Running head: FUNDAMENTALS OF CORPORATE FINANCE 1

Unit 4: Capital Budgeting and Risk (Lessons 10, 11 and12)

Name
Institution
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Lesson 10: Capital Budgeting

Concepts Review and Critical Thinking Questions/Problems

Chapter 9:

Q1. Payback Period and Net Present Value [LO1, 2]. If a project with conventional cash

flows has a payback period less than the project’s life, can you definitively state the

algebraic sign of the NPV? Why or why not? If you know that the discounted payback

period is less than the project’s life, what can you say about the NPV? Explain.

When the Project’s life is greater than the Payback period, it has the meaning that the NPV

is positive for a zero discount rate. For a discount rate more than zero, the payback period will be

less compared to the project’s life. However, the NPV is likely to be positive, negative or zero

based on whether the discount rate is less than, greater, or equal to the IRR. Thus, the discounted

payback involves the effect of the relevant discount rate. If the discounted rate of payback period

of a project is less than the project’s life, it should then be the case that NPV is positive (Ross,

Westerfield, & Jordon, 2013).

Q5. Average Accounting Return [LO4] Concerning AAR:

A. Describe how the average accounting return is usually calculated, and describe the

information this measure provides about a sequence of cash flows. What is the AAR

criterion decision rule?

Accounting performance average measure of a project within a given period. The average

accounting return is usually calculated by dividing the average net income by its average book

value. On the other hand, the decision rule is accepting the project if it’s AAR is greater than the

anticipated AAR (Ross, Westerfield, & Jordon, 2013).

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B. What are the problems associated with using the AAR to evaluate a project’s cash

flows? What underlying feature of AAR is most troubling to you from a financial

perspective? Does the AAR have any redeeming qualities?

Some of the problems associated with using AAR in the evaluation of a project’s cash is

that it is not a true rate of return as time value of money is disregarded or ignored. The other

problem associated with it is that it uses arbitrary benchmark cutoff rate. It is also based on

accounting numbers and not market values and cash flows as well (Ross, Westerfield, & Jordon,

2013).

The most troubling aspect is the reliance on accounting numbers more than the relevant

market data as well as time value of money exclusion. Lastly, AAR redeeming qualities includes

easy to calculate and the required information will always be available (Ross, Westerfield, &

Jordon, 2013).

Q7. Internal Rate of Return [LO5] Concerning IRR:

A. Describe how the IRR is calculated, and describe the information this measure provides

about a sequence of cash flows. What is the IRR criterion decision rule?

The IRR is calculated as the break-even point, which is the discount rate that is used in the

calculation of a zero Net Present Value in a series of cash flows. The IRR criterion decision rule

considers the project the moment the IRR is found to be greater than the discount rate, and rejects

it in case the IRR is lower than the discount rate (Ross, Westerfield, & Jordon, 2013).

B. What is the relationship between IRR and NPV? Are there any situations in which you

might prefer one method over the other? Explain.

The relationship between NPV and IRR is that IRR refers to the discount rate that leads to

the NPV being zero. There are situations when one is preferable compared to the other. For
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instance, it is preferable using the Net Present Value since IRR results can be off for projects

having non-conventional cash flows (Ross, Westerfield, & Jordon, 2013).

C. Despite its shortcomings in some situations, why do most financial managers use IRR

along with NPV when evaluating projects? Can you think of a situation in which IRR

might be a more appropriate measure to use than NPV? Explain

IRR is mostly used by financial analysts to speak in relative terms and not in definitive

dollar terms. Percent losses and gains can bring in the bigger picture of the overall situation as

compared to that of dollar. IRR is likely to be a more significant measured that is majorly used

compared to NPV when discount rate is uncertain. In such a case, the IRR would still provide a

better discount rate for zero NPV, where the NPV would in turn lead to an unreliable value (Ross,

Westerfield, & Jordon, 2013).

Q11. Capital Budgeting Problems [LO1].

What difficulties might come up in actual applications of the various criteria we discussed

in this chapter? Which one would be the easiest to implement in actual applications? The

most difficult?

The significant difficulty in the actual application of various criterion, in this case, is

coming up with a reliable cash flow estimates. The determination of an appropriate discount rate

is also not an easy task. The payback method is the simplest approach then followed by AAR.

However, even these approaches need revenue and cost projections. The discounted cash flows

lead to discounted payback, IRR, NPV and profitability index are slightly difficult in practice

(Ross, Westerfield, & Jordon, 2013).

Q15. Internal Rate of Return [LO5].

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It is sometimes stated that “the internal rate of return approach assumes reinvestment of

the intermediate cash flows at the internal rate of return.” Is this claim correct? To answer,

suppose you calculate the IRR of a project in the usual way. Next, suppose you do the

following:

a. Calculate the future value (as of the end of the project) of all the cash flows other than

the initial outlay assuming they are reinvested at the IRR, producing a single future

value figure for the project.

