Corporate Finance 1 Final
In practice, there is a great deal of estimation error involved in estimating the discount rate.
True
In the Average Accounting Return Rule, Ranking Criteria and Minimum Acceptance Criteria is set by management.
True
Independent projects must exceed a minimum acceptance criteria.
True
Inflation is an important fact of economic life and must be considered in capital budgeting
True
Market research, market study, feasibility study and original purchase values are typical examples of sunk costs.
True
Market risk is non-diversifiable, and unique risk is diversifiable.
True
Much of the work in evaluating a project lies in taking accounting numbers and generating cash flows.
True
Zero growth, constant growth and differential growth all determine the valuation of different types of stocks.
True
any decision that requires the use resources (financial or otherwise) is an investment
True
With incremental cash flows, historical costs before the acceptance of the project should be taken into account.
False
With independent projects, accepting or rejecting one project effects the decision of the other projects.
False
With sunk costs, you can recover the costs once it has been spent.
False
In a reasonably diversified portfolio, only unique risk matters
False only market risk matters
True or false, you can construct a portfolio with a beta of 0.75 by investing .75 of the investment budget in T-bills and the remainder in the market portfolio
False, that would give you a beta of .25 not .75
While the nominal rates has fluctuated with inflation, most of the time the real rate has exhibited far more variance than the nominal rate.
False, the real rate has way less variance than the nominal
True or false, stock with a beta of zero offer an expected rate of return of zero
False, they offer the risk free rate
True or false, the CAPM implies that investors require a higher rate of return to hold highly volatile securities
False, volatility is total risk and CAPM, Beta is just market risk
A proper analysis involves
- Obtaining information from various departments - Ensuring that everyone involved with the forecasts uses a consistent set of economic assumptions - Making sure that no biases are inherent in the forecasts
A common stock just paid a dividend of $2. The dividend is expected to grow at 8% for 3 years, then it will grow at 4% in perpetuity. What is the stock worth today? The discount rate is 12%
$28.89
A common stock just paid a dividend of $2. The dividend is expected to grow at 8% for 3 years, then it will grow at 4% in perpetuity. What is the stock worth in Year 3? The discount rate is 12%.
$32.75
Suppose you expect Longs Drug Stores to pay an annual dividend of $.56 per share in the coming year and to trade $45.50 per share at the end of the year. If investments with equivalent risk to Longs' stock have an expected return of 6.80%, what is the most you would pay today for Longs' stock?
$43.13
Apple plans to pay $2.30 per share in dividends in the coming year. If its equity cost of capital is 7% and dividends are expected to grow by 2% per year in the future, estimate the value of Apple's Stock
$46
McDonald's Corp plans to pay $3.08 in dividends in the coming year. If its equity cost of capital is 7%, and dividends are expected to grow by 2% per year in the future, estimate the price of McDonald's stock today.
$61.60
WACC Formula
(%equity x re) + (%debt x rd)(1- tax rate)
Variance of the Return Distribution
((return - expected return) squared x percent of total) + ((return - expected return) squared x percent of total)
Fisher relationship
(1 + Nominal Rate) = (1 + Real Rate) × (1 + Inflation Rate) For low rates of inflation, this is often approximated as Nominal Rate = Real Rate + Inflation Rate
The Average Accounting Return Rule (AAR)
(Average Net income/ Average Book Value of Investment), Minimum Acceptance Criteria set by management
Coupon Payment formula
(Coupon rate * face value)/ # of coupon payments per year
Expected (Mean) Return
(Return x percent of total) + (Return x percent of total)
The variance of the rate of return on the two risky assets portfolio is
(Wb x stdev b) squared + (Ws x stdev s) squared + 2(Wb x stdev b) x (Ws x stdev s) x Pbs
Perpetual Tax Shield
(rd x D x Tc)/ rd
Estimating NPV
- 1. Estimate future cash flows: how much? when? - 2. Estimate discount rate - 3. Estimate initial costs
Cash Flows—Not Accounting Earnings
- Accounting earnings consider depreciation expense. - You never write a check made out to "depreciation" - Much of the work in evaluating a project lies in taking accounting numbers and generating cash flows
The Payback Period Rule Advantages
- Easy to understand - Biased toward liquidity
Reasons to use market averages and indexes
- Gauge general market conditions - Compare your portfolio performance to large, diversified portfolio - Study market cycles, trends and behaviors to forecast future market behavior
The Payback Period Rule Disadvantages
- Ignores the time value of money - Ignores cash flows after the payback period - Biased against long-term projects - Requires an arbitrary acceptance criteria - A project accepted based on the payback criteria may not have a positive NPV
Disadvantages of The Average Accounting Return Rule (AAR)
- Ignores the time value of money - Uses an arbitrary benchmark cutoff rate - Based on book values, not cash flows and market values
Advantages of PI
- May be useful when available investment funds are limited - Easy to understand and communicate - Correct decision when evaluating independent projects
Dow Jones Industrial Average (DJIA)
- Most popular average, also called Dow30 - Comprised of 30 high quality, diversified stocks - Tracks overall market activity - Dow Jones provides seven other indexes for tracking specific industry sectors (such as DJ Transportation index, DJ Utilities index, DJ Small cap index etc)
A disadvantage of the Profitability Index (PI) Rule is:
It should not be used when there are no constraints
Estimating cash flows
1. Cash flows from investments (don't forget after tax salvage value) 2. Cash flows from NWC 3. Cash flows from Operations -- operating cash flow = EBIT - taxes + depreciation
How to value differential growth stock
1. Estimate future dividends in the foreseeable future. 2. Estimate the future stock price when the stock becomes a Constant Growth Stock . 3. Compute the total present value of the estimated future dividends and future stock price at the appropriate discount rate.
