FN Midterm practice questions
What does hard capital rationing refer to
"Hard" capital rationing refers to how the maximum total expenditure is viewed, implying that under no circumstances can that maximum be exceeded.
What does soft capital rationing refer to
"Soft" capital rationing refers to when management may consider exceeding its self-imposed capital expenditure limit. The firm sets a spending limit, but depending upon project desirability and the firm's condition at the time decisions are actually made, the firm may over- or underspend relative to that limit.
why do managers want to know expected inflation rates?
Expectations about inflation affect required returns and thus computations involved in capital budgeting decisions.
expensed
Expensed means recognizing an outlay as an expense for tax purposes at the time it is incurred.
MACRS
MACRS (pronounced "makers") stands for Modified ACRS. ACRS (pronounced "acres") stands for accelerated cost recovery system,
net operating cash flow
Net operating cash flow, CFAT (cash flow after tax), is the change in cash receipts minus the change in cash operating expense minus the taxes paid.
non-operating cash flows
Non-operating cash flows are the future cash flows that are not associated with current operations. These are usually additions or subtractions from the investment in capital assets or working capital.
In terms of capital budgeting, what do options recognize?
Options recognize the value to expand, postpone, or abandon a capital budgeting project.
What does simulation involve?
Simulation involves using a mathematical model to imitate a situation many times to estimate the likelihood of possible outcomes.
How is EAC calculated?
The EAC is calculated as an ordinary annuity payment that has the same present value as the asset's costs.
How can we break down the net initial outlay?
The net initial outlay can be broken down into four categories. First, we have cash expenditures for the new capital assets. Second, we have changes in net working capital. Third, there is cash flow from the sale of old equipment. Fourth, there is the tax impact of the sale of old equipment. Adding up the value of each category produces the net cash flow (or initial start-up costs) for the project.
What is the net-benefit-to-leverage factor?
The net-benefit-to-leverage factor is a linear approximation of a factor, T*, that allows us to operationalize the total impact of leverage on firm value in the capital market imperfections view of capital structure.
What does the pecking order view of capital structure refer to?
The pecking order view of capital structure refers to the argument that external financing transaction costs create a preference, or pecking order, of preferred sources of financing.
What is the perfect market view of capital structure?
The perfect market view of capital structure is the analysis in a perfect capital market environment, which shows that a firm's capital structure does not affect its value in a perfect capital market environment.
What does the personal tax view of capital structure refer to?
The personal tax view of capital structure refers to the argument that the difference in personal tax rates between income from debt and income from equity eliminates the disadvantage from the double (corporate and individual) taxation of income from equity.
T/F: According to the corporate tax view of capital structure, the expected after-tax cash flows to investors increase with leverage because the government will collect fewer tax dollars.
True
T/F: Agency costs create pitfalls for the use of capital rationing, but other market imperfections can make capital rationing beneficial.
True
T/F: An arbitrage argument can be used to show that if two firms have identical operating profitability but different capital structures, then buying and selling among investors will ensure that the two firms have equal market values.
True
T/F: Asymmetric information is a situation where information is known to some participants but not others.
True
T/F: Capital rationing places limits on what a manager spends on capital budgeting.
True
T/F: For most capital structure models, the required returns on equity and debt (re and rd, respectively) depend on the amount of debt.
True
T/F: Future investment opportunities are options to identify additional, more valuable investment possibilities in the future that result from a current investment.
True
T/F: Loss carryforwards and loss carrybacks are sometimes limited, so that some of the corporate tax shield resulting from leverage may be lost during a period financial distress.
True
T/F: Options are valuable, but there can be problems when combining option values.
True
T/F: Sometimes the most cost-efficient information is what you already have
True
T/F: Sometimes the opportunity costs of forgone alternatives and options are simply impossible to measure.
True
T/F: Tax differences on equity and debt give rise to the corporate tax view of capital structure
True
T/F: The difference in personal taxes for equity and debt offsets the corporate tax asymmetry when (1 − Td) = (1 − Te)(1 − T).
True
T/F: The existence of various leverage clienteles mitigates some, but not all, of the arguments in favor of capital structure relevance.
True
T/F: When transaction costs must be incurred to identify and hire additional employees, those costs decrease the project's NPV.
True
T/F: When we compute a project's NPV or IRR, the Discount rate includes in it the opportunity cost for obtaining financing for the project
True
T/F: With tax asymmetry, an all-equity firm can increase its value by issuing debt.
True
T/F: lowering the level of decision-making authority within a firm may reduce the net cost of making decisions, including the opportunity cost of delay when time is critical
True
True/False: Inflation effects can be complex because asset value is a function of both the required return and the expected future cash flows.
True
True/False: Non-Operating cash flows are cash flows not associated with operations and can occur at various points during the life of a capital project
True
True/False: Suppose a firm has discovered how to make a product that would be better than one of its existing products. For example, suppose Proctor & Gamble created a new soap. Such a new product can cause what is called erosion of one or more existing products.
True
True/False: The incremental financing costs are implicitly included in the project's cost of capital (or its required return).
True
True/False: The net operating cash flow, CFAT, can be expressed as (ΔR − ΔE) minus the tax liability on this amount
True
True/False: The net salvage value is the after-tax net cash flow for terminating the project
True
True/False: The relevant cash flow is the amount left after all taxes have been paid
True
What is the formula for WACC?
WACC = (1 − L)re + L(1 − T)rd where L = , re is the required return for equity, T is the corporate tax rate, and rd is the required return for debt.
What is the formula for WACC for the corporate tax view of capital structure?
WACC = r(1 − TL) where r is the unleveraged cost of capital, T is the corporate tax rate, and L is the market-value proportion of debt financing given by L = where D is the value of debt and E is the value of equity.
Name some ways of reducing the agency costs of debt.
Ways of reducing the agency costs of debt include having a sinking fund provisions and securing debt by using tangible assets as collateral.
In terms of capital budgeting, what do we consider when we use the Risk-Return Trade-Off Principle?
We consider the risk of the capital budgeting project when determining the project's cost of capital or required rate of return.
In terms of capital budgeting, what do we mean by comparative advantage?
We mean we look for capital budgeting projects that use the firm's comparative advantage to add value.
In terms of capital budgeting, what do we mean by valuable ideas
We mean we look for ideas to use as a basis for capital budgeting projects that will create value.
