Corporate finance

Question 1

What is the Intrinsic value?

Answer 1

The value everyone would agree upon if everyone knew all the relevant information and how to interpret it

Question 2

Trading signal?

Answer 2

(1) IV > MP : Buy
(2) IV < MP : Sell or short sell
(3) IV = MP : Hold (fairly priced)

Question 3

What happened to the required return on equity when growth rate changes?

Answer 3

Remains the same:

(1) Once the good news is (instantaneously) incorporated into the price (EMH), the return should be consistent with the risk of the company
(2) Capital gains return component has increased, but dividend yield has decreased, exactly offsetting each other

-> if the risk does not change the required return on equity should remain the same

Question 4

Where does growth come from?

Answer 4

Earnings reinvestment policy is a tradeoff between large dividends now (high payout ratio) or high dividends in the future (from high g and high plowback):

-> think about the life cycle -> good investment opportunities tend to disappear with time

Question 5

Justify reinvestment

Answer 5

=> To justify reinvestment, the company’s investments must return more than (or equal to) the return shareholders could earn on their own (in other companies for example), i.e., ROE ≥ re
=> This is equivalent to choosing positive NPV projects, but not negative ones
=> Such reinvestment will increase value (by increasing PVGO)
=> Reinvestment when ROE < re will depress share price (negative PVGO) because it is less profitable (relative to the level of risk) than if shareholders received the income and invested it themselves.

– However, even value reducing reinvestment will lead to dividend and price growth (as long as ROE is positive)

Question 6

What is working capital?

Answer 6

Working capital (WC) is cash that is tied up in a project but not an actual expense because it is recovered at the end of the project
– e.g., inventory that must be kept on hand, bank balance that must be maintained as a buffer between timing mismatches in accounts receivable and accounts payable

Question 7

How could one raise equity finance?

Answer 7

The initial capital that is required to start a business is usually provided by the entrepreneur and their immediate family (FFF)

(1) Angel investors - individuals who buy equity in small private firms (typically difficult to find)
(2) Crowdfunding
(3) Venture capital firm - limited partnership that specializes in raising money to invest in
the private equity of young firms
– Benefit: expertise
– Disadvantage: costly, VC usually takes a lot of the equity

Question 8

What is initial Public Offering (IPO)

Answer 8

Initial Public Offering (IPO) - the process of selling stock to the public for the first time

– Underwriter: an investment bank that manages a security issuance, designs its structure and guarantees a certain amount of capital will be raised
• Lead underwriter - the primary investment banking firm responsible for managing a security issuance
• Syndicate - a group of underwriters who jointly underwrite and distribute a security issuance

Question 9

Advantages and disadvantages of going public?

Answer 9

(1) Advantages:
– Greater liquidity
• Private equity investors get the ability to diversify.
– Better access to capital
• Public companies typically have access to much larger amounts of capital through the public markets.

(2) Disadvantages:
– The equity holders become more widely dispersed.
• This makes it difficult to monitor management (increased agency costs).
– The firm must satisfy all of the requirements of public companies. • Continuous public disclosure, financial reporting and auditing, etc.

Question 10

What is prospectus?

Answer 10

Lengthy document prepared by a company prior to an IPO that is circulated to investors before the stock is offered

Question 11

What is Road show?

Answer 11

During an IPO, when a company’s senior management and its underwriters travel around promoting the company and explaining their rationale for an offer price to the underwriters’ largest customers

Question 12

What is Book building?

Answer 12

A process used by underwriters for coming up with an offer price based on customers’ expressions of interest

Question 13

What is Lockup?

Answer 13

A restriction that prevents existing shareholders from selling their shares for some period, usually 180 days, after an IPO

Question 14

What is Underpricing?

Answer 14

Generally, underwriters set the issue price so that the average first-day return is positive (empirical evidence: 75% of first-day returns are positive, on average in the US 18.3%).