The pecking order theory of corporate financing states that:
1. Firms prefer internal finance, these funds are raised without sending any adverse signals that may lower the stock price 2. If external finance is required, firms issue the safest security first, ie, they start with debt, then possibly a hybrid of securities such as convertible bonds, then perhaps equity as a last resort.
What Capital Budgeting methods are used most by CEOs
1. IRR (76%) 2. NPV (75%) 3. Payback (57%)
Capital Investment Process
1. Identification -- Type of investment: Finding out opportunities and generating investment proposals 2. Evaluation -- Input: Estimating the project's relevant cash flows and appropriate discount rate (Finance) 3. Selection -- Decision rule: Choosing a decision-making rule (accept/reject decision) (Finance) 4. Implementation and follow-up (audit) -- Establishing an audit and a follow-up procedure (most complex)
Three Pitfalls of IRR Approach
1. Investing or Financing 2. Multiple Rates of Return 3. Scale effect
Common Measures of Risk and Return
1. Probability Distributions 2. Expected Return 3. Variance and Standard Deviation ' 4. Betas
What are the different investment decisions
1. Replacement needed to continue profitable operations 2. Replacement to reduce costs 3. Expansion of existing products or markets 4. Expansion into new products or markets 5. Contraction decisions 6. Safety and/or environmental projects 7. Mergers
increased leverage affects the costs of financial distress
1. The more the firm owes, the higher the chance of default and thus, the greater the expected value of the associated costs=> reduces current market value of the firm. 2. Creditors foresee the costs and realize that if default occurs, the bankruptcy costs will reduce the value of the firm. They demand compensation in advance in the form of a higher promised interest rate. 3. This in turn reduces the possible payoffs to shareholders and reduces the current market value of their shares
Good Attributes of the NPV Rule
1. Uses cash flows 2. Uses ALL cash flows of the project 3. Discounts ALL cash flows properly
3 Types of valuation of different types of stocks
1. Zero growth 2. Constant growth 3. Differential growth
Three types of dividends that could be paid
1. cash 2. stocks 3. "In-Kind"
What makes up CFI (investing cash flows)
1. initial investment 2. salvage value 3. opportunity cost
a proper analysis involves: A. Ensuring that everyone involved with the forecast uses a consistent set of economic assumptions B. Making sure that biases are inherent in the forecasts C. Obtaining information from one department
A. Ensuring that everyone involved with the forecast uses a consistent set of economic assumptions
ACRS stands for:
Accelerated Cost Recovery Schedule
IRR < r
Accept for financing
IRR > r
Accept for investing
Minimum Acceptance Criteria: NPV
Accept if NPV > 0
Minimum Acceptance Criteria PI
Accept if PI > 0
Minimum Acceptance Criteria: IRR
Accept if the IRR exceeds the required return. (IRR > r)
Independent Projects
Accepting or rejecting one project does not affect the decision of the other projects. - Must exceed a MINIMUM acceptance criteria
Price Earnings Ratio
Also called the multiple - Calculated as current stock price divided by annual EPS The Wall Street Journal uses last 4 quarter's earnings Want this to be low so you don't overpay
Constant growth
Assume that dividends will grow at a constant rate, g, forever. Since future cash flows grow at a constant rate forever, the value of a constant growth stock is the present value of a growing perpetuity. You always need to use the next periods dividend. Increase in g = increase in P
Differential Growth
Assume that dividends will grow at different rates in the foreseeable future and then will grow at a constant rate thereafter
Different Betas
B > 1 aggressive stock, moves more than market B < 1 defensive stock B = 1 market B = 0 risk free B < 0 counter cyclical, goes in opposite direction of the stock market (gold)
The legal mechanism for allowing creditors to take over the firm when the decline in the value of its assets triggers a default on outstanding debt is called:
Bankruptcy
The _____ of a stock measures the risk in a stock that cannot be diversified away.