In terms of capital budgeting, what do we mean by the Time-Value-of-Money?
We refer to the measurement used to value the capital budgeting project. The NPV takes into consideration this measurement by putting everything in today's dollars.
Discuss the meaning of expensing or capitalizing a new investment
When a firm buys a capital asset, the cost is not usually recognized immediately. Capitalizing an asset involves recording the outlay as an asset and allocating (depreciating) the cost over future time periods. Capitalizing leads to depreciation expense. It allocates the cost of the asset to two or more time periods. In contrast, cash expenditures that are expensed are immediately recognized for tax purposes. Expensed items do not have any subsequent tax consequences. Generally, the earlier an expense is recognized, the earlier the tax savings will occur.
There are other significant taxes besides corporate income taxes. Discuss these.
While the firm pays taxes on its income, investors also pay personal income taxes on their income from the firm. And the rates investors pay are not all the same. The rates depend on the form of the investment, in particular whether it is equity or debt. Historically, tax laws have favored investors in equity due to lower tax rates on both dividends received and capital gains achieved when investors sell shares for a profit. Whereas interest and dividends are taxed when they are received, capital gains are not taxed until the asset is sold. Therefore, a shareholder can postpone the tax on a gain by not selling the shares. At the same time, there is a mirror image treatment of losses. The shareholder can claim the tax shield resulting from a loss right away by selling the asset.
What is WACC?
With only equity and debt, the WACC is the weighted average of re and rd adjusted for taxes.
________ the level of decision-making authority within a firm may reduce the net cost of making decisions, including the opportunity cost of delay when time is critical. a. Lowering b. Increasing c. Ignoring d. none of these
a
Due to asymmetric information, the market fears that a firm issuing securities will do so when the stock is . a. undervalued. b. overvalued. c. caught up in a bear market. d. being sold by insiders.
b
A corporation has been trying to decide if it should continue with a project. An argument in favor of continuing is that a lot of money has already been spent on the project. What is the major problem with this argument? a. It ignores the opportunity cost of the money spent. b. It includes sunk costs in the decision. c. It includes the opportunity cost of the money spent. d. It excludes sunk costs in the decision.
b
Capital rationing limits the firm's . a. capital structure. b. capital expenditures. c. human capital. d. a & b
b
Capital rationing seeks to control wasteful management practices by placing limits on the company's ________. a. capital structure. b. capital expenditures. c. past dividend payout. d. b & c
b
Capital structure irrelevance can be illustrated with a(n) argument. a. information asymmetry b. arbitrage c. tax asymmetry d. transaction costs
b
There are five basic concepts to keep in mind when calculating a project's cash flows. These include which (if any) of the following? a. Costs and benefits are measured in terms of net income. b. Cash flow timing is critical because timing affects value, even beyond simple time-value-of-money considerations. c. Cash flows must not always be measured on an incremental, or marginal, basis. d. none of these
b
When an estimate excludes inflation, it is said to be stated in . a. real terms b. nominal terms c. risky terms d. beta terms
b
Which (if any) of the following statements is true? a. Enhancement is an innovation that has a negative impact on one or more of a firm's existing products. b. Enhancement is an innovation that has a positive impact on one or more of a firm's existing products. c. Erosion is an innovation that has a positive impact on one or more of a firm's existing products. d. none of these
b
Which (if any) of the following statements is true? a. Erosion has both a negative and a positive impact on one or more of a firm's existing products. b. Enhancement has a positive influence on one or more of a firm's existing products. c. Erosion is an innovation that has a positive impact on one or more of a firm's existing products. d. none
b
The nonmonetary values , but it is simply more accurate to include them after all other costs that are more easily quantified have been included. a. are immaterial b. are not relevant c. are not irrelevant d. are irrelevant
c
________ can reduce costs associated with finding managers for new company projects. a. An opportunity cost b. Adverse selection c. Capital rationing d. b & c
c
A capital budgeting project's cash flows fall into four basic categories. These categories include which of the following? a. Net initial investment outlay. b. Expected future net operating cash flows. c. Non operating cash flows to support the project, such as those for an overhaul. d. all of these
d
Because of _________ , great financial management rarely makes a firm extraordinarily profitable. a. adverse selection b. capital rationing c. asymmetric information d. capital market efficiency
d
Beyond innovative ideas, a firm should search for ways to make high-quality use of its __________. a. time. b. current expertise. c. comparative advantages. d. b & c
d
One form of a(n) ________ is to determine the value of abandonment, versus continued operation, of an entire project. a. soft rationing policy b. hard rationing policy c. indenture d. postaudit
d
The net initial outlay can be broken down into various categories. These include which of the following? a. cash expenditures for the old capital assets b. changes in net working capital c. cash flow from the sale of old equipment d. b & c
d
The postponement option is the option to postpone, rather than , an expansion alternative. a. put off b. reschedule c. delay d. cancel
d
There are five basic concepts to keep in mind when calculating a project's cash flows. These include which of the following? a. Costs and benefits are measured in terms of cash flow and not income. b. Expected future cash flows should be measured on an after tax basis. c. Cash flows must be measured on an incremental, or marginal, basis. d. all of these
d
There are five very important things to remember about cash flow estimation. These include which of the following? a. It is indeed cash flow that's relevant b. Cash flows are measured on an after-tax basis. c. The Principle of Incremental Benefits reminds us that it is the incremental cash
d
There are five very important things to remember about cash flow estimation. These include which of the following? a. The Time-Value-of-Money Principle reminds us that the value of a cash flow depends on its timing. b. The standard cash flow estimation does not explicitly identify the financing costs. c. Relevant cash flows are measured on a before-tax basis. d. a & b
d
There are two important tax considerations for a capital budgeting project. These include which (if any) of the following? a. It is indeed cash flow that's irrelevant. b. The standard cash flow estimation does not explicitly identify the financing costs. c. The Principle of Incremental Benefits reminds us that it is the incremental cash flow that's relevant. d. none of these
d
There is an arbitrage argument for the irrelevance of capital structure based upon the possibility that shareholders can . a. create their own leverage by borrowing and investing in stock b. can borrow at a higher rate than the firm c. can reproduce any capital structure making a firm's choice of leverage irrelevant d. both a & c are correct
d
Which (if any) of the following statements is true? a. Capitalized involves recording an outlay as an asset and allocating (depreciating) the cost over past time periods. b. Net operating cash flow, CFAT (cash flow after tax) is the change in cash receipts minus the change in cash operating expense plus the taxes paid. c. Depreciation refers to a credit against taxes due that is based on the amount of new capital outlays. d. none of these
d
