# FIN-3403 Lecture Notes - Lecture 91: Capital Asset Pricing Model, Windstream Holdings, Capital Budgeting

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Exam 3 Study Guide

(not necessarily exhaustive)

Capital Budgeting Project Analysis and Evaluation:

1. What is the standalone principle? Why is it important to capital budgeting?

2. What are relevant, incremental cash flows and why are they used for capital budgeting analysis?

3. What is an opportunity cost? Be able to identify in examples.

4. What is a sunk cost? Be able to identify in examples.

5. Why are side effects of capital projects considered in capital budgeting analysis? Be able to

identify in examples.

6. Why is net working capital included in capital budgeting analysis? At what time(s) does this

effect occur across the project’s life?

7. Are financing costs included in capital budgeting analysis? If so, how?

8. How and why are taxes considered in capital budgeting analysis?

9. What is a proforma financial statement?

10. Explain the difference between depreciation as calculated on the income statement and

depreciation as calculated for taxes. What is the cash effect of each?

11. How can a decision to buy a new piece of equipment be made if the two alternatives have

different functional lives? Be able to calculate if provided an example.

12. Be able to calculate for any project year any of the cash items that should be considered in a

capital budgeting problem, given a detailed example.

13. In the context of capital budgeting, what is forecasting risk?

14. Describe scenario analysis.

15. What is sensitivity analysis?

16. What is breakeven analysis? How does it differ from sensitivity analysis?

17. Describe simulation analysis. What is its biggest downfall?

Capital Markets History:

1. Why do we commonly use percentage rather than dollar returns? Why do we calculate annual

returns?

2. Explain the relationship between risk and reward.

3. What information do financial markets provide us about returns?

4. Rank large stocks, small stocks, government bonds and treasury bills according to historical risk

and return. (You do not need to know historical numbers, but should know relative levels of

return and risk.)

5. What type of market security do we normally use to represent the risk-free rate?

6. What is a risk premium?

7. What statistic is commonly used as a measure of the total risk of an asset?

8. What is the difference between an arithmetic and geometric average? When should each be used?

9. What does the Efficient Capital Markets hypothesis say about markets? Define strong form,

semistrong form and weak form efficient markets.

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Risk, Return and the Security Market Line:

1. What is an expected return? An unexpected return?

2. What is the principle of diversification?

3. Describe the concept of systematic and unsystematic risk. What is used as a measure of

systematic risk?

4. What risk can an investor expect to be compensated for?

5. What does the security market line represent?

6. Explain the Capital Asset Pricing Model.

7. What discount rate should be used to analyze a project under consideration for investment?

Calculation Summary:

1. Appropriate cash flows for a project: capital investment, annual after-tax operating, depreciation

tax shield, salvage value (including the tax effect).

2. Effective annual cost for comparison of equipment with unequal lives.

3. Geometric and arithmetic average returns.

4. Variance and standard deviation of historic returns.

5. Expected return, variance and standard deviation for an asset and portfolio. Portfolio weights for

assets in a portfolio. Beta coefficient for a portfolio given the component security information.

Required return for an asset given inputs to CAPM.

Extra Problems:

1. Which one of the following is an example of a sunk cost?

A. $1,500 of lost sales because an item was out of stock

B. $1,200 paid to repair a machine last year

C. $20,000 project that must be forfeited if another project is accepted

D. $4,500 reduction in current shoe sales if a store commences selling sandals

E. $1,800 increase in comic book sales if a store commences selling puzzles

2. Which one of the following best illustrates erosion as it relates to a hot dog stand located on the

beach?

A. providing both ketchup and mustard for its customers’ use

B. repairing the roof of the hot dog stand because of water damage

C. selling fewer hot dogs because hamburgers were added to the menu

D. offering French fries but not onion rings

E. losing sales due to bad weather

3. Phone Home, Inc. is considering a new 6-year expansion project that requires an initial fixed

asset investment of $5.994 million. The fixed assets fall into a 5-year MACRS category, and it is

expected that the assets will have no salvage value at the end of the project. The project is

estimated to generate $5,328,000 in annual sales, with costs of $2,131,200. The tax rate is 31

percent. What is the total cash flow for this project in year 1?

4. Consider an asset that costs $176,000 and is in a seven-year MACRS class. The asset is to be

used in a 7-year project; at the end of the project, the asset can be sold for $22,000. The relevant

tax rate is 30 percent. What is the after-tax cash flow from the sale of this asset?

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