Beta
The decision to enter a new market is a:
Broad strategic decision
Mergers
Buying a whole firm (or division). Basic capital budgeting procedures are used when making merger decisions
C & r in terms of price and par
C = r -- Price = par @ par value C > r -- Price > par @ premium C < r -- Price < par @ discount
What does CAPM stand for?
Capital Asset Pricing Model
The firm's financing mix is known as its
Capital structure
The firm's financing mix is known as its:
Capital structure
Identifying Relevant Cashflows
Cash flows matter—not accounting earnings - Incremental cash flows matter - Opportunity costs matter - Side effects like cannibalism and erosion matter - Taxes matter: we want incremental after-tax cash flows - Inflation matters - Sunk costs do not matter
Ranking Criteria
Choose the highest NPV
Standard & Poor's 500 Composite Index (S&P500)
Comprised of 500 stocks from major industry sectors - More broad-based and representative of overall market than DJIA - True index calculated from 1941-1943 base period closing market values
Relationship depends on
Correlation coefficient +1 no risk reduction is possible, -1 complete risk reduction is possible
Current Yield
Coupon/Price
Debt to Value ratio
D/ (D+E)
Types of financial distress costs
Direct & indirect
Where does r come from?
Discount rate can be broken down into two parts 1. The dividend yield 2. The growth rate (in dividends) -- capital gains
The expected annual dividend of the stock divided by its current price is the:
Dividend yield
Disadvantages of IRR
Does not distinguish between investing and financing. IRR may not exist or there may be multiple IRRs Scale effect - the problem with size
Operating Cash Flow =
EBIT - Taxes + Depreciation
ROA
EBIT/ Assets
What makes up CFO (operating cash flows)
EBT - tax + depreciation
Advantages of IRR
Easy to understand and communicate
Some portfolios have higher returns for the same level of risk or less. These comprise the:
Efficient frontier
Broad strategic decisions
Entering new areas of business Entering new markets Acquiring other companies
Most high tech firms such as Intel and Microsoft, and biotech, software and internet companies rely almost wholly on
Equity finance
Contraction decisions
Especially during bad recessions where there is excess capacity within the firm, the management has to decide whether to downsize.
Replacement to reduce costs
Example: to replace a serviceable but obsolete equipment in order to lower costs. A fairly detailed analysis would be needed since it entails a larger expenditure
Replacement needed to continue profitable operations
Example: to replace an essential conveyor belt on a profitable manufacturing line. Production manager could make this investment without an elaborate review process.
Safety and/or environmental projects
Expenditures required to comply with environmental orders, labor agreements or insurance policy terms
All assets in a company passing through bankruptcy will be diminished considerably
False
All portfolios are created equal.
False
An unbalanced portfolio has less risk than stocks or bonds held in isolation.
False
Capital structure is immutable
False
Diversification works best when the returns are positively correlated, i.e. when they move in the same directions.
False
Firms cannot raise capital from debt.
False
Generally, an unlevered firm would pay less taxes than one with debt
False
If someone likes to take risks, they are said to have a risk aversion.
False
If the actual price is higher than the fundamental value, then the stock is a "bargain".
False
In equilibrium, the intrinsic price must surpass the actual price
False
Market values are the same as the values recorded by accountants in the company's books.
False
Pecking order and financial slack is a theory stating that firms prefer to issue equity rather than debt if internal financing is insufficient.
False
Portfolio diversification works because prices of different stocks move exactly together.
False
Risk should be avoided at all costs, and should never be sought out.
False
Small changes in expected g and r cause small changes in stock prices.
False
The Average Accounting Return Rule takes into consideration the time value of money.
False
The NPV Rule only uses select cash flows of the project.
False
The expected total return of the stock should surpass the expected return of other investments available in the market with equivalent risk.
False
The historical record shows that returns on high-risk assets are lower than those of low risk assets.
False
The pecking order theory starts with symmetric information, where managers know the same as outside investors about their companies' prospects, risks and values.
False
To value a Differential Growth Stock, we need to compute the total value of the estimated past dividends and past stock price at the appropriate discount rate.
False
True or False projects that are acceptable, using the decision rule, should decrease the value of the firm accepting them while projects that do not meet the requirements would increase value if the firm invested in them.
False
Typically, a project will experience cash inflows at the beginning of the project and thereafter, cash outflows till the end of the project.
False
When EBIT is low, it is a good time to take on more debt
False
When accounting for inflation in capital budgeting, the important rule is that one must avoid using real cash flows discounted at real rates or nominal cash flows discounted at nominal rates
False
When identifying relevant cashflows, opportunity costs do not matter.
