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FI 311 > Exam 3 > Flashcards

Exam 3 Flashcards

1
Q

WACC equation

A

Wdrd(1-T)+WpRp+Wc*Rs

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2
Q

Government gives tax break on interest paid to debt so

A

Cost of issuing bond(interst to bond holders) is tax desuctable

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3
Q

Should analysis be focused on historical cost or marginal costs

A

Marginal cost

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4
Q

Rp is

A

The marginal cost of preferred stock which is the return investors require on a firms preferred stock

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5
Q

Cost of preferred stock formula

A

Dp/Pp

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6
Q

Is preferred stock more or less risky

A

More because they are not required to pay dividends

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7
Q

Why is the yeild on preferred lower than debt

A

Corps own most preferred and 70% are excluded from tax so BT yield will be lower

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8
Q

Rs is

A

The marginal cost of common equity using retained earnings

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9
Q

Three ways to determine the cost of common equity

A

CAPM, DCF, and bond yield plus risk premium

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10
Q

CAPM formula

A

Rs=Rrf+ (Rm-Rrf)b

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11
Q

DCF equation

A

Rs= (D1/P0) +g

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12
Q

Bond yield plus risk premium equation

A

Rs=Rd+RP

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13
Q

Direct cost related to retained earnings and stock

A

When a company issues new CS they also have to pay a flotation cost to the underwriters

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14
Q

Indirect cost related to RE and CS

A

Issing new stick may send a neg message signal to the markets wish may depress the stock price

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15
Q

Price of equity with flotation cost equation

A

Re=D0(1+g)/P0(1-F) +g

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16
Q

Flotation cost depend

A

On the firms risk and the type of capital being raised and amount being raise

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17
Q

Floation cost are highest for

A

Common equity but per project cost are small

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18
Q

What factors influence a companys composite WACC

A

Market conditions, captial structure and dividend policy, investment policy, interest rate and stock price

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19
Q

Riskier projects will have a higher

A

WACC

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20
Q

What is capital budgeting

A

Analysis of potential additons to fixed assets. Long term decisions with large expenditures

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21
Q

Steps to capital budgeting

A

Estimate CF, assess riskiness of CF, determine appropriate cost of capital, find NPV or IRR, accept or decline

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22
Q

Accept project if

A

NPV>0 and or IRR>WACC

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23
Q

Independent projects

A

If the cash flows of one are unaffected by the acceptance of the other

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24
Q

Mutually exclusice projects

A

If the cash flows of one can be adversly impacted by the acceptance of the other

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25
Q

Normal cash flow streams

A

Cost followed by a series of positive cash inflows

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26
Q

Nonnormal cash flows

A

Two or more changes of signs

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27
Q

Net present value

A

Sum of the PV of all cash inflows and outflows of a project

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28
Q

IRR is

A

The discount rate that forces PV of inflows equal to cost and the NPV equal 0

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29
Q

IRR formula

A

Sum of (CF/(1+IRR)^t

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30
Q

If IRR>WACC

A

The projects return exceeds its costs and there is some return left over to boost stockholders returns

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31
Q

The lower the cost of capital the NPV should

A

Become higher

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32
Q

Reasons shy NPV profiles cross

A

Size differences, timing differences, value of CFs

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33
Q

Size differences

A

The smaller project frees up funds at time 0 for investment. Higher opp cost the more valuable these funds so a high WACC favors small projects

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34
Q

Timing differneces

A

The project with faster payback provides more CF in early years for reinvestment. If WACC is high early CF especually good

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35
Q

Value of CF:

A

CF can be reinvested and earn addtional interest

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36
Q

NPV method assumes CF are reinvested at

A

The WACC

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37
Q

IRR mthod assumes CF are reinvest at

A

IRR

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38
Q

NPV is the best for reinvestment because

A

CF are reinvested at the opp cost of capital

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39
Q

MIRR

A

The discount rate that causes the PV of a projects terminal value to equal the PV of cost

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40
Q

MIRR assumes cash flows are reinvest at

A

WACC

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41
Q

Payback period

A

The number of years required to recover a projexts cost

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42
Q

Strengths of payback period

A

Provides an indication of a projects risk and liqudity. Easy to calculate and understand

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43
Q

Weaknesses of the payback period

A

Ignores the time value of money, ignores CFs after payback period

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44
Q

When to use MIRR instead of IRR

A

When there are nonnormal CFs and more than one IRR

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45
Q

3 types of cash flows

A

During operation cash flows, investment stage cash flows, disinvestment stage cash flows

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46
Q

Estimate relevant cash flows

A

Calc annual operating cash flows, identifying changes in net op working cap, calc terminal cash flows

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47
Q

How is NOWC recovered

A

From inventory

48
Q

Is there always a tax in SV

A

As long as it is positive then yes there will be a tax instead of reinvestment

49
Q

Is the tax on SV ever a positive cash flow

A

Tc(MV-BV)

50
Q

Should financing effects be included in cash flows?