Question 15

Name four types of dividends

Answer 15

(1) Regular dividend
– Annual or semi-annual payments (“interim” and “final”)
(2) Special dividend -> once in a “lifetime”
– A one-time dividend payment a firm makes, which is usually much larger than a regular dividend
(3) Stock split (stock dividend) -> not an actual dividend
– When a company issues a dividend in shares of stock rather than cash to its shareholders
(4) Liquidating dividend -> settle debt and pay out
– A return of capital to shareholders from a business operation that is being terminated

Question 16

What is an open market repurchase?

Answer 16

– When a firm repurchases shares in the open market

– Open market share repurchases represent about 95% of all repurchase transactions.

Question 17

What is a Tender offer?

Answer 17

An offer to all existing shareholders to buy back a specified amount of shares at a specified price (typically set at a 10%-20% premium to the current market price) over a specified period of time (usually about 20 days)

-> buy shares from shareholders (with current price plus market premium)

Question 18

What is a Dutch auction?

Answer 18

A share repurchase method in which the firm lists different prices at which it is prepared to buy shares, and shareholders in turn indicate how many shares they are willing to sell at each price. The firm then pays the lowest price at which it can buy back its desired number of shares

-> at what price you would be willing to sell back shares?

Question 19

What is a Targeted repurchase?

Answer 19

Direct negotiation with major shareholders (e.g., greenmail)

-> go to key shareholders and negotiate the sell price

Question 20

How dividends are paid?

Answer 20

(1) Declaration date (announcement date) -> announce the dividend to the market
– The date on which the board of directors authorizes the payment of a dividend

(2) Record date -> date to look at to see who gets the dividends
– When a firm pays a dividend, only shareholders on record on this date (at the close of business) receive the dividend.

(3) Ex-dividend date -> two days before record date -> don’t get dividends if stock purchased on this day -> price decreases by the level of dividend
– A date, two days prior to a dividend’s record date, on or after which anyone buying the stock will not be eligible for the dividend

(4) Payment date (distribution date)
– A date, generally within a month after the record date, on which a firm makes dividend payments to its shareholders

Question 21

What is Modigliani and Miller (1961) dividend irrelevance proposition?

Answer 21

MM: In perfect capital markets, holding fixed the investment policy of a firm, the firm’s choice of dividend policy is irrelevant and does not affect the initial share price (or shareholder wealth).

Thus, investors are indifferent between:

1. Free cash flow being paid out as a dividend
2. Free cash flow being used to repurchase shares
3. Shares being issued to pay a dividend larger than free cash flows

Question 22

Why wouldn’t investors care about how their wealth is allocated between cash and shares?

Answer 22

Because investors can adjust the allocation themselves by buying or selling shares (in this company or some other)
– i.e., “homemade dividends” and “dividend reinvestment”
Effectively, investors can undo the company-level payout policy and set their own payout policy according to their cash/shares needs

Question 23

Modigliani and Miller key assumptions

Answer 23

• Fixed investment plan which is not affected by payout policy - There are no personal or corporate taxes
• There are no costs of issuing shares
• There are no costs of trading shares
• All market participants (management and shareholders) have the same information

-> The assumptions are where the beauty of the theory lies because they tell us why payout policy is relevant

Question 24

Perfect capital market assumptions

Answer 24

(1) In a perfect capital market, when a dividend is paid, the share price drops by the amount of the dividend when the stock begins to trade ex-dividend.
(2) In perfect capital markets, an open market share repurchase has no effect on the stock price, and the stock price is the same as the cum-dividend price if a dividend were paid instead.
(3) In perfect capital markets, investors are indifferent between the firm distributing funds via dividends or share repurchases. By reinvesting dividends or selling shares, they can replicate either payout method on
their own.

Question 25

What are homemade dividend?

Answer 25

If the firm pays a dividend and the investor would prefer stock, they can use the dividend to purchase additional shares.

e.g. if the firm repurchases shares instead paying dividend and the investor wants cash, the investor can raise cash by selling shares.

