Dump from TOMG Flashcards
Net Present Value (NPV) considers both the magnitude and timing of cash flows.
True.
What does the Internal Rate of Return (IRR) represent?
The discount rate that makes NPV equal zero.
In the context of capital budgetingwhat does a positive NPV indicate about a project?
it will be profitable
(TF) The payback period is a measure of how quickly an investment reaches its breakeven point in terms of cash inflows.
True.
What is the primary drawback of using the payback period as a measure of a project’s worth?
It does not consider the time value of money or cash flows after the payback period.
When considering mutually exclusive projects
which method is typically preferred for making a decision?
How does terminal value impact the calculation of a firm’s value in capital budgeting?
It accounts for the value of cash flows beyond a forecast period into perpetuity.
(TF) In capital budgeting
a project’s IRR can be less than the required rate of return even if its NPV is positive.
What is the key principle behind diversification in investment?
Reducing unsystematic risk by investing in a variety of assets.
What does a stock’s Beta measure in the context of investment?
The stock’s non-diversifiable (systematic or market) risk.
Why is the Weighted Average Cost of Capital (WACC) important in capital budgeting?
It represents the minimum return a company must earn on existing asset base to satisfy its investors.
What is the three-step method for calculating WACC?
1) Calculate the market value proportions of each capital component
How does debt financing affect a firm’s WACC?
Debt financing typically lowers WACC due to the tax deductibility of interest payments.
(TF) A firm’s risk profile determines its Weighted Average Cost of Capital (WACC).
True.
What is the formula for calculating the after-tax cost of debt?
Cost of debt x (1 - Tax rate).
In the context of WACC
how do you calculate the required return on equity?
How does the market value of equity and debt affect the calculation of WACC?
They determine the proportionate weights of each component in the overall capital structure.
Why do preferred stocks generally have a higher required return than debt?
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.
(TF) The risk-free rate is always lower than the market return in the CAPM model.
True.
How can a firm adjust its WACC to incorporate both common and preferred stock?
By calculating the weighted average of the required returns on common stock
What role does venture capital play in financing new firms?
Venture capital provides funding for new firms
Describe the role of investment bankers in an Initial Public Offering (IPO).
Investment bankers underwrite
What are the key considerations when choosing a venture capitalist?
Financial strength
(TF) The success of an IPO can depend heavily on the reputation of the investment banker.
True.
What is the impact of underpricing an IPO on the issuing company?
It may lead to a reduced capital amount raised but can create excitement and success for future offerings.
In Modigliani and Miller’s Proposition 1
what happens to a firm’s value when taxes are introduced?
How does the trade-off theory explain a firm’s capital structure?
It balances the tax benefits of debt financing with the costs of financial distress.
What does the pecking order theory suggest about a firm’s financing preferences?
Firms prefer internal financing
Describe the effect of financial leverage on a company’s earnings.
Financial leverage can amplify both gains and losses
(TF) According to the trade-off theory
there is a clearly identifiable optimal capital structure for every firm.
What is the primary purpose of an Initial Public Offering (IPO) for a company?
To raise capital by offering shares to the public for the first time.
How does diversification reduce investment risk?
By spreading investments across various assets
What is the impact of a high Beta on a stock’s required return?
A high Beta indicates higher market risk
Describe the significance of the Weighted Average Cost of Capital (WACC) in decision-making.
WACC is used as a hurdle rate for evaluating the feasibility of investment projects.
(TF) The Payback Period method ignores the time value of money.
True.
How does the Net Present Value (NPV) method assess the viability of a project?
By calculating the present value of the project’s cash inflows and outflows to determine net gain or loss.
What does a negative Internal Rate of Return (IRR) indicate about a project?
That the project’s expected return is less than the initial investment
In the context of the Capital Asset Pricing Model (CAPM)
what does the market risk premium represent?
Why might a company prefer debt over equity financing?
Debt can be cheaper due to tax deductibility of interest and doesn’t dilute ownership like equity.
What is the Modigliani and Miller Proposition 2 about capital structure?
It states that a firm’s cost of equity increases with financial leverage due to the increased risk.
How does issuing preferred stock affect a company’s WACC?
Preferred stock typically has a higher cost than debt but lower than common equity
What is the primary advantage of using the NPV method for capital budgeting?
NPV provides a direct estimate of the value added to the firm by the project.
(TF) In an efficient market
the historical performance of stocks is a good predictor of future performance.