Internal rate of return approach considers investment of the so-called intermediate cash

flows at the IRR. The provided statement is incorrect, in that if all the future intermediate cash

flows are calculated the end of project life at IRR, will automatically equal to the IRR calculated

using the ordinary method (Ross, Westerfield, & Jordon, 2013). It is worth noting that it is similar

to Net Present Value where the accumulated cash flow from the project is significant and not

concerned regarding the future use of such cash flow. In that IRR is not concerned regarding the

future use of cash flow but concerned only with the cash flow accumulated from the project.

Project M

Cash flow is =-$200

Year 1 cash flow = $100

Year 2 cash flow = $150

At IRR Net Present Value is noted to be zero

Therefore, making an assumption that NPV = 0

1𝑠𝑡 𝑦𝑒𝑎𝑟 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 2𝑛𝑑 𝑦𝑒𝑎𝑟 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤

Then; NPV =−𝑐𝑎𝑠ℎ 𝑜𝑢𝑡𝑓𝑙𝑜𝑤 + +
(1+𝐼𝑅𝑅) (1+𝐼𝑅𝑅)2

$100 $150
0 = −$200 + +
(1 + 𝐼𝑅𝑅) (1 + 𝐼𝑅𝑅)2
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$100 $150
$200 = +
(1 + 0.1514) (1 + 0.1514)2

$200 = $200.

For year 2: Including the reinvestment

$0 $25.14
0 = −$200 + +
(1 + 𝐼𝑅𝑅) (1 + 𝐼𝑅𝑅)2

$0 $265.14
$200 = +
(1 + 0.1514) (1 + 0.1514)2

$200 = $200 (𝐴𝑝𝑝𝑟𝑜𝑥𝑖𝑚𝑎𝑡𝑒𝑙𝑦)

Chapter 12:

Q8. Stocks versus Gambling [LO4].

Critically evaluate the following statement: Playing the stock market is like gambling. Such

speculative investing has no social value other than the pleasure people get from this form

of gambling.

The consistent returns in the stock market are positive, which has the meaning that every

individual has the opportunity to win, as opposed to gambling game. Additionally, speculators

includes liquidity to markets enhancing efficiency (Ross, Westerfield, & Jordon, 2013).

Q9. Efficient Markets Hypothesis [LO4].

Several celebrated investors and stock pickers frequently mentioned in the financial press

have recorded huge returns on their investments over the past two decades. Is the success

of these particular investors and invalidation of the EMH? Explain.

The efficient market hypothesis states that market assets are priced fairly. The success

range amongst the investors, is still noted to be evenly distributed. While some of the investors are

likely to experience important success within the market over a given period, there would be more

who have been understanding at the same time (Firer et al., 2012).
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Lesson 11: Risk

Task Number 1: Discussion Board

Q1. State run lotteries have become very popular in the U.S. Why do you think this is the

case? Have you participated in a lottery?

It is true that state-run lotteries in the United States have become popular, and the primary

reason as to why this has become so, is that it acts as a form of tax. As a form of tax, it has been

noted that state-run lotteries have a significant impact on the state finance. In the year 2009 state-

run Lotteries generated about $17.6 billion across all the states. It further rose to about $17.9 billion

in 2010, as most of the Americans invests their earned wages in the game for ultimate cash reward.

It is also a fact that while the chances of winning the lottery are less it has the meaning that

participants should increase as well. Therefore, with such substantial gain, state-run Lotteries have

become popular. On my case, I have never participated in any Lottery as I take it as a waste of

hard-earned money (Ross, Westerfield, & Jordon, 2013).

Task Number 2: Concepts Reviews and Critical Thinking Questions

Chapter 13:

Q1. Diversifiable and Non-diversifiable Risks [LO3]:

In broad terms, why is some risk diversifiable? Why are some risks nondiversifiable? Does

it follow that an investor can control the level of unsystematic risk in a portfolio, but not

the level of systematic risk?

Some risks are diversifiable in the aspect that they are created from the portfolio

composition (Ross, Westerfield, & Jordon, 2013). For instance, if all stocks in the portfolio are

technology stock, it will then have a tremendous unsystematic risk because failure in the
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technology will result in the decline of the entire portfolio. Unsystematic risk is likely to be reduced

through the diversification of the portfolio to various sectors and market caps as well (Ross, 2007).

On the other hand, some risks are not diversifiable since they are the underlying risks of

the entire system. Most of these risks generates from the general macroeconomic climate. For

instance, irrespective of how diversified a portfolio is, a worldwide financial meltdown will result

in a decline in the portfolio despite not having an unsystematic risk (Firer et al., 2012).

It is a fact that systematic risk level cannot be reduced while the unsystematic risks can be

reduced through stock diversification (Ross, Westerfield, & Jordon, 2013). Thus, the investor is in

the position of controlling unsystematic risks but not systematic risks.

