Exam 2 Part 2 Answer any EIGHT of the ten questions. Each question is worth 5 points. Return your answers to me by 11:59 PM Sunday 11 November 2012 1. A number of publicly traded firms pay no dividends yet investors are willing to buy shares in these firms. How is this possible? Does this violate our basic principle of stock valuation? Explain. Our basic principle of stock valuation is that the value of a share of stock is simply equal to the present value of all of the expected dividends on the stock.
According to the dividend growth model, an asset that has no expected cash flows has a value of zero, so if investors are willing to purchase shares of stock in firms that pay no dividends, they evidently expect that the firms will begin paying dividends at some point in the future. 2. Explain why some bond investors are subject to liquidity risk, default risk, and/or taxability risk. How does each of these risks affect the yield of a bond? Liquidity problems exist in thinly traded bonds making some bonds difficult to sell at their actual value. Default risk is the likelihood the corporation will default on its bond obligations.
Taxability risk reflects the fact that some bonds are taxed disadvantageously compared to others. If any of these risks exist, investors will require compensation by demanding a high yield. 3. The discussion of asset pricing in the text suggests that an investor will be indifferent between two bonds which have equal yields to maturity as long as they have equivalent default risk. Can you think of any real-world factors which might make a given investor prefer one of these bonds over the other? 4. Why do corporations issue 100-year bonds, knowing that interest rate risk is highest for very long-term bonds?
How does the interest rate risk affect the issuer? Treasury bonds make great safe, long-term investments, but is there any point in Why would the Fed consider issuing a bond with a 100-year maturation, are backed by the U. S. Government and typically have a very slim risk of default. 5. The market value of an investment project should be viewed as the sum of the standard NPV and the value of managerial options. Explain three different real or managerial options that management may have, what they are, and how they would influence market value. 6. Explain the use of real and nominal discount rates in discounting cash flows.
Which is used more often and why? Discounted cash flow (DCF) analysis is a method of valuing a project, company, or asset using the concepts of the time value of money. All future cash flows are estimated and discounted to give their present values (PVs) — the sum of all future cash flows, both incoming and outgoing, is the net present value (NPV), which is taken as the value or price of the cash flows in question. Using DCF analysis to compute the NPV takes as input cash flows and a discount rate and gives as output a price; the opposite process — taking cash flows and a price and inferring a discount rate, is called the yield.
Discounted cash flow analysis is widely used in investment finance, real estate development, and corporate financial management. 7. Consider two firms with the same P/E ratio. Explain how one could be described as expensive compared to the other. 8. Explain how important a firm’s growth is by creating an example of a growth and no-growth stock. 9. Everything held constant, would you rather depreciate a project with straight-line depreciation or with MACRS? 10. A local bank is contemplating opening a new branch bank in a large superstore across town from their main office.
It is estimated that the new branch will generate $20,000 after expenses each month. The manager wonders if all these revenues should be considered an incremental cash flow. Given this information, explain which of the following statements is correct. A. $20,000 is generated by the new branch bank and therefore it is an incremental cash flow. B. We would first need to assess the opportunity cost of placing a branch in a different location to answer this question. C. Some amount less than the $20,000 is incremental because of substitutionary effects. D. Some amount less than the $20,000 is incremental because of complementary effects.