False
The Trade-off Theory of Capital Structure
Financial managers often think of the firm's Debt-Equity decision as a trade-off between interest tax shields and the costs of financial distress. target debt ratios may vary from firm to firm: - Companies with safe, tangible assets and plenty of taxable income to shield ought to have high target debt ratios. - Unprofitable companies with risky, intangible assets ought to rely primarily on equity financing.
In fashion
Firms whose shares are "in fashion" sell at high multiples. Growth stocks for example. (growth investing, more risk)
Out of Favor
Firms whose shares are out of favor sell at low multiples. Value stocks for example (means cheap), (value investing, less risk)
To get to the cost of capital, we need to
First estimate the cost of borrowing money And then weight debt and equity in the proportions that they are used in financing.
_______ is a function of how much of the firm's earnings are retained and what returns it receives on its retained earnings.
Growth
Earnings Growth
Growth is a function of how much of the firms earnings are retained and what returns it receives on its retained earnings g= Retention rate * return on new investment
When discussing the value of a firm, what does g and r stand for?
Growth rate and discount rate
Firms whose shares are "in fashion" sell at _____ multiples. Firms whose shares are out of favor sell at _____ multiples.
High; Low
______ companies such as Microsoft or Pfizer use mostly equity finance
Highly profitable growth
The Discounted Payback Period Rule
How long does it take the project to "pay back" its initial investment taking the time value of money into account? Always round up to the next year
The Payback Period Rule
How long does it take the project to "pay back" its initial investment? Payback Period = number of years to recover initial costs Minimum Acceptance Criteria is set by management The payback rule maybe adequate but it is also easy to lead to nonsensical decisions
Internal Rate of Return (IRR) Rule
IRR: the discount rate that sets NPV to zero i.e., Solve for r when NPV = 0
Pitfall 3: Scale effect
If you give a dollar and get back $1.5 that has a higher IRR than if you give $10 and get back $11 but it has a lower NPV. So a high IRR on a small amount is worth less than an small IRR on a big value. The problem with IRR is that it ignores issues of scale so use NPV over IRR
Indirect Costs of Financial Distress
Impaired ability to conduct business (e.g., lost sales, departing employees, shorter supplier credit)
When do you need to consider inflation
Inflation is an important fact of economic life and must be considered in capital budgeting
The pecking order theory of corporate financing states that firms prefer:
Internal financing
Which of the following is an advantage of the Internal Rate of Return (IRR) Rule?
It is easy to understand and communicate
Decisions on delivering a needed service, Routine
Lease or buy a distribution system Creating or delivering a management information system outsourcing
Direct Costs of Financial Distress
Legal and administrative costs
An equally weighted portfolio (50% in stocks and 50% in bonds) has more/less risk than stocks or bonds held in isolation
Less
Companies with a _____ P:E ratio are considered undervalued:
Low
Decisions about the level of inventory and terms of credit in a company are:
Management decisions
What type of risk is the risk that oil prices rise, increasing production costs
Market risk
What type of risk is the risk that the economy slows, reducing demand for the firm's products
Market risk
_____ stems from economy-wide perils that threaten all businesses. It explains why stocks tend to move together, so that even well-diversified portfolios are exposed to market movements.
Market risk
for a reasonably diversified portfolio what matters?
Market risk
Different types of risk
Market risk = beta Total risk = market + unique
The compensation for risk of common stock ownership is known as the:
Market risk premium
Suppose that in the coming year, you expect Microsoft stock to have a volatility of 23% and a beta of 1.28, and McDonald's stock to have a volatility of 37% and a beta of 0.99. Which stock carries more total risk?
McDonalds
What types of projects are most common?
Mutually exclusive projects are more common than independent projects
Which capital budgeting decision is the most superior?
NPV
The Minimum Acceptance Criteria for the Net Present Value Rule is:
NPV > 0
When do you accept a project?
NPV > 0
The fertilizer will require a new factory that can be built at a cost of $81.6 million. Estimated return on the new fertilizer will be $28 million after the first year, and lasting four years. Cost of capital is 10%
NPV is $7.2 million and they should undertake the investment.
The Profitability Index (PI) Rule
NPV/ Constrained factor (money, resources, investment)
ROE
Net Income/ BV equity
The Net Present Value (NPV) Rule
Net Present Value (NPV) = Total PV of future CF's - Initial Investment
Unlevered
No debt just equity
If given nominal interest rate 14% and inflation rate 5% calculate real and nominal
Nominal discount cash flows with 14% Real 1.14/1.05 = 1.09 discount cash flows with 9%
Mutually Exclusive Projects
Only ONE of several potential projects can be chosen, e.g. acquiring an accounting system. - RANK all alternatives and select the best one.
