CFA Corporate Finance

Question 1

Explain why the cost of capital used in capital budgeting should be a weighted average of the costs of various types of capital the company uses. Define the target (optimal) capital structure

Answer 1

Most firms are financed with a combination of debt and equity. Because the firm should be viewed as a going concern, it is more appropriate to use a weighted average cost of each capital component rather than the specific cost of financing for a particular project. The optimal capital structure is the mix of debt and equity that maximises the stock price The target capital structure is the mix of debt and equity the firm plans to raise

Question 2

Define and calculate the component cost of (1) debt, (2) preferred stock, (3) retained earnings (3 different methods) and (4) newly issued stock or external equity.

Answer 2

The after tax cost of debt [k_d (1-t)] is used to compute the weighted average cost of capital. It is the interest rate on new debt (k_d) less the tax savings due to the deductibility of interest (k_d)(t).

The cost of preferred of preferred stock (k_ps) is:

k_ps = D_ps/P_net

D_ps = preferred stock dividends, and P_net = net issuing price after flotation costs.

The cost of retained earnings (k_s), is the rate of return stockholders require on the equity capital the firm retains from earnings.

1. The CAPM approach: ks = RFR + Beta (k_market - k _RFR)
2. The bond yield + risk premium approach: ks = bond yield + risk premium
3. The discounted cash flow or dividend yield plus growth rate approach: P₀ = D₁/(K_s-g)

The cost of new comm. equity (k_s) is k_e = [D₁/ P₀(1-F))]+g

Question 3

Define and calculate a company’s weighted average cost of capital

Define and calculate a company’s marginal cost of capital

Answer 3

The weighted average cost of capital (WACC) is the average cost of debt, preferred stock, and common stock, weighted by the market values of each capital component. It is given by:

WACC = (W_d)[K_d(1-t)] + (W_ps)(K_ps) + (W_ce)(K_s)

The marginal cost of capital (MCC) is the cost of the last dollar of new capital the company raises. The marginal cost increases as additional capital is raised.

Question 4

Distinguish between the weighted average cost of capital and the marginal cost of capital

Answer 4

The WACC is the weighted average cost of each capital component (debt, preferred stock, and common equity). MCC is the cost of the last dollar of new capital raised; therefore, the WACC increases as additional capital is raised.

Question 5

Explain the factors that affect the cost of capital and distinguish between those factors that can and cannot be controlled by the company

Answer 5

Factors the firm cannot control

• The level of interest rates. As interest rates rise, the cost of debt will certainly increase and the cost of capital will rise. Rising inteest rates will also most likely affect the cost of equity.
• Tax rates: As tax rates change, the after tax cost of debt will change

Factors the firm can control

• Capital structure policy: The firm can ater its target capital structbure. As the firm issues more and more debt, the cost of debt rises. The same argument holds true for equity. As more equity is issued, the cost of equity rises.
• Dividend policy: The firm can change its payout ratio thus shifting the breakpoin of the MCC schedule
• Investment Policy: The major assumption is that all investments have the same degree of risk. By changing the riskiness of investments, the firm will cause the cost of both equity and debt to change.

Question 6

Define Capital Budgeting

Describe the role of the post audit in the capital budgeting process

Answer 6

Capital budgeting is the process of analyzing projects for inclusion in fixed assets

Performing a post audit involbes comparing the actual results with the original forecast and analysing the differences. A post audit introduces accountability into the capital budgeting process thereby improving forecasting and operations.

Question 7

Describe payback period and discounted payback period, net present value (NPV), and internal rate of return (IRR) and evaluate capital projects using each method.

Answer 7

The payback period is defined as the number of years it will take before the original investment is recovered. The disadvantage of the payback period is that it ignores the time value of money and the cash flows received after the payback period.

The discounted payback period is similar to the payback period except that the cash flows are discounted by the project cost of capital. Discounted payback solves the TVM problem but still ignores the cash flows that are received after the payback.

The NPV method finds the present value of each cash flow discounted at the project’s cost of capital. For independent projects if NPV > 0, reject the project. For mutually exclusive projects, choose the project with the hightest NPV (assuming it is positive).

