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Business Test 1 > Unit 6- Risk, Return, Cost of Capital, and Firm Valuation > Flashcards

Unit 6- Risk, Return, Cost of Capital, and Firm Valuation Flashcards

1
Q

Cost of Capital

A

Rate of return the corporation must earn on its invested capital in order to compensate for the time value of money and risk

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2
Q

Weighted Average Cost of Capital (WACC)

A

Weighted average of Cost of debt and Cost of equity

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3
Q

WACC=

A

(Cost of Debt) x (1-Tax Rate) x (Debt/(Debt+Equity)) + Cost of Equity x (Equity/Debt+Equity))

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4
Q

Interest paid on debt is…

A

Tax deductable

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5
Q

Most important factors that influence a company’s choice of capital structure

A
  1. Taxes
  2. Stability of cash flows and earnings
  3. Financial and operating flexibility
  4. Type of assets
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6
Q

Companies that can support higher debt levels are…

A

in mature industries with fairly stable cash flows, tangible assets, and few investment opportunities

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7
Q

Companies that can support low debt levels are…

A

in growth industries with significant investment opportunities, high variable cash flows, and intangible assets

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8
Q

Cost of Debt

A

the rate of interest that the firm would pay on any new bank borrowing or bond issue

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9
Q

Factors that Cost of Debt Depend on…

A
  • Current interest rate on US Treasury bonds with the same maturity
  • Default risk
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10
Q

Cost of Debt =

A

Treasury Bond Rate + Default Premium

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11
Q

High Quality Bond Ratings

A

AAA, AA

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12
Q

Medium Quality Bond Ratings

A

A, Baa, BBB

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13
Q

Low quality bond ratings

A

Ba, B, BB

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14
Q

Lowest Quality Bond Ratings

A

Caa, Ca, C, CCC, CC, C

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15
Q

Speculative Grade:

A

Low or Lowest bond ratings, “Junk Bonds”

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16
Q

Pre-Tax Cost of Debt=

A

Treasury Yield (10 year Bond) + Default Spread (Bond Rating)

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17
Q

Cost of Equity

A

an Opportunity Cost. The rate of return that stockholders expect the firm to earn on its equity capital.

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18
Q

2 Most important factors that Cost of Equity depends on…

A

1) Current interest rate on long-term US Treasury Bonds

2) Risk of Equity

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19
Q

Cost of Equity=

A

Treasury Bond Rate + Risk Premium

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20
Q

Reducing Risk through Diversification

A

As the number of companies gets larger, the standard deviation of the portfolio approaches the average covariance between companies

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21
Q

Firm-Specific Risk

A
  • Firm’s CEO suddenly dies
  • A company loses a major lawsuit
  • A wildcat strike in one of the firm’s plants
  • An unexpected entry of a competitor
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22
Q

Market Risk Factors

A
  • An unexpected increase in long-term interest rates
  • Changes in monetary or fiscal policy
  • US Congress votes for a massive tax cut
  • An unexpected decline in the value of the US Dollar
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23
Q

Since firm-specific risk can be…

A

diversified away, only market risk matters to investors.

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24
Q

Stock’s Beta

A

The market risk for an individual stock

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25
Q

The average stock has a beta of…

A

1.0

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26
Q

Stocks with betas greater than 1.0 are…

A

more sensitive to economy-wide risk factors

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27
Q

Stocks with betas less than 1.0 are…

A

less sensitive to economy-wide risk factors

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28
Q

The more cyclical a company’s business, the…

A

higher will be its beta

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29
Q

The risk of a well-diversified portfolio depends on…

A

the average beta of the stocks in the portfolio

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30
Q

Total Portfolio Risk=

A

Avg. beta x Market standard deviation

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31
Q

Cost of Equity=

A

US Treasury Rate + (Market Risk Premium) x Beta

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32
Q

Market Risk Premium

A

The average difference in the rate of return on stocks and long-term US Treasury bonds

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33
Q

Firm Valuation used for…

A
  • Structuring mergers and leveraged buyouts
  • Security analysts and undervalued stocks
  • Pricing Initial Public Offerings
  • Corporate strategy and value based management
  • Venture Capitalists evaluation of new investment opportunities
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34
Q

Firm Value

A

PV of expected future free cash flow - WACC

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35
Q

Equity Value =

A

Firm Value - Cost of Debt

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36
Q

WACC is the…

A

overall expected return the firm must earn on its existing assets to maintain it’s value

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37
Q

The WACC reflects…

A

the risk and the capital structure of the firm’s existing assets

38
Q

The WACC is an appropriate…

A

discount rate for the firm or for a project that is a replica of the firm

39
Q

CF =

A

Free Cash Flow

40
Q

EBIT=

A

Earnings before Interest and Taxes

41
Q

T=

A

Corporate Tax Rate

42
Q

DEPR=

A

Depreciation

43
Q

CAPEX=

A

Capital Expenditures

44
Q

NWC=

A

Increase in Net Working Capital

45
Q

CF t=

A

EBITt * (1-T) + DEPRt - CAPEXt - NWCt

46
Q

Comparables Method

A

Choose firms with Similar Value Characteristics

47
Q

Similar Value Characteristics:

