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International Corporate Finance > Capital Budgeting > Flashcards

Capital Budgeting Flashcards

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1
Q

What is NPV?

A

the present value of all future free cash flow, discounted at an appropriate rate, minus the initial net cash outlay for the project.

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2
Q

Is NPV consistent with shareholders’ wealth maximisation?

A

Yes, NPV evaluates investments in the same way the company’s shareholders do, and thus is consistent with shareholder’s wealth maximization.

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3
Q

True or false: The NPV criterion obeys the value additively principle; that is, the NPV of a set of independent projects is just the sum of NPV’s of the individual projects.

A

True

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4
Q

What is the basic capital budgeting rule?

A

the manager should pick the combination of projects that maximize shareholder’s wealth; that is, pick the set of project that present the highest overall NPV (sum of individual projects).

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5
Q

Besides NPV, what are other evaluation tools?

A

Internal Rate of Return
Payback Period
Discounted Payback Period
Weighted Average Profitability Index

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6
Q

What is FCF?

A

cash generated by the firm’s operations that is available for all sources of finance: debtholders and shareholders.

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7
Q

What is incremental FCF?

A

Incremental FCF of a project represent the extra (change) FCF that a specific project will generate for the existing firm.

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8
Q

What is the incremental value generated by the project?

A

EBIT or EBITDA should represent the incremental value generated by the project for this firm.

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9
Q

What is CAPEX?

A

CAPEX represents the increment in capital expenditures (expenditures in fixed assets). If the project implies a disinvestment in fixed assets (negative CAPEX) it should be considered the sale value net of costs (please note that this assumes that the asset was fully depreciated and has a null book value).

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10
Q

Should interest payments be included in the FCF?

A

No, interest payments should never be included in the FCF computation because they represent a type of payment do debtholders.

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11
Q

True or false: each component in the Balance Sheet has its own opportunity cost.

A

True, 𝑟 𝑈 represents the firm’s cost of capital for its business risk, 𝑟 𝐷 is the opportunity cost of capital demanded by debtholders and 𝑟 𝐸 is the opportunity cost of capital for shareholders.

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12
Q

What are the 6 assumptions of Modigliani Miller World?

A
  • Investment policy held constant: all future investments are predetermined.
  • Markets are efficient: there are no arbitrage opportunities.
  • No transaction costs: buy and selling securities have no extra costs.
  • Managers maximize shareholder’s wealth: no choices that imply a negative NPV.
  • No taxes: no taxes of any kind (corporate taxes, taxes on interests and taxes on equity income).
  • No costs of financial distress: no direct or indirect costs of financial distress.
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13
Q

What is the Proposition I of MM?

A

Proposition I: Under Modigliani Miller (MM) assumptions, changes in the firm’s capital structure are irrelevant. This implies that changes in the firm’s debt and equity will not affect the firm’s value (the value of the firm’s operations).

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14
Q

Under MM world, is the levered value the same as the unlevered value?

A

Yes

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15
Q

What is Proposition II of MM?

A

Proposition II: under MM assumption, changes in the firm’s capital structure will not change the firm’s cost of capital (unlevered cost of capital or pretax WACC). This implies that changes in D/(D+E) and E/(D+E) will not impact rU.

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16
Q

True of false: the higher the debt-to-equity ratio the higher will be the return demand by shareholders

A

True

17
Q

According to Proposition II, do changes in the capital structure impact the firm’s operational systematic risk?

A

No

18
Q

What is the firm’s beta of assets?

A

The firm’s beta of assets for a given firm is the weighted average of all unlevered betas from all its different business activities (weighted average of all its asset’s betas in market values)

19
Q

When does Ba equals Bu?

A

When the firm only has one kind of business and no excess cash (excess cash has zero beta).

20
Q

When can we use ru to find Vl?

A

With all MM assumptions.

21
Q

Does the firm’s Equity react with announcement?

A

Yes, when the firm’s manager announces that the firm will pursue an unexpected new investment opportunity the firm’s Equity reacts by the NPV expected by investors.

22
Q

When does the manager raise funds?

A

After announcement.

23
Q

When all MM assumptions are valid besides taxes, where does the added value come from?

A

Interest Tax Shields (ITS)

24
Q

What is the ITS?

A

The ITS is defined by the amount of cash saved in taxes due to interest payments.

25
Q

When does a firm have a constant capital structure?

A

A firm is considered to have a constant capital structure if its manager continuously adjusts the firm’s leverage (debt) in order to maintain the ratios: D/E, D/(D+E) and E/(D + E) forever constant.

26
Q

True or false: If the firm decides to change its capital structure and keeps it constant after the change, the firm still has a constant capital structure.

A

True

27
Q

True or false: If the firm decides to change its capital structure and keeps it constant after the change, the WACC value won’t change.

A

False

28
Q

What is APV?

A

APV is a technique that allows to determine the firm’s value including any desire impact (can be applied even if none of the assumptions from MM are valid).

29
Q

True or false: when the capital structure is kept constant, it is expected that the ITS grow at the same growth rate as the firm’s FCF.

A

True

30
Q

When does a firm have permanent debt?

A

When the firm’s debt is composed only by permanent debt the firm’s keeps the market value of debt constant forever. Permanent debt is an example of pre-determined debt.

31
Q

When can we use the formulas for permanent debt?

A

When the firm has permanent debt and the firm’s FCF grow at a constant growth rate in perpetuity.

32
Q
A

International Corporate Finance (10 decks)

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