The IRR is the rate of return which equates the PV of the project’s expected cash inflows with the present value of the project’s cost. If the project’s are independent then IRR > cost of capital (hurdle rate), accept the project. If IRR < the cost of capital (hurdle rate), reject the project. If projects are mutually exclusive, the projects are ranked on the basis of their IRR’s.

Question 8

Explain the NPV rule

Question 9

Explain the relative advantages and disadvantages of the NPV and the IRR methods, particularly with respect to independent versus mutually exclusive projects.

Answer 9

For independent projects, the IRR and NPV will result in the same accept/ reject decisions.

When evaluating mutually exclusive projects, the IRR and the NPV methods can give conflicting results. NPV assumes that the rate of return on the project can be reinvested at the firm’s cost of capital. IRR assumes the firm can reinvest at the IRR rate.

NPV directly measures the dollar benefit of a capital project. Its main weakness is not that it does not measure the size of the project, just the dollar return.

IRR is a measure of profitability stated as a percentage rate of return. IRR indicates how low the project’s return could fall before risking the firm’s cost of capital.

Question 10

Explain the “multiple IRR problem” and the cash flow pattern that causes the problem

Answer 10

If a project has cash outflows during its life or at the end of its life (where the sign of the net cash flow goes from minus to plus back to minus) the project is said to have a non-normal cash flow pattern. Projects with such cash flows may have multiple IRR’s.

Question 11

Explain why the NPV and IRR methods can produce conflicting rankings for capital projects.

Answer 11

In the case of independent projects, the NPV and IRR will always result in the same accept or reject decisions.

This is not always the case with mutualy exclusive projects. A conflict may exist when the cost of capital is less than the crossover rate.

NPV profiles cross when:

Project size differences exist

Timing differences exist

Question 12

Distinguish between cash flows and accounting profits

Answer 12

Cash flows versus accounting income: In capital budgeting we use annual net cash gflows and not accounting income to make our decision. We define net cash flow as:

NCF = Net Income + Depreciation = Return on Capital + Return of Capital

Note: Net cash flows should reflect all non-cash changes, not just depreciation. Depreciation is usually the largest non-cash change for a firm.

Question 13

Define the following trems and discuss their relevance to capital budgeting:

• Incremental cash flow
• Sunk Cost
• Opportunity Cost
• Externality and Cannibalisation

Answer 13

Incremental Cash Flows can be defined as cash flows that occur if and only if the project is accepted. These cash flows represent the change in the firm’s total cash flow that occurs due to the acquisition of the project.

Sunk Cost are cash outlay that has already been committted or has occurred. Since these costs are not incremental they should not be included in the amalysis.

Opportunity costs are cash flows that a firm is passing up by acquiring the asset in question.

Externalities refer to the effects the acceptance of a project may have on the parts of the firm. They primarily refer to cannibalisation. Cannabilisation is when a new project takes sales from an existing product. When considering externalities, the full implication of the new project (loss in sales of existing products) should be taken into account.

Question 14

Explain the importance of changes in net working capital in the capital budgeting process.

Answer 14

Changes in net working capital (current assets - current liabilities) will result in an increase or decrease in cash.

If there is an increase in net working capital, additional financing will be required over and above the cost of the assets, and represents a cash outflow. A decrese in net working capital would provide an inflow of cash.

Question 15

Determine the NPV analysis whether a replacement project should be undertaken

Answer 15

An expasion project involves new assets in order to increase sales. A replacement project involves a decision regarding whether or not to replace an existing asset.

Steps involved in NPV analysis:

1. Project the expected cash flows, including any cash flows from the disposal of old assets
2. Estimate risk and determine the discount rate
3. Discount the expected cash flows to present
4. Compute the NPV by subtracting the cost of the project from the present value of the expected cash flows

If the NPV is positive, accept the project.

Question 16

Define initial investment outlay, operating cash flow over a project’s life and terminal year cash flow, and compute each for an expansion project and a replacement project.

Answer 16

Initial investment outlay: These are the up-front costs associated with the project. Components are price (which includes shipping and installation), and changes innet working capital.

Operating cash flows: These are the incremental cash flows over the economic life of the asset. We can define these as:

cash flow = [(revenue-cost-depreciation)(1-t)] + depreciation

cash flow = (revenue-cost)(1-t)+(d)(t)

Now estimate the terminal year cash flows. There are two elements:

1. return on net working capital
2. salvage values

Question 17

Compare two projects with unequal lives, using both the replacement chain and equivalent annual anuity approaches

Answer 17

If mutually exclusive projects have unequal lives, it may be necessary to adjust the analysis and put the projects on an equal life basis. There are two methods that can be used to do this.