Incremental Cash Flows Opportunity Costs
Opportunity costs matter - We should consider the best alternative that has was given up when accepting the project - If the lost opportunity was considered when the project was initiated, then the opportunity would be regained when the project ceases
NPV = ?
PV(future cash flows) - investment
The number of years it takes to recover initial costs of an investment is the:
Payback Period
Formula for zero growth
Po = Div/r
Formula for constant growth
Po = Div1 / (r-g) --- P5 = Div6/ (r-g)
Positive and Negative about debt
Positive: tax shields Negative: financial distress
Management decisions
Product mix to carry Level of inventory and credit terms
Difference between cash and profits
Profits is what you get artificially and cash is what you can actually invest
Probability Distribution of Returns for a stock
Return * Probability and add them all up
How is the rate of return on common stocks estimated?
Risk free rate + market risk premium
Ranking Criteria PI
Select alternative with highest PI
Ranking Criteria: IRR
Select alternative with the highest IRR
Disadvantages of PI
Should not be used when there are no constraints
Incremental Cash Flows Side Effects
Side effects matter - Erosion and cannibalism are both bad things. If our new product causes existing customers to demand less of current products, we need to recognize that. - In contrast, synergies result in either increasing revenues or decreasing costs and hence, are relevant for analysis
Between 1926-2008, which of the following investments had the highest percentage of Return Volatility?
Small stocks
Between 1926-2008, which of the following investments had the highest percentage of average annual return?
Small stocks
If your relative wanted to invest $100 dollars for you at the end of 1925, which area of investment would yield the highest return in 2009?
Small stocks
List in order from highest excess return to lowest of investments
Small stocks S&P 500 Corporate bonds Treasury bills
List in order from highest return to lowest of investments
Small stocks - 18.7% S&P 500 - 11.7% Corporate bonds - 6.6% Treasury bills - 3.6%
List in order from highest return volatility (standard deviation) to lowest of investments
Small stocks - 39.2% S&P 500 - 20.3% Corporate bonds - 7% Treasury bills - 3.1%
Standard Deviation of the Return Distribution
Square root of variance
What is volatility
Standard Deviation
What is the best measure of risk
Standard deviation, it shows what percent you can swing up or down by
Incremental Cash Flows
Sunk costs are not relevant = Costs that were incurred (historical costs) before the acceptance of the project; market research, market study, feasibility study, original purchase values Incremental costs matter- We are only concerned with the additional costs that we incur (or additional revenues we gain) when we evaluate the viability of a project
Factors in Target D/E Ratio
Taxes - the higher the taxes the more you should borrow Types of Assets- financial distress depends on types of assets you have, more tangible borrow more Uncertainty of Operating Income - you are more likely to have financial distress Pecking Order and Financial Slack - firms prefer to issue debt rather than equity if internal financing is insufficient
Advantages of The Average Accounting Return Rule (AAR)
The accounting information is usually available Easy to calculate
If stock prices are not volatile, then this means there isn't a good flow of information and markets are seen as inefficient.
True
In a large portfolio the variance terms are effectively diversified away, but the covariance terms are not.
True
The slope of the regression corresponds to...
The beta of the stock, and measures the riskiness of the stock
The value of a firm is defined to be the sum of the value of
The firm's debt and the firm's equity (V= D + E)
Pecking Order of Financing Choices definition
The pecking order theory starts with asymmetric information, where managers know more about their companies' prospects, risks and values than do outside investors. investors would interpret the announcement of a stock issue as a bad signal and mark down the stock price accordingly. As such, for optimistic managers, issuing stock is always the last resort
Bankruptcy risk versus bankruptcy cost
The possibility of bankruptcy has a negative effect on the value of the firm. • However, it is not the risk of bankruptcy itself that lowers value. Rather, it is the costs associated with bankruptcy. • It is the stockholders who bear these costs.
The Fisher relationship is
The relationship between interest rates and inflation
CK Shoes expects to have earnings per share of $6 in the coming year. Rather than reinvest these earnings and grow, the firm plans to pay out all of its earnings as dividends. With these expectations of no growth, CK's current share price is $60. Suppose CK Shoes cut its dividend payout rate to 75% for the foreseeable future and use the retained earnings to open new stores. The return on its investment in these stores is expected to be 12%. Assuming its equity cost of capital is unchanged, what effect would this new policy have on CK Shoes' stock price?
The share price will go up to $64.29
When the firm is financed entirely by common stock, all those cashflows belong to:
The shareholders
Estimates of Parameters in the Dividend-Discount Model
The value of a firm depends upon its growth rate, g, and its discount rate, r
If we graph NPV versus discount rate, we can see the IRR as _____
The x-axis intercept
Expansion of existing products or markets
These decisions require a forecast of growth in demand and a more detailed analysis is required. Go or no-go decisions are generally made at a higher level in the organization than replacement decisions
Expansion into new products or markets
These investments involve strategic decisions that could change the fundamental nature of the business. A detailed analysis is required, and top officers make the final decision, possibly with board approval
What do investment decision rules allow us to do?
