Final

Question 1

What is the decision rule used to decide whether or not to do a project based on NPV (Net Present Value?)

Answer 1

If the NPV is a positive number, the firm should go forward with the project

Question 2

What is used as the discount rate when figuring out the Net Present Value (NPV) of a project?

Answer 2

Use the weighted average cost of capital (WACC), assuming that the project has similar risk characteristics to the existing businesses at the company.

Question 3

What is the decision making criterion to decide whether or not to do a project based on an Internal Rate of Return (IRR) calculation?

Answer 3

If the IRR exceeds the hurdle rate, then the firm should go ahead with the project.

Question 4

Assuming a proposed project has similar risk characteristics to the existing activities of a business, what typically is used as:
• the hurdle rate for making a go/no go decision based on an Internal Rate of Return (IRR) calculation
• the discount rate for making an NPV calculation?

Answer 4

The weighted average cost of capital (WACC)

Question 5

What is the Net Present Value (NPV) of a project if you use the internal rate of return (IRR) as the discount rate?

Answer 5

By definition the IRR is the discount rate that sets the NPV of a project equal to zero.

Question 6

What is the key consideration in deciding whether or not to include a particular cash flow in an NPV or IRR calculation?

Answer 6

The with/without criterion. You only factor in cash flows that will change if you do the project. So your baseline is what would cash flows be if you don’t do the project (without). Then you can see the cash flows that will come about if you do the project (with).

Question 7

Give an example of a sunk cost.

Answer 7

The idea of a sunk cost is that it is an expense that has already been incurred and so should not be considered when decided whether or not to do a project. An example from the book would be a marketing study completed before deciding whether or not to add a product line. The expense of the study is gone, regardless of whether or not the product line is added. So, having done the study, a model of the cash flows from the new product line should not include the cost of the study. (Of course, the results of the study should influence projections for sales, etc.; it is just the cost of the study that should be excluded)

Question 8

By convention, in this class, in calculating the weightings for the Weighted Average Cost of Capital, what figure is used to calculate:
• The value of Debt
• The value of Equity

Answer 8

1) The book value (i.e. what appears on the balance sheet) is used for debt
2) The market value (i.e. the publicly-traded share price x the number of shares outstanding) is used for equity.

Question 9

What is the key modification that is made to the average interest rate that appears on the balance sheet when calculating the cost of debt in weighted average cost of capital (WACC

Answer 9

The average interest rate is multiplied by (1-tax rate) to accurately estimate the real after-tax cost of debt.

Question 10

If a company has a tax rate of 30% and an average cost of debt on the balance sheet of 7%, what is the after-tax cost of debt?

Answer 10

4.9%

Calculated: 0.07 *(1-0.30) = 0.049

Question 11

In making a weighted average cost of capital calculation, how is the cost of equity typically calculated?

Answer 11

By using the Capital Asset Pricing Model:
Re = Rf+ Beta(Rm –Rf)
Where:
Re = the return equity investors expect from the firm
Rf = the risk-free rate of return
Beta = The stock’s sensitivity to market fluctuations
Rm = the return equity investors expect from the market as a whole

Question 12

If you are running a company to be as efficient in its use of assets as possible, would you like to see Days Sales in Inventory (DSI) rising or falling?

Answer 12

Falling. Maintaining inventory requires capital, you want to employ as little capital as possible.

Question 13

From the standpoint of assets required, what would be a perfect business?

Answer 13

A business that generates cash without requiring any assets. The example given in class was a wallet that just magically refilled itself, but even there, you have an asset in the form of the wallet. Perhaps the perfect business would be a magic spell, which, when uttered, causes cash to appear in your hand.

Question 14

If you are running a company to be as efficient in its use of cash as possible, would you like to see Days Sales Outstanding (DSO) rising or falling?

Answer 14

Falling. DSO represents sales where you have not yet collected the cash. You are effectively making a loan to your customers. The loan appears as an asset on your balance sheet. To maximize your cash on hand, you want to collect the money from your customers as quickly as possible.

Question 15

If you are running a company to be as efficient in its use of cash as possible, would you like to see Days Payable Outstanding (DPO) rising or falling?

Answer 15

Rising: Your payables are supplies that you have received but not yet paid for, they effectively represent a loan from your suppliers, so you want to take advantage of that free credit as much as possible.

Question 16

What was the basic ratio that is used to analyze how comfortably the cash generating capacity of a business can meet the firm’s debt requirements?

Answer 16

“Times interest earned

Question 17

What is the formula for ‘Times Interest Earned’?

