FINANCE FINAL
Which of the following would likely encourage a firm to increase the debt in its capital structure? a. The corporate tax rate increases.
An increase in the corporate tax rate would encourage a firm to increase the amount of debt in its capital structure because a higher tax rate increases the interest deductibility feature of debt.
Which of the following would likely encourage a firm to increase the debt in its capital structure? b. The personal tax rate increases
An increase in the personal tax rate would cause investors to shift from bonds to stocks due to the attractiveness of the deferral of capital gains taxes. This would raise the cost of debt relative to equity; thus, firms would be encouraged to use less debt in their capital structures.
Assume that the risk-free rate increases, but the market risk premium remains constant. What impact would this have on the cost of debt? What impact would it have on the cost of equity?
An increase in the risk-free rate will increase the cost of debt. Remember from Chapter 6, r = rRF+ DRP + LP + MRP. Thus, if rRF increases so does r (the cost of debt). Similarly, if the risk-free rate increases so does the cost of equity. From the CAPM equation, rs = rRF + (rM - rRF)b. Consequently, if rRF increases rs will increase too.
Why do public utilities generally use different capital structures than biotechnology companies?
Biotechnology companies use relatively little debt because their industries tend to be cyclical, oriented toward research, or subject to huge product liability suits. Utility companies, on the other hand, use debt relatively heavily because their fixed assets make good security for mortgage bonds and also because their relatively stable sales make it safe to carry more-than- average levels of debt.
Explain why sunk costs should not be included in a. capital budgeting analysis but opportunity costs and externalities should be included. Give an example of each
Capital budgeting analysis should only include those cash flows that will be affected by the decision. Sunk costs are unrecoverable and cannot be changed, so they have no bearing on the capital budgeting decision. Opportunity costs represent the cash flows the firm gives up by investing in this project rather than its next best alternative, and externalities are the cash flows (both positive and negative) to other projects that result from the firm undertaking this project. These cash flows occur only because the firm took on the capital budgeting project; therefore, they must be included in the analysis.
Most firms generate cash inflows every day, not just once at the end of the year. In capital budgeting, should we recognize this fact by estimating daily project cash flows and then using them in the analysis? If we do not, are our results biased? If so, would the NPV be biased up or down? Explain.
Daily cash flows would be theoretically best, but they would be costly to estimate and probably no more accurate than annual estimates because we simply cannot forecast accurately at a daily level. Therefore, in most cases we simply assume that all cash flows occur at the end of the year. However, for some projects it might be useful to assume that cash flows occur at mid- year, or even quarterly or monthly. There is no clear upward or downward bias on NPV since both revenues and costs are being recognized at the end of the year. Unless revenues and costs are distributed radically different throughout the year, there should be no bias.
Why is EBIT generally considered independent of financial leverage? Why might EBIT actually be affected by financial leverage at high debt levels?
EBIT depends on sales and operating costs that generally are not affected by the firm's use of financial leverage, because interest is deducted from EBIT. At high debt levels, however, firms lose business, employees worry, and operations are not continuous because of financing difficulties. Thus, financial leverage can influence sales and cost, hence EBIT, if excessive leverage causes investors, customers, and employees to be concerned about the firm's future.
How should the capital structure weights used to calculate the WACC be determined?
Each firm has an optimal capital structure, defined as that mix of debt, preferred, and common equity that causes its stock price to be maximized. A value-maximizing firm will determine its optimal capital structure, use it as a target, and then raise new capital in a manner designed to keep the actual capital structure on target over time. The target proportions of debt, preferred stock, and common equity, along with the costs of those components, are used to calculate the firm's weighted average cost of capital, WACC. The weights could be based either on the accounting values shown on the firm's balance sheet (book values) or on the market values of the different securities. Theoretically, the weights should be based on market values, but if a firm's book-value weights are reasonably close to its market-value weights, book-value weights can be used as a proxy for market-value weights. Consequently, target market-value weights should be used in the WACC equation.
Is the debt level maximizes a firms expected EPS the same as the debt level that maximizes its stock price? Explain.