They allow us to formalize the process and specify what condition or conditions need to be met for a project to be acceptable
What do stock market indexes measure
They measure the current price behavior relative to a base value set at an earlier point in time
What do stock market averages reflect
They reflect the arithmetic average price behavior at a given point in time
______ are used by a publicly traded company when its trades are reported on the real time electronic display of trading activity.
Ticker symbols
The Net Present Value (NPV) =
Total PV of future CFs - Initial Investment
The theory that says firms should avoid extreme debt predictions and adopt moderate debt ratios is the:
Trade-off Theory
What role do industries play in the capital structure choice for a firm? which theory best explains this?
Trade-off theory explains industry differences. If you are in an industry with lots of intangible assets such as the technology industry you are going to have more equity than debt. The trade-off theory is the tradeoff between tax shields and financial distress. Industries with stable income, high profit margins, and a high tax rate should borrow more. On the other hand firms with intangible assets most likely will have a higher borrowing rate so they are more likely to end up with financial distress so they choose to finance with equity more.
A firm's basic financial resource is the stream of cashflows produced by its assets and operations
True
Common stock is a share of ownership in the corporation, which gives its owner rights to vote on the election of directors, mergers, or other major events.
True
Creditors will minimize their risks by requiring protective covenants for all debt issues
True
Debt levels are determined by book values, and equity by market values.
True
Diversification is a strategy designed to reduce risk by spreading the portfolio across many investments.
True
One of the main pitfalls of the IRR approach is that it has multiple rates of return.
True
Operations, investments and changes in Net Working Capital are three categories of cash flow.
True
Since interest is tax deductible, highly profitable firms should use more debt.
True
The Average Accounting Return Rule uses accounting information that is usually available.
True
The S&P 500 is an index of the 500 largest companies listed in the US.
True
The cost of capital must be based on what investors are actually willing to pay for the company's outstanding securities - that is based on the securities' market values.
True
The cost of debt for a firm is the rate at which it can borrow money today.
True
The current borrowing rate is a good estimation of the cost of debt.
True
The expected rate of return on the portfolio is a weighted average of the expected returns on the securities in the portfolio.
True
The rate of return on the portfolio is a weighted average of the returns on the stocks and bonds in the portfolio.
True
The variance and standard deviation of the return distribution are measures of volatility. Volatility implies risk.
True
To estimate Net Present Value, estimate future cash flows, the discount rate and initial costs.
True
True or False Investors and businesses must make a tradeoff between higher rewards that potentially come with opportunity, and higher risk that has to be borne as a consequence of danger.
True
True or False a good investment decision rule should work across a variety of investments - whether revenue-generating investments or cost-saving investments.
True
True or False stock market averages and indexes measure the general behavior of stock prices over time
True
True or False the Payback Period Rule ignores cash flows after the payback period.
True
True or False the Payback Period Rule ignores the time value of money.
True
True or False the value of a zero growth stock is the present value of a perpetuity
True
True or False, there is a great deal of estimation error involved in estimating r
True
True or false the lower the r the higher the NPV
True
Using a long term government rate as the risk-free rate on all of the cash flows in a long term analysis will yield a close approximation of the true value.
True
When a firm issues stock, investors will generally interpret this as a bad signal.
True
When determining the value of the stock, it is fundamentals of the company that matters, not who owns the stock and how long he/she holds it for.
True
When identifying relevant cashflows, sunk costs do not matter.
True
When you use equity, you are not allowed to deduct payments to equity (such as dividends) to arrive at taxable income
True
With incremental cash flows, opportunity costs and side effects matter.
True
With mutually exclusive projects, only one of several potential projects can be chosen.
True
True or false in a large portfolio the variance terms are effectively diversified away?
True, Diversifiable Risk; Nonsystematic Risk; Firm Specific Risk; Unique Risk are all diversified away so only market risk matters
What type of risk is the risk that the founder and CEO retires
Unique
If a company has a volatility of 60% what is its variance and stand and dev
Variance = 36% Stdev = 60%
WACC stands for
Weighted average Cost of Capital
Capital Budgeting Decisions
When faced with new investments and projects, firms have to decide whether or not to invest in them.
Pitfall 1: Investing or Financing?