Which of the below is true? a. Just as one interaction among products may cause a decrease in value, another interaction may cause an increase in value. If there is an increase, it is called enhancement. b. Enhancement occurs when the production of one product decreases the value of another. c. An innovation that causes a reduction in the cost of installing a home swimming pool may cause an increase in the sales of swimming pools d. a & c
d
Which of the following is a capital budgeting options? a. the abandonment option b. past investment opportunities c. the postponement option d. a & c
d
Which of the following represents the corporate tax view of capital structure? a. Firm value depends only on its expected future operating cash flows and the cost of capital, not on how those cash flows are divided between the debtholders and the shareholders. b. Corporate taxes cause debt to be cheaper than equity. c. Maximum firm value results from being essentially all-debt financed. d. both b & c are correct
d
Which of the following represents the corporate tax view of capital structure? a. The differential between tax rates on personal income from equity and from debt cancels out the corporate tax asymmetry. b. The firm operates in a perfect capital market environment, except for corporate and personal income taxes. c. A before-tax dollar singly taxed at Td provides the same net amount to an investor as a before-tax dollar taxed at T and then taxed again at Te. d. none of these
d
Which of the following represents the perfect capital market view of capital structure? a. The value of the leveraged firm is equal to the value of the unleveraged firm plus the tax rate times the amount of debt. b. Corporate taxes cause debt to be cheaper than equity. c. Maximum firm value results from being essentially all-debt financed. d. none of these
d
Which of the following represents the personal tax view of capital structure? a. The differential between tax rates on personal income from equity and from debt cancels out the corporate tax asymmetry. b. The firm operates in a perfect capital market environment, except for corporate and personal income taxes. c. A before-tax dollar singly taxed at Td provides the same net amount to an investor as a before-tax dollar taxed at T and then taxed again at Te. d. all of these
d
Which of the following statements is true? a. Capitalized involves recording an outlay as an asset and allocating (depreciating) the cost over future time periods. b. Expensed involves recognizing an outlay as an expense for tax purposes at the time it is incurred. c. Investment tax credit refers to a credit against taxes due that is based on the amount of new capital outlays. d. all of these
d
Which of the following statements is true? a. The EAC is calculated as an ordinary annuity payment that has the same present value as the asset's costs. b. EAC is the equivalent cost per year of owning an asset over its entire life. c. EAA is the ordinary annuity payment with a present value equal to the project's NPV. d. all of these
d
4 basic categories of capital budgeting project's cash flows
(1) Net initial investment outlay. (2) Expected future net operating cash flows. (3) Non operating cash flows to support the project, such as those for an overhaul. (4) Net salvage value, which is the after-tax total amount of cash received and/or spent when the project ends. Discounting all of these cash flows and adding them up gives the net present value (NPV) of the project. If the NPV is positive then we accept the project.
Discuss the relationship between debt and agency conflicts.
A major agency conflict that arises from the use of debt financing is the possibility that shareholders (agents) will expropriate wealth from the debtholders (principals) using asset substitution. Suppose debtholders loan money to shareholders assuming that the firm will invest in a low-risk project, and therefore they agree to a low interest rate on the loan. If the firm then invests in a (substitute) high-risk project, the risk of the loan will increase. This increases the required return on the loan and lowers the present value of the loan. In this case the shareholders (agents) have expropriated wealth from debtholders (principals). As a second example, consider the problem of claim dilution. Let's assume that the firm borrows money to invest in its business, and immediately thereafter the firm's managers do a leveraged buyout. That is, they take over ownership of the firm with a very small amount of equity financing and a tremendous amount of debt. What happens to the value of the original debt? Because of the higher risk, the present value of the original debt decreases, and the decrease is lost to those debtholders, but gained by the shareholders. Once again, the shareholders (agents) have expropriated wealth from debtholders (principals).
describe a postponement option
A postponement option is the option of postponing a project without eliminating the possibility of undertaking it.
Replacement cycle
A replacement cycle is the time between when an asset is purchased, operated and then replaced with an essentially equivalent asset.
What does a tax-timing option give to security holders?
A tax-timing option gives security holders the opportunity to sell assets when there is a tax loss that can be realized.
describe an abandonment option
An abandonment option is the option of terminating an investment earlier than originally planned.
investment tax credit
An investment tax credit is a credit against taxes due that is based on the amount of new capital outlays.
What is an option? Discuss the value of capital budgeting options for managers.
An option is the right to do something without any obligation to do it. When the option is costless, it can simply add to a project's value. However, not all options are costless. Therefore, a project's NPV can be expressed as its "basic" NPV from discounted cash flows (DCF−NPV) plus the value of all options associated with the project minus any costs connected with getting or maintaining those options: NPV = DCF-NPV + Value of options − Cost of options. Unfortunately, we do not have an option pricing model for all options, so we cannot always get the "value of options" to use in an equation. However, it is important to understand that the lack of a convenient option pricing model does not diminish the importance of an option. Managerial options have been shown to have substantial value. For example, consider mineral mining operations. A mining firm has the option to suspend mining operations during times when the price of the mineral is too low to make extraction profitable. The firm can then restart operations whenever mineral prices rise and extraction becomes profitable again. This option substantially increases the value of the mine.
asymmetric information refers to what
Asymmetric information refers to information that is known to some participants but not others.
What is the break-even point
Break-even point is an accounting term defined as the point at which the total contribution margin equals the total fixed costs of producing a product or service. At this point, total revenue equals total cost and profit equals zero.
Name the types of capital rationing. Discuss capital rationing as a planning tool and comment on the role of computers in this process.
Capital rationing can be of two types. "Hard" capital rationing refers to how the maximum total expenditure is viewed, implying that under no circumstances can that maximum be exceeded. Alternatively, management may consider exceeding its self-imposed capital expenditure limit, a condition called "soft" capital rationing: The firm sets a spending limit, but depending upon project desirability and the firm's condition at the time decisions are actually made, the firm may over- or under spend relative to that limit. A firm can get a good picture of the trade-offs among alternative projects using sensitivity analysis, which entails varying the maximum expenditure limit. For example, a firm may find that a small increase in the total expenditure would allow it to undertake the next most desirable project, which may be a worthwhile trade-off. Computer software is particularly useful for soft capital rationing and sensitivity analysis. Once the problem has been formulated, the computer can be conveniently used to obtain alternative solutions simply by amending the constraint values.
