Deck 1: The Fundamental Principles of Finance

Question 1

Describe in your own words the nature of the relationship between risk and return, how changes in one affect changes in the other and what human trait is responsible for that relationship.

Answer 1

The relationship between risk and return is positive or direct; as one increases, so does the other. If risk is perceived to have increased, investors will require a higher return to compensate for that increase in risk. This is due to the human trait of risk aversion.

Question 2

Describe in your own words the method for determining the value of an asset.

Answer 2

The value of an asset is calculated as the sum of the present values of the cash flows the asset is expected to produce over its economic life.

Question 3

Describe in your own words the nature of the relationship between the price of an asset and the percentage return it earns, how changes in one affect the other and the basic principle that determines that relationship.

Answer 3

The relationship between price and return is inverse or negative; as one increases, the other decreases. If the price of an asset increases, holding the cash flows constant, the asset's return will decrease. This reflects the relationship between the terms of a fraction.

Question 4

Describe in your own words the relationship between the value of an asset and the discount rate used to calculate its value.

Question 5

Describe in your own words the relationship between the discount rate used to value an asset and the risk of the asset, as well as the relationship between the risk of an asset and the value of the asset.

Question 6

Describe in your own words the impact of the timing of an asset's cash flows on the value of the asset.

Question 7

What purpose do the principles given in this chapter serve?

Question 8

What purpose do the precepts given in this chapter serve?

Question 9

Suppose you purchased a corporate bond for its par value of $1,000 when it was issued. The bond pays a 10% coupon ($100) annually. After two years, you sell the bond to another investor for $950. How will the change in the bond's market value affect the new owner's yield on the bond?

Question 10

The production manager at a manufacturing plant wants to invest in a new technology for producing the firm's product. This new technology will replace one of the employees currently used to produce the item. How can you determine the value of this new technology?

Question 11

You win a contest for which you get to pick your prize. Your options are:
a. $1,000 in the first month, $2,000 in the second month, $3,000 in the third month and so on for one year;
b. $5,000 per month for one year;
c. $12,000 in the first month, $11,000 in the second month, $10,000 in the third month and so on for one year.
Which prize should you pick?

Question 12

The marketing manager at your firm shows you an analysis he performed of a new production process that he believes will reduce production costs and show a slight profit after taking into account the cost of operating the new technology. While the marketing manager believes the project is of average risk, you believe the new technology is riskier than the projects the firm normally invests in. How will this affect your evaluation of the new technology?