# Understanding Financial Concepts and Investment Strategies

## What is Unsystematic Risk and How Can It Be Eliminated?

Unsystematic risk, also known as stock-specific risk, affects a single stock price but not the entire market. It can be eliminated through *diversification* by purchasing various securities or equities. For example, Apple reporting a bad quarter would be considered unsystematic risk.

### How Does Beta Differ From Standard Deviation as a Measure of Risk?

#### Beta (Systematic Risk)

Measures the risk of the market as a whole and total volatility.

#### Standard Deviation (Total Risk)

Measures the risk of an individual stock and its total volatility.

## What Does NPV Represent?

NPV (Net Present Value) is the difference between the present value of cash inflows and the present value of cash outflows.

## Explain Systematic Risk and How to Measure It

Systematic risk is the uncertainty inherent to the entire market. It consists of the day-to-day fluctuations in a stock’s price and represents total market risk. It is measured through *Beta*. The beta coefficient tells us the relative sensitivity of a stock to market movements.

## If Boeing’s Reward-to-Risk Ratio Exceeds the Market Risk Premium, What are the Implications?

The stock is expected to return a greater amount than it should (high return). The stock is underpriced (above the Security Market Line), indicating a high reward and potential profit opportunity. We expect the stock price to go up as a result.

## How Does APR Differ From EAR?

APR (Annual Percentage Rate) could be compounded periodically, while EAR (Effective Annual Rate) is compounded on a yearly basis.

## Explain the Concept of Financial Risk

Financial risk encompasses various types of risk associated with financing, including financial transactions that involve company loans in risk of default.

## If Interest Expense is a Cash Disbursement, Why is it Excluded from Operating Cash Flow?

While interest expense is a cash disbursement, it’s already factored into Net Income. It affects Operating Cash Flow (OCF) but isn’t a separate line item.

## Since Depreciation is a Non-Cash Expense, Does it Have an Affect on NPV and IRR? Explain.

Depreciation increases NPV due to the depreciation tax shield, which protects a portion of income from taxation. This increases cash flow for the year, leading to a higher NPV. A higher NPV typically corresponds to a lower IRR (Internal Rate of Return).

## What Determines the Value of an Economic Asset?

The present value of all future cash flows determines the value of an economic asset.

## Why Would Investors Demand a Return on an Investment That Has No Risk?

Investors demand a return even on risk-free investments due to *opportunity cost* – the potential return they could earn from alternative investments.

## Why Does the Present Value of a Future Cash Flow Decline as the Required Return Increases?

As the required return increases, the variability of returns also increases, making the likelihood of receiving that future return lower. This reduces the present value of the future cash flow.

## Explain Why Historical Information Should Be Useless in Predicting the Stock Market.

According to the Efficient Market Hypothesis (EMH), all publicly available information is already reflected in stock prices. Changes in prices are due to unpredictable surprises. Historical information should have already been exploited, rendering it useless for predicting future market movements.

## If Apple Announced Record Earnings and Its Stock Price Didn’t Go Up in Response, How Could That Be Explained and What Does it Say About the EMH?

This suggests that the market had already anticipated the record earnings and factored them into the stock price. The announcement wasn’t a surprise. The EMH argues that all valuable information is already incorporated into current prices.

## If Your Financial Advisor Claims to Have Beaten the Market for Ten Years Straight, What Do You Think?

It’s highly unlikely that anyone can consistently outperform the market based solely on skill. In an efficient market, opportunities for extraordinary earnings are rare, and price changes are often random and unpredictable.

## If Wal-Mart Was Considering the Acquisition of a Generic Drug Manufacturer, Should it Use its Corporate WACC to Value the Deal? Explain.

Yes, since the acquisition aligns with Walmart’s existing pharmacy business, the risks involved are within the scope of their operations. Therefore, using their corporate Weighted Average Cost of Capital (WACC) is appropriate.

## Is it Ever Appropriate for a Company to Accept a Capital Investment That Provides an NPV of Zero? Explain.

Yes, an NPV of zero indicates that the project is expected to generate a return that meets the required rate of return, satisfying investors’ expectations.

## The Book Says That “All Stocks in an Efficient Market are Zero NPV Investments.” Why Should This Be True?

In an efficient market, stock prices should accurately reflect all available information. This implies that all stocks should lie on the Security Market Line (SML), indicating a zero NPV.

## Do the NPV and IRR Decision Rules Ever Conflict? Discuss.

Yes, conflicts can arise with non-conventional projects (cash flow signs change more than once) and mutually exclusive projects (choosing between highest return and most value). In these situations, IRR can be unreliable, and NPV should be the primary decision-making tool.

## What’s Wrong with Payback as a Decision Criteria?

Payback period only considers the time it takes to recover the initial investment and ignores cash flows beyond that point, potentially leading to suboptimal decisions.

