Corporate Finance

Question 1

What affects a capital structure?

Answer 1

Decisions on whether to accumulate cash, pay off debt or pay dividends.

Question 2

D

Answer 2

market value of debt

Question 3

E

Answer 3

Market value of equity

Question 4

V=D+E

Answer 4

Market value of the firm

Question 5

rD

Answer 5

expected return (cost of capital) of debt. Expected return demanded by investors who lend to the company

Question 6

rE

Answer 6

expected return of equity

Question 7

D/V

Answer 7

Firm’s debt to value ratio, is the fraction of the firm’s total value that corresponds to debt

Question 8

Why does utilities have a higher average debt to value ratio of 50%?

Answer 8

Services are used frequently so they can afford this cuz cash flows are predictable.

Question 9

Choice of D/V

Answer 9

tax benefits from claiming interest on debt
predictability of cash flow

Question 10

How should a firm raise the funds it needs to undertake its investments?

Answer 10

Depends on the value the market applies to its security. The Valuation Principle tells us that the price of any securities issued by the
firm will be the present value of the cash flows accruing to them

Question 11

Equity financing for private companies can seek funding from several potential sources…

Answer 11

Angel investors: Individual investors who buy equity in small private firms (often start up firms)

Venture Capital: Business that specializes in raising money to invest in the private equity of young firms (start ups)

Private Equity firms: Similar to VC, but invest in the equity of existing privately held firms rather than start up companies. Often initiate their investment by finding a publicly traded firm and purchasing all outstanding equity.

Question 12

Raising equity capital using an IPO

Answer 12

Process of selling stock to the public.
Advantages: Going public provides companies with greater liquidity and better access to capital.
Disadvantage: Equity holders of the corporation become more widely dispersed. Investors’ ability to monitor the company’s management decreases.

Question 13

Seasoned Equity Offering

Answer 13

A public company’s return to the equity markets with an offer of new shares for sale. When issuing stock using an SEO, a firm follows many of same steps as IPO. Compared to IPO not as unsure of what the share price should be.

Question 14

Debt Financing

Answer 14

Does not dilute the ownership of the firm. But loan must be repayed. The firm is legally obligated to make interest and principal payments on its
debt. If it fails to do so, it is in default and can be forced into bankruptcy

Question 15

Corporate debt can be

Answer 15

Private Debt: negotiated directly with a bank or a small group of investors
Public Debt: Trades in a public market (Bonds)

Question 16

Public Corporate debt

Answer 16

public bond issue is similar to stock issue. Firm provides an indenture to the market, a formal contract that specifies the firms obligation to bondholders. They almost always pay coupons semi-annually & have maturity of 30 years or less.

Question 17

Unsecured Debt

Answer 17

In the event of bankruptcy, bondholders have a claim to only the assets of the firm that are not already pledged as collateral on other debt

Question 18

Secured Debt

Answer 18

Specific Assets are pledged as collateral that bondholders have a direct claim to in the event of a bankruptcy. Mortgage bonds are an example of secured corporate debt in which real
property is pledged as collateral

Question 19

Corporate Debt seniority

Answer 19

priority is seniority.When a firm conducts a subsequent debenture issue that has lower priority than
its outstanding debt, that is called a subordinated debenture.

Question 20

What is capital budgeting?

Answer 20

Process of allocating the firm’s capital for investment is known as capital budgeting

Question 21

What is the value of an investment?

Answer 21

The present value of a stream of future cash flows generated by the assets/project.

Question 22

Net present value rule

Answer 22

When choosing among investment alternatives, take the alternative with the highest NPV.
Accept positive-NPV projects; accepting them is equivalent to adding the NPV value to the firm today
Reject negative-NPV projects; accepting them would reduce the value of the firm

Question 23

Net present value formula

Question 24

True or False discount rate is extremely important in capital budgeting

Answer 24

True: higher project risk, higher discount rate (risk and return)

Question 25

What is a NPV Profile?

Answer 25

Sensitivity analysis. estimating discount rate is very difficult so this is helpful tool. The NPV Profile shows the range of discount rates for which the project will have positive NPV. It also shows that there is an interesting discount rate, which makes the NPV equal to zero. This discount rate is known as the Internal Rate of Return (IRR). So the NPV profile also helps determine the project’s IRR

Question 26

How do you calculate NPV profile?

Answer 26

We start by defining a range for the discount rate; in this case, let’s use [1%,61%]
- We select several discount rates within this interval, and for each one we
calculate the NPV
- Plot the NPV as a function of the discount rates

Question 27

Internal Rate of return

Answer 27

Measures the return of the project. The discount rate that equates the PV of the project’s inflows to the PV of the
project’s outflows (discount rate that makes NPV=0) If the project’s discount rate is greater than the IRR. The project’s NPV will be negative
If the project’s discount rate is lower than the IRR. The project’s NPV will be positive

Question 28

discount rate

Answer 28

How much fund costs us

Question 29

Problems with IRR?

Answer 29

May lead to incorrect decisions when comparing mutually exclusive projects.

Question 30

Payback Period Rule

Answer 30

Payback period: amount of time until the cash flows from a project offset the initial investment.
Rule: accept a project if its payback period is less than a pre specified length of time

Question 31

Issues with Payback Decision Rule

Answer 31

It ignores time value of money, not risk-adjusted.
Does not consider cash flows after the payback period.
It favours short-term projects.

Question 32

Profitability Index

Answer 32

PI = Value Created/Resource Used = NPV/C0
This is used to identify the optimal combination of projects to undertake in such situations (bang for buck)

Question 33

Advantages of using CAPM

Answer 33

it explicitly adjusts for risk
It applies no matter what the firm’s dividend policy is. It applies both to companies with steady dividend growth and without steady dividend growth.

Question 34

Disadvantage of CAPM

Answer 34

Uses historical data (beta) to predict future rates.
If the estimates of the market risk premium and beta are poor, the resulting
cost of equity can be inaccurate.

Question 35

coupon rate

Answer 35

rate issuer is giving to investor

Question 36

Gordon Growth model

Answer 36

gives price of one stock.

Question 37

When assessing NPV’s what should you check?

Answer 37

Discount cash flows! Not profits.

Question 38

Reasons cash flows can differ from profits

Answer 38

Depreciation. Noncash expense, recorded in the income statement but do not involve an actual cash transaction. Timing of revenue / expense recognition.

Question 39

How to determine relevant cash flows

Answer 39

Will this cash flow occur only if we accept the project? If yes then include in analysis. If no do not include. If part of it: Include only the part that occurs as a direct result of the project.

Question 40

Scenario Analysis

Answer 40

Examines different but consistent combinations of variables.
One combination of variables (one scenario) us compared with another scenario of assumptions

Question 41

What are the disadvantages of using payback period as your investment criteria?

Answer 41

Does not adjust for risk, requires a cut off period, problematic with cash flows after payback period, ignores time value of money.