Question 26

What are Payout policy alternatives?

Answer 26

(1) pay dividends with excess cash
(2) share repurchase
(3) large dividend financed via an equity issue

Question 27

Breaking the assumptions: Fixed investment policy

Answer 27

Recall that increasing/decreasing a dividend to increase/decrease reinvestment in firm changes firm intrinsic value. When increasing a dividend,
– ROE < re => price (value of company) rises
– ROE > re => price (value of company) falls

This is not inconsistent with M&M because this is a change to the investment policy (critical assumption) and investment policy is relevant

This suggests dividend policy should be guided by the availability of positive NPV projects.
– ROE < re -> negative NPV projects -> Pay higher dividends to increase company value
– ROE>re -> positive NPV projects -> Pay less dividends (reinvest more) to increase company value

Particularly true when:
– Cost of raising funds is significant, and
– Capital structure signaling effects exist (later)

Question 28

Breaking the assumptions: Fixed investment policy / Agency costs

Answer 28

When firms have excessive cash, managers may use the funds inefficiently by paying excessive executive perks, over-paying for acquisitions, etc.
– Effectively negative NPV projects
– Can be considered as poor investment choices

-> Dividend discipline: paying out excess cash through dividends or share repurchases, rather than retaining cash, can increase the stock price by reducing managers’ ability and temptation to waste resources.

Question 29

Breaking the assumptions: Taxes

Answer 29

Shareholders must pay taxes on the dividends they receive and they must also pay capital gains taxes when they sell their shares.
-> Dividends are often taxed at a higher rate than capital gains. In fact, long-term investors can defer the capital gains tax forever by not selling.

A higher tax rate on dividends makes it undesirable for a firm to raise funds to pay a dividend.
– If a firm raises money by issuing shares and gives that money back to shareholders as a dividend, shareholders’ wealth is reduced (due to the tax).
– When dividends are taxed more than capital gains, investors will pay more for stocks with low dividend yields

Question 30

What is Clientele effect?

Answer 30

When the dividend policy of a firm reflects the tax preference of its investor clientele

Question 31

What is Dividend-capture theory?

Answer 31

– The theory that absent transaction costs, investors can trade shares at the time of the dividend so that non-taxed investors (or those with lowest *d ) receive the dividend
• Should see large trading volume in a stock around the ex-dividend day

Question 32

Breaking the assumptions: Transaction costs

Answer 32

Another way for a clientele effect to occur is if transaction costs prevent investors from costlessly using the “homemade dividend” mechanism to adjust their income and capital gain
– Investors have preferences for income (dividend) levels (e.g., pension funds) and flock to stocks that pay dividends at their desired rate
– Firms adjust dividend payout rates to attract clientele, which increases demand for their stock

Question 33

Explain bird in the hand theory

Answer 33

Bird in the hand theory: receiving dividend now is less risky than receiving dividend in future (lower re, higher P)
– If investors can make homemade dividends costlessly, then this is irrelevant
– All else equal, greater transaction costs will lead to larger dividends

Question 34

Breaking the assumptions: Costs of issuing shares (1)

Answer 34

When raising capital by issuing shares is costly, firms are more likely to accumulate cash if there is a reasonable chance that future earnings will be insufficient to fund future positive-NPV investment opportunities.

Costs of financial distress (missed investment opportunities, liquidation costs) further reinforce this effect on payout policy

Question 35

Breaking the assumptions: Homogenous information

Answer 35

Reality: asymmetric information (managers know more about firm prospects than investors)
• Implication: Dividend signaling hypothesis
– Investors believe that dividend changes signal information about managers’ views about a firm’s future earning prospects
– Implication: dividend increases signal good news -> price rises dividend reductions signal bad news  price falls
– Managers are aware of this and therefore are reluctant to cut dividends – either maintain or increase (consistent with empirical evidence).
– Managers smooth dividends in this process
– The signal is noisy (e.g., cut dividend because of future positive NPV projects, or vice versa lack of investment opportunities)

Question 36

Why are stock repurchases overtaking traditional dividends?

