final finance

Which is NOT a determinant of business risk? Competition Demand variability Financial leverage Input cost variability Operating leverage

3: Financial leverage increases financial risk, not business risk. On the other hand, more competition reduces the firm's pricing power, thus increasing business risk. Similarly, higher variability of demand or input costs makes the business riskier, as does a high degree of operating leverage.

Financial risk is the additional risk for _____ that results from _____. bondholders; debt financing bondholders; equity financing stockholders; debt financing stockholders; equity financing

3: Financial risk is the additional risk for stockholders that results from debt financing. In other words, financial leverage creates financial risk.

Which decision criterion leads most consistently to the correct decision? Average accounting return Internal rate of return Net present value Payback period

3: NPV is the best decision criterion. IRR can be misleading when projects are mutually exclusive or cash flows are non-conventional. The other two criteria are generally inferior.

Which piece of information is always unnecessary to find the intrinsic value of a stock using P/E ratios? The company's most recent earnings per share The company's expected earnings per share The company's current stock price The company's historical PE ratios The PE ratios of similar companies

3: P = P/E * E, so we need a relevant P/E benchmark, either from the company's own history or from similar companies, and the most recent or expected earnings per share. The stock price is the result of the calculation, not an input.

The optimal capital structure maximizes the value of the firm, which is the same as maximizing the book value of assets maximizing the book value of equity minimizing the cost of capital minimizing the market value of debt

3: Since the market value of the firm equals the present value of all future cash flows, a lower cost of capital results in a lower discount rate and higher present values. Minimizing the cost of capital is thus the same as maximizing firm value when it comes to capital structure decisions.

How does the WACC change as a company takes on more and more debt? It gets lower and lower It gets higher and higher It falls first, then rises It rises first, then falls

3: The WACC decreases at first as the company takes on some debt due to the present value of the interest tax shield. However, beyond a certain amount of debt, the expected costs of financial distress more than offset the interest tax shield, resulting in a rising WACC.

The cost of debt is the _______ of the company's bonds. coupon rate current yield yield to maturity price

3: The cost of debt is the interest rate the company must pay on new loans. Yield to maturity gives the currently required rate, while the coupon rate only reflects the required interest rate at the time the bond was issued.

The constant growth model is based on the assumption that stock prices grow by a constant amount every period dividends grow by a constant amount every period dividends grow at a constant rate discount rates grow at a constant rate

It assumes that dividends grow at some constant rate g every period, such that Dt = Dt-1 (1+g).

The P/E ratio measures the growth rate of dividends the expected capital gain the price equivalent of $1 of earnings the price an investor pays for $1 of earnings

The P/E ratio measures the growth rate of dividends the expected capital gain the price equivalent of $1 of earnings the price an investor pays for $1 of earnings

The capital structure weights to be used in the WACC calculation should ideally reflect observed book values observed market values target book values target weights

We should use target capital structure weights when calculating the WACC, on the assumption that companies with capital structure targets will maintain their capital structure in line with their targets. If we don't know the target weights, we should use observed market values as a second-best alternative.

The business risk of a firm's equity depends on the _____ of the firm's assets, while the financial risk of the firm's equity depends on the _____. systematic risk; firm's financial structure systematic risk; risk of default total risk; firm's financial structure total risk; risk of default

1: Business risk reflects the systematic risk of the firm's assets, i.e., the sensitivity of the company's cash flows with regard to common factors such as the business cycle. Financial risk stems from the use of debt financing, which increases both the volatility of cash flows and the risk of bankruptcy.

Which is NOT an example of capital restructuring? Buying inventory on credit Issuing new debt Issuing new equity Issuing new equity to repurchase debt

1: Buying inventory on credit increases current assets and current liabilities, but does not affect long-term debt or equity. Capital restructuring means changing the capital structure of a company, i.e., changing long-term debt or equity.

In a world with taxes but without financial distress, the optimal capital structure consists of only debt only equity equal shares of debt and equity a mix of debt and equity that minimizes the WACC

1: Financial leverage increases the value of the firm through the present value of the interest tax shield. If there's no cost of financial distress, the optimal capital structure consists of 100% debt (M&M proposition 1 with taxes).

Costs of corporate financial distress include all of the following, EXCEPT customers defaulting on credit sales legal and administrative expenses of bankruptcy loss of employees or suppliers lost sales due to customer distrust

1: If a customer defaults on a loan from the company, e.g., a sale on credit, it's probably because the customer is experienceing financial distress, not the company. The legal and administrative expenses incurred during the bankruptcy process are direct costs of financial distress. Indirect costs, such as loss of employees, suppliers or customers account for a far larger fraction of the overall costs of financial distress, but are more difficult to measure.

The non-constant growth dividend discount model is most appropriate for companies that are new mature unchanging declining

1: New companies, such as startups, often grow very quickly initially before their business matures and their growth rate settles down to a value that is approximately constant.