What does capital rationing place limits on
Capital rationing places one or more limits on the amount of new investment undertaken by a firm, either by using a higher required return or by setting a maximum on the capital budget.
What is capital structure?
Capital structure is the makeup of the liabilities and stockholders' equity side of the balance sheet, especially the ratio of debt to equity.
capitilized
Capitalized means recording an outlay as an asset and allocating (depreciating) the cost over future time periods.
enhancement
Enhancement is an innovation that has a positive impact on one or more of a firm's existing products.
equivalent annual annuity
Equivalent annual annuity (EAA) is an annualized annuity payment with a present value equal to the present value of a project.
equivalent annual cost
Equivalent annual cost (EAC) is the equivalent cost per year of owning an asset over its entire life.
Erosion
Erosion is an innovation that has a negative influence on one or more of a firm's existing products.
T/F: The expected costs of financial distress and bankruptcy depend totally on the uniqueness, or degree of specialization, of the firm's assets.
False: Depend in part not totally
T/F: Tax-exempt investors may find debt securities less attractive than other investors.
False: MORE not less
True/False: The term salvage value typically refers to the after-tax difference between the sales price (S) and the clean up and removal expense (REX)
False: Should be before-tax instead of after-tax
T/F: A firm's mix of financing methods is called its capital budget.
False: Should be capital structure instead of capital budgeting
True/False: Suppose a firm has discovered how to make a product that would be better than one of its existing products. For example, suppose Boeing created a new airplane. Such a new product can cause what is called enhancement of one or more existing products.
False: Should be erosion instead of enhancement
T/F: One obvious consequence of using a higher discount rate for conventional projects is that the project's NPV will be overstated.
False: Should be understated not overstated
T/F: Agency conflicts between equityholders and debtholders can be minimized by creating contracts without restrictive covenants.
False: Should be with restrictive covenants instead of without restrictive covenants.
T/F: All of the views of capital structure, beyond that of a perfect capital market, are based on maximizing the value lost to one or more imperfections.
False: minimizing not maximizing
True/False: Sunk costs occur in the past and therefore should be considered in capital budgeting decision making
False: should NOT be considered
T/F: It is easier to abandon projects that have tangible assets.
False: should be INTANGIBLE instead of TANGIBLE
T/F: Investors with high marginal tax rates may find debt securities more attractive.
False: should be LESS not more
T/F: The capital gain tax-timing option raises the effective tax rate on equity income.
False: should be LOWERS not RAISES
T/F: Capital rationing can add to problems associated with asymmetric information
False: should be REDUCE instead of ADD TO
True/False: Expansion decisions are, in effect, decisions whether to continue producing a product and even whether to remain in that line of business.
False: should be Replacement instead of Expansion
T/F: The NPV of a project is simply the salvage value from terminating the project by selling or scrapping its assets.
False: should be abandonment value instead of NPV
True/False: Replacement decisions are complicated when the choice involves choosing between two new assets with the same lives.
False: should be different lives instead of the same lives
T/F: One obvious consequence of using a lower discount rate for conventional projects is that the project's NPV will be understated.
False: should be higher instead of lower
T/F: MACRS is a credit against taxes due based on new capital investment
False: should be investment tax credit, not MACRS
T/F: A firm can get a good picture of the trade-offs among alternative projects using sensitivity analysis, which entails varying the minimum expenditure limit.
False: should be maximum instead of a minimum
True/False: If we choose an asset with a longer replacement cycle, then we have an additional option, namely, there is less chance that a mechanically sound machine will be made useless by a technological advance.
False: should be shorter replacement cycle instead of longer replacement cycle
What type of risk comes with leveraged?
Financial risk results from the use of debt. This contrasts with business risk which results from the choice of assets.
5 important things for calculating a project's cash flow
First, costs and benefits are measured in terms of cash flow and not income. This distinction is critical because, among other things, income calculations reflect non-cash items and ignore the time value of money. Also, including indirect (noncash) benefits and costs leads to ambiguity and subjective (nonfinancial) choices that might hide any principal-agent problems between the managers and shareholders. Second, cash flow timing is critical because timing affects value, even beyond simple time-value-of-money considerations. Firms often depend on expected cash inflows to meet their financial obligations. Insufficient cash inflow can cause failure to meet these obligations, which in turn can lead to penalty fees and even bankruptcy. The third important concept is embodied in the Principle of Incremental Benefits: Cash flows must be measured on an incremental, or marginal, basis. They are the difference between the firm's cash flows with and without the project. For example, consider a sequential set of capital budgeting decisions concerning the research and development of a new product. Initial funds are spent for research; subsequent funds may or may not be approved for product development, test marketing, and production. At each stage, previous expenditures are sunk costs. Therefore, at each stage of the decision making process, only future expenditures and revenues are relevant to the decision of whether to proceed with product development. Fourth, the Principle of Incremental Benefits further requires that expected future cash flows are measured on an after tax basis. A firm is concerned with after tax cash flows in the same way that you as an individual are interested in take home pay: ultimately, that's what you can spend. Shareholders are interested in the net gain in wealth, and taxes take away from the wealth gain. Fifth, we want to alert you to a subtle aspect of the standard capital budgeting analysis: Financing costs are not explicitly identified. However, please don't think they have been left out. The incremental financing costs are implicitly included in the project's cost of capital--its required return. In other words, when we compute a project's NPV or IRR, the discount rate includes in it the opportunity cost for obtaining financing for the project.
5 important things about cash flow estimation
First, it is indeed cash flow that's relevant because a cash flow is distinctly different from a firm's accounting net income. Second, these cash flows are measured on an after-tax basis. The relevant cash flow is the amount left after all taxes have been paid. Third, the Principle of Incremental Benefits reminds us that it is the incremental cash flow that's relevant. Fourth, the Time-Value-of-Money Principle reminds us that the value of a cash flow a cash flow depends on its timing. Money is worth more, the sooner you get it. Fifth, the standard cash flow estimation does not explicitly identify the financing costs. The incremental financing costs are implicitly included in the project's cost of capital--its required return.