Answer 36

(1) Personal tax savings
(2) Preserves financial flexibility – does not implicitly promise continued payment (as divs do due to signaling)
(3) Correct undervaluation
(4) Remove low valuation shareholders, decrease probability of unwanted takeover
(4) Improve reported EPS (cosmetic earnings management)
(5) Avoid disadvantaging managerial stock option holders (exercise price not adjusted for dividends)

Question 37

How companies decide on their payout?

Answer 37

Survey evidence is consistent with theory discussed so far, in particular the signaling effects of dividends
– Reluctance to cut dividends
– Smoothing of dividends
– Dividend changes, rather than levels matter

Explains the lifecycle pattern:
– Young firms: many profitable investment opportunities and a need for financing -> pay little in dividends
– Mature firms: sufficient earnings to finance future projects, fewer profitable investment opportunities -> pay more in dividends

Question 38

What capital structure will maximize the value of the firm (M&M proposition nr. 1) ?

Answer 38

In a perfect capital market, the total value of a firm is equal to the market value of the total cash flows generated by its assets and is not affected by its choice of capital structure.

Question 39

What is homemade leverage?

Answer 39

If investors would prefer an alternative capital structure to the one the firm has chosen, investors can borrow or lend on their own and achieve the same result.
–>Effectively investors can undo company-level capital structure decisions and set their own capital structure

   – Option 1: Buy the unlevered company and earn the expected return
on assets ( = rA ) = Required return on unlevered company ( = rU )
   – Option 2: Buy both the equity and debt of a levered company and earn a weighted average of the expected return on the levered equity (= rE ) and the return on debt (= rE )

Question 40

Key assumptions in M&M proposition?

Answer 40

– Fixed investment policy
– No personal or corporate taxes
– No transaction costs
– Firms and individuals can borrow at the same rates
– No costs associated with liquidation or reorganization in financial distress
– Homogeneous information

Question 41

What capital structure will maximize the value of the firm (M&M proposition nr.2) ?

Answer 41

The expected return on equity in a levered firm increases in proportion to the debt-equity ratio (D/E), expressed in market values.
• The rate of increase depends on the spread between rA, the expected return on a portfolio of all of the firm’s securities (“asset risk”, “total business risk”), and rD, the expected return on the debt.

– The increase occurs because leverage makes equity riskier
– The increase ensures that levered equity is not a “free lunch” … the additional EPS from leverage are exactly offset by the higher rE so that levered equity is not worth more (ruling out arb)

Question 42

The effects of leverage on risk and return

Answer 42

Leverage benefits shareholders when income is high, but harms when income is low

Question 43

But why does leverage offer higher expected returns?

Answer 43

The answer is risk.
– Leverage increases risk even when bankruptcy is not possible
(both systematic and idiosyncratic).
– Look at slope of the EBIT-EPS relation for diff levels of leverage
– There is a wider range of possible outcomes (greater risk) for shareholders in the levered firm, so:
 shareholders demand more compensation (rE is higher)
 such that the higher expected CFs are discounted more heavily
to arrive at the same stock price (to rule out arbitrage).

Question 44

What capital structure will maximize the value of the firm (M&M proposition nr.3) ?

Answer 44

The appropriate discount rate for a particular investment proposal is independent of how the proposal is to be financed

Intuition: recall the WACC is the weighted average of the cost of debt, 𝑟 (relatively cheap) and the cost of equity 𝑟 (relatively 𝑑𝑒 expensive). As you put more of the cheap stuff in the mix (𝑟 ) 𝑑 you don’t manage to drag down the weighted average because the expensive stuff (𝑟 ) gets more expensive (proposition 2) 𝑒

Question 45

M&M proposition nr. 1 with taxes?

Answer 45

M&M proposition I with taxes: slicing matters because
you can reduce the size of the government’s slice
– The total value of the levered firm exceeds the value of the firm without leverage due to the present value of the tax savings from
debt:

Question 46

Direct costs of bankruptcy?

