue 500,000 shares to finance an all-equity firm. Soon thereafter your hearing about your new business, your bank is willing to extend you long-term loan/debt in perpetuity of $3.50M as long as you can pay an interest rate of 8%. Assuming that the chances of bankruptcy are negligible with this amount of ongoing debt on your balance sheet, if you take this debt and retire shares using the debt, the value of the firm will go:

a) Remain the same.

b) Down.

c) Cannot determine based on the available information.

d) Up.

Q14. You are planning on opening a consulting firm. You have projected an EBIT of $2 million starting next year (t = 1) with a growth rate of 3% over the foreseeable future thereafter. This endeavor will require a substantial investment and you will have to convince investors to provide you the capital to do so. You will invest some of your own money, convincing other investors will of course be useful for your valuing your own investment decision. A critical piece of your analysis is figuring out the present value of the cash flows of the business. Your research has revealed the following information: similar consulting businesses equity has an average beta of 2.40 and the average debt-to-equity ratio in this industry is close to zero. The risk-free rate is 3.20% and the expected market risk premium (the average difference between the market return and the risk-free rate) is 4.50%. The corporate tax rate is 35% and interest payments on debt are tax deductible. You decide to start the business and issue 500,000 shares to finance an all-equity firm. Soon thereafter your hearing about your new business, your bank is willing to extend you long-term loan/debt in perpetuity of $3.50M as long as you can pay an interest rate of 8%. Realizing that the chances of bankruptcy are negligible with this amount of ongoing debt on your balance sheet, and the riskiness of the tax shield of debt is the same as the riskiness of debt, you are seriously contemplating taking on the debt and using all of it to retire some shares. If you decide to enter this debt contract with the bank, the value of the firm will become (Enter the nearest rounded dollar number without any $ or comma sign):

Q15. You are planning on opening a consulting firm. You have projected an EBIT of $2 million starting next year (t = 1) with a growth rate of 3% over the foreseeable future thereafter. This endeavor will require a substantial investment and you will have to convince investors to provide you the capital to do so. You will invest some of your own money, convincing other investors will of course be useful for your valuing your own investment decision. A critical piece of your analysis is figuring out the present value of the cash flows of the business. Your research has revealed the following information: similar consulting businesses equity has an average beta of 2.40 and the average debt-to-equity ratio in this industry is close to zero. The risk-free rate is 3.20% and the expected market risk premium (the average difference between the market return and the risk-free rate) is 4.50%. The corporate tax rate is 35% and interest payments on debt are tax deductible. Soon thereafter hearing about your new business, your bank is willing to extend you long-term loan/debt in perpetuity of $3.50M as long as you can pay an interest rate of 8%. Realizing that the chances of bankruptcy are negligible with this amount of ongoing debt on your balance sheet, and the riskiness of the tax shield of debt is the same as the riskiness of debt, you are seriously contemplating taking on the debt and using all of it to retire some shares. If you decide to enter this debt contract with the bank, what will be the price per share of the remaining shares? (Enter the nearest rounded dollar number without any $ or comma sign):

F1 Q6-Q10

Please show all workings/give explanations

Note: Questions 6 â 10 are based on the same mega problem. For convenience

we have included the entire set of information in every question. For purposes

of the questions that follow, assume that changes in working capital are

negligible and capex and depreciation are of the same magnitude and therefore

cancel each other. This is the assumption we made in most of the videos to

focus on valuation effects of borrowing and taxes and to figure out the key differences between alternative valuation methods.

XYZ, Inc.âs revenues have been $500,000 and total costs have been $250,000;

both costs and revenues are expected to remain the same in perpetuity. XYZ,

Inc. is an all equity firm (i.e., it has no debt) and has 125,000 shares outstanding.

The market knows that the company has no other investment (or growth)

opportunities. XYZ, Inc. currently pays out all its earnings as dividends (100%

payout) and is expected to do so forever. The dividends on the basis of last

yearâs earnings have just been paid out. If the appropriate discount rate for XYZ,

Inc. is 7.50%, For this question, assume taxes are zero. (Enter the number with up to two decimals but without any $ or comma sign.)

Q6 What is the price per share of XYZ, Inc.?

Q7 What is the price-to-earnings ratio?

XYZ, Inc.âs revenues have been $500,000 and total costs have been $250,000;

both costs and revenues are expected to remain the same in perpetuity. XYZ,

Inc. is an all equity firm (i.e., it has no debt) and has 125,000 shares outstanding.

The market knows that the company has no other investment (or growth)

opportunities. XYZ, Inc. currently pays out all its earnings as dividends (100%

payout) and is expected to do so forever. The dividends on the basis of last

yearâs earnings have just been paid out. The appropriate discount rate for XYZ,

Inc. is 7.50%. The CEO of XYZ, Inc. has a very exciting plan to make her company

look more attractive to investors. She suggests to her CFO that if the firm issues

$2.50M debt in perpetuity with a return of 5%, and uses this debt to repurchase

some of the shares of the company, it will make the firm more attractive to

acquirers. The CFO is skeptical of the CEOâs plan and argues with her about the

logic behind it. Frustrated with her CFOâs argumentative stance, the CEO finally

simply states: âI do not have to convince you, Gautam, especially since my plan

is fool proof. My debt-based strategy will make our company attractive to any

acquirer because it will lower our price-earnings ratio and, consequently, make

them offer us a lot more money for our assets than they would otherwise.â Is

the CEO correct in believing that the price-earnings ratio of XYZ, Inc. will drop?

For this question, assume taxes are zero.

Q8 Is the CEO correct in believing that the price-earnings ratio of XYZ, Inc. will drop?

Yes

It depends

Q9 What will be the new price-earnings ratio of XYZ?

Q10 What will the value of the firm be?

3,000,000

2,333,333

3,333,333

None of the above

FIN 300 Lecture Notes - Lecture 5: Cash Flow, Discount Window, Arbitrage

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