1. The replacement chain method assumes each project can be repeated until both reach a common life span. The project with the higher NPV over the common life is accepted.
2. The equivalent annual annuity method computes the annual payments of the project as if they were an annuity (use your financial calculator to solve for payment given the NPV, term, and discount rate). The project with the higher annuity is accpeted.

Question 18

Discuss the effects of inflation on capital budgeting analysis

Answer 18

1. Expected inflation is built into interest rates because inflation expectations are impounded in the expected returns used to calculate WACC
2. The NPV involes finding the PV of future cash flows. Inflation will cause the WACC to increase, which causes the PV of furure cash flows to fall, which lowers the NPV. Accordingly NPV is adjusted for inflation through the WACC
3. Since inflation is in the WACC, future cash flows must be adjusted upward to reflect inflation. If this adjustment is not made the NPV will be biased downward.

Question 19

Distinguish among three types of project risk; stand-alone corporate and market

Answer 19

Stand-alone risk: An asset’s risk if it were a firm’s only asset and if investors owned only one stock. It is measured by variability of the asset’s expected returns.

Corporate Risk: Project’s risk to the firm, considering that the project represents only one of many of the firm’s assets, this, some of the risk on the firm’s profits is diversified away. This is measured by the variability of earnings.

Market (beta) risk: The portion of project’s risk that cannot be eliminated by diversification. This is measured by the project’s effect on the company’s beta coefficient.

Question 20

Distinguish among sensitivity analysis, scenario analysis, and Monte Carlo simulation as risk analysis techniques.

Answer 20

Sensitivity analysis: A method of analysis which indicates how much NPV will change in response to a given change in an input variable, assuming all other things are held constant. Typically, key variables are altered one at a time and the resulting NPV &/or IRR changes are observed.

Scenario analysis: Techniques of risk analysis which considers both sensitivity of NPV to changes in key variables and the likely range of variable values. “bad” and “good” sets of financial circumstances are compared with a base case simulation.

Monte Carlo simulation: Ties together sensitivities and input variables probability distributions. Probable future events are simulated on a computer and estimated rates of return and risk indexes are generated.

Question 21

Describe how the security market line is used in the capital budgeting process

Answer 21

The capital asset pricing model does offer insights into risk analysis in capital budgeting. The SML equation shows the risk/return relationship that can be used to estimate the project cost of capital.

K_s = K_rf + Beta(K_market - K_rf)

Question 22

Describe the pure play and accounting beta methods for estimating individual project betas

Answer 22

Pure play method: The firm attempts to find single product firms in the same line of business as the project under consideration and then averages those firms’ beta to determine the cost of capital for the project. The purpose of calculating and averaging the comparable firms’ betas to find an approximation for the company’s own project’s beta.

Accounting beta method: This method is used when it is not possible to find a single product, publicly traded firms, suitable for the pure play method. Accounting beta methods runs a regression of the firm’s ROA against the average ROA for a large sample of firms in order to estimate a project’s beta.

Question 23

Define and discuss the procedure for developing a risk adjusted discount rate.

Define capital rationing

Answer 23

The risk adjusted discount rate is the rate used to evaluate a specific project. It is based on the firm’s WACC, which is increased to riskier projects, and decreased for less risky projects. This is also referred to as the project cost of capital.

Capital rationing occurs when a firm deliberately foregoes profitable projects because of constraints placed on the capital budget.

Question 24

Explain and calculate the effects of changes in sales or earnings before interest and taxes (EBIT) on earnings per share for companies with differing amounts of debt financing.

Answer 24

For a company with no debt financing, EBIT will equal pretax income to any changes in sales or EBUT would lead to similar changes (net of income tax) in EPS

A company with debt financing would subtract interest expense from EBIT in deriving pretax income. An increase in EBIT would improve profitability. A decrease in EBIT would cause profitability to deteroriate as the fixed interest expense would magnify the loss

For example if a firm has no debt, pretax income is higher because of the absence of interest expense. If debt is added, pretax earnings and net income are lower. If EBIT decreases, the impact on net income and EPS is magnified.

