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1
Q

Net Present Value (NPV) considers both the magnitude and timing of cash flows.

A

True.

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2
Q

What does the Internal Rate of Return (IRR) represent?

A

The discount rate that makes NPV equal zero.

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3
Q

In the context of capital budgetingwhat does a positive NPV indicate about a project?

A

it will be profitable

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4
Q

(TF) The payback period is a measure of how quickly an investment reaches its breakeven point in terms of cash inflows.

A

True.

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5
Q

What is the primary drawback of using the payback period as a measure of a project’s worth?

A

It does not consider the time value of money or cash flows after the payback period.

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6
Q

When considering mutually exclusive projects

A

which method is typically preferred for making a decision?

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7
Q

How does terminal value impact the calculation of a firm’s value in capital budgeting?

A

It accounts for the value of cash flows beyond a forecast period into perpetuity.

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8
Q

(TF) In capital budgeting

A

a project’s IRR can be less than the required rate of return even if its NPV is positive.

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9
Q

What is the key principle behind diversification in investment?

A

Reducing unsystematic risk by investing in a variety of assets.

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10
Q

What does a stock’s Beta measure in the context of investment?

A

The stock’s non-diversifiable (systematic or market) risk.

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11
Q

Why is the Weighted Average Cost of Capital (WACC) important in capital budgeting?

A

It represents the minimum return a company must earn on existing asset base to satisfy its investors.

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12
Q

What is the three-step method for calculating WACC?

A

1) Calculate the market value proportions of each capital component

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13
Q

How does debt financing affect a firm’s WACC?

A

Debt financing typically lowers WACC due to the tax deductibility of interest payments.

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14
Q

(TF) A firm’s risk profile determines its Weighted Average Cost of Capital (WACC).

A

True.

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15
Q

What is the formula for calculating the after-tax cost of debt?

A

Cost of debt x (1 - Tax rate).

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16
Q

In the context of WACC

A

how do you calculate the required return on equity?

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17
Q

How does the market value of equity and debt affect the calculation of WACC?

A

They determine the proportionate weights of each component in the overall capital structure.

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18
Q

Why do preferred stocks generally have a higher required return than debt?

A

Preferred stocks are riskier than debt since they don’t have the same obligation for payment as debt and are junior to debt in case of liquidation.

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19
Q

(TF) The risk-free rate is always lower than the market return in the CAPM model.

A

True.

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20
Q

How can a firm adjust its WACC to incorporate both common and preferred stock?

A

By calculating the weighted average of the required returns on common stock

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21
Q

What role does venture capital play in financing new firms?

A

Venture capital provides funding for new firms

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22
Q

Describe the role of investment bankers in an Initial Public Offering (IPO).

A

Investment bankers underwrite

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23
Q

What are the key considerations when choosing a venture capitalist?

A

Financial strength

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24
Q

(TF) The success of an IPO can depend heavily on the reputation of the investment banker.

A

True.

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25
Q

What is the impact of underpricing an IPO on the issuing company?

A

It may lead to a reduced capital amount raised but can create excitement and success for future offerings.

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26
Q

In Modigliani and Miller’s Proposition 1

A

what happens to a firm’s value when taxes are introduced?

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27
Q

How does the trade-off theory explain a firm’s capital structure?

A

It balances the tax benefits of debt financing with the costs of financial distress.

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28
Q

What does the pecking order theory suggest about a firm’s financing preferences?

A

Firms prefer internal financing

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29
Q

Describe the effect of financial leverage on a company’s earnings.

A

Financial leverage can amplify both gains and losses

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30
Q

(TF) According to the trade-off theory

A

there is a clearly identifiable optimal capital structure for every firm.

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31
Q

What is the primary purpose of an Initial Public Offering (IPO) for a company?

A

To raise capital by offering shares to the public for the first time.

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32
Q

How does diversification reduce investment risk?