Expected EPS is generally measured as EPS for the coming years, and we typically do not reflect in this calculation any bankruptcy-related costs. Also, EPS does not reflect (in a major way) the increase in risk and rs that accompanies an increase in the debt-to-capital ratio, whereas P0 does reflect these factors. Thus, the stock price will be maximized at a debt level that is lower than the EPS-maximizing debt level.
Which of the following would likely encourage a firm to increase the debt in its capital structure? c. Due to market changes, the firms assets become less liquid
Firms whose assets are illiquid and would have to be sold at "fire sale" prices should limit their use of debt financing. Consequently, this would discourage the firm from increasing the amount of debt in its capital structure.
Which of the following would likely encourage a firm to increase the debt in its capital structure? e. The firm's sales and earnings become more volatile
Firms whose earnings are more volatile and thus have higher business risk, all else equal, face a greater chance of bankruptcy and, therefore, should use less debt than more stable firms.
Which of the following would likely encourage a firm to increase the debt in its capital structure? d. Changes in the bankruptcy code make bankruptcy less costly to the firm
If changes to the bankruptcy code made bankruptcy less costly, then firms would tend to increase the amount of debt in their capital structures.
Discuss the following statement: All else equal, firms with relatively stable sales are able to carry relatively high debt ratios. Is the statement true or false? Why?
If sales tend to fluctuate widely, then cash flows and the ability to service fixed charges will also vary. Consequently, there is a relatively large risk that the firm will be unable to meet its fixed charges. As a result, firms in unstable industries tend to use less debt than those whose sales are subject to only moderate fluctuations, or relatively stable sales.
Suppose a firm estimates its WACC to be 10%. Should the WACC be used to evaluate all of its potential projects, even if they vary in risk? If not, what might be "reasonable" costs of capital for average-, high-, and low-risk projects?
In general, failing to adjust for differences in risk would lead the firm to accept too many risky projects and reject too many safe ones. Over time, the firm would become more risky, its WACC would increase, and shareholder value would suffer. The cost of capital for average-risk projects would be the firm's cost of capital, 10%. A somewhat higher cost would be used for more risky projects, and a lower cost would be used for less risky ones. For example, we might use 12% for more risky projects and 9% for less risky projects. These choices are arbitrary.
What are some differences in the analysis for a replacement project versus that for a new expansion project?
In replacement projects, the benefits are generally cost savings, although the new machinery may also permit additional output. The data for replacement analysis are generally easier to obtain than for new products, but the analysis itself is somewhat more complicated because almost all of the cash flows are incremental, found by subtracting the new cost numbers from the old numbers. Similarly, differences in depreciation and any other factor that affects cash flows must also be determined.
What is a mutually exclusive project? How should managers rank mutually exclusive projects?
Mutually exclusive projects are a set of projects in which only one of the projects can be accepted. For example, the installation of a conveyor-belt system in a warehouse and the purchase of a fleet of forklifts for the same warehouse would be mutually exclusive projects— accepting one implies rejection of the other. When choosing between mutually exclusive projects, managers should rank the projects based on the NPV decision rule. The mutually exclusive project with the highest positive NPV should be chosen. The NPV decision rule properly ranks the projects because it assumes the appropriate reinvestment rate is the cost of capital.
Operating cash flows rather than accounting income are listed in Table 12.1. Why do we focus on cash flows as opposed to net income in capital budgeting?
Only cash can be spent or reinvested, and since accounting profits do not represent cash, they are of less fundamental importance than cash flows for investment analysis. Recall that in the stock valuation chapter we focused on dividends, which represent cash flows, rather than on earnings per share.
Changes in sales cause changes in profits. Would the profit change associated with sales changes be larger or smaller if a firm increased its operating leverage? Explain your answer.
Operating leverage is the extent to which fixed costs are used in a firm's operations. If operating leverage is increased (fixed costs are high), then even a small decline in sales can lead to a large decline in profits and in its ROIC.
Why might it be rational for a small firm that does not have access to the capital markets to use the payback method rather than the NPV method?
Payback provides information on how long funds will be tied up in a project. The shorter the payback, other things held constant, the greater the project's liquidity. This factor is often important for smaller firms that don't have ready access to the capital markets. Also, cash flows expected in the distant future are generally riskier than near-term cash flows, so the payback can be used as a risk indicator.
