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