A

By spreading investments across various assets

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33
Q

What is the impact of a high Beta on a stock’s required return?

A

A high Beta indicates higher market risk

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34
Q

Describe the significance of the Weighted Average Cost of Capital (WACC) in decision-making.

A

WACC is used as a hurdle rate for evaluating the feasibility of investment projects.

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35
Q

(TF) The Payback Period method ignores the time value of money.

A

True.

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36
Q

How does the Net Present Value (NPV) method assess the viability of a project?

A

By calculating the present value of the project’s cash inflows and outflows to determine net gain or loss.

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37
Q

What does a negative Internal Rate of Return (IRR) indicate about a project?

A

That the project’s expected return is less than the initial investment

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38
Q

In the context of the Capital Asset Pricing Model (CAPM)

A

what does the market risk premium represent?

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39
Q

Why might a company prefer debt over equity financing?

A

Debt can be cheaper due to tax deductibility of interest and doesn’t dilute ownership like equity.

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40
Q

What is the Modigliani and Miller Proposition 2 about capital structure?

A

It states that a firm’s cost of equity increases with financial leverage due to the increased risk.

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41
Q

How does issuing preferred stock affect a company’s WACC?

A

Preferred stock typically has a higher cost than debt but lower than common equity

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42
Q

What is the primary advantage of using the NPV method for capital budgeting?

A

NPV provides a direct estimate of the value added to the firm by the project.

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43
Q

(TF) In an efficient market

A

the historical performance of stocks is a good predictor of future performance.

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44
Q

What is the main limitation of the IRR method when comparing two mutually exclusive projects?

A

IRR may not rank projects consistently with NPV

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45
Q

Explain the difference between systematic and unsystematic risk.

A

Systematic risk affects the entire market

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46
Q

How does the cost of capital relate to a firm’s investment decisions?

A

The cost of capital acts as a benchmark rate for evaluating the returns of potential investments.

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47
Q

What factors influence a company’s decision to go public?

A

The need for capital

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48
Q

(TF) Debt financing always reduces a company’s WACC due to the tax shield on interest payments.

A

False. While the tax shield can reduce WACC

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49
Q

Describe the role of the discount rate in the NPV calculation.

A

The discount rate is used to calculate the present value of future cash flows

50
Q

Why might a company with high profitability have a low debt-to-equity ratio according to the pecking order theory?

A

Highly profitable companies may rely more on retained earnings

51
Q

How does the ‘dividend discount model’ evaluate a stock’s value?

A

By discounting future dividends to the present value.

52
Q

What is ‘terminal value’ in capital budgeting and why is it important?

A

It’s the value of a project’s cash flows beyond the forecast period

53
Q

(TF) A high Beta value for a stock implies it is less volatile than the market.

A

False. A high Beta indicates higher volatility compared to the market.

54
Q

How can a firm’s capital structure affect its overall risk?

A

A higher proportion of debt increases financial leverage and risk

55
Q

In what way does the payback period method differ from NPV and IRR methods?

A

The payback period method focuses on liquidity and quick recovery of investment

56
Q

What does a positive Net Present Value (NPV) indicate about a project’s return relative to its cost?

A

It indicates the project’s return exceeds its cost

57
Q

Why is the Internal Rate of Return (IRR) preferred in some cases over NPV?

A

IRR provides a clear percentage return

58
Q

How does diversification reduce unsystematic risk?

A

By spreading investments across various unrelated assets

59
Q

(TF) Weighted Average Cost of Capital (WACC) remains constant regardless of a firm’s capital structure.

A

False. WACC changes with the proportion of debt and equity in the capital structure.

60
Q

In the CAPM formula

A

what does the term (rm - rf) represent?

61
Q

What factors influence a firm’s decision to issue preferred stock?

A

Preferred stock is often issued to balance debt and equity

62
Q

Explain how the market risk premium affects the expected return of a stock according to CAPM.

A

The market risk premium (rm - rf) influences the additional return expected from a stock based on its Beta.