Q5. Expected Portfolio Returns [LO1]:

If a portfolio has a positive investment in every asset, can the expected return on the

portfolio be greater than that on every asset in the portfolio? Can it be less than that on

every asset in the portfolio? If you answer yes to one or both of these questions, give an

example to support your answer.

In case a portfolio has a positive investment in every asset, the expected return on the

portfolio can neither be higher than that on each asset nor can it be lower than that on each asset

in the portfolio (Ross, Westerfield, & Jordon, 2013). In this case, the portfolio expected return are

the weighted average of the anticipated returns on every asset. Hence, the expected return on

portfolio should be higher than the asset with low return and should be lesser than the assets with

higher yields.

For instance, in case the expected return on the portfolio is 12%, which comprises of assets

A with 15% return and B with 12%, C with 7% and lastly D at 9% return. In such case, the expected
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return on the portfolio is less the return on A and higher than yields of both D and C. However, it

is neither greater nor lesser than every portfolio asset (Firer et al., 2012).

Q11. Calculating Portfolio Betas [LO4]:

You own a stock portfolio invested 35 percent in Stock Q, 25 percent in Stock R, 30 percent

in Stock S, and 10 percent in Stock T. The betas for these four stocks are .84, 1.17, 1.11,

and 1.36, respectively. What is the portfolio beta?

Given that:

 Stock portfolio invested 35% in stock Q

 Invested 25% in stock R

 Invested 30% in stock S

 Invested 10% in stock T

On the other hand, the beta stocks are as follows 0.84, 1.17, 1.11, and 1.36 respectively.

The beta portfolio in this case refers to the sum of every asset weight multiplied by the beta

of each asset. Therefore, the beta portfolio is calculated as follows;

βp = (0.35x0.84) + (0.25x1.17) + (0.30x1.11) + (0.10x1.36) = 1.06 Ans.

Q13. Using CAPM [LO4]:

A stock has a beta of 1.05, the expected return on the market is 10 percent, and the risk-

free rate is 3.8 percent. What must the expected return on this stock be?

Given that:

 A stock has a beta of 1.05

 Expected return on market is 10%

 Risk-free rate is 3.8%

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CAPM shows the link between an asset risk and its anticipated return. CAPM is calculated as

follows;

E (Ri) = Rf + [E (RM) – Rf] x βi

E (Ri) = 0.038 + (0.10 – 0.038) (1.05) = 0.1031 or 10.31% Ans.

Lesson 12:

Task Number 3 (Mini-Case): A Job at S&S Air (pg. 410-411)

Q1. What advantages do the mutual funds offer compared to the company stock?

One of the key advantage of mutual fund is diversification. In that mutual funds, have

several portfolio assets. Thus, diversification is likely to reduce the investment risk by dispersing

the risks to various assets. Therefore, a mutual fund, one can diversify your holdings across the

companies and assets as well (Ross, 2007).

Q2. Assume that you invest 5 percent of your salary and receive the full 5 percent match

from S&S Air. What EAR do you earn from the match? What conclusions do you draw

about matching plans?

Both the EAR and APR are infinite. In this case EAR = 100% if the possible market return

and inflation are excluded. But the expected return of 401(k) investment is based on the actual

return of the plan. Therefore, we can invest in several other types of 401(k) (Ross, 2007).

Q3. Assume you decide you should invest at least part of your money in large-capitalization

stocks of companies based in the United States. What are the advantages and disadvantages

of choosing the Bledsoe Large-Company Stock Fund compared to the Bledsoe S&P 500 Index

Fund?

The Bledsoe Large-Company Stock Fund (LCSF) is regarded to large capitalization

organizations implying that the fund is less diverse compared to Bledsoe S&P 500 (BSP).
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Therefore, the fund loses part of the benefit due to diversification. On the other hand, the principal

disadvantage is the aspect of poor performance in the market. Additionally, most of the mutual

funds are not performing in the market for quite a given period (Firer et al., 2012).
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Reference

Berk, J., DeMarzo, P., Harford, J., Ford, G., Mollica, V., & Finch, N. (2013). Fundamentals of

corporate finance. Pearson Higher Education AU.

Firer, C., Ross, S. A., Westerfield, R., & Jordan, B. D. (2012). Fundamentals of corporate

finance. McGraw-Hill Higher Education.

International Business Machines Corp (IBM.N), Retrieved March 4, 2012, from

http://www.reuters.com/finance/stocks/financialHighlights?symbol=IBM.N

Parrino, R., Kidwell, D. S., & Bates, T. (2011). Fundamentals of corporate finance. John Wiley

& Sons.

Ross, S., Westerfield, R., & Jordon, B. (2013). Fundamentals of corporate finance (10th Ed.).

New York: McGraw-Hill Irwin. Textbook ISBN: 0078034639, ISBN: 978-0078034633.

Ross, S. A. (2007). Corporate finance: core principles & applications. Irwin/McGraw-Hill.