Question 25

Define target (optimal) capital structure

Define financial leverage

Answer 25

The optimal capital structure is the mix of debt and equity that maximises the stock price

The target capital structure is the mix of debt and equity the firm plans to raise.

Finanial leverage refers to the use of fixed income securities (debt and preferred stock) within a company’s capital structbure.

Question 26

Define and state the impact of changes in factors that influence a company’s capital structure decision.

Answer 26

1. Business Risk - the greater a firm’s business risk, the lower the optimal debt ratio
2. Tax position - the largest advantage of debt is the tax dedcutibility of interest. If most of firm’s income is already sheltered from taxes by other items, added debt may not be as advantageous.
3. Financial flexibility - the ability to raise capitfal on reasonable terms under adverse conditions.
4. Managerial conservatism/ aggressiveness - agressive managers may use more debt to increase profits.

Question 27

Explain business risk and financial risk and discuss factors that influence each risk

Answer 27

Business risk is the uncertainty of future ROA. It is the most important determinant of the firm’s capital structure. Business risk depeds on:

• Sales demand - the more demand varies, the higher the business risk
• Sale price variability - increases business risk relative to stable sales
• Input price variability - the uncertainty of input prices causes higher business risk
• Ability to adjust output prices when unput prices change - if output prices can be increased quickly when costs rise, then business risk is lower
• Fixed costs or operating leverage - high fixed costs result in high business risk

Financial Risk refers to the additional common stockholders have to bear because of financial leverage. Financial leverage magnifies the variability of earnings pershare due to the existence of the required interest payments.

Question 28

Define operating leverage and expalin how it affects a project’s or company’s expected rate of return

Answer 28

Operating leverage is the trade off between variable costs and fixed costs. If a high percentage of a firm’s total costs are fixed, the firm is said to have a high operating leverage. In business terms, high operating leverage, other things held constant, means that a relatively small change in sales will result in a large change in operating income.

Question 29

Describe the relationship between financial levergae and financial risk

Discuss why the use of greater amounts of debt in the capital structure can raise both th ecost of debt and the cost of equity capital.

Answer 29

Financial leverage is the use of debt and preferred stock within a company’s capital structure . Financial risk is the added risk placed on common shareholders as a result of financila leverage.

An important issue is whether or not the higher expected rate of return associated with debt is sufficient to compensate shareholders for the higher risk resulting from the use of debt.

As a firm incurs more debt, its creditors will require higher returns because of higher finanial risk, that is, the more likelihood of financial distress. More debt results in higher risk to the shareholders as well since debt has a higher priority of payment in bankruptcy. Shareholders must be compensated for this risk through higher returns.

Question 30

Describe how changes in the use of debt can cause changes in the company’s earnings per share and in the company’s stock price.

Answer 30

To the extent that debt (leverage) increases expected earnings per share and ultimately dividends, the stock price will increase. However debt increases risk. Risk increases the cost of equity, which in turn decreases the stock price.

There is an optimal capital structure that maximises the stock price (minimises the WACC); however the optimal capital structure does not necessarlity maximise EPS. Incresing debt beyond the optimal capital structure usually increases EPS; however, the perceived benefit of higher EPS is more offset by the increase in risk (higher cost of debt and equity capital).

Question 31

Distinguish between the value of a company and the value of a company’s common stock

Answer 31

A company’s common stock represents the valuation of the residual claim on the company; whereas the value of a company is determined by the sum of the value of the debt holder’s stake, the preferred stakeholders stake, and the value of the common equity.

Question 32

Explain the effect of taxes and bankruptcy costs on the cost of capital, the optimal capital structure, and the Modigliani & Miller capital structure irrelevance theory.

Answer 32

Generally, the cost of debt is less than the cost of equity due to the favourable tax treatment from the deductibility of interest expense. Although dividend payments are taxable, capital gains on stock are taxed at lower rates and can be deferred by the owner if desired.

According to Midigliani and Miller, a firm’s capital structure has no effect on its valuation when taxes are ignored. Therefore changing the mixture of debt and equity will not matter. Increasing the use of lower cost debt will be exactly offset by the higher cost of equity. Therefore the WACC will not change.

When the tax deductibility of interest is considered, more debt will lower the WACC, however, more debt increases the possibility of the bankruptcy. Bankruptcy risk will eventually raise the cost of both debt and equity capital.