What do future investment opportunities refer to
Future investment opportunities refer to the options to identify additional valuable investment opportunities in the future that result from a current investment.
Discuss the relationships between good capital budgeting decisions and cooperative relationships among a firm's worker.
Good decision making requires cooperation. This holds for capital budgeting as well. Interpersonal relationships can play a key role. Feuds between people and/or divisions hurt the firm. People within the same functional area, such as marketing research, obviously must be able to work together successfully. In addition, cooperation among the various decision-making levels plays a critical role. Good capital budgeting decisions also require members of different functional areas to work together successfully. For example, marketing research and finance must exchange information to estimate project cash flows. Procedures that provide authority by area and amount, with a hierarchy of amounts, are designed to minimize problems among individuals, levels, and areas. This is best achieved when workers are cooperative and aim to achieve common goals.
What does Two-Sided Transactions consider?
It considers why the other party to a transaction is willing to participate.
what does postaudit refer to
Postaudit refers to a set of procedures for evaluating a capital budgeting decision after the fact.
salvage value
Salvage value is the before-tax difference between the sale price of the assets and the clean-up and removal expenses.
What does scenario analysis involve?
Scenario analysis involves finding the profitability of a project for alternative "scenarios" where the values for the key variables are different for each scenario.
What does sensitivity analysis involve?
Sensitivity analysis involves varying key values in a process to determine the sensitivity of outcomes to the variation.
What does signaling consider
Signaling considers the actions of others and how these actions communicate information.
What does the agency cost view of capital structure refer to?
The agency cost view of capital structure refers to the argument that the various agency costs create a complex environment in which total agency costs are at a minimum with some, but less than 100%, debt financing.
What does the bankruptcy cost view of capital structure refer to?
The bankruptcy cost view of capital structure refers to the argument that the expected indirect and direct costs of financial distress and bankruptcy reduce the benefits to additional debt financing.
What does the capital market imperfections view of capital structure refer to?
The capital market imperfections view of capital structure refers to view that debt financing is generally valuable, but a firm's optimal choice of capital structure is a dynamic process in a complex environment that involves a mixture of financing methods. The exact mix at any particular point results from considerations of asymmetric taxes, asymmetric information, and transaction costs.
What does the clientele effect refer to?
The clientele effect refers to the grouping of investors who have a preference that the firm follow a particular financing policy, such as the amount of leverage it uses.
How does tax asymmetry influence a manager's debt and equity choices?
The interest paid on debt (unlike the dividends paid to stockholders) lowers the firm's taxable income. This favors a manager choose debt financing over equity financing.
Describe the corporate tax view of capital structure which is the Modigliani and Miller (1963) tax model. What does this view ignore?
The corporate tax view of capital structure model posits a positive change in firm value when managers issue perpetual riskless debt to retire risky equity. The model stems from the work of Modigliani and Miller (1963). They assert that the gain to leverage (GL) is the corporate tax rate (T) multiplied by debt value (D). Their equation (referred to for simplicity at the MM) equation is: GL = TD with D = where CPN is the perpetual cash flow for debt owners, and rd is the cost of debt (rd is the riskless rate for MM). This equation is incomplete since its derivation ignores possible effects stemming from either personal taxes or leverage costs. The latter includes bankruptcy considerations consisting of both direct and indirect expenses related to firms experiencing failure. It also includes agency considerations, which can be either positive or negative depending on the amount of debt.
What does the corporate tax view of capital structure refer to?
The corporate tax view of capital structure refers to the argument that double (corporate and individual) taxation of equity returns makes debt a cheaper financing method.
Discuss some of the expected financial distress or bankruptcy costs when a firm takes on debt. Mention both the direct and indirect costs in your discussion.
The expected cost of financial distress and bankruptcy includes indirect costs and direct costs such as notification costs, court costs, and legal fees. Somewhat surprisingly, the direct costs are relatively small when compared to the firm's value or the indirect costs of bankruptcy. The indirect costs of financial distress and bankruptcy can involve virtually every aspect of the firm. It can be very costly to have management's attention diverted from the day-to-day operation of the business in order to deal with the financial distress and bankruptcy process. After filing for bankruptcy, every major decision a firm makes may require approval by the Bankruptcy Court. A firm may lose tax shields during periods of financial distress. The most significant potential cost of financial distress and bankruptcy is an indirect cost that can be difficult to measure but should not be underestimated. It arises because of the possibility that the firm will not continue as a going concern. This likelihood is important, because it can dramatically affect the value of the firm's products and dramatically hurt sales. When potential customers fear product discontinuation, they will force the firm to sell its product for a lower price than what it would otherwise be worth. Even though it is an opportunity cost that's difficult to measure, this loss is the largest of the financial distress and bankruptcy costs by a wide margin.
Describe the formula for the value of the leveraged firm for the corporate tax view of capital structure.
The formula for the value of the leveraged firm is VL = + TD where I¯ the before-tax perpetuity, T is the corporate tax rate, r is the unleveraged cost of capital, and D is the value of debt. In this formula, the value of the leveraged firm is simply the value of the unleveraged firm plus the value of the debt tax shield.
Describe the formula for the value of the unleveraged firm.
The formula for the value of the unleveraged firm is VU = where I¯ the before-tax perpetuity, T is the corporate tax rate, and r is the unleveraged cost of capital.
Describe and discuss the postponement option. Cite some examples in your discussion.
The postponement option refers to the option to postpone, rather than cancel, an expansion alternative. A price increase now, followed by an expansion in production capacity, additional advertising, and perhaps even a price decrease later, might be superior to a simple price increase now. Of course, the analysis can become very complex when such additional alternatives are included, because of interactions among the various alternatives. There are many postponement decisions in your personal life. Should you study for an exam now or postpone your studying? Should you try to enter an MBA program now or delay for a period of time. In business, the timing of investments is critical. A profitable investment is sometimes more profitable if it's delayed. Timing decisions are not easy. For example, consider the difficult decision a college has to make as to remain in school or sign a lucrative pro contract.
What is the arbitrage argument for the irrelevance of capital structure based on?
There is an arbitrage argument for the irrelevance of capital structure based on the possibility that shareholders can create their own leverage by borrowing and investing in stock.