A
  • Risk
  • Growth Rate
  • Capital Structure
  • Size and Timing of Cash Flows
48
Q

Weaknesses of Comparables Method

A
  • Valuation of Private Firms
  • Financial Information often unavailable
  • Valuations may by misguided
49
Q

Public Firms (Comparables Method)

A
  • Price/Earnings Ratio
  • Price/EBIT as an alternative
  • Enterprise Value/Sales
  • Market Value of Equity/Book Value of Equity
50
Q

Private Firms (Comparables Method)

A
  • Internet- Number of Subscribers
  • Biotechnology- Number of Patents
  • Industry Specific Multiples More Explanatory Power
51
Q

If you use Public Market Comparables to Value Private companies…

A

Use discount for liquidity- 20-25%

52
Q

Opportunity Cost of Capital

A

the incremental return on investment that a business foregoes when it elects to use funds for an internal project, rather than investing cash in a marketable security

53
Q

Opportunity Cost

A

the loss of potential gain from other alternatives when one alternative is chosen.

54
Q

Capital Charge=

A

r x TC

Opportunity cost of capital (r) x Total Capital?

55
Q

To create economic value the investment project must earn…

A

positive economic profits, not just positive accounting profits

56
Q

Economic Profits=

A

Accounting profits - charge for capital

57
Q

Creating economic value for shareholders requires the corporation to…

A

earn positive economic profits

58
Q

A corporation’s ability to earn positive economic profits depends on its…

A
  • Operating efficiency

- Capital efficiency

59
Q

Operating Efficiency=

A

NOPAT/Sales

60
Q

Capital Efficiency=

A

Capital Turnover

61
Q

Capital Turnover (CT)=

A

Sales/Total Capital

62
Q

ROTC (Return on Total Capital)=

A

NOPAT/TC

63
Q

Economic Profit=

A
  • Accounting Profit - Capital Charge
  • NOPAT - (R x TC)
  • (R* - r) x TC
64
Q

Companies earn a positive economic profits only if…

A

the Return on Total Capital (r*) is greater than its Cost of Capital

65
Q

Key to financial success:

A

Earning positive economic profit

66
Q

Companies that cannot earn economic profits will find it difficult to…

A

attract capital from investors

67
Q

Economic profits are also sometimes called…

A

Economic Value Added (EVA)

68
Q

NPV=

A

(EVA1/(1 + r)) + (EVA2/(1+R)^2)…

69
Q

MVA (Market Value Added)=

A

Market Value or Equity - Book Value of Equity

70
Q

MVA measures

A

the total wealth created for shareholders by the corporation

71
Q

A large positive MVA of publicly traded company represents…

A

the belief that the company can achieve return on invested capital which exceeds the capital cost over a sustained period in future. (if competitive advantage is sustainable)

72
Q

3 ways a company can improve it’s economic profits and increase it’s stock price:

A

1) Manage
2) Build
3) Harvest

73
Q

Manage

A

Increase efficiency of existing operations and thus improve the spread between r* and r.

74
Q

Build

A

Invest in businesses and projects with positive spreads between r* and r.

75
Q

Harvest

A

Withdraw capital from operations or activities where r* is less than r.

76
Q

Advantages of economic profits as a measure of performance

A
  • Rewards managers for what shareholders value the most- economic profits.
  • Accounts for all the costs associated with running a business, including the cost of capital.
  • Gives managers the incentive to improve both operating efficiency and capital efficiency
  • Provides clear-cut benchmark for evaluating performance.
77
Q

The economic value created by the long-lived investments projects is measured by…

A

NPV

78
Q

To create value for shareholders…

A

invest in projects with positive NPV

79
Q

Stocks are valued as the…

A

present value of all future expected dividends

80
Q

The cost of equity depends on…

A

the current level of interest rates and the risk of the stock

81
Q

Risk is measured by…

A

a stock’s beta

82
Q

The Capital Asset Pricing Model (CAPM) provides…

A

a practical method for estimating the cost of equity based upon the stock’s beta

83
Q

Cost of Equity=

A

Treasury bond rate + (Market Risk Premium) x Beta

84
Q

Cost of Capital is the …

A

rate of return the corporation must earn on it’s invested capital in order to compensate for the time value of money and risk

85
Q

The cost of capital is a weighted average of the…

A

cost of debt and the cost of equity. (WACC)

86
Q

WACC=

A

Cost of Debt x (1 - Tax Rate) x (Debt/(Debt+Equity)) + Cost of Equity x (Equity/(Debt + Equity))

87
Q

The value of a firm =

A

PV of projected FCF - WACC

88
Q

Economic Profits measure…

A

the value created for shraeholders in a given year. Earning positive economic profits is the key to financial success for any business

89
Q

Economic Profits=

A
  • NOPAT - (R x Total Capital)

- (r* - r) x Total Capital

90
Q

Stock Prices are highly correlated with…

A

Changes in the company’s economic profits

91
Q

Market Value Added (MVA) measures

A

the total wealth created for shareholders by management. It reflects investor’s confidence in the company’s ability to create economic profits in the future.

92
Q

MVA=

A

Market Value of Equity- Book Value of Equity

Business Test 1 (25 decks)

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