What is the main limitation of the IRR method when comparing two mutually exclusive projects?
IRR may not rank projects consistently with NPV
Explain the difference between systematic and unsystematic risk.
Systematic risk affects the entire market
How does the cost of capital relate to a firm’s investment decisions?
The cost of capital acts as a benchmark rate for evaluating the returns of potential investments.
What factors influence a company’s decision to go public?
The need for capital
(TF) Debt financing always reduces a company’s WACC due to the tax shield on interest payments.
False. While the tax shield can reduce WACC
Describe the role of the discount rate in the NPV calculation.
The discount rate is used to calculate the present value of future cash flows
Why might a company with high profitability have a low debt-to-equity ratio according to the pecking order theory?
Highly profitable companies may rely more on retained earnings
How does the ‘dividend discount model’ evaluate a stock’s value?
By discounting future dividends to the present value.
What is ‘terminal value’ in capital budgeting and why is it important?
It’s the value of a project’s cash flows beyond the forecast period
(TF) A high Beta value for a stock implies it is less volatile than the market.
False. A high Beta indicates higher volatility compared to the market.
How can a firm’s capital structure affect its overall risk?
A higher proportion of debt increases financial leverage and risk
In what way does the payback period method differ from NPV and IRR methods?
The payback period method focuses on liquidity and quick recovery of investment
What does a positive Net Present Value (NPV) indicate about a project’s return relative to its cost?
It indicates the project’s return exceeds its cost
Why is the Internal Rate of Return (IRR) preferred in some cases over NPV?
IRR provides a clear percentage return
How does diversification reduce unsystematic risk?
By spreading investments across various unrelated assets
(TF) Weighted Average Cost of Capital (WACC) remains constant regardless of a firm’s capital structure.
False. WACC changes with the proportion of debt and equity in the capital structure.
In the CAPM formula
what does the term (rm - rf) represent?
What factors influence a firm’s decision to issue preferred stock?
Preferred stock is often issued to balance debt and equity
Explain how the market risk premium affects the expected return of a stock according to CAPM.
The market risk premium (rm - rf) influences the additional return expected from a stock based on its Beta.
(TF) In capital budgeting
terminal value assumes cash flows continue indefinitely.
What is the effect of financial distress costs on a firm’s capital structure?
High financial distress costs may discourage excessive debt
Why might a company choose to issue debt instead of equity?
To take advantage of tax shields
Describe the relationship between a stock’s Beta and its required return in the CAPM.
The higher the Beta
What is the primary goal of diversification in an investment portfolio?
To minimize unsystematic risk and improve the risk-return profile of the portfolio.
(TF) The cost of equity is generally lower than the cost of debt due to its lower risk.
False. Equity is riskier and generally has a higher cost than debt.
How does the concept of risk and return influence investment decisions?
Investors seek higher returns for higher risk
What is the implication of a project’s IRR being lower than the WACC?
It suggests the project is not generating sufficient returns to justify its risk and investment
What is the significance of the Modigliani and Miller Proposition 1 in finance?
It suggests that in a perfect market
How does the cost of debt differ from the cost of equity?
The cost of debt is generally lower due to its tax-deductible nature and lower risk compared to equity.
(TF) The payback period method is the most comprehensive method for evaluating the viability of a project.
False. The payback period method does not account for the time value of money or returns after the payback period.
What is the primary advantage of debt financing from a tax perspective?
Interest payments on debt are tax-deductible
Why might a firm with stable cash flows choose a higher level of debt in its capital structure?
Firms with stable cash flows can handle the regular interest payments associated with debt
How does the risk-free rate factor into the CAPM equation?
It represents the return expected from an investment with zero risk
In what situation might a firm prefer equity financing over debt financing?
When a firm wants to avoid fixed interest obligations or when it has high financial distress costs.
(TF) High Beta stocks are less sensitive to market movements than low Beta stocks.
False. High Beta stocks are more sensitive to market movements.
What role does an investment banker play in a firm’s capital raising process?
An investment banker advises on capital raising strategies
Describe the concept of ‘terminal value’ in DCF models.
Terminal value estimates the value of a business or cash flows beyond a forecast period
What is the primary benefit of the Net Present Value (NPV) method in project evaluation?
It measures the actual value added to the firm by the project.
(TF) The Internal Rate of Return (IRR) is the most reliable method for projects with unconventional cash flows.
False. IRR can be misleading for projects with unconventional cash flows.