Question 33

Compare the MM capital structure irrelevance proposition and the trade-off theory of leverage.

Answer 33

MM proved, under some very restrictive assumptions, that the value of the firm is unaffected by its capital structure. It is not relevant how a firm finances itself

Under the trade-off theory of leverage, firms trade-off the benefits of debt financing against higher interest rates and bankruptcy costs. MM maintain that the optimal capital structure balances the tax benefits of debt with the costs associated with bankruptcy.

Question 34

Describe how a company signals its prospects through its financing

Answer 34

According to signaling theory, a firm’s management can take actions which provides clues to investors regarding how management views the firm’s prospects. If managemet has a very positive outlook, they may prefer not to share future gains with new shareholders, and therefore issue debt rather than equity. Similarly, if management has a negative outlook, they may be more willing to issue new equity to entice new shareholders in to share in potential losses. For example, an announcement of a stock offering may be taken as a signal that the company’s prospects, as seen by management, are not favourable.

Question 35

Calculate degree of operating leverage, degree of financial leverage, degree of total leverage

Answer 35

The DOL is the percentage change in operating income (EBIT) that results from a given percentage change in sales

DOL = %change in EBIT / %change in Sales

DFL is the percentage change in EPS that results from a given percentage change in earnings before interest and taxes

DFL = [% change EPS]/ [%change in EBIT]

DFL -EBIT/ [EBIT - 1]

DTL is the combination of operating leverage and financial leverage and shows how a given change in sales will effect EPS

Question 36

Describe the dividend irrelevance theory, the “bird in the hand” theory, and the tax preference theory

Answer 36

MM maintain that dividend policy has no effect on the firm’s stock price or its cost of capital so dividend policy is irrelevant as well. This is based on the concept of homemade dividends. If the dividend is too high, an investor can take the excess and buy more stock. If the dividend is to small, an investor can sell a portion of the shares to raise cash.

According to the bird in the hand theory, a high dividend payout is preferred since dividends are considered less risky when compared to future capital gains.

The tax preference theory suggests three reasons an investor may prefer stock offering a low dividend payout because:

• Capital gains are taxed at a lower rate than dividends
• Capital gains are not paid until realized
• If the stock is held until death, the stock’s basis is increased and no capital gain tax is paid

Question 37

Explai the dividend irrelevance theory in the context of the determinants of the value of the company.

Answer 37

MM argued that the value of a firm is determined by its earning power and business risk, not dividend policy. The value of the firm depends on the income produced not on the income split between dividends and retained earnings. Accordingly, dividend policy does not affect the firm’s stock price or its cost of capital.

Question 38

Discuss the principle conclusion for dividend policy of the dividend irrelavance policy

Answer 38

Dividend policy has no effect on the firm’s stock price or its cost of capital. Thus, there is no optimal dividend policy a firm should follow. However, the irrelevance theory ignores brokerage costs and taxes. Therefore, dividend policy may in fact be relevant

Question 39

Describe how and when a shareholder can construct his or her own dividend policy

Answer 39

Assume, for example, that you are a shareholder and you dont like the firm’s dividend policy. If the firm’s cash dividend is too big, you can just take the excess cash received and use it to buy more of the firm’s stock. If the cash dividend you received is too small, you can just sell a little bit of your stcok in the firm and get the cash flow you want. In either case, the combination of your investment in the firm and your cash in hand will be the same.

Question 40

Calculate, assuming a constant return on equity, a company’s dividend growth rate, given a company’s dividend payout rate.

Answer 40

The dividend growth rate is a function of the firm’s retention rate (1 - dividend payout ratio) and return on equity (ROE)

g = (1 - dividend payout ratio) x ROE

aSSUME A FIRM HAS A roe of 14% and has a dividend payout ratio of 30%. The firm’s growth rate is: (1 - 0.3) x 14% = 9.8%

Question 41

Describe how managers signal their company’s earnings forecast through changes in dividend policy.

Answer 41

Investors may regard an unexpected change in dividends as a signal of management’s forecast of future earnings. Thus, there is informational content in dividend announcements. According to this theory, a firm that unexpectedly increases its dividend is sending a positive signal about the future earnings and vice versa. Investors’ reactions to changing dividends are generally attributed to the future dividends, not the dividend policy itself.