Answer 17

TIE = EBIT/Interest expense

EBIT: Earnings Before Interest and Taxes

Question 18

What is the formula for return on equity (ROE)?

Answer 18

ROE = Net Income/Equity

Note that this is the book value of equity. Do not use the market value of equity in this calculation

Question 19

In a DuPont Analysis, what is the mnemonic for remembering the 3 components into which Return on Equity can be broken down?

Answer 19

ROE is your PAL
P = profit margin = Net Income/Sales
A = asset turns = Sales/Assets
L = Leverage = Assets/Equity

Question 20

Does a well-run business wants to see each ratio within the DuPont analys as high as possible, or as low as possible?

Answer 20

As high as possible – the higher each element is, the better the return on equity.

Question 21

Miller-Modigliani’s basic insight was that, in the absense of either taxes or bankruptcy, the value of a company could not be changed by changing the debt/equity structure of the company. And yet, if a company has a cost of equity of 10% and a cost of debt of 5%, it would appear you could lower the cost of capital by borrowing more. What happens when the company borrows more that causes its value to be unchanged?

Answer 21

As the company borrows more, the equity becomes riskier, so the cost of equity rises. The rise in the cost of equity exactly offsets the cheaper capital raised by debt.

Question 22

When only taxes are added to the Miller-Modigliani model, what becomes the ideal capital structure?

Answer 22

For the firm to use debt as essentially its only source of funds. (Of course owners would need to retain a tiny sliver of equity in order to have a funnel through which to get paid).

Question 23

In the real world where there are both taxes and the possibility of bankruptcy, what is the optimal capital structure for a company?

Answer 23

The firm will borrow up to the point where the costs of the bankruptcy risk exactly offset the tax-shield benefit they get from borrowing.

Question 24

Bankruptcy has direct and indirect costs. Give an example of each:

Answer 24

Direct costs = when you actually go bankrupt, the result is generally enormous legal fees while the situation is sorted out.
Indirect costs = what a firm may do because it fears bankruptcy. For example, it may:
1) Neglect needed research and development to conserve cash
2) Anger its suppliers by slowing down its payments (raising the Days Payments Outstanding) to conserve cash
3) Try ‘long shot’ projects that don’t actually have good risk adjusted returns, because they are “Gambling for Redemption”.

Question 25

How does an investment bank make money from Initial Public Offerings, IPOs?

Answer 25

It charges a fee that it is a percentage of the money raised – typically from about 2% in a mega-deal to 6-7% in a small/normal sized IPO

Question 26

When someone talks about a broker ‘churning’ an account, what does that mean?

Answer 26

Doing more trades than are necessary in order to earn more commissions,

Question 27

Under current rules, a broker does not have to act in a client’s best interest. Instead, what obligation does a broker have to a client?

Answer 27

To put a client into a ‘suitable’ investment

Question 28

The Labor Department is proposing that brokers be required to put their client’s interests first in retirement accounts. What is the term that describes the obligation to act in the client’s best interests

Answer 28

Fiduciary duty

Question 29

What is a Ponzi scheme?

Answer 29

A scam where a promoter brings in money and claims to invest it with great success. However, no investment is actually made, the promoter simply pockets the money. When an early investor asks for some or all of his/her capital back, the promoter uses funds that have been raised more recently from new victims to meet the redemption. The scheme only works so long as new money is constantly coming in and the earlier investors redeem slowly. (Oh, and the whole reason for doing it is that the promoter simply spends most of the money that comes in on himself. By buying really choice stuff, the promoter further builds the impression that he or she is a big success.)

Question 30

In 2008, the largest Ponzi scheme in history was uncovered. Who was the principal behind the scheme?

Answer 30

Bernard “Bernie” Madoff”

Question 31

What is the ‘mosaic theory’

Answer 31

The idea that rather than trading on insider information, an investor reached an important conclusion about an investment based on putting together a pattern from numerous small pieces of publicly-available information.

Question 32

What is ‘front-running’?

Answer 32

Front running is where someone with knowledge of a second party’s intentions to make a trade may cut in ahead of the trade in order to profit. if a broker has a client who is about to place a $1 million order for a stock, the broker may be very confident that the purchase will drive the stock price up. So, the broker buys a few shares for himself ahead of placing the client’s order. Then the broker places the client’s order, and sells some of the shares he just bought to the client at a profit!

Question 33

What is ‘insider trading’?

Answer 33

‘Insider trading’ is making trades based on ““material non-public information””. For example, you know that your employer is about to be bought out by a competitor and the deal is not yet announced. You buy shares in your firm and profit mightily when the deal is announced. Such behavior is illegal.