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Chapter 11 Capital Budgeting Cash Flows and Risk Refinements  Instructor’s Resources Overview This chapter expands upon the capital budgeting techniques presented in the previous chapter (Chapter 10). Shareholder wealth maximization relies upon selection of projects that have positive net present values. The most important and difficult aspects of the capital budgeting process is developing good estimates of the relevant cash flows. Chapter 11 focuses on the basics of determining relevant after-tax cash flows of a project, from the initial cash outlay to annual cash stream of costs and benefits and terminal cash flow. It expands capital budgeting to consider risk with such methods as scenario analysis and simulation. Additionally, two basic risk-adjustment techniques are examined: certainty equivalents and risk-adjusted discount rates.  Answers to Review Questions 1. Capital budgeting projects should be evaluated using incremental after-tax cash flows , since after-tax cash flows are what is available to the firm. When evaluating a project, concern is placed only on added cash flows expected to result from its implementation. Expansion decisions can be treated as replacement decisions in which all cash flows from the old assets are zero. Both expansion and replacement decisions involve purchasing new assets. Replacement decisions are more complex because incremental cash flows resulting from the replacement must be determined. 2. The three components of cash flow for any project are (1) initial investment, (2) operating cash flows, and (3) terminal cash flows. 3. No aspect of the company is being replaced in an expansion decision . Consequently, managers only have to deal with additional revenues and costs. In a replacement decision , managers are focusing on incremental cash inflows and outflows. For instance, in a replacement decision managers have to consider any after-tax cash received from the liquidation of an old asset when a replacement asset is being considered. The expansion decision is a special type of replacement decision, wherein cash flows from the “old” asset (i.e., situation) are zero. 4. Sunk costs are costs that have already been incurred and thus the money has already been spent. Opportunity costs are cash flows that could be realized from the next best alternative use of an owned asset. Sunk costs are not relevant to the investment decision because they are not incremental. These costs will not change no matter what the final accept/reject decision. Opportunity costs are a relevant cost. These cash flows could be realized if the decision is made not to change the current asset structure but to utilize the owned asset for this alternative purpose. © 2012 Pearson Education, Inc. Publishing as Prentice Hall

FIN | 301 | Financial Management | lecture notes | Chapter 11 Capital Budgeting C

Part 3 Valuation of Securities Chapters in this Part Chapter 6 Interest Rates and Bond Valuation Chapter 7 Stock Valuation Chapter 6 Interest Rates and Bond Valuation  Instructor’s Resources Overview This chapter begins with a thorough discussion of interest rates, yield curves, and their relationship to required returns. Features of the major types of bond issues are presented along with their legal issues, risk characteristics, and indenture covenants. The chapter then introduces students to the important concept of valuation and demonstrates the impact of cash flows, timing, and risk on value. It explains models for valuing bonds and the calculation of yield-to-maturity using either an approximate yield formula or calcualtor. Students learn how interest rates may affect their ability to borrow and expand business operations or assets under personal control.  Answers to Review Questions © 2012 Pearson Education, Inc. Publishing as Prentice Hall 104 Gitman/Zutter • Principles of Managerial Finance, Brief, Sixth Edition 1. The real rate of interest is the rate that creates an equilibrium between the supply of savings and demand for investment funds. The nominal rate of interest is the actual rate of interest charged by the supplier and paid by the demander. The nominal rate of interest differs from the real rate of interest due to two factors: (1) a premium due to inflationary expectations ( IP ) and (2) a premium due to issuer and issue characteristic risks ( RP ). The nominal rate of interest for a security can be defined as r 1  r *  IP  RP . For a three-month U.S. Treasury bill, the nominal rate of interest can be stated as r 1  r *  IP . The default risk premium, RP , is assumed to be zero since the security is backed by the U.S. government; this security is commonly considered the risk-free asset. 2. The term structure of interest rates is the relationship of the rate of return to the time to maturity for any class of similar-risk securities. The graphic presentation of this relationship is the yield curve. 3. For a given class of securities, the slope of the curve reflects an expectation about the movement of interest rates over time. The most commonly used class of securities is U.S. Treasury securities. a. Downward sloping: Long-term borrowing costs are lower than short-term borrowing costs. b. Upward sloping: Short-term borrowing costs are lower than long-term borrowing costs. c. Flat: Borrowing costs are relatively similar for short- and long-term loans. The upward-sloping yield curve has been the most prevalent historically. 4. a. According to the expectations theory , the yield curve reflects investor expectations about future interest rates, with the differences based on inflation expectations. The curve can take any of the three forms. An upward-sloping curve is the result of increasing inflationary expectations, and vice versa. b. The liquidity preference theory is an explanation for the upward-sloping yield curve. This theory states that long-term rates are generally higher than short-term rates due to the desire of investors for greater liquidity, and thus a premium must be offered to attract adequate long-term investment. c. The market segmentation theory is another theory that can explain any of the three curve shapes. Since the market for loans can be segmented based on maturity, sources of supply and demand for loans within each segment determine the prevailing interest rate. If supply is greater than demand for short-term funds at a time when demand for long-term loans is higher than the supply of funding, the yield curve would be upward sloping. Obviously, the reverse also holds true. 5. In the Fisher equation, r  r *  IP  RP , the risk premium, RP , consists of the following issuer- and issue-related components:  Default risk : The possibility that the issuer will not pay the contractual interest or principal as scheduled.  Maturity ( interest rate ) risk : The possibility that changes in the interest rates on similar securities will cause the value of the security to change by a greater amount the longer its maturity, and vice versa.  Liquidity risk : The ease with which securities can be converted to cash without a loss in value.  Contractual provisions : Covenants included in a debt agreement or stock issue defining the rights and restrictions of the issuer and the purchaser. These can increase or reduce the risk of a security. © 2012 Pearson Education, Inc. Publishing as Prentice Hall