## If Two Companies Valued the Same Capital Project, Should the Resulting NPVs Be the Same? Discuss.

Not necessarily. Different companies may have different discount rates (WACC), leading to variations in NPV calculations.

## Explain What is Meant by Market Efficiency.

Market efficiency refers to how effectively and quickly new information is disseminated and incorporated into asset prices by investors.

## Does the EMH Imply Pricing Perfection? Do Stock Market Bubbles Disprove the EMH?

The EMH doesn’t imply pricing perfection. It suggests that prices reflect all *available* information, not necessarily all information that may exist. Stock market bubbles are often attributed to behavioral factors and market sentiment, which can deviate from rational pricing predicted by the EMH.

## What is Beta? How is it Related to Expected Return?

Beta measures a stock’s systematic risk (market risk) and is the only risk that cannot be diversified away. It’s directly related to expected return through the Capital Asset Pricing Model (CAPM).

## A Company Can’t Spend its Net Income. Explain Why.

Net income is based on accrual accounting, which includes non-cash expenses like depreciation. Therefore, it doesn’t represent actual cash available to the company.

## Is it Always Correct to Reject a Capital Project That Has an IRR Less Than its WACC?

No, rejecting a project solely based on IRR being less than WACC can be incorrect for non-conventional cash flow projects. NPV should be the primary decision criteria in such cases.

## If Google Doesn’t Pay a Dividend, Why is its Stock Worth Over $650 Per Share?

Google’s stock value is driven by expectations of future growth and profitability. By reinvesting earnings into positive NPV projects, the company aims to increase its overall value.

## Why Invest in a Portfolio of Stocks Instead of Just One?

Investing in a portfolio allows for diversification, reducing overall risk compared to holding a single stock.

## Explain What’s Meant by the Term “Time Value of Money.”

The time value of money concept states that money available today is worth more than the same amount in the future due to its potential earning capacity.

## Explain Why WACC Would Affect a Firm’s Stock Price.

A lower WACC implies higher NPVs for potential projects, leading to increased investment opportunities and potentially higher future cash flows, which can positively impact the stock price.

## What Effect Does Borrowing Have on a Firm’s WACC?

Borrowing typically increases a firm’s WACC due to the added cost of debt.

## What Does the Security Market Line Represent?

The Security Market Line (SML) graphically represents the Capital Asset Pricing Model (CAPM), showing the expected return of a security as a function of its systematic risk (beta).

## Discuss What Diversification Does and How it Works.

Diversification involves spreading investments across different assets to reduce the impact of any single asset’s performance on the overall portfolio. This lowers the portfolio’s beta and standard deviation, reducing overall risk.

## If NPV and IRR Give You Conflicting Decisions, What Do You Think?

In cases of conflict, NPV should be prioritized as the more reliable decision-making tool.

## You are Reviewing a Capital Investment Proposal with Multiple Cash Outflows. What are the Implications?

Multiple cash outflows will impact the calculation of free cash flows, ultimately affecting the NPV of the project.

## When Discussing a Capital Investment, What is Meant by a “Conventional Project”?

A conventional project has an initial negative cash flow (outflow) followed by one or more positive cash flows (inflows).

## Explain Why a Capital Investment’s NPV Profile May Not Be Downward Sloping to the Right.

An upward-sloping NPV profile can occur if there’s a positive IRR lower than the company’s WACC, resulting in a negative NPV at higher discount rates.

## If You Invested $1000 and Three Years Later You Got $1000 Back, Could the Annual Arithmetic Average Return Be Anything Other Than Zero? What About the Mean Geometric Return? Why?

The arithmetic average return would be zero. However, the geometric mean return would be negative, reflecting the lack of growth in the investment over time.

## Is it Appropriate for a Company to Match Capital Investment Projects with the Specific Sources of Capital Used to Finance Them?

Matching capital investment projects with specific funding sources is generally not recommended. Investment decisions should be based on the project’s merits and potential returns, independent of the financing method.

## If J.C. Penney Acquired Neiman Marcus and Used Their Own WACC to Value the Deal, What’s the Consequence?

Using J.C. Penney’s WACC to value Neiman Marcus would be inappropriate as they operate in different market segments with different risk profiles. This could lead to an inaccurate valuation and potentially a poor investment decision.

## According to the EMH, it’s Improbable That Investors Should Be Able to Consistently “Beat the Market.” Why?

The EMH suggests that all publicly available information is already reflected in stock prices, making it difficult to consistently achieve above-market returns through stock selection.

## Why Do Bond Prices Go Down if Interest Rates Go Up?

Bond prices and interest rates have an inverse relationship. When interest rates rise, newly issued bonds offer higher yields, making existing bonds with lower coupon rates less attractive. Consequently, the prices of existing bonds must decrease to align with the prevailing market yields.