Question 42

Describe the clienteel effect

Answer 42

Shareholders have different dividend payout preferences. The dividend clientelle effect states that high tax bracket investors (like individuals) prefer low dividend payouts and low tax bracket investors (like corporations and pension funds) prefer high dividend payouts. This is because corporate shareholders receive a dividend exclusion (tax benefit) and some investors are tax exempt, thus high payouts are preferred. Since dividends are taxed at ordinary income rates, individual investors in high tax brackets usually prefer low payouts. Therefore, the firm will attract investors who like the firm’s dividend payout policy.

Question 43

Describe the residual dividend model and discuss the model’s possible advantages or disadvantages to the company.

Answer 43

For a given firm, the optimal payout ratio is a function of the following factors:

1. Investors preferences for dividends versus capital gains
2. The firm’s investment opportunity schedule
3. The firm’s target capital structure
4. The availability and cost of external capital to the firm. The last three items constitute the residual dividen model

The four steps determine the target payout ratio:

1. Determine the firm’s optimal capital budget
2. Determine the amount of equity needed to finance that capital budget given the firm’s target capital structure
3. Use retained earnings to meet equity requirements to the geartest extent possible
4. Pay dividends only if more earnings are available than are needed to support the optimal capital budget

Question 44

Describe the dividend payment procedures, including the declaration, holder of record, ex dividend, and payment dates.

Answer 44

The actual payment procedure is as follows:

• The declaration date is the date the board of directors approves payment
• The ex-dididend date is the cut off date for receiving the dividend. The ex-dividend date is four business days before the date of record. (Note:its now two days). If you buy the share on or after the ex-dividend date, you will not receive the diviend.
• Holder of Record date is the date on which the shareholders of record are designated
• Date of payment is the date the dividend cheques are mailed out.

Question 45

Describe stock dividends and stock splits and explain their likely pricing effects.

Answer 45

Stock dividends are dividends paid out in new shares of stock rather than cash. In this case, there will be more shares outstanding, but each one will be worth less

Stock splits divide up each existing share into multiple shares, thus creating more shares. There are now more shares, but the price of each share will drop correspondingly to the number of shares created. So there is no change in the owner’s wealth.

Pricing effects:

• Stock prices tend to rise after a split or dividend
• Price increases appear to be due to signaling about future earnings
• If good news does not follow, prices tend to revert to their original level
• Stock splits and dividends tend to reduce liquidity due to higher brokerage fees on lower priced stocks.

Question 46

Discuss the advantages and disadvantages of stock repurchases and calculate the price effect of stock repurchase

Answer 46

Advantages of repurchase:

1. A repurchase is viewed as a positive signal by investors
2. A repurchase gives stockholders a choice
3. A repurchase can keep the price per share down
4. A repurchase gives the firm flexibility
5. Repurchases can be used to produce large scale changes in capital structures

Disadvantages of repurchases

1. Stockholders may not be indifferent between dividends and capital gains
2. Selling stockholders may not understand the implications of a repurchase
3. The corporation may pay too high a price for the repurchased stock.

Question 47

Explain the decision rule for making invetsmnet decisions under the net present value and internal rate of return methods.

Answer 47

NPV Decision Rule

1. If an investment’s NPV is positive, it will increase shareholder wealth and we should accept the project.
2. If an investment’s NPV is negative, it will decrease shareholder wealth and we should not undertake the project
3. If we have two projects for investment, but can only choose one (meaning the projects are mutually exclusive), choose the investment with the higher positive NPV.

IRR Decision Rule

1. If the investment’s IRR is greater than the required rate of return, accept the project.
2. If the investment’s IRR is less than the required rate of return, reject the project.

Question 48

Discuss problems associated with the internal rate of return method

Answer 48

• For independent projects, the IRR and NPV methods always give the same accept or reject decision
• For mutually exclusve projects, the NPV, and IRR methods can give diffrenet accept or reject decisions
• Mathematically, the NPV method assumes the reinvestment of cash flows is at the cost of capital while the IRR assumes the reinvestment rate to the the IRR. As a result, the NPV method selects the project that maximies shareholder wealth. Because shareholder wealth is the bottom line, always use the NPV rule when the IRR and NPV rules conflict.