Project X is very risky and has an NPV of 3 million. Project Y is very safe and has an NPV of 2.5 million. They are mutually exclusive, and project risk has been properly considered in the NPV analyses. Which project should be chosen? Explain.
Project X should be chosen over Project Y. Because the two projects are mutually exclusive, only one project can be accepted. The decision rule that should be used is NPV. Since Project X has the higher NPV, it should be chosen. The cost of capital used in the NPV analysis appropriately includes risk.
How are project classifications used in the capital budgeting process?
Project classification schemes can be used to indicate how much analysis is required to evaluate a given project, the level of the executive who must approve the project, and the cost of capital that should be used to calculate the project's NPV. Thus, classification schemes can increase the efficiency of the capital budgeting process.
Why is the NPV of a relatively long-term project (one for which a high percentage of its cash flows occurs in the distant future) more sensitive to changes in the WACC than that of a short-term project?
The NPV is obtained by discounting future cash flows, and the discounting process actually compounds the interest rate over time. Thus, an increase in the discount rate has a much greater impact on a cash flow in Year 5 than on a cash flow in Year 1.
What reinvestment rate assumptions are built into NPV, IRR, and MIRR methods?
The NPV method assumes reinvestment at the cost of capital, while the IRR method assumes reinvestment at the IRR. MIRR is a modified version of IRR that assumes reinvestment at the cost of capital. The NPV method assumes that the rate of return that the firm can invest differential cash flows it would receive if it chose a smaller project is the cost of capital. With NPV we are calculating present values and the interest rate or discount rate is the cost of capital. When we find the IRR we are discounting at the rate that causes NPV to equal zero, which means that the IRR method assumes that cash flows can be reinvested at the IRR (the project's rate of return). With MIRR, since positive cash flows are compounded at the cost of capital and negative cash flows are discounted at the cost of capital, the MIRR assumes that the cash flows are reinvested at the cost of capital.
Would each of the following increase, decrease, or have an indeterminant effect on a firm's break-even point (unit sales)? c. A new firm decides to use MACRS depreciation for both book and tax purposes rather than the straight-line depreciation method
The break-even point will be increased because fixed costs have increased.
Would each of the following increase, decrease, or have an indeterminant effect on a firm's break-even point (unit sales)? d. Variable labor costs decline; other things are held constant.
The break-even point will be lowered.
Would each of the following increase, decrease, or have an indeterminate effect on a firm's break-even point (unit sales)? a. The sales price increases with no change in unit costs
The break-even point will be lowered.
The WACC is a weighted average of the costs of debt, preferred stock, and common equity. Would the WACC be different if the equity for the coming year came solely in the form of retained earnings versus some equity from the sale of new common stock? Would the calculated WACC depend in any way on the site of the capital budget? How might dividend policy affect the WACC?
The cost of retained earnings is lower than the cost of new common equity; therefore, if new common stock had to be issued then the firm's WACC would increase. The calculated WACC does depend on the size of the capital budget. A firm calculates its retained earnings breakpoint (and any other capital breakpoints for additional debt and preferred). This R/E breakpoint represents the amount of capital raised beyond which new common stock must be issued. Thus, a capital budget smaller than this breakpoint would use the lower-cost retained earnings and thus a lower WACC. A capital budget greater than this breakpoint would use the higher cost of new equity and thus a higher WACC. Dividend policy has a significant impact on the WACC. The R/E breakpoint is calculated as the addition to retained earnings divided by the equity fraction. The higher the firm's dividend payout, the smaller the addition to retained earnings and the lower the R/E breakpoint. (That is, the firm's WACC will increase at a smaller capital budget.)
Why are interest charges not deducted when a project's cash flows for use in a capital budgeting analysis are calculated?
The costs associated with financing are reflected in the weighted average cost of capital. To include interest expense in the capital budgeting cash flow analysis would "double count" the cost of debt financing.
Would each of the following increase, decrease, or have an indeterminant effect on a firm's break-even point (unit sales)? b. An increase in fixed costs is accompanied by a decrease in variable costs.
The effect on the break-even point is indeterminant. An increase in fixed costs will increase the break-even point. However, a lowering of the variable cost lowers the break-even point. So it's unclear which effect will have the greater impact.
