Chapter 13 Flashcards
What causes operating leverage to increase?
Higher fixed costs and lower variable costs in a firm’s cost structure.
What happens to project evaluation if the wrong discount rate is used?
It can lead to rejecting good projects or accepting bad ones.
What kind of projects should an all-equity firm accept?
Projects with IRRs that exceed the cost of equity capital.
Why might a firm use an industry beta?
When a firm’s operations are similar to others in the industry.
What does it mean if a project’s IRR is above the firm’s cost of capital?
The project adds value and should be accepted.
What is the purpose of using project-specific betas?
To more accurately reflect the risk of individual projects.
What is the main assumption when using CAPM in capital budgeting?
Investors are well-diversified, so only systematic risk matters.
What happens to equity beta when a firm adds debt?
It increases, assuming the firm’s asset beta stays constant.
What does the Security Market Line (SML) show?
The relationship between expected return and beta (systematic risk).
What does financial leverage refer to?
The use of debt to finance operations, increasing equity beta.
What determines the value of a risky capital-budgeting project?
The present value of its expected cash flows, discounted at an appropriate rate.
What financial information is used to estimate a firm’s cost of debt via YTM?
Yield to maturity on the firm’s existing bonds.
What’s one reason to use bond ratings instead of YTM for debt cost?
Bond ratings offer a simplified estimate when bond market data is limited or inconsistent.
Why is using the same discount rate for all projects risky?
It can result in taking on too much risk and reducing firm value.
What affects a firm’s beta?
Business risk, operating leverage, and financial leverage.
What is the cost of debt?
The interest rate the firm must pay to issue new debt.
What does the term “marginal tax rate” refer to in WACC?
The tax rate applied to the next dollar of taxable income.
What is the hurdle rate in capital budgeting?
The minimum required rate of return for a project to be accepted.
Why is market value preferred over book value in WACC calculations?
Market value reflects current investor expectations and asset values.
What does beta measure?
A stock’s sensitivity to market movements or systematic risk.
What is operating leverage?
The degree to which a firm’s cost structure is fixed versus variable.
What is the cost of equity capital?
The expected return required by equity investors for investing in a firm’s equity.
What are two methods for estimating the market risk premium?
Historical returns and the Dividend Discount Model.
How can betas vary over time?
Due to changes in a firm’s operations, industry conditions, or capital structure.
Should project risk always equal firm risk?
No. Different projects can have different levels of risk.
Why do we adjust cost of debt for taxes?
Because interest is tax-deductible, lowering the effective cost.
When is it appropriate to use a firm’s WACC for a project?
When the project has the same risk and capital structure as the firm.
What happens if a project’s beta is lower than the firm’s beta?
The project should have a lower discount rate.
What is the formula for the Weighted Average Cost of Capital (WACC)?
What kind of risk does the CAPM ignore in return estimation?
Unsystematic (diversifiable) risk.
Why does financial leverage increase equity beta?
Because equity holders bear more risk when the firm is financed with debt.
What are two ways to estimate the cost of debt?
Using the bond rating or yield to maturity.
What values are typically used to weight debt and equity in WACC?
Market values.
What is asset beta?
The beta of a firm if it were financed entirely with equity.
What is a common proxy for the risk-free rate?
U.S. Treasury securities.
How does cyclicality of revenues influence beta?
Firms with cyclical revenues tend to have higher betas.
What is the effect of using a single discount rate across all projects?
It can increase firm risk and reduce firm value over time.
What is the WACC used for?
As a discount rate for evaluating projects with risk similar to the firm’s.
What is the CAPM formula for cost of equity?
What three inputs are needed to estimate the cost of equity using CAPM?
Risk-free rate, beta, and market risk premium.