Nobel Prize winners Modigliani and Miller (1963), referred to as MM, developed a capital structure model for an unleveraged (or all-equity) firm issuing perpetual riskless debt to replace risky equity. Discuss the strengths and weakness of this model.
This model is the corporate tax view of capital structure and states that the gain to leverage (GL) equals the corporate tax rate times debt value. The simplicity of this MM equation for GL is an advantage and makes it (even today) a popular mathematical expression to describe the impact of debt on firm value. Financial managers can use it as an ad hoc estimate of the impact of debt on firm value. This view stemming from the MM equation is limited in its applicability since it implies that financial executives issue unrestricted amounts of debt. Its limitations have inspired theoreticians to examine personal taxes and a variety of leverage costs. The post-MM research offers managers marginal practical improvement since specified leverage costs are hard to measure. From a utility perspective, how are the indirect and direct costs of bankruptcy or the various agency costs to be measured? Researchers offer diverse opinions concerning these costs. Some argue that such costs are negligible, while others offer contrary evidence.
Working relationships with suppliers, particular expertise, and experience are three factors that can at times exercise an impact on a project's value. Discuss the value of these three factors to a firm.
Working relationships with suppliers can be either good or bad. The importance of interpersonal relationships within a firm extends to relationships with individuals and departments in other firms. An individual working for a supplier can cause a costly delay (provide special help) because of a personal vendetta (great relationship). Particular expertise is often needed by employees to make a project successful. When choosing capital rationing, firms face problems of information asymmetry in the labor markets and can have trouble identifying high-quality employees. When transaction costs must be incurred to identify and hire additional employees, those costs decrease the project's NPV. Similarly, when existing employees have expertise that can be used for a project, transaction costs associated with undertaking the project, such as training, will be lower, which in turn increases the project's NPV. Experience with the quality of machines and/or service from particular manufacturers can be valuable. As with relationships with suppliers, good or bad service or parts availability from a manufacturer can decrease or increase the firm's expenses. Likewise, when a machine is known to have a better or worse "cost/quality" relationship, it will increase or decrease the project's NPV. Also, improved knowledge of the expenses connected with using a machine may increase the accuracy of the forecast cash flows. Such improved knowledge is more likely when dealing with machines that use existing technology than machines using innovative technology.
Is the EAA an ordinary annuity payment?
Yes, the EAA is an ordinary annuity payment with a present value equal to the project's NPV.
"Hard" capital rationing refers to the rationing . a. imposed by external factors. b. imposed internally by the shareholders. c. always imposed by competitors. d. always imposed by debtholders.
a
A(n)_________ is a set of procedures for evaluating a capital budgeting decision after the fact. a. postaudit b. net present value profile c. indenture d. stockout
a
Capital structure is irrelevant in terms of firm value in a perfect capital market environment where there are . a. no taxes b. transaction costs c. bankruptcy costs d. both a & b are correct
a
For which (if any) of the following reasons is it important to identify and use only incremental cash flows in capital investment decisions? a. We use incremental cash flows because ultimately it is the change in a firm's overall future cash flows that matter. b. Incremental cash flows are the simplest to identify. c. a & b d. none of these
a
If capital budgeting decisions were _______, there would not be much reason to study the process. a. trivial b. important c. not trifling d. none of these
a
In efficient markets like the U.S., you should think long and hard before you conclude that a market price is . a. wrong. b. fair. c. followed by many analysts. d. all of these
a
Pursuing valuable ideas is the best way . a. to achieve extraordinary returns. b. to get yourself in trouble. c. to restrain your spending. d. to avoid risk.
a
The corporate tax view of capital structure states that WACC equals . a. r(1 − TL) b. r ÷ (1 − TL) c. rT(1 −L) d. none of these
a
The net initial outlay can be broken down into various categories. These include which of the following? a. cash expenditures for the new capital assets b. changes in current liabilities c. cash flow from the depreciation of old equipment d. the tax impact of selling assets at book value
a
The value of an unleveraged firm can be written as . a. VU = I¯(1 − T) ÷ r where I¯ is the expected perpetual cash inflow per year (on a before-tax basis), T is the applicable tax rate, and r is the unleveraged cost of capital b. VU = I¯(1 − T) ÷ r where I¯ is the expected perpetual cash inflow per year (on an after-tax basis), T is the applicable tax rate, and r is the unleveraged cost of capital c. VU = I¯(1 − T) ÷ r where I¯ is the expected perpetual cash inflow per year (on a before-tax basis), T is the applicable tax rate, and r is the leveraged cost of capital d. none of these
a
There are five basic concepts to keep in mind when calculating a project's cash flows. These include which of the following? a. Financing costs are not explicitly identified. b. Principle of Incremental Benefits requires that expected future cash flows are measured on a before tax basis. c. Cash flows must consider sunk costs. d. Costs, but not benefits, are measured in terms of cash flow and not income.