A firm is about to double its assets to serve its rapidly growing market. It must choose between a highly automated production process and a less automated one. It also must choose a capital structure for financing the expansion. Should the asset investment and financing decisions be jointly determined, or should each decision be made separately? How would these decisions affect one another? How could the leverage concept be used to help management analyze the situation?
The firm may want to assess the asset investment and financing decisions jointly. For instance, the highly automated process would require fancy, new equipment (capital intensive) so fixed costs would be high. A less automated production process, on the other hand, would be labor intensive, with high variable costs. If sales fell, the process that demands more fixed costs might be detrimental to the firm if it has much debt financing. The less automated process, however, would allow the firm to lay off workers and reduce variable costs if sales dropped; thus, debt financing would be more attractive. Operating leverage and financial leverage are interrelated. The highly automated process would increase the firm's operating leverage; thus, its optimal capital structure would call for less debt. On the other hand, the less automated process would call for less operating leverage; thus, the firm's optimal capital structure would call for more debt.
If two mutually exclusive projects were being compared, would a high cost of capital favor the longer-term or the shorter-term project? Why? If the cost of capital declined, would that lead firms to invest more in longer-term projects or shorter-term projects? Would a decline (or an increase) in the WACC cause changes in the IRR ranking of mutually exclusive projects? Explain.
The first question is related to Question 11-3 and the same rationale applies. A high cost of capital favors a shorter-term project. If the cost of capital declined, it would lead firms to invest more in long-term projects. With regard to the last question, the answer is no; the IRR rankings are constant and independent of the firm's cost of capital.
What are three potential flaws with the regular payback method? Does the discounted payback method correct all three flaws? Explain
The regular payback method has three main flaws: (1) Dollars received in different years are all given the same weight. (2) Cash flows beyond the payback year are given no consideration whatever, regardless of how large they might be. (3) Unlike the NPV, which tells us by how much the project should increase shareholder wealth, and the IRR, which tells us how much a project yields over the cost of capital, the payback merely tells us when we recover our investment. The discounted payback corrects the first flaw, but the other two flaws still remain.
Discuss the following statements: If a firm has only independent projects, a constant WACC, and projects with normal cash flows, the NPV and IRR methods will always lead to identical capital budgeting decisions. What does this imply about the choice between iRR and NPV? If each of the assumptions were changed (one by one), how would your answer change?
The statement is true. The NPV and IRR methods result in conflicts only if mutually exclusive projects are being considered because the NPV is positive if and only if the IRR is greater than the cost of capital. If the assumptions were changed so that the firm had mutually exclusive projects, then the IRR and NPV methods could lead to different conclusions. A change in the cost of capital or in the cash flow streams would not lead to conflicts if the projects were independent. Therefore, the IRR method can be used in lieu of the NPV if the projects being considered are independent.
If a firm goes from zero debt to successively higher levels of debt, why would you expect its stock price to rise first, then hit a peak, and then begin to decline?
The tax benefits from debt increase linearly, which causes a continuous increase in the firm's value and stock price. However, bankruptcy-related costs begin to be felt after some amount of debt has been employed, and these costs offset the benefits of debt. See Figure 13.8 in the textbook.
Explain why net operating working capital is included in a capital budgeting analysis and how it is recovered at the end of a project's life.
When a firm takes on a new capital budgeting project, it typically must increase its investment in receivables and inventories, over and above the increase in payables and accruals, thus increasing its net operating working capital (NOWC). Since this increase must be financed, it is included as an outflow in Year 0 of the analysis. At the end of the project's life, inventories are depleted and receivables are collected. Thus, there is a decrease (or reduction) in NOWC, which represents an inflow in the final year of the project's life.
When do you accept a project?
When the rate of return is greater than the WACC
When the Bell System was broken up, the old AT&T was split into a new AT&T and seven regional telephone companies. The specific reason for forcing the breakup was to increase the degree of competition in the telephone industry. AT&T had a monopoly on local service, long distance, and the manufacture of all equipment used by telephone companies; and the breakup was expected to open most of those markets to competition. In the court order that set the terms of the breakup, the capital structures of the surviving companies were specified and much attention was given to the increased competition telephone companies could expect in the future. Do you think the optimal capital structure after the breakup was the same as the pre-breakup optimal capital structure? Explain your position.