Answer 46

Direct costs of bankruptcy:
– The bankruptcy process is complex, time-consuming, and costly.
– Costly outside experts are often hired by the firm to assist with the bankruptcy process.
– The direct costs of bankruptcy reduce the value of the assets that the firm’s investors will ultimately receive.
– The average direct costs of bankruptcy are approximately 3% to 4% of the pre-bankruptcy market value of total assets.

Loss of intangible assets:
– Loss of customers
– Loss of suppliers
– Loss of employees
– Loss of receivables
– Fire sale of assets
– Delayed liquidation
– Costs to creditors of external consultants

Question 47

Costs of financial distress without bankruptcy?

Answer 47

Costs of financial distress without bankruptcy:
– Customers cautious about doing business
– Suppliers cautious about doing business
– Higher financing costs
– Lost profitable investment opportunities

Question 48

What can arise when a manager has a fixed salary – no bonuses or stock options, just $X per month?

Answer 48

• Reduced effort
– Finding highly profitable projects is high-effort, high-pressure activity. Mangers may be tempted to slack off (read newspaper)

• Perks
– Temptation for managers to take “private benefits” or “managerial rents”, e.g., business lunches at fancy restaurants, luxury “business” car, lavish office accommodation, jets, etc.

• Empire building
– Growing large, not because the investments carry positive NPVs, but simply because manager wants to run a large business

• Entrenching investment
– Choosing projects that they will be able to manage rather than better projects (in NPV terms) that require different management

• Avoiding risk
– If the manager only receives fixed remuneration, they cannot share in the upside of risky projects, but if a risky project goes bad their job might be on the line
– May result in “inefficient” diversification investments

• Increasing exposure
– Draw media attention to favor own reputation and career prospects

Question 49

Monitoring as a methods of reducing agency costs?

Answer 49

Monitoring
– Ideally shareholders would do the monitoring, but in practice shareholders elect a board of directors that monitor management (not perfect because directors could be friends of management)
-> Delegated monitoring particularly important when ownership is widely dispersed (as opposed to concentrated, e.g., large shareholder)
– Free-rider problem: everyone prefers someone else to do the monitoring

Question 50

Other methods of reducing agency costs?

Answer 50

• Market for corporate control -> built in mechanism -> price
• Managerial compensation
– Can be based on input (e.g., effort) or output (e.g., actual returns)
– Problems:
• Input impossible to accurately observe, and
• Output can be due to manager or luck or factors beyond mangers’ control (e.g., business cycle)

• One strategy is to issue stock options to management
– If the company does well the options become valuable and the manager gets compensation for doing a good job (or being lucky), but if the price falls the options expire worthless
– This is one way to tie the compensation of managers to the value of the company

Question 51

Disadvantages of stock options as remuneration?

Answer 51

Disadvantages of stock options as remuneration:
– Reward absolute not relative performance. Managers bear market or industry risk/return.
– Stock prices reflect expectations of earnings. When a company announces the appointment of a good manager, the price shoots up in anticipation of good earnings. If the managers does perform well and deliver the expectation, the return is just the normal average rate of return.
– Create incentives for managers to withhold bad news or manipulate earnings
– Short-termism?
• Additionally, recent research has found evidence suggesting that many executives have engaged in backdating their option grants.
– Choose date of the grant that coincides with a lower stock price so that compensation is larger (options issued at the money)

Question 52

Accounting based measures of performance?

Answer 52

Accounting based measures of performance
– More often used for middle and lower management particularly to measure performance of managers responsible for a division or plant
– They overcome the problem of market expectations being impounded into market prices
• Disadvantages:
– Can lead to “short-termism” in the sense that short-term profits can be increased by cutting maintenance or training expenses leaving long-run problems to the successor
– Accounting earnings can be manipulated by creative accounting practices, and are biased by accounting concepts like depreciation
– Accounting earnings do not necessarily translate to shareholder value (recall what happens to price when we reinvest in positive ROE projects that have ROE < re)

Question 53

The first game of financial distress: Overinvestment:

Answer 53

The first game involves long-shot bets at the creditors’ expense. Effectively, the equity holders are gambling with the debt holders’ money. -> investing too much (potentially in negative net present value projects).