a
WACC equals . a. (1 − L)re + L(1 − T)rd where L is the leverage ratio consisting of debt divided by firm value b. (1 − L)(1 − T)re + L(1 − T)rd where L is the leverage ratio consisting of debt divided by firm value c. (1 − L)re + L(T)rd where L is the leverage ratio consisting of debt divided by firm value d. (1 − L)re + L(1 − T)rd where L is the leverage ratio consisting of equity divided by firm value
a
Ways of reducing the agency costs of debt include . a. having a sinking fund provision b. securing debt by using intangible assets as collateral c. allowing additional debt or dividends d. none of these
a
What does one call returns that have not been adjusted for inflation? (NOTE. By "not adjusted for inflation," we mean we have not taken out an inflation premium.) a. nominal returns b. average returns c. taxable returns d. a & b
a
When options exist, the _______ of a project is its DCF-NPV plus the expected value of the option minus the cost of the option. a. NPV b. payback c. IRR d. PI
a
Which (if any) of the following statements is false? a. Enhancement always has a negative impact on one or more of a firm's existing products. b. EAA is the ordinary annuity payment with a present value equal to the project's NPV. c. EAC is the equivalent cost per year of owning an asset over its entire life. d. none of these
a
Which (if any) of the following statements regarding NPV analysis is correct? a. NPV calculations are only as good as the information that goes into their calculation. b. NPV calculations can ignore inflation. c. NPV calculations do not depend critically on cash flow projections. d. none of these
a
Which of the following represents the perfect capital market view of capital structure? a. Firm value depends only on its expected future operating cash flows and the cost of capital, not on how those cash flows are divided between the debtholders and the shareholders. b. The differential between tax rates on personal income from equity and from debt cancels out the corporate tax asymmetry. c. A before-tax dollar singly taxed at Td provides the same net amount to an investor as a before-tax dollar taxed at T and then taxed again at Te. d. none of these
a
Which of the following represents the perfect capital market view of capital structure? a. Firm value depends only on its expected future operating cash flows and the cost of capital, not on how those cash flows are divided between the debtholders and the shareholders. b. The value of the leveraged firm is equal to the value of the unleveraged firm plus the tax rate times the amount of debt. c. Maximum firm value results from being essentially all-debt financed. d. none of these
a
Which of the following statements is false? a. Enhancement is an innovation that has a negative impact on one or more of a firm's existing products. b. Enhancement is an innovation that has a positive impact on one or more of a firm's existing products. c. Erosion is an innovation that has a negative impact on one or more of a firm's existing products. d. all of these
a
Which of the following statements is true? a. The Principle of Incremental Benefits says to consider the possible ways to minimize the value lost to capital market imperfections, such as asymmetric taxes, asymmetric information, and transaction costs. b. The Behavioral Principle suggests to look for opportunities to create value by issuing securities that are in short supply, perhaps resulting from changes in tax law. c. The Principle of Valuable Ideas advises to include any time-value-of-money tax benefits from capital structure choices. d. all of these
a
________ assets (such as special production processes, patents, and copyrights) are less likely to have organized markets. a. Intangible b. Tangible c. Collateralized d. Concrete
a
________ is a situation where information is known to some participants but not others. a. Asymmetric information b. Abandonment information c. Postponement information d. a & c
a
Which of the following represents the corporate tax view of capital structure? a. Firm value depends only on its expected future operating cash flows and the cost of capital, not on how those cash flows are divided between the debtholders and the shareholders. b. The value of the leveraged firm is equal to the value of the unleveraged firm plus the tax rate times the amount of debt. c. Maximum firm value results from being essentially all-equity financed. d. Corporate taxes cause debt to be more expensive than equity.
b
Which of the following represents the corporate tax view of capital structure? a. The differential between tax rates on personal income from equity and from debt cancels out the corporate tax asymmetry. b. The value of the leveraged firm is equal to the value of the unleveraged firm plus the tax rate times the amount of debt. c. A before-tax dollar singly taxed at Td provides the same net amount to an investor as a before-tax dollar taxed at T and then taxed again at Te. d. Corporate taxes cause debt to be more expensive than equity.
b
Which of the following represents the personal tax view of capital structure? a. Firm value depends only on its expected future operating cash flows and the cost of capital, not on how those cash flows are divided between the debtholders and the shareholders. b. The firm operates in a perfect capital market environment, except for corporate and personal income taxes. c. Maximum firm value results from being essentially all-equity financed. d. Corporate taxes cause debt to be more expensive than equity.
b
Which of the following statements is false? a. The EAA is the ordinary annuity payment with a present value equal to the project's NPV. b. EAA is the ordinary annuity payment with a present value equal to the project's present value of its operating cash flows. c. EAC is the equivalent cost per year of owning an asset over its entire life. d. EAC is calculated as an ordinary annuity payment that has the same present value as the asset's costs.
b
Which of the following statements is true? a. EAC is an annualized annuity payment with a present value equal to the present value of a project. b. EAA is the ordinary annuity payment with a present value equal to the project's NPV. c. EAC is the equivalent annual cost per year of owning an asset over part of its life. d. EAA is calculated as an ordinary annuity payment that has the same present value as the asset's costs.
b
Which of the following statements is true? a. The Principle of Incremental Benefits says to recognize that the potential to increase firm value through capital structure is smaller than the potential to increase firm value through the introduction of valuable new ideas and wise use of the firm's comparative advantages. b. The Behavioral Principle states to look to the information contained in the capital structure decisions and financing transactions of other firms for guidance in choosing a capital structure. c. The Time Value of Money Principle says to consider any possible change in capital structure carefully, because financing transactions and capital structure changes convey information to outsiders and can be misunderstood. d. none of these
b
Which of the following statements is true? a. The Signaling Principle says to recognize that capital structure changes made at fair market security prices, which also change equity-debt risk bearing, are simply a risk-return trade-off. Such transactions don't affect firm value (except for possible signaling effects). b. The Time Value of Money Principle advises to include any time-value-of-money tax benefits from capital structure choices. c. The Behavioral Principle suggests to look for opportunities to create value by issuing securities that are in short supply, perhaps resulting from changes in tax law. d. none of these
b
Which of these statements is true? a. Future investment opportunities are options to abandon investment possibilities in the future that result from a current opportunity or operation. b. When a firm makes a capital budgeting decision, one option to consider is the possibility of stopping the project earlier than originally planned. c. The abandonment option is the option to postpone, rather than cancel, an expansion. d. none of these
b
With tax asymmetry, . a. an all-debt firm can increase its value by issuing debt b. an all-equity firm can increase its value by issuing debt c. an all-equity firm can decrease its value by issuing debt but increase its value by issuing preferred stock d. an all-debt firm can increase its value by issuing equity
b
A capital budgeting project's cash flows fall into four basic categories. These categories include which of the following? a. Net salvage value, which is the before-tax total amount of cash received and / or spent when the project ends. b. Expected future interest payments. c. Non operating cash flows to support the project, such as those for an overhaul. d. b & c
c
Return on investment (ROI) does not have a consistent relationship with NPV. Therefore, it does not measure managerial success in choosing projects ________. a. that have a positive net present value. b. that create value. c. a & b d. none of these
c
The arbitrage argument shows . a. that if two firms have identical operating profitability but different capital structures, arbitrage among investors will ensure that the two firms have unequal market values. b. that if two firms have different profitability but different capital structures, arbitrage among investors will ensure that the two firms have equal market values. c. that if two firms have identical operating profitability but different capital structures, arbitrage among investors will ensure that the two firms have equal market values. d. none of these
c
The corporate tax view of capital structure states that WACC equals . a. (1 − L)rd + L(1 − T)re b. r ÷ (1 − TL) c. r(1 − TL) d. none of these
c
The nominal rate can be obtained by simply compounding . a. the real rate. b. the inflation rate. c. the real rate and the inflation rate. d. none of these
c
The value of an unleveraged firm can be written as . a. VU = T(I¯÷ r) where I¯ is the expected perpetual cash inflow per year (on a before-tax basis), T is the applicable tax rate, and r is the unleveraged cost of capital b. VU = I¯ ÷ r where I¯ is the expected perpetual cash inflow per year (on a before-tax basis), T is the applicable tax rate, and r is the unleveraged cost of capital c. VU = I¯(1 − T) ÷ r where I¯ is the expected perpetual cash inflow per year (on a before-tax basis), T is the applicable tax rate, and r is the unleveraged cost of capital d. none of these
c
There are two important tax considerations for a capital budgeting project. These include which (if any) of the following? a. whether the assets will be expensed or capitalized b. tax consequences of selling old assets c. a & b d. none of these
c
To obtain funds from the capital market, a firm must convince investors that they can expect to earn at least their ________ a. expected return. b. realized return. c. required return. d. none of these
c
Under capital rationing, a good tool to use is the . a. IRR method. b. payback method. c. PI method. d. NPV method.
