Discounted cash flow valuation Flashcards
How can ROE be calculated based on ‘Return on Investment’, ‘Interest’ and ‘D/E’ ratio?
ROE=ROI+(ROI-i)*D/E
If a company increases its leverage, and everything else is held equal, which of the following statements is true?
a) ROI increases
b) ROE increases
c) ROE decreases
d) Nothing changes
e) ROI decreases
f) Both ROE and ROI increases
g) Both ROE and ROI decreases
(b) ROE increases
Leverage magnifies the volatility of accounting profitability and – on average – increases it: that is, with leverage, risk is higher, with a ROE distribution deviating more significantly from the ROI.
True or false,
In a world with no income taxes, a change in financial leverage (D/E) will either increase or decrease the enterprise value, dependent if the leverage increases or decreases.
False.
In a world with no income taxes, a change in financial leverage does not affect enterprise value.
What is true about risk and leverage?
a) The risk is not dependent on leverage
b) Higher risk with lower leverage
c) Higher risk with higher leverage
d) Risk is dependent of several factors, and cannot be concluded on based on change in leverage
(c)
While debt amplifying any positive investment return (increases cash flow which increases the value), it also increases risk, which entails the requirement of a higher discount factor (expected return on investment), which outweighs the increase in CF.
Which of the following statements are true, when a company is fully equity financed (several answers)?
a) ROE is higher than ROI
b) ROE is lower than ROI
c) Net income is equal to EBIT
d) Net income is equal to EBIT less interest
e) ROE is equal to ROI
(c) and (e).
c is true because fully equity financing implies no interest expenses.
Which of the following statements are true, when a company is partly debt financed?
a) ROE is higher than ROI
b) ROE is lower than ROI
c) Net income is equal to EBIT
d) Net income is equal to EBIT less interest
e) ROE is equal to ROI
(a) and (d)
That is because given the presence of leverage financing and given that the ROI is higher than the cost of debt (interest), the expected ROE will be higher. This is made possible because leverage amplifies the investment return (higher ROI as compared to ROI with no leverage, given that that the ROI is higher than interest rate).
If FCFE=FCFO, which of the following statements is true?
a) A company is 50/50 debt and equity financed
b) The relationship between FCFE and FCFO cannot be determined with the D/E ratio
c) A company has no debt
d) A company if fully debt financed
(c)
Why does the enterprise value increase, when debt increases (in a tax world)?
a) Taxes decreases
b) You have more money available in the corporation
c) Lower future tax shields
d) Higher future tax shields
(d)
From the sources’ perspective, D and E holders now have their own separate required returns. CF at market value now also includes a new CF, the PV of all future tax shields (assume its risk is equivalent to debt).
True or false.
Given the presence of income tax, WACC increases as leverage decreases, due to the correspondingly higher tax savings.
False.
Given the presence of income tax, WACC decreases as leverage increases, due to the correspondingly higher tax savings.
Which of the following steps does not belong in the DCF-approach?
a) Develop/ get business plan
b) Compute discount rates
c) Estimate the terminal value
d) Discount Net income and net debt
e) Discount FCFO–> EV
f) Subtract net debt, +/- other times –> EqV
(d)
It’s only the FCFO that is discounted.
At terminal value, the FCF should be normalized to represent a steady state. Which of the following do not represent steady state (several answers)?
a) CAPEX = D&A
b) (\delta)NWC = 100%
c) Payout ratio=0%
d) No change in gross debt
(b) and (c)
(\delta)NWC should be equal to zero and the payout ratio to 100%.
Under the terminal value assumptions, how is the FCFE and total CF affected?
a) FCFE = Change in D and Total CF=0
b) FCFE = not affected and Total CF=0
c) FCFE = Change in E and Total CF=0
d) FCFE = Change in E and Total CF = Changes with the same value as FCFE
(c)
What is true about the relationship between ROI, WACC and growth?
a) If WACC is equal to ROI, the growth rate becomes irrelevant for the value
b) If WACC is higher than ROI, growth decreases ROI due to negative spread between WACC and ROI
c) If WACC is lower than ROI, growth increases ROI due to negative spread between WACC and ROI
d) All of the above
(d) All of the above