With increased competition after the breakup ofAT&T, the new AT&T and the seven Bell operating companies' business risk increased. With this component of total company risk increasing, the new companies probably decided to reduce their financial risk, and use less debt, to compensate. With increased competition the chance of bankruptcy increases and lowering debt usage makes this less of a possibility. If we consider the tax issue alone, interest on debt is tax deductible; thus, the higher the firm's tax rate the more beneficial the deductibility of interest is. However, competition and business risk have tended to outweigh the tax aspect as we can see from the actual debt ratios of the Bell companies.
A firm has a 100 million capital budget. It is considering two projects, each costing $100 million. Project A has an IRR 20% and an NPV of $9 millions; it will be terminated after 1 year at a profit of $20 million, resulting in an immediate increase in EPS. Project B, which cannot be postponed, has an IRR of 30% and an NPV of $50 million. However, the firm's short run EPS will be reduced if it accepts Project B because no revenues will be generated for several years. A. Should the short-run effects on EPS influence the choice between the two projects? B. How might situations like this influence a firm's decision to use payback?
a. In general, the answer is no. The objective of management should be to maximize value, and as we point out in subsequent chapters, stock values are determined by both earnings and growth. The NPV calculation automatically takes this into account, and if the NPV of a long-term project exceeds that of a short-term project, the higher future growth from the long-term project must be more than enough to compensate for the lower earnings in early years. b. If the same $100 million had been spent on a short-term project—one with a faster payback—reported profits would have been higher for a period of years. This is, of course, another reason why firms sometimes use the payback method.
How would the film merging with another firm whose earnings are countercyclical both to those of the first firm and to the stock market affect the firms cost of debt, rd (1-T), the firms cost of equity, rs, and the WACC? raise, lower, or no affect, all things constant
decrease cost of debt, decrease cost of equity, decrease WACC
How would a firm being an electric utility with a large investment in nuclear plants with several states considering a ban on nuclear generation affect the firms cost of debt, rd (1-T), the firms cost of equity, rs, and the WACC? raise, lower, or no affect, all things constant
increase cost of debt, increase cost of equity, increase WACC
How would investors becoming more risk averse affect the firms cost of debt, rd (1-T), the firms cost of equity, rs, and the WACC? raise, lower, or no affect, all things constant
increase cost of debt, increase cost of equity, increase WACC
How would the Federal Reserve tightening credit affect the firms cost of debt, rd (1-T), the firms cost of equity, rs, and the WACC? raise, lower, or no affect, all things constant
increase cost of debt, increase cost of equity, increase WACC
How would the firm expanding into a risky new area affect the firms cost of debt, rd (1-T), the firms cost of equity, rs, and the WACC? raise, lower, or no affect, all things constant
increase cost of debt, increase cost of equity, increase WACC
How would lowering the corporate tax rate affect the firms cost of debt, rd (1-T), the firms cost of equity, rs, and the WACC? raise, lower, or an indeterminate affect, all things constant
increase cost of debt, indeterminate affect on cost equity and increase WACC
How would the firm using more debt (increasing debt ratio) affect the firms cost of debt, rd (1-T), the firms cost of equity, rs, and the WACC? raise, lower, or no affect, all things constant
increase the cost of debt, increase the cost of equity, indeterminate affect on WACC
How would increasing the dividend payout ratio affect the firms cost of debt, rd (1-T), the firms cost of equity, rs, and the WACC? raise, lower, or no affect, all things constant
indeterminate affect on cost of debt, equity and WACC
How would the stock market falling drastically and the firms stock price falls along with the rest affect the firms cost of debt, rd (1-T), the firms cost of equity, rs, and the WACC? raise, lower, or no affect, all things constant
indeterminate affect on cost of debt, increase cost of equity, increase WACC
How would the firm doubling the amount of capital it raises during the year affect the firms cost of debt, rd (1-T), the firms cost of equity, rs, and the WACC? raise, lower, or no affect, all things constant
indeterminate or increase debt, indeterminate or increase equity, indeterminate or increase WACC