When we invest, we want a high rate of return, and when we are borrowing money, we want a low rate of return. Hence, for financing decisions, the IRR rule is the opposite: IRR< Opportunity cost of capital = Accept
Interrest Tax Shields
When you borrow money, you are allowed to deduct interest expenses from your income to arrive at taxable income. This reduces your taxes. • When you use equity, you are not allowed to deduct payments to equity (such as dividends) to arrive at taxable income. • The dollar tax benefit from the interest payment in any year is a function of your tax rate and the interest payment:
Do firms change their capital structure
Yes, capital structure is not immutable. Firms change their capital structure over time
Which risk can you eliminate
You can try to eliminate firm specific risk when diversifying, it's almost impossible to eliminate market risk
Pitfall 2: Multiple Rates of Return
You must cut the X-axis once to get an IRR if more than once you get multiple IRRs and if it doesn't cross you get zero IRRs and you shouldn't use this method
The weighted cost of capital (WACC)
a composite cost to the firm of raising financing to fund its projects. Must use market values for debt and equity. The WACC is the rate of return that the firm must expect to earn on its average-risk investments in order to provide a fair expected return to all its security holders. We use it to value new assets that have the same risk as the old ones and that support the same ratio of debt.
Bankruptcy is
a legal mechanism for allowing creditors to take over the firm when the decline in the value of its assets triggers a default on outstanding debt. If the company cannot pay its debts, the company is turned over to the creditors, who become the new owners; the old shareholders are left with nothing
When it issues both debt and equity, the firm splits the cashflows into two streams:
a relatively safe stream that goes to the bondholders and a more risky one that goes to the stockholders
What type of company has a high P/E
a risky, growth company
Common stock
a share of ownership in the corporation, which gives its owner rights to vote on the election of directors, mergers, or other major events. Common stock carries the right to share in the profits of the corporation through dividend payments.
Diversification
a strategy designed to reduce risk by spreading the portfolio across many investments
The expected rate of return on the portfolio is
a weighted average of the expected returns on the securities in the portfolio
The rate of return on the portfolio is...
a weighted average of the returns on the stocks and bonds in the portfolio. rp = Wb x Wr + Ws x Wr
Which of the following is NOT a common measure of risk and return? a. Expected loss b. Probability distributions c. Variance and standard deviation
a. Expected loss
The Average Accounting Return Rule: a. Uses an arbitrary benchmark cutoff rate b. Is difficult to calculate c. Is based on cash flows and market values, not book values
a. Uses an arbitrary benchmark cutoff rate
Unique risk
arises because many of the dangers that surround an individual company are peculiar to the company and perhaps its direct competitors. Firm specific, diversifiable, non systematic,
Zero growth
assume dividends will remain at the same level, future cash flows are constant
Which of the following is NOT a factor in target debt/equity ratio? a. Types of assets b. Concrete operating income c. Taxes
b. Concrete operating income
Which of the following is a disadvantage of the Payback Period Rule? a. It is easy to understand b. It requires an arbitrary acceptance criteria c. It is biased toward liquidity
b. It requires an arbitrary acceptance criteria
Why does portfolio diversification work?
because prices of different stocks do not move exactly together
WACC is an appropriate discount rate only for a project that is a _______ of the firm's existing business
carbon copy
Where do you get cash flows
cashflows are rarely just given, rather, managers must estimate them based on information collected from sources both inside and outside of the company.
What makes up CF NWC (cash flows from change in net working capital)
change in NWC
What does the market risk premium provide for
compensation of risk
as new information arrives investors ________ update their estimates of g & r
continuously
Current Yield
coupon payment/ stock price
airlines, food processing firms and utilities rely mostly on ____ financing
debt
The value of a firm is defined to be the sum of
debt + equity
Firms raise money through
debt and equity
By increasing the cash flows paid to debt holders through interest payments, a firm:
decreases the amount paid in taxes
Computing the Price of Common Stock
determine the future cash flows and discount them to the present at an appropriate discount rate
Legal and administrative costs are _________ of financial distress.
direct costs
Preferences for Internal Financing
don't reveal info to market, avoid restrictions imposed by banks, faster and less expensive, avoid loss of control associated with equity, avoid negative signals associated with equity, greater flexibility using own money, avoid bankruptcy risk,
Preference for internal financing
don't reveal info to market, avoid restrictions imposed by banks, fasters and less expensive, avoid loss of control associated with external equity, avoid negative signaling associated with equity (firm over valued), greater flexibility w/ using own money, avoid bankruptcy risk
The trade off theory says that firms should avoid _____
extreme debt predictions and adopt moderate debt ratios
The interest rate on Treasury Bills provides for the compensation for risk, while the market risk premium provides for the time value of money.
false
A higher ROE means
greater returns to shareholders
Creditors demand compensation in advance of bankruptcy in the form of a:
higher promised interest rate
The trade-off theory explains ______ differences in capital structure
industry differences in capital structure
Losses are greatest for the _______ assets that are linked to the health of the company as a going concern, for e.g; ____
intangible; technology, human capital and brand image
Rate of return on common stock
interest rate on t-bills + market risk premium
The increase in total cash flows paid to investors is the _______
interest tax shield
Explain the concept of interest tax shields. Which stakeholder benefits from the tax savings from interest payments? If interest tax shields always increase firm value, is there a limit to how much tax shields a company could enjoy?
interest tax shields are when you don't have to pay taxes on interest. It shows that borrowing has advantages. Stakeholders benefit from the tax shield because it makes net income greater. There is a limit to borrowing because if a company has too much debt their borrowing rate will go up and the interest will be more than the tax shield.