FIN | 301 | Financial Management | lecture notes | Part 3 Valuation of Securities

ch17 Student: ___________________________________________________________________________ 1. When liquidity risk problems occur at a DI, they often threaten the solvency of the institution. True False 2. Depository institutions generally rely on each other for cash and to meet their daily liquidity needs. True False 3. During the financial crisis of 2008, liquidity problems were avoided as banks continued to provide lending to each other. True False 4. During the financial crisis of 2008, there were large deposit inflows to the banking system. True False 5. Mutual funds tend to have less exposure to liquidity risk than do banks and thrifts. True False 6. An FI's most liquid asset is cash. True False 7. Demand deposits pose a liquidity risk for FIs because funds may be withdrawn at any time. True False 8. A bank must be ready to pay out all demand deposit liabilities on any given day. True False 9. Liquidity risk for an FI includes the possibility of an unexpected inflow of funds. True False 10. Bank runs occur because customers know that banks will be forced to liquidate assets at fire-sale prices. True False 11. Asset-side liquidity risk may be a result of OBS lending commitments. True False 12. Core deposits represent a relatively short-term source of funds. True False 13. An expected net deposit drain on any given day means that deposit withdrawals are less than deposit inflows. True False 14. Purchased liquidity risk management usually involves purchased funds such as Fed funds, repurchase agreements and CDs. True False 15. Purchased liquidity management carries the potential risk of significant increases in the cost of funds during periods of high interest rate volatility. True False 16. Because cash reserves at the Federal Reserve do not earn interest, DIs do not hold any excess cash reserves beyond the minimum requirements. True False 17. Managing asset-side liquidity risk can involve either purchased liquidity management or stored liquidity management. True False 18. Liquid funds can be obtained by a DI through unlimited borrowing in the money or purchased funds markets. True False 19. High loan commitment banks face less liquidity risk exposure than low commitment banks. True False 20. The liquidity index should be a number that is either greater than one or less than zero. True False 21. The greater the difference between fair market prices and fire-sale prices for assets, the less liquid the DI's portfolio of assets. True False 22. In terms of liquidity risk measurement, the financing gap is defined as rate sensitive assets minus rate sensitive liabilities. True False 23. Maturity ladder/scenario analysis is a method of measuring liquidity risk and net funding requirements. True False 24. The relative time frame for active liquidity management is 2 to 4 months. True False 25. Liquidity planning primarily is designed to assist management in dealing with relatively predictable events. True False 26. Abnormally large and unexpected deposit withdrawals can occur because of concerns by depositors about a bank's solvency relative to other banks. True False 27. The cost of stored liquidity management is the interest that must be paid on the stored funds. True False 28. The future liquidity position of a DI cannot be forecasted. True False 29. Deposit insurance is the only deterrent to bank runs, contagious runs, and bank panics. True False 30. A liquidity plan for a DI should provide a detailed list of fund providers who are most likely to withdraw in the case of a liquidity crisis. True False 31. Even with liquidity planning, net deposit withdrawals and/or the exercise of loan commitments can pose significant liquidity problems for banks. True False 32. Liquidity planning should identify the size of potential deposit withdrawals over various time horizons in the future, as well as alternative emergency private funding sources to meet those withdrawals. True False 33. In the event of a bank run, depositor claims on the bank are satisfied on a pro rata basis. True False

FIN | 321 | Risk Management | assessment | ch17 Student: __

Mutual Fund Operations  13 A) True B) False ANSWER: A 78. Because money market funds contain instruments with short-term maturities, their market values are not very sensitive to movements in market interest rates. A) True B) False ANSWER: A 79. Equity REITs are sometimes purchased to hedge against inflation, as rents and property values tend to rise with

Madura_FMI9e_TB_ch23.doc-Mutual Fund Operations  13 A)

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