Why is the cost of equity typically higher than the cost of debt?
Equity investors require higher returns due to higher risk and lack of tax benefits that debt offers.
In what way does issuing bonds affect a company’s balance sheet?
Issuing bonds increases both the assets (cash) and liabilities (debt) on the balance sheet.
How can the Dividend Discount Model be used to value a stock?
By estimating the present value of all future dividends the stock is expected to pay.
What does a negative Net Present Value (NPV) indicate about a project?
That the project’s costs outweigh its benefits and it is likely to decrease the firm’s value.
Describe the risk-return tradeoff in investment decisions.
Investors expect to be compensated with higher returns for taking on higher risk.
(TF) Diversification can eliminate all risks associated with investing in stocks.
False. Diversification can reduce unsystematic risk but not systematic risk.
What is the significance of a company’s Weighted Average Cost of Capital (WACC)?
WACC is used as a discount rate to evaluate projects and reflects the cost of the company’s capital.
Why might a company prefer equity financing over debt financing despite its higher cost?
To avoid fixed financial obligations and the risk of bankruptcy associated with debt.
What is the primary purpose of calculating a firm’s WACC?
To determine the average cost of capital a firm pays for its financing sources.
How does an increase in a company’s debt level affect its WACC and why?
It can decrease WACC due to the tax deductibility of interest
(TF) The Net Present Value (NPV) method always provides a definitive decision for all types of investment projects.
False. NPV may not be sufficient for projects with multiple IRRs or non-conventional cash flows.
What is the implication of a stock having a Beta greater than 1?
The stock is more volatile than the market and tends to have larger fluctuations in price.
Why do companies undergo Initial Public Offerings (IPOs)?
To raise capital
How does the risk-free rate in the CAPM formula influence the required return on equity?
A higher risk-free rate increases the required return on equity
What are the advantages of equity financing over debt financing?
No obligation for regular payments
(TF) The Internal Rate of Return (IRR) takes into account the time value of money in project evaluation.
True.
Why might a company with volatile earnings prefer equity financing?
To avoid the risks associated with fixed debt repayments during periods of low earnings.
Describe how the market risk premium is used in the CAPM.
It’s multiplied by the Beta of the stock to determine the risk premium over the risk-free rate.
What is the impact of a project’s IRR being higher than the WACC?
It indicates the project is expected to generate returns greater than the cost of capital
(TF) Preferred stockholders have voting rights in corporate decisions.
False. Preferred stockholders typically do not have voting rights.
Why is understanding a firm’s cost of equity important?
It helps in determining the return required by investors for investing in the company’s equity
How does a stock’s Beta relate to its volatility compared to the overall market?
A Beta greater than 1 indicates the stock is more volatile than the market
What is the primary purpose of an IPO from an investor’s perspective?
To invest in a company’s growth potential and possibly gain from the increase in stock value.
Describe the role of diversification in managing investment risk.
Diversification spreads risk across various assets
(TF) Debt financing always increases a company’s financial risk.
False. While debt increases financial obligations
Why might a firm with a high Beta choose a lower level of debt in its capital structure?
To avoid adding financial risk to its already high market risk.
In what way does the Net Present Value (NPV) method consider the time value of money?
It discounts future cash flows to their present value
How does the market risk premium in the CAPM formula affect the cost of equity?
It increases the cost of equity
What is the impact of a project’s IRR being higher than the WACC?
It indicates the project is expected to generate returns greater than the cost of capital
(TF) Preferred stockholders have voting rights in corporate decisions.
False. Preferred stockholders typically do not have voting rights.
Why is understanding a firm’s cost of equity important?
It helps in determining the return required by investors for investing in the company’s equity
How does a stock’s Beta relate to its volatility compared to the overall market?
A Beta greater than 1 indicates the stock is more volatile than the market
What is the primary purpose of an IPO from an investor’s perspective?
To invest in a company’s growth potential and possibly gain from the increase in stock value.
Describe the role of diversification in managing investment risk.
Diversification spreads risk across various assets
(TF) Debt financing always increases a company’s financial risk.
False. While debt increases financial obligations
Why might a firm with a high Beta choose a lower level of debt in its capital structure?
To avoid adding financial risk to its already high market risk.
In what way does the Net Present Value (NPV) method consider the time value of money?
It discounts future cash flows to their present value
How does the market risk premium in the CAPM formula affect the cost of equity?
It increases the cost of equity