When a company takes on more and more debt, the benefits of debt will eventually be offset by the cost of bankruptcy the cost of bankruptcy will eventually be offset by the benefits of debt the value of the firm will increase consistently the value of the firm will decrease consistently

1: While increased leverage increases the interest tax shield, it also increases the probability of financial distress. Beyond a certain level of debt, the benefits of debt financing are more than offset by the expected cost of financial distress, lowering the value of the firm as a result.

For a firm without long-term debt, its WACC will be equal to its cost of debt its cost of equity the YTM on its bonds the weighted average of its cost of debt and its cost of equity

2: A company without long-term debt has no bonds outstanding, and is purely equity-financed. As such, its cost of capital is equal to the cost of equity.

The term capital structure refers to the company's bonds use of long-term debt and equity willingness to restructure its capital yield curve

2: Capital structure refers to the relative weight of debt and equity on the right-hand side of a firm's balance sheet.

The dividend yield increases as the stock price increases the stock price decreases earnings per share increase earnings per share decrease

2: Dividend yield equals the ratio of dividends per share over the stock price (D/P), so a lower stock price implies a higher dividend yiel

The interest tax shield refers to tax savings by firms due to the deductibility of dividends by firms due to the deductibility of interest payments by bondholders due to the deductibility of interest by holders of municipal bonds due to their exemption from federal taxes

2: Interest payments reduce taxable income and thus taxes. The interest tax shield is the amount of taxes saved each period = tax rate * interest payment = tax rate * amount of debt * cost of debt = Tc * D * rD.

Everything else equal, greater _____ increase(s) operating leverage. financial leverge fixed costs operating efficiency variable costs

2: Operating leverage is the extend to which a firm incurs fixed costs in its operations. Fixed costs are those that do not vary with the level of production. When a company has a high degree of operating leverage, small changes in sales result in large changes in ROIC.

Based on the NPV criterion, we should accept a project if the NPV is negative positive greater than the required return greater than 1

2: We should accept a project if NPV ≥ 0.

Project cash flows are considered conventional or normal if only the first cash flow is negative and the rest are positive the first (one or more) cash flows are negative and the rest are positive there are more positive than negative cash flows the last cash flow is positive

2: With conventional cash flows, the sign of cash flows changes only once, i.e., after one or more negative cash flows initially, all the remaining cash flows are positive.

Based on the IRR criterion, we should accept a project if the IRR is negative positive greater than the required return greater than 1

3

Based on the payback period criterion, we should accept a project if the payback period is less than zero greater than zero less than some cutoff value greater than some cutoff value

3

Which statement is true about book value (BV) and market value (MV)? The BV of equity is usually similar to the MV of equity The BV of equity is usually greater than the MV of equity The BV of debt is usually similar to the MV of debt The BV of debt is usually greater than the MV of debt

3: BV and MV of debt are usually similar, while the BV of equity is usually less than the MV of equity.

Business risk is the risk inherent to the company's _____ _____. financing; even if it uses no debt financing; if it uses debt operations; even if it uses no debt operations; if it uses debt

3: Business risk is the risk inherent to the company's operations even if it uses no debt. In other words, business risk is the riskiness of the company's assets or of the cash flows generated by these assets in the absence of debt. Business risk increases if the company has highly variable demand or input costs, among other factors.

A common measure of business risk is the standard deviation of ROA ROE ROIC Stock returns

3: The standard deviation of ROIC is a common measure of business risk. Since ROIC = EBIT (1-T) / Invested capital, and Invested capital is the sum of long-term debt and equity, ROIC is unaffected by capital restructuring (which changes the D/E ratio, while keeping total capital constant), and thus is not affected by financial leverage. As a result, the variability of ROIC is a measure of business risk only, unaffected by financial risk.

Which statement is FALSE? Shareholders elect the board of directors. The board of directors appoints and monitors the executive board. Shareholders supervise the executive board. The board of directors has a fiduciary duty to shareholders.

3: There are too many shareholders to effectively supervise the executive board. That is why shareholders elect a board of directors to supervise the top managers on their behalf.

The assets and operations of two firms are the same in a world without taxes. Firm 1 is all equity financed, while firm 2 uses debt and equity. The all-equity firm is more valuable The firm using debt and equity is more valuable The value of both firms is the same Value depends on cash flows, which we don't know

3: Without taxes, the way a firm is financed is irrelevant for the value of the firm (M&M proposition 1).

The IRR is the discount rate that discounts all cash flows to their present value discounts all internal cash flows treats all cash flows as internal sets NPV equal to 0

4

The expected return on a stock is called the ______ from the investor's perspective, and the ____ from the company's perspective. excess return; cost of capital excess return; cost of equity required return; cost of capital required return; cost of equity

4

Costs of financial distress are first incurred when a company files for bankruptcy has been declared bankrupt has gone bankrupt is perceived as threatened by bankruptcy

4: As soon as a company is perceived to be threatened by bankruptcy, some employees leave and some customers take their business elsewhere. Suppliers may also refuse to grant credit and lenders charge higher interest rates on future loans.