c
WACC equals . a. (1 − L)rd + L(1 − T)re where L is the leverage ratio consisting of debt divided by firm value b. (1 − L)(1 − T)re + Lrd where L is the leverage ratio consisting of debt divided by firm value c. (1 − L)re + L(1 − T)rd where L is the leverage ratio consisting of debt divided by firm value d. (1 − L)re + L(1 − T)rd where L is the leverage ratio consisting of equity divided by firm value
c
Which of the following represents the personal tax view of capital structure? a. Firm value depends only on its expected future operating cash flows and the cost of capital, not on how those cash flows are divided between the debtholders and the shareholders. b. Corporate taxes cause debt to be cheaper than equity. c. The differential between tax rates on personal income from equity and from debt cancels out the corporate tax asymmetry. d. both a & b are correct
c
Which of the following statements (if any) is true? a. Hard capital rationing refers to the rationing imposed internally by limited funds for borrowing from outside sources. b. Soft capital rationing refers to the rationing imposed externally by the firm. c. Future investment opportunities are options to identify additional, more valuable investment possibilities in the future that result from a current opportunity or operation. d. none of these
c
Which of the following statements is true? a. Soft capital rationing refers to the rationing imposed externally by limited funds for borrowing from outside sources. b. Hard capital rationing refers to the rationing imposed internally by the firm. c. A postaudit is a set of procedures for evaluating a capital budgeting decision after the fact. d. all of these
c
Which of the following statements is true? a. The Principle of Capital Market Efficiency says to consider the possible ways to minimize the value lost to capital market imperfections, such as asymmetric taxes, asymmetric information, and transaction costs. b. The Behavioral Principle suggests to look for opportunities to create value by issuing securities that are in short supply, perhaps resulting from changes in tax law. c. The Signaling Principle says to consider any possible change in capital structure carefully, because financing transactions and capital structure changes convey information to outsiders and can be misunderstood. d. all of these
c
Which of these statements is false? a. Future investment opportunities are options to identify additional, more valuable investment possibilities in the future that result from a current opportunity or operation. b. When a firm makes a capital budgeting decision, one option to consider is the possibility of stopping the project earlier than originally planned. c. The postponement option is the option to abandon, rather than cancel, an expansion. d. all of these
c
Which statement is false? a. Capitalized involves recording an outlay as an asset and allocating (depreciating) the cost over future time periods. b. Expensed involves recognizing an outlay as an expense for tax purposes at the time it is incurred. c. Salvage value refers to a credit against taxes due that is based on the amount of new capital outlays. d. Net operating cash flow, CFAT (cash flow after tax) is the change in cash receipts minus the change in cash operating expense minus the taxes paid.
c
Which statement is true? a. Expensed involves recording an outlay as an asset and allocating (depreciating) the cost over future time periods. b. Capitalized involves recognizing an outlay as an expense for tax purposes at the time it is incurred. c. Investment tax credit refers to a credit against taxes due that is based on the amount of new capital outlays. d. Net operating cash flow is the change in cash receipts plus the change in cash operating expense minus the taxes paid.
c
Which of the following statements is true? a. The Principle of Capital Market Efficiency says to recognize that the potential to increase firm value through capital structure is smaller than the potential to increase firm value through the introduction of valuable new ideas and wise use of the firm's comparative advantages. b. The Behavioral Principle states to look to the information contained in the capital structure decisions and financing transactions of other firms for guidance in choosing a capital structure. c. The Signaling Principle says to consider any possible change in capital structure carefully, because financing transactions and capital structure changes convey information to outsiders and can be misunderstood. d. all of these
d
Which of the following statements is true? a. The Principle of Incremental Benefits says to consider the possible ways to minimize the value lost to capital market imperfections, such as asymmetric taxes, asymmetric information, and transaction costs. b. The Principle of Valuable Ideas suggests to look for opportunities to create value by issuing securities that are in short supply, perhaps resulting from changes in tax law. c. The Time Value of Money Principle advises to include any time-value-of-money tax benefits from capital structure choices. d. all of these
d
Which of these statements is false? a. Future investment opportunities are options to identify additional, more valuable investment possibilities in the future that result from a current opportunity or operation. b. When a firm makes a capital budgeting decision, one option to consider is the possibility of stopping the project earlier than originally planned. c. The postponement option is the option to postpone, rather than cancel, an expansion. d. none of these
d
Which of these statements is true? a. A postaudit is a set of procedures for evaluating a capital budgeting decision after the fact. b. When a firm makes a capital budgeting decision, one option to consider is the possibility of stopping the project earlier than originally planned. c. The postponement option is the option to postpone, rather than cancel, an expansion. d. all of these
d
With tax asymmetry, . a. an all-debt firm can increase its value by issuing debt b. an all-equity firm can increase its value by retiring debt c. an all-equity firm can decrease its value by issuing debt d. an all-equity firm can increase its value by issuing debt
d
________ can be beneficial because it is a way a firm can manage the problems and costs of asymmetric information connected with getting additional financing for new projects. a. Capital expenditures b. Capital budgeting c. Initial public offerings d. Capital rationing
d