• Over-investment problem:
– When a firm faces financial distress, shareholders can gain at the expense of debt holders by taking a negative-NPV project, if it is sufficiently risky.
– This cost can be viewed as an indirect cost of financial distress because the temptation to play it is strongest near default

Question 54

The second game: Underinvestment

Answer 54

Under-investment problem
– A situation in which equity holders choose not to invest in a positive NPV project because the firm is in financial distress and the value of undertaking the investment opportunity will accrue to bondholders rather than themselves.

– Also known as “debt overhang” problem
– Can also inhibit debt financing of the positive NPV project if the existing (due to default) debtholders are entitled to a share of the project’s profits, and turns the NPV negative for the potential new debtholders

Question 55

The third game: Cashing out

Answer 55

Cashing out:
• When a firm faces financial distress, shareholders have
an incentive to withdraw money from the firm, if possible.
– For example, if it is likely the company will default, the firm may sell assets below market value and use the funds to pay an immediate cash dividend to the shareholders.
– A deadweight loss (asset destruction) and a wealth transfer from bondholders to shareholders (mainly) and the parties that bought the assets for below market value (partly)

Question 56

The fourth game: Playing for time

Answer 56

Playing for time:
• When a firm is in financial distress, creditors would like to salvage what they can by forcing the firm to settle up quickly
– Stockholders want to delay this process in hope that some miracle will come along and save the firm
– Delaying this process destroys further value (value that the stock holders would not have collected anyway because it would have gone to the bondholders, so again, stockholders exploit bondholders)
– Bondholders should not want a delay given they have limited upside and a lot of downside
– A deadweight loss and a wealth transfer (because equity becomes more valuable due to upside potential, while debt suffers due to capped upside and whole downside)

Question 57

The fifth game: Bait and switch

Answer 57

Bait and switch: Start with a conservative capital structure policy issuing a relatively small amount of safe debt on fixed terms and rates
• Suddenly switch and issue a lot more equally senior debt
– All debt becomes riskier and the old bondholders lose (equity holders gain from the old debt locked in at low rates)
– Not always played in financial distress, but can get firm into distress

Question 58

When a firm adds leverage to its capital structure, the decision has two effects on the share price:

Answer 58

1. The share price benefits from equity holders’ ability to exploit debt holders in times of distress.
2. The debt holders recognize this possibility and pay less for the debt when it is issued, reducing the amount the firm can distribute to shareholders.
   • Debt holders lose more than shareholders gain from these activities (due to deadweight economic losses) and the net effect is a reduction in the initial share price of the firm.

Question 59

What are the benefits of leverage in the reduction of agency costs?

Answer 59

1: Ownership concentration: leverage allows the original owners of the firm to maintain their equity stake.
– As major shareholders, they will have a strong interest in doing what is best for the firm thereby reducing agency costs
– Using leverage can benefit the firm by preserving ownership concentration as opposed to creating ownership dispersion.

2: Free Cash Flow Hypothesis / debt discipline
– The view that wasteful spending is more likely to occur when firms have high levels of cash flow in excess of what is needed after making all positive-NPV investments and payments to debt holders
– Leverage increases firm value because it commits the firm to making future interest payments, thereby reducing excess cash flows and wasteful investment by managers.
– A similar argument can justify paying dividends.

3: Leverage can reduce the degree of managerial entrenchment because managers are more likely to be fired when a firm faces financial distress.
– Managers who are less entrenched may be more concerned about their performance and less likely to engage in wasteful investment.
– Another form of “debt discipline”

4: In addition, when the firm is highly levered, creditors themselves will closely monitor the actions of managers, providing an additional layer of management oversight.

