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Question 1

What is corporate finance

Answer 1

Investment
Financing
Liquidity

Question 2

What is corporate finance
Investment

Answer 2

-Choose best projects
-capital budgeting

Question 3

What is corporate finance
Financing

Answer 3

-choose the source of financing for investment
-capital structure

Question 4

What is corporate finance
Liquidity

Answer 4

-Ensure you have enough cash and inventory
-short term financial planning

Question 5

Responsibilities of a financial manager

Answer 5

Responsible for
Investment
Decisions

Responsible for
Financing Decisions

Responsible for
Short-Term
Financial Planning

Oversee
Accounting and
Audit Function in
Firm

Ensure the
Financial Welfare
of the Firm

Question 6

Goal of financial management

Answer 6

-manage risk
-maximise share price
-avoid financial distress

Question 7

Primary Markets

Answer 7

-Securities are sold to investors
-Money that is raised goes to issuing firm
-First share issue is called an InitialPublic Offering

Question 8

Secondary markets

Answer 8

-Investors trade securities with each other
-Money that is raised goes to seller of securities
-Share Prices

Question 9

NPV investment rule

Answer 9

Accept if NPV>0 Decline if NPV<0

Question 10

Strengths of NPV

Answer 10

Uses CashFlows
• Cash Flows are better than Earnings
Uses all CashFlows
• Other approaches ignore cashflows beyond a certain date
DiscountsCash Flows
• Fullyincorporatesthe TimeValue ofMoney

Question 11

The payback period method

Answer 11

Accept if payback period is less than benchmark ———— Reject if payback period is greater than benchmark

Question 12

Advantages of Payback Period

Answer 12

-Very small scale investments
-Firms with severe capital rationing
-Exceptionally Simple to Understand

Question 13

Problems with the Payback Period

Answer 13

-Timing of Cash Flows
-Payments after the Payback Period
-Arbitrary Standard for the Payback Period

Question 14

Strengths and Weakness of Discounted Payback Period

Answer 14

——Strengths
• Simple
• Uses Time Value of Money
—-Weaknesses
• Ignores Cash Flows beyond benchmark
• Arbitrary Benchmark

Question 15

Strengths and Weaknesses of the
Average Accounting Return

Answer 15

Strengths
• Simple return- based measure Weaknesses
• Does not use cash flows
• Does not use time value of money
• Arbitrary target rate

Question 16

The Internal Rate of Return

Answer 16

-Accept if the Internal Rate of Return is greater than the discount rate
-Reject if the Internal Rate of Return is less than the discount rate

Question 17

Independent Project

Answer 17

An independent project is one whose acceptance or rejection is independent of the acceptance or rejection
of other projects

Question 18

Mutually Exclusive projects

Answer 18

With mutually exclusive projects, you can accept A or you can accept B or you can reject both of them, but you cannot accept both of them

Question 19

Normal Cash Flow Pattern (First Cash Flow Negative, Remaining Cash Flows Positive)

Answer 19

Rules:

Number of IRRs: There is usually only 1 IRR.
IRR Rule:
Accept if IRR > Required Rate of Return (R).
Reject if IRR < Required Rate of Return (R).
NPV Rule:
Accept if NPV > 0.
Reject if NPV < 0.

Question 20

First Cash Flow Positive, Remaining Cash Flows Negative

Answer 20

Number of IRRs: There is usually just 1 IRR in this case.
IRR Rule:
Accept if IRR < Required Rate of Return (R). (This is the opposite of the usual investment decision.)
Reject if IRR > Required Rate of Return (R).
This is because a lower IRR in this context would mean lower repayment costs or a better loan deal.
NPV Rule:
Accept if NPV > 0.
Reject if NPV < 0.

Question 21

First Cash Flow Positive, Remaining Cash Flows Negative

Answer 21

Number of IRRs: Typically, there may be more than 1 IRR, or sometimes no valid IRR at all. The reason is that the IRR equation may have multiple solutions or no real solution, depending on the specific pattern of cash flows.
IRR Rule: In this case, because of potential multiple IRRs, relying on IRR alone can be misleading. Therefore, IRR might not be a valid criterion.

Question 22

Scale of cash flows and IRR

Answer 22

IRR Doesn’t Account for Project Size: A small project could have a very high IRR but still contribute less value overall than a larger project with a lower IRR.

Question 23

Incremental IRR

Answer 23

When scale is an issue, calculate the incremental
cash flows and IRR from them

Question 24

Profitability Index

Answer 24

Accept if Profitability Index is Greater than 1
Reject if Profitability Index is Less than 1

Question 25

Profitability Index: Capital Rationing

Answer 25

-Capital Rationing occurs when there is not enough cash to invest in all positive NPV projects
-Under Capital Rationing you cannot rank projects according to NPV
-Should use Profitability Index or Incremental NPV

Question 26

Sunk Costs

Answer 26

Definition
• A sunk cost is a cash flow that has already occurred
RULE
• Ignore all sunk costs

Question 27

Opportunity Costs

Answer 27

Definition
• Opportunity costs are lost revenues that you forego as a result of making the proposed investment
Rule
• Incorporate Opportunity Costs into your analysis

Question 28

Side Effects in Corporate Finance
EROSION AND SYNERGY

Answer 28

A side effect is classified as either erosion or synergy

Erosion: When a new project reduces cash flows of existing products (cannibalization).
Synergy: When a new project increases cash flows of existing products.
Rule: Always include side effects in project evaluation.

Example:
Erosion: A new product reduces sales of an older one.
Synergy: A new product boosts sales of existing products.

Question 29

Allocated Costs in Corporate Finance

Answer 29

Definition: Accounting measure that distributes expenses or asset use across the company.
Rule: Treat as a cash outflow only if it’s an incremental cost directly tied to the project.

Question 30

Cash Flow and Inflation
-NOMINAL AND Real cash flow

Answer 30

Nominal Cash Flow: The actual amount of money paid or received, without adjusting for inflation.
Real Cash Flow: The purchasing power of cash, adjusted for inflation.

Question 31

Rule for Discounting Cash Flows

Answer 31

Nominal Cash Flows: Discount using the nominal rate (includes inflation).
Real Cash Flows: Discount using the real rate (excludes inflation).

Question 32

To Estimate Cost of Equity Capital you need
to know

Answer 32

The Risk- Free Rate
The Market Risk Premium
The Company Beta

Question 33

Problems and Solutions in Estimating Betas

Answer 33

Problems

Betas may vary over time: The beta of a security can change due to market conditions.
Sample Size may be inadequate: Insufficient data can lead to unreliable beta estimates.
Betas are influenced by changing financial leverage and business risk: Variations in a firm’s capital structure or operational risks can impact beta

Solutions

For the first two problems: Use better statistical methods to improve the estimation of betas.
For the third problem: Adjust for business and financial risk to obtain a more accurate beta.
Consider average beta estimates: Analyze the average betas of several comparable firms within the same industry to derive a more stable beta estimate.