A

No

51
Q

Should improvement cost from previous year be included

A

No, ignore sunk costs

52
Q

If building could be leased out include

A

Yes

53
Q

If the nee line decreases the sales of the firms other lines would this affect

A

Yes because of externalitys

54
Q

Postive externality

A

Buying more ipods will increase the sales of itunes

55
Q

Negative externality

A

Ipod mini decreases sales of regular ipod

56
Q

Stand alone risk

A

Risk of the project itself

57
Q

Corporate risk

A

Project risk considering firms other projects

58
Q

Market risk

A

Projexts risk to a well diversified investor

59
Q

Sensitivity analysis

A

Measures the effect of changes in a variable on the projects NPV

60
Q

Advantages to sensitivity anaysis

A

Identifies variables that may have the greatest potential impact on profitability and allows management to focus on these variables

61
Q

Disadvtages to sensitivity analysis

A

Does not relfect the effects of diverification, does not incorporate any info about possible magnitude of the forcast error

62
Q

If the project was highly correlated witht the economy, how would corporate and market risk be affected

A

The corp risk would not be directlu effected but combinded with high stand alone and corrleation with econ would suggest a high market risk beta

63
Q

Monte carlo simulation

A

Large number of scenarios are run by the computer by randomly picking each variables to calc NPVs and SD

64
Q

When you do risk analysis

A

Qualitative factors should also be counted

65
Q

If project could have a lawsuit then

A

It has more risk

66
Q

If assets can be sold easilu

A

The project could be less risky

67
Q

If involving foreign investment

A

Higher risk

68
Q

Business risk

A

The riskiness inherent in the firms operations if it uses no debt. Commonly measured by ROIC

69
Q

ROIC equation

A

EBIT(1-T)/total capital

70
Q

What determines business risk

A

Competition, uncertianty about demand, output prices and cost, product obsolescence, foreign risk exposure, regulatory risk and legal exposure, operating leverage

71
Q

Operating leverage

A

Is the use of fixed costs rather than variable cost

72
Q

If most cost are fixed then

A

The firm has a high op leverage

73
Q

More operating leverage leads to

A

More business risk for then small sales declone causes a big profit decline

74
Q

ROIC

A

Meaures the after tax return that the company provides for all its investodz

75
Q

Financial leverage

A

Is the use of debt and preferred stock

76
Q

Financial risk is

A

The addiontal risk concentrated on common stockholdwrs as a result of financail leverage

77
Q

Business risk depends on

A

Business factos such as competition, product obsolesence, and operating leverage

78
Q

Financila risk depends on

A

The type of securities issued

79
Q

As a company starts to borrow money

A

SD and ROE increase

80
Q

For leverage to raise expected ROE

A

Must have ROIC>rd(1-T) because AT interest will be higer than the AT operating income

81
Q

Optimal captial structure

A

The capital structure at which P0 is maxed

82
Q

The target capital structure is

A

The mix of debt, preferred abd common equity with which the firm intends to raise capital

83
Q

Why do bond rating and cost of debt depend upon the amount of debt borrowed?

A

Borrowig more increases financial risk that means a lower bond rating meaning investors require higher interest meaning cost of debt increases

84
Q

As you borrow more money

A

EPS increases and TIE decreases

85
Q

What effect does more devt have on a firms cost of equity

A

Risk increases, cost increases

86
Q

Hamada equation

A

Attempts to quanitify the increases cost of equitu due to financial leverage

87
Q

The hamada equation formula

A

Bl=Bu(1+(1-t)(D/E))

Rs=Rrf+(RPm) Bl

88
Q

How to find optimal capital structure

A

Min WACC or max stock price

89
Q

With higher business risk and cap structure

A

Then the prob of financial distress would be greater at any debt level and OCS would be one that had less debt

90
Q

Lower business risk

A

Would lead to an OCS with more debt

91
Q

Sales stability affects target cap structure

A

Good=lower business risk

92
Q

High op leverage an TCS

A

Business risk higher so lower debt

93
Q

Increase corp tax rate and TCS

A

Higher debt level

94
Q

Increase personal tax and TCS

A

RE higher and lower debt

95
Q

Increase bankrupcy cost and TCS

A

Lower debt level

96
Q

Managers spending more and TCS

A

Higher debt level

97
Q

Morigliani miller irrelevance theory

A

Firms shouldnt change its cap structure under perfect market conditions

98
Q

To make cap structure relevant need to relax

A

Frictionless market, equal access to market price, rational investors, equal access to info

99
Q

Signaling effects

A

Issue stock=overvalued
Issue devt=undervalued
Investors react negitivlu

100
Q

Pecking order hypothesis

A

Manager have a preferred order(RE-Debt-common stock)

101
Q

Windows of opportunity

A

Cap structure is determined by attempts to time the market. Issue with overvalued and repurchase with under

102
Q

What happens to WACC if interest rates rise

A

Cost of debt increases causing WACC to rise

103
Q

What happens to WACC if stock prices decline

A

Cost of equity will rise causing WACC to rise

104
Q

What happens to WACC if tax rates are lowered

A

Cost of equity and WACC decline

105
Q

What happens to WACC if target debt ratio increases

A

WACC declines

106
Q

What happens to WACC if dividends increase

A

Cost of equity and WACC increase

107
Q

What happens to WACC if a firm invest in risky assets

A

Debt, equity and WACC will increase

108
Q

NPV profiles

A

Find NPV at a number of different discount rates a then plot on a graph

109
Q

Crossover rate

A

The cost of capital at which the NPV profiles of two projects cross and thus at which the projects NPVs are equal

110
Q

Less competition

A

Lowers business risk

111
Q

The more stable the demand

A

The lower the business risk

112
Q

Sales price is stable

A

Less business risk

113
Q

Input cost are uncertain

A

High business risk

114
Q

The faster the produce becomes obsolete the

A

Greater the business risk

115
Q

High fixed cost

A

High business risk

FI 311 (3 decks)

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