Which is not a source of expected returns in the dividend discount model? Expected dividend yield Expected growth rate of dividends Expected capital gain Most recent dividend

4: E(r) = D1/P + g, where D1/P is the expected dividend yield and g is the growth rate of both dividends and the share price, thus reflecting the expected capital gain. The most recent dividend, D0, is not a source of expected return.

Financial leverage refers to the use of current liabilities on the right-hand side of the balance sheet equity in a company's capital structure large net working capital long-term debt in a company's capital structure

4: Financial leverage denotes the extent to which a company relies on long-term debt in its capital structure. Highly leveraged companies use a lot of debt relative to equity, while unleveraged companies use no long-term debt at all to finance their assets.

A capital gains yield of zero implies a positive dividend yield a zero dividend yield a positive growth rate of dividends a zero growth rate of dividends

4: In the dividend discount model, the stock price appreciates at the same rate as dividends. A capital gains yield of zero means a constant stock price, which is only possible if the growth rate of dividends is zero.

Starting from a position without debt, increasing financial leverage _____ the value of the firm because of the ______. decreases; costs of financial distress decreases; present value of the interest tax shield increases; costs of financial distress increases; present value of the interest tax shield

4: Increasing leverage reduces taxable income and taxes, thus increasing the value of the firm by the amount of the present value of the interest tax shield (TC * D).

Which of these factors affecting the WACC can the firm NOT control? Capital budgeting decision rules Capital structure Dividend payout ratio Investors' risk aversion

4: Investors' risk aversion is not under the control of the company.

Financial leverage decreases gains and losses decreases gains and increases losses increases gains and decreases losses increases gains and losses

4: Just as a lever in physics magnifies the applied force, financial leverage magnifies both gains and losses compared to a situation with less debt or no debt. Leverage thus increases risk for both bondholders and shareholders.

The stock of a levered firm is ______ the stock of an unlevered firm because _____. as risky as; of M&M proposition 1 as risky as; of M&M proposition 2 riskier than; leverage increases business risk riskier than; leverage increases financial risk

4: Leverage increases financial risk and thus increases the cost of equity (the required return on equity). In a world without taxes, the overall cost of capital (WACC) is unaffected by leverage, but the cost of equity increases with leverage.

Which of the following is the perfect method for deciding whether or not to undertake a project? The payback rule The average accounting return rule The internal rate of return rule None of the above. All of these methods have their own problems.

4: None of the above. Each of these methods has its own weaknesses. They should only be used in conjunction with other decision rules to assess whether or not a project is worth undertaking.

Which statement is FALSE? Corporations have to hold regular elections for the board of directors. Each share of stock has one vote. Shareholders can transfer their right to vote to someone else. Shareholders must vote in person at the annual meeting.

4: Shareholders can vote in person at the annual meeting, but don't have to. It is more common to transfer their right to vote to someone else, by means of a proxy (a permission to vote on someone else's behalf).

Which is NOT a factor making stock valuation more difficult than bond valuation? There is no fixed maturity date Future periodic cash flows are uncertain The future price is uncertain The discount rate is unobservable

4: Stocks have no maturity date, and future dividends and the stock price are uncertain, while bonds have a maturity date and their interest payment and face value are known. However, the discount rate is unobservable for both stocks and bonds.

Which is NOT a problem of the payback period criterion? It ignores the time value of money. It ignores the risk of a project. It uses an arbitrary cutoff value. It ignores cash flows after the cutoff date. It is difficult to calculate. It doesn't show the value created by a project.

5

Which is NOT a factor influencing the company's overall cost of capital? Business or operational risk Cost of debt Cost of equity Sources of funding for the company overall Sources of funding for financing a particular project

5: The WACC is the overall cost of capital. It is affected by the costs of debt and equity and by the capital structure weights (reflecting the sources of funding for the company overall). The cost of equity in turn reflects both the business risk of the company's assets and the financial risk of debt financing.

Starting from a position without debt, increasing financial leverage _____ the cost of debt and _____ the cost of equity, while ________ the WACC. decreases; decreases; decreasing decreases; decreases; increasing decreases; increases; decreasing decreases; increases; increasing increases; decreases; decreasing increases; decreases; increasing increases; increases; decreasing increases; increases; increasing

7: Increasing leverage increases the probability of financial distress, including defaulting on debt and declaring bankruptcy. As a result, the cost of both debt and equity increase with leverage. Counterintuitively, however, the WACC decreases initially, since increasing leverage tilts the capital structure weights away from equity and towards debt, and the cost of debt is always lower than the cost of equity, resulting in a lower WACC.

Which is NOT a means of making a takeover more difficult? Allowing existing shareholders to buy shares at a reduced price (poisen pill) Attempting to get enough rights to vote to replace the directors (proxy fight) Electing only a fraction of directors every year (staggered board) Requiring much more than 50% of shareholders to approve a merger (supermajority)

: A proxy fight is often done to replace the management or directors in a corporate takeover.