Corporate Finance

Question 1

ESG Investing

Answer 1

The U.S. Department of Labor has stated that for two investments with the same relevant financial characteristics, using ESG factors to choose one over the other is not a violation of fiduciary duty.

• Negative screening refers to excluding companies in specific industries from consideration for the portfolio based on their practices regarding human rights, environmental concerns, or corruption.
• Positive screening attempts to identify companies that have positive ESG practices such as environmental sustainability, employee rights and safety, and overall governance practices.
• Best-in-class approach seeks to identify companies within each industry group with the best ESG practices.
• ESG integration (ESG incorporation) refers broadly to integrating qualitative and quantitative characteristics associated with good ESG management practices.
• Impact investing refers to investing in order to promote specific social or environmental goals. This can be an investment in a specific company or project. Investors seek to make a profit while, at the same time, having a positive impact on society or the environment.
• Thematic investing refers to investing in an industry or sector based on a single goal, such as the development of sustainable energy sources, clean water resources, or climate change.

Question 2

Capital Budgeting Steps

Answer 2

1. Generating ideas.
2. Analyzing project proposals.
3. Creating the firm’s capital budget.
4. Monitoring decisions and conducting a post-audit.

Question 3

Five Key Principles of Capital Budgeting

Answer 3

1. Decisions are based on incremental cash flows. Sunk costs are not considered. Externalities, including cannibalization of sales of the firm’s current products, should be included in the analysis.
2. Cash flows are based on opportunity costs, which are the cash flows the firm will lose by undertaking the project.
3. Timing of the cash flows is important.
4. Cash flows are analyzed on an after-tax basis.
5. Financing costs are reflected in the required rate of return on the project, not in the incremental cash flows.

Question 4

Capital Budgeting Method

Answer 4

• Payback period
• Discounted payback period
• Profitability Index
• NPV
• IRR

Question 5

Profitability Index (PI)

Answer 5

The profitability index (PI) is the present value of a project’s future cash flows divided by the initial cash outlay:

PI = PV of future cash flows / CF₀ = 1 + (NPV / CF₀)

If PI > 1.0, accept the project.

If PI < 1.0, reject the project.

Question 6

Cost of equity capital

Answer 6

1. CAPM approach: k_ce = RFR + ß(R_market – RFR).
2. Discounted cash flow approach: k_ce = (D₁ / P₀) + g.
3. Bond yield plus risk premium approach: k_ce = current market yield on the firm’s long-term debt + risk premium.

Question 7

Optimal Capital Budget

Answer 7

A firm’s WACC can increase as it raises larger amounts of capital, which means the firm has an upward sloping marginal cost of capital curve. If the firm ranks its potential projects in descending IRR order, the result is a downward sloping investment opportunity schedule. The amount of the capital investment required to fund all projects for which the IRR is greater than the marginal cost of capital is the firm’s optimal capital budget.

Question 8

Country Risk Premium (CRP)

Answer 8

Question 9

Pure-Play method project beta

Answer 9

Question 10

Degree of Operation Leverage (DOL)

Answer 10

DOL = (% chang in EBIT) / (% change in Sales)

At level of sale Q:

DOL = [Q (P - V)] / [Q (P -V) -F] = (S - TVC) / (S - TVC -F)

If F = 0, DOL = 1

Question 11

Degree of Finance Leverage (DFL)

Answer 11

DFL = (% chang in EPS) / (% change in EBIT)

At level of sale Q:

DFL = EBIT /(EBIT - Interest Expense)

If interest expense = 0, DFL = 1

Question 12

Degree of Total Leverage (DTL)

Answer 12

Question 13

Primary and Secondary Source of Liquidity

Answer 13

• Primary sources of liquidity: cash balances, short-term funding, cash flow management of collections and payment.
• Secondary sources of liquidity: liquidating assets, negotiating debt agreements, bankruptcy protection.

Question 14

Cost of Trade Credit

Answer 14

Question 15

Factoring

Answer 15

The actual sale of receivables at a discount from their face value. The factor takes on the responsibility for collecting receivables and the credit risk of the receivables portfolio.

Question 16

Commercial paper

Answer 16

Large, creditworthy companies can also issue short-term debt securities called commercial paper. Interest costs are typically slightly less than the rate the firm could get from a bank.

Question 17

Sell-out rights

Answer 17

Sell-out rights protect minority shareholders in acquisition situations by forcing acquirers to buy out minority shareholders at a fair price, even if those shareholders initially voted against the acquirer’s offer.

Question 18

Clawback provision

Answer 18

Clawback provisions allow companies to recover executive remuneration under certain circumstances, to the benefit of all shareholders.

Question 19

Relationship between Discount-Basis Yield (DBY), Money Market Yield (MMY), and Bond Equivalent Yield (BEY)

Answer 19

Question 20

Pull vs drag on liquidity

Answer 20

A “pull” on liquidity occurs when disbursements are made too quickly (e.g., current liabilities are paid instead of being held or when credit availability is reduced or limited). A “drag” on liquidity occurs when receipts lag (i.e., non-cash current assets do not convert to cash quickly).

Question 21

Float Factor

Answer 21

Float Factor = Average Daily Float / Average Daily Deposit

Average Daily Deposit = Total amount of checks deposited / Number of days

Question 22

Calculate PV_perpetuity

Answer 22

PV_perpetuity = Periodic Payment / Period Interest Rate

Question 23

Externality

Answer 23

An externality is the effect of an investment on other things besides the investment itself. Frequently, an investment affects the cash flows of other parts of the company, and these externalities can be positive or negative.