Lecture 4 - TP 3B - Small Q's - APV, WACC & FTE

Question 1

Theoretically, the calculation of beta is straightforward. Expose three problems faced in the estimation of beta. Are there solutions to those problems?

Answer 1

1) estimating beta is based upon historical data - we assume the future will be the same which it may not be.
SOLUTION: Switch method or don’t use historical data or account for volatility to a higher extent.

2) The size of the sample affects the outcome.
SOLUTION: Larger samples are always better as we have more data to use.

3) Changes in financial leverages and business risks in the future - can’t be accounted for now.

Question 2

What is the difference between business risk and financial risk?

Answer 2

Financial risks is about the management of debt and leverage while business risks is about to what extent the firm can cover it’s operational expenses with the revenue generated.

Question 3

Define briefly liquidity. Expose the relation between liquidity and the cost of capital.

Answer 3

Liquidity = degree to which an asset or security can be bought or sold in the market without affecting the asset’s price AND to which extent a firm can turn assets into cash.

Trading costs → liquidity → expected return on asset
→ cost of capital

Question 4

Define briefly adverse selection.

Answer 4

When buyers and sellers utilize their superior knowledge to maximize/minimize a transaction value, to benefit themselves, on the expense of another party.

Information Asymmetries are being used –> could lead to bad business for many people.

Question 5

Expose four side effects of financing.

Answer 5

1) TAX SUBSIDIES
2) ISSUANCE COSTS - agencies may want costs to provide their service.
3) FINANCIAL DISTRESS - more debt increases the risk of default
4) SUBSIDIES TO DEBT FINANCING - affect the relation with share-/debtholders.

Question 6

Compare the APV, FTE and WACC Approaches. What are the main differences? These three methods for calculating the value of a proposed project should be viewed as complementary. Could you expose briefly the main similarities and differences between the three methods, concerning the initial investment, the cash flows and discount rates to be used?

Answer 6

APV:
Initial Investment: All
Cash flows: Unlevered
Discount rate: K_A
PV of Financing effects: YES

WACC: 
Initial Investment: All
Cash flows: Unlevered
Discount rate: K_WACC
PV of Financing effects: NO

FTE: 
Initial Investment: Equity portion only
Cash flows: levered
Discount rate: K_E
PV of Financing effects: NO

Question 7

Expose the effect of leverage and corporate taxes on the beta.

Answer 7

β_Equity =β_U +(1−T_C)(β_U −β_Debt)*D/E

1) Higher tax –> Lower β_Equity
2) Higher D/E –> Higher β_Equity

Question 8

Financial leverage always decreases the equity beta relative to the asset beta, TRUE or FALSE?

Answer 8

FALSE: Always increases

Question 9

Adverse selection refers to the notion that traders with better information can take advantage of specialists and other traders who have less information, TRUE or FALSE?

Answer 9

FALSE: notion that some traders have better information than others. Adverse selection and moral hazard may be consequences of the advantage of specialists using this information.

Question 10

An increase in liquidity, i.e. reduction in trading costs, increases a firm’s cost of capital, TRUE or FALSE?

Answer 10

FALSE: it lowers a firm’s cost of capital.

Question 11

APV has the conceptual advantage of separating the value of the unlevered investment from the value of financing side-effects, TRUE or FALSE?

Answer 11

TRUE

Question 12

The Capital Cash Flow (CCF) Method cannot be used when the capital structure is not constant, TRUE or FALSE?

Answer 12

FALSE: CCF)Method is mainly used to value a firm when the capital structure is not constant.

Question 13

The difference between the Adjusted Present Value (APV) Method and the Capital Cash Flow (CCF) Method is that the CCF method values interest tax shields at the cost of unlevered equity rather than the cost of debt, TRUE or FALSE?

Answer 13

TRUE

Question 14

How do we value a firm when the capital structure is not constant?

Answer 14

we use the CCF method because the APV method is slightly more difficult because CCF values TS at cost of unlevered equity, rather than the cost of debt.

Question 15

Why would you choose the Capital Cash Flow (CCF) method instead of the FCF discounted by the WACC method?

Answer 15

FCF with WACC → problem when L changes over time

CCF = CFs available to equity → INCLUDES TS

Question 16

What is of the main advantage of the CCF?

Answer 16

• simplicity : easy to adjust for changing capital structure

- expected return to assets as discount rates→no need to re-estimate

Question 17

What differentiates the WACC compared to the CCF method regarding valueweights?

Answer 17

• WACC : depends on them, so value of firm has to be estimated simultaneously
• CCF : avoids complexity

Question 18

How does the WACC formula change when there are more than two sources of financing?

Answer 18

We split the WACC into another or more weights, to account for the new source of financing. This will bring new rates for costs of financing as well.

Question 19

The WACC formula seems to imply that debt is “cheaper” than equity – e.g., that a firm with more debt could use a lower discount rate. Does this make sense? Explain briefly.

Answer 19

-YES and No : positive effect of TS vs too large Debt ratio

Question 20

What discount rate should be used to value safe, nominal cash flows? Explain briefly

Answer 20

After-tax borrowing or lending rates