63
Q

(TF) In capital budgeting

A

terminal value assumes cash flows continue indefinitely.

64
Q

What is the effect of financial distress costs on a firm’s capital structure?

A

High financial distress costs may discourage excessive debt

65
Q

Why might a company choose to issue debt instead of equity?

A

To take advantage of tax shields

66
Q

Describe the relationship between a stock’s Beta and its required return in the CAPM.

A

The higher the Beta

67
Q

What is the primary goal of diversification in an investment portfolio?

A

To minimize unsystematic risk and improve the risk-return profile of the portfolio.

68
Q

(TF) The cost of equity is generally lower than the cost of debt due to its lower risk.

A

False. Equity is riskier and generally has a higher cost than debt.

69
Q

How does the concept of risk and return influence investment decisions?

A

Investors seek higher returns for higher risk

70
Q

What is the implication of a project’s IRR being lower than the WACC?

A

It suggests the project is not generating sufficient returns to justify its risk and investment

71
Q

What is the significance of the Modigliani and Miller Proposition 1 in finance?

A

It suggests that in a perfect market

72
Q

How does the cost of debt differ from the cost of equity?

A

The cost of debt is generally lower due to its tax-deductible nature and lower risk compared to equity.

73
Q

(TF) The payback period method is the most comprehensive method for evaluating the viability of a project.

A

False. The payback period method does not account for the time value of money or returns after the payback period.

74
Q

What is the primary advantage of debt financing from a tax perspective?

A

Interest payments on debt are tax-deductible

75
Q

Why might a firm with stable cash flows choose a higher level of debt in its capital structure?

A

Firms with stable cash flows can handle the regular interest payments associated with debt

76
Q

How does the risk-free rate factor into the CAPM equation?

A

It represents the return expected from an investment with zero risk

77
Q

In what situation might a firm prefer equity financing over debt financing?

A

When a firm wants to avoid fixed interest obligations or when it has high financial distress costs.

78
Q

(TF) High Beta stocks are less sensitive to market movements than low Beta stocks.

A

False. High Beta stocks are more sensitive to market movements.

79
Q

What role does an investment banker play in a firm’s capital raising process?

A

An investment banker advises on capital raising strategies

80
Q

Describe the concept of ‘terminal value’ in DCF models.

A

Terminal value estimates the value of a business or cash flows beyond a forecast period

81
Q

What is the primary benefit of the Net Present Value (NPV) method in project evaluation?

A

It measures the actual value added to the firm by the project.

82
Q

(TF) The Internal Rate of Return (IRR) is the most reliable method for projects with unconventional cash flows.

A

False. IRR can be misleading for projects with unconventional cash flows.

83
Q

Why is the cost of equity typically higher than the cost of debt?

A

Equity investors require higher returns due to higher risk and lack of tax benefits that debt offers.

84
Q

In what way does issuing bonds affect a company’s balance sheet?

A

Issuing bonds increases both the assets (cash) and liabilities (debt) on the balance sheet.

85
Q

How can the Dividend Discount Model be used to value a stock?

A

By estimating the present value of all future dividends the stock is expected to pay.

86
Q

What does a negative Net Present Value (NPV) indicate about a project?

A

That the project’s costs outweigh its benefits and it is likely to decrease the firm’s value.

87
Q

Describe the risk-return tradeoff in investment decisions.

A

Investors expect to be compensated with higher returns for taking on higher risk.

88
Q

(TF) Diversification can eliminate all risks associated with investing in stocks.

A

False. Diversification can reduce unsystematic risk but not systematic risk.

89
Q

What is the significance of a company’s Weighted Average Cost of Capital (WACC)?

A

WACC is used as a discount rate to evaluate projects and reflects the cost of the company’s capital.

90
Q

Why might a company prefer equity financing over debt financing despite its higher cost?

A

To avoid fixed financial obligations and the risk of bankruptcy associated with debt.