Question 60

Tradeoff theory of debt?

Answer 60

The tradeoff theory states that firms should increase their leverage until it reaches the level for which the firm value is maximized.
– At this point, the tax savings that result from increasing leverage are perfectly offset by the increased probability of incurring the costs of financial distress.
• At this point, marginal costs of an additional unit of debt are equal to marginal benefits of additional debt

According to the tradeoff theory, the total value of a levered firm equals the value of the firm without leverage plus the benefits and minus the costs of debt (present value of the tax savings from debt, less the present value of financial distress costs, +/- agency cost effects)

Question 61

What is Adverse selection?

Answer 61

When a seller has private information about the value of a good, buyers will discount the price they are willing to pay due to adverse selection (sellers will typically sell ‘bad’/’faulty’ items and keep good ones).
When the buyers and sellers have different information, the average quality of assets in the market will be lower than the average quality overall.
–> “Lemons principle”

A classic example of adverse selection and the lemons principle is the used car market.
– If the seller has private information about the quality of the car, then his desire to sell reveals the car is probably of low quality.
– Buyers are therefore reluctant to buy except at heavily discounted prices.
– Owners of high-quality cars are reluctant to sell because they know buyers will think they are selling a lemon and offer only a low price.
– Consequently, the quality and prices of cars sold in the used-car market are both low.

Question 62

Pecking order theory of financing choices

Answer 62

In financial markets: firms that sell new equity have private information about future prospects
– Due to the lemons principle, buyers are reluctant to believe management’s assessment of the new projects and are only willing to buy the new equity at heavily discounted prices.
– Therefore, managers who know their prospects are good (and whose securities will have a high value) will not sell new equity, only those with poor prospects will, e.g.,

– > Managers will prefer to fund investments by first using retained earnings, then debt, then hybrids (e.g., convertible bonds, preference stock) and equity only as a last resort
– Explains why most profitable firms borrow least: they have enough earnings to fund investment
– Think about similarities with signaling effects of payout policy

Question 63

Assumptions of the weighted average cost of capital method

Answer 63

(1) Note that the variables above refer to the firm as a whole and hence should only be used to evaluate projects that are similar to the firm (particularly regarding level of business risk, and means of financing)
(2) Note that it also requires the project to not have a significant impact on the levels of debt and equity, otherwise incorrect value
(3) Note that the company must rebalance to maintain constant D/E

Question 64

When computing the WACC (to reflect the firm’s business assets), why di we typically use net debt?

Answer 64

The reason is that cash is a risk free asset and therefore reduces the risk of the firm’s assets
– Think of cash as reverse leverage
– By subtracting it from debt we get a clearer picture of the business risk and degree of leverage

Question 65

A comparison of the methods?

Answer 65

(1) Typically, the WACC method is the easiest to use when the firm will maintain a fixed debt-to-value ratio over the life of the investment.
– Also most widely used in practice
– Even when the firm will not continuously rebalance capital structure, practitioners often use the first set of unlever/relever equations as an approximation and the WACC method

• For alternative leverage policies, the APV method is usually the simplest approach.
– APV is also easier when there are many side-effects to consider, e.g., it is better at dealing with default and agency costs

The FCFE method is typically used only in complicated settings where the values in the firm’s capital structure or the interest tax shield are difficult to determine.

Question 66

Conditions under which the methods are valid?

Answer 66

Review of conditions under which the methods are valid:
1. The business risk of the project is equal to that of the parent company

2. For WACC and FCFE:
   The project will not change the capital structure of the company (i.e., the project will be financed with the same D/E as the parent)
3. For WACC and FCFE:
   The company must rebalance its capital structure to maintain a constant D/E

– We can deal with breaches of (1) by using business risk estimates from comparable projects (adjusted for capital structure differences with 3-step procedure)
– We can deal with breaches of (2) using our 3-step procedure to estimate WACC at alternative capital structures