Capital budgeting
investing
The cost of debt for a firm is the rate at which:
it can borrow money today
Small changes in expected g & r cause _______ changes in stock prices
large
Some assets, like good commercial real estate, can pass through bankruptcy and reorganization .......
largely unscathed; the value of other assets are likely to be considerably diminished
Tactical decisions
less strategic shorter time frame (1-2 years)
debt ratios are ____ in the pharmaceutical industry
low; because value depends on continued success in research and development which isn't tangible. Also in many service industries where value depends on human capital
Market or Firm Risk? oil prices rise, increasing production costs
market
When accounting for inflation in capital budgeting, the important rule is
one must use real cash flows discounted at real rates or nominal cash flows discounted at nominal rates.
Dividends
periodic payments, usually in the form of cash that are made to shareholders as a partial return on their investment in the corporation. Shareholders are paid dividends in proportion to the amount of shares they own
Market risk
stems from economy-wide perils that threaten all businesses. Market risk explains why stocks tend to move together, so that even well-diversified portfolios are exposed to market movements. Macro economic, non diversifiable, systematic
Creditors will minimize their risks by requiring _____
protective covenants for all debt issues
Capital structure
raising money, financing
Interest payment
rd * Debt
Annual Tax Shield
rd X D x Tc or Tax rate * interest payment
By increasing the cash flows paid to debt holders through interest payments, a firm ______ the amount paid in taxes
reduces
Equation for market risk premium
return of the market - risk free rate
Expected return on an individual security
risk free + beta (market risk premium) or risk free + beta( return of market - risk free rate)
Expected Return on the Market
risk free + market risk premium
What is Risk
risk is a mix of danger and opportunity It illustrates the tradeoff that every investor and business has to make between higher rewards that potentially come with the opportunity and higher risk that has to be borne as a consequence of danger
efficient frontier
some portfolios are better than others. They have higher returns for the same level of risk or less
It is the ________ who bear the costs of bankruptcy.
stockholders
What else is the intrinsic price is sometimes called?
the fair, or fundamental, price.
Market equilibrium
the intrinsic price must equal the actual price, if the actual price is lower than the fundamental value, then the stock is a bargain, buy orders will exceed sell orders, the actual price will be bid up
market risk premium
the premium that investors demand for investing in a higher risk investment than the riskfree rate
The cost of debt for a firm is
the rate at which it can borrow money today. The current borrowing rate (or weighted average of existing debt) is a good estimation of the cost of debt
beta of a stock measures
the risk in a stock that cannot be diversified away. It is determined by both how volatile a stock is and how it moves with the market. It is a regression model
When the firm is financed entirely by common stock, all those cashflows belong to .....
the shareholders
A firm's basic financial resource is .....
the stream of cashflows produced by its assets and operations
If the goal of the management of the firm is to make the firm as valuable as possible....
the the firm should pick the debt-equity ratio that makes the pie as big as possible.
Changes in capital structure benefit the stock holders if and only if:
the value of the firm increases
changes in capital structure benefit the stockholders if and only if
the value of the firm increases
Levered
there is debt
If stock prices aren't volatile this means that .....
there isn't a good flow of information and markets are seen as inefficient (volatility actually implies greater efficiency)
What does the interest rates on T-bills provide for
time-value of money
Riskfree Rate
to have an actual return be equal to the expected return, there has to be no default risk, which generally implies that the security has to be issued by the government. Note, however, that not all governments can be viewed as default free. Using a longterm (10year) government rate as the riskfree rate on all of the cash flows in a long term analysis will yield a close approximation of the true value
The Capital Investment Process features identification of opportunities and generating investment proposals, evaluation of the project's relevant cash flows, appropriate discount rate, and the selection of a decision-making rule, and the implementation and follow-up.
true
Market or Firm Risk? CEO retires
unique/ firm
Ticker symbols
used by a publicly traded company when its trades are reported on the real- time electronic display of trading activity (ticker) -- Ex. Walmart is WMT
When does diversification work best?
when the returns are negatively correlated, ie when they move in opposite directions so that the net effect cancels out and you make an average profit under different circumstances