91
Q

What is the primary purpose of calculating a firm’s WACC?

A

To determine the average cost of capital a firm pays for its financing sources.

92
Q

How does an increase in a company’s debt level affect its WACC and why?

A

It can decrease WACC due to the tax deductibility of interest

93
Q

(TF) The Net Present Value (NPV) method always provides a definitive decision for all types of investment projects.

A

False. NPV may not be sufficient for projects with multiple IRRs or non-conventional cash flows.

94
Q

What is the implication of a stock having a Beta greater than 1?

A

The stock is more volatile than the market and tends to have larger fluctuations in price.

95
Q

Why do companies undergo Initial Public Offerings (IPOs)?

A

To raise capital

96
Q

How does the risk-free rate in the CAPM formula influence the required return on equity?

A

A higher risk-free rate increases the required return on equity

97
Q

What are the advantages of equity financing over debt financing?

A

No obligation for regular payments

98
Q

(TF) The Internal Rate of Return (IRR) takes into account the time value of money in project evaluation.

A

True.

99
Q

Why might a company with volatile earnings prefer equity financing?

A

To avoid the risks associated with fixed debt repayments during periods of low earnings.

100
Q

Describe how the market risk premium is used in the CAPM.

A

It’s multiplied by the Beta of the stock to determine the risk premium over the risk-free rate.

101
Q

What is the impact of a project’s IRR being higher than the WACC?

A

It indicates the project is expected to generate returns greater than the cost of capital

102
Q

(TF) Preferred stockholders have voting rights in corporate decisions.

A

False. Preferred stockholders typically do not have voting rights.

103
Q

Why is understanding a firm’s cost of equity important?

A

It helps in determining the return required by investors for investing in the company’s equity

104
Q

How does a stock’s Beta relate to its volatility compared to the overall market?

A

A Beta greater than 1 indicates the stock is more volatile than the market

105
Q

What is the primary purpose of an IPO from an investor’s perspective?

A

To invest in a company’s growth potential and possibly gain from the increase in stock value.

106
Q

Describe the role of diversification in managing investment risk.

A

Diversification spreads risk across various assets

107
Q

(TF) Debt financing always increases a company’s financial risk.

A

False. While debt increases financial obligations

108
Q

Why might a firm with a high Beta choose a lower level of debt in its capital structure?

A

To avoid adding financial risk to its already high market risk.

109
Q

In what way does the Net Present Value (NPV) method consider the time value of money?

A

It discounts future cash flows to their present value

110
Q

How does the market risk premium in the CAPM formula affect the cost of equity?

A

It increases the cost of equity

111
Q

What is the impact of a project’s IRR being higher than the WACC?

A

It indicates the project is expected to generate returns greater than the cost of capital

112
Q

(TF) Preferred stockholders have voting rights in corporate decisions.

A

False. Preferred stockholders typically do not have voting rights.

113
Q

Why is understanding a firm’s cost of equity important?

A

It helps in determining the return required by investors for investing in the company’s equity

114
Q

How does a stock’s Beta relate to its volatility compared to the overall market?

A

A Beta greater than 1 indicates the stock is more volatile than the market

115
Q

What is the primary purpose of an IPO from an investor’s perspective?

A

To invest in a company’s growth potential and possibly gain from the increase in stock value.

116
Q

Describe the role of diversification in managing investment risk.

A

Diversification spreads risk across various assets

117
Q

(TF) Debt financing always increases a company’s financial risk.

A

False. While debt increases financial obligations

118
Q

Why might a firm with a high Beta choose a lower level of debt in its capital structure?

A

To avoid adding financial risk to its already high market risk.

119
Q

In what way does the Net Present Value (NPV) method consider the time value of money?

A

It discounts future cash flows to their present value

120
Q

How does the market risk premium in the CAPM formula affect the cost of equity?

A

It increases the cost of equity

Zuo-mba finance 614 (8 decks)

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