Finance & Accounting: theory of exam
Finance
Leverage increases the risk of equity even when there is no risk that the firm will
default.
The cost of capital of levered equity increases with the firm's market value debtequity ratio.
A firm's weighted average cost of capital (WACC) is equal to its equity cost of
capital if it is unlevered, which matches the cost of capital of its assets.
When firms raise funds from outside investors, the most common choices are
financing through equity alone and financing through a combination of debt and
equity.
The relative proportions of debt, equity, and other securities that a firm has
outstanding constitute its capital structure.
When the cash flows of a project depend on the overall economy, these cash flows
contain market risk and equity investors therefore demand a risk premium.
According to MM Proposition I, with perfect capital markets homemade leverage
is a perfect substitute for firm leverage.
On the market value balance sheet, the total value of all securities issued by the
firm must equal the total value of the firm's assets.
When a firm uses a leveraged recapitalization to change its capital structure, then
the firm's share price will not change.
Personal taxes offset some of the corporate tax benefits of leverage.
Because interest expense is tax deductible, leverage increases the total amount of
income available to all investors.
The optimal fraction of debt, as a proportion of a firm's capital structure, declines
with the growth rate of the firm.
Agency cost of leverage can arise in the form of an asset substitution problem - that
is, shareholders can gain by making negative-NPV investments that sufficiently
increase the firm's risk.
Agency cost of leverage can arise in the form of a debt overhang problem, which
ultimately leads to a leverage ratchet effect - that is, shareholders will not have an incentive
to decrease leverage by buying back debt, even if it will increase the value of the firm.
Agency cost of leverage can arise in the form of a debt overhang problem - that is,
shareholders are unwilling to finance new, positive-NPV projects.
Leverage has agency benefits and can improve incentives for managers to run a
firm more efficiently and effectively due to reduced free cash flow.
Leverage has agency benefits and can improve incentives for managers to run a
firm more efficiently and effectively due to reduced managerial entrenchment and
increased commitment.
Leverage has agency benefits and can improve incentives for managers to run a
firm more efficiently and effectively due to increased ownership concentration.
The practice of maintaining relatively constant dividends is called dividend
smoothing.
According to the dividend signaling hypothesis, dividend changes reflect managers'
views about a firm's future earnings prospects.
A reverse stock split decreases the number of shares outstanding and therefore
results in a higher stock price.
In perfect capital markets, stock prices drop by exactly the amount of the dividend when the
stock begins to trade ex-dividend.
A stock dividend is a payment of additional shares to shareholders in lieu of cash.
When the market risk of the project is similar to the average market risk of the
firm's investments, then the project's cost of capital is equal to the firm's weighted
average cost of capital.
Because the WACC method incorporates the tax savings from debt, we can
compute the levered value of an investment, which is its value including the benefit of
interest tax shields given the firm's leverage policy, by discounting its future free cash flow
using the weighted average cost of capital.
The first step in the APV method is to calculate the value of free cash flows using the
project's unlevered cost of capital.
The WACC method incorporates the benefit of the interest tax shield by using the after-tax
cost of debt.
With a constant interest coverage policy, the value of the interest tax shield is proportional to
the project's unlevered value.
When the firm keeps its interest payments to a target fraction of its free cash flow, we say it
has a constant interest coverage ratio.
When debt levels are set according to a fixed schedule, we can discount the predetermined
interest tax shields using the debt cost of capital, rD.
Options where the strike price and the stock price are very far apart are referred to
as deep in-the-money or deep out-of-the-money.
European options allow their holders to exercise the option only on the expiration
date - holders cannot exercise before the expiration date.
Options allow investors to speculate, or place a bet on the direction in which they
believe the market is likely to move.
Because a short position in an option is the other side of a long position, the profits
from a short position in an option are just the negative of the profits of a long
position.
Although payouts on a long position in an option contract are never negative, the
profit from purchasing an option and holding it to expiration could well be negative
because the payout at expiration might be less than the initial cost of the option.
A long position in a put option cannot be worth more than the option’s strike price.
You can think of the debt holders as owning the firm and having sold a call option
with a strike price equal to the required debt payment.
Viewing debt as an option portfolio is useful as it provides insight into how credit
spreads for risky debt are determined.
We can eliminate a bond's credit risk by buying a put option on the firm's assets.
The WACC valuation method takes interest tax deductibility into account as it uses the
weighted average cost of capital as the discount rate
A firm’s net debt is equal to its debt less its holdings of cash and other risk-free securities.
Leverage can raise a firm’s expected earnings per share, but it also increases the volatility of
earnings per share. As a result, shareholders are not better off and the value of equity is
unchanged.
With perfect capital markets, financial transactions are zero-NPV activities that neither add
nor destroy value on their own.
Agency costs represent another cost of increasing the firm’s leverage that will affect the
firm's optimal capital structure choice.
An under-investment problem occurs when shareholders choose to not invest in a positive
NPV project.
When a firm faces financial distress, it may choose not to finance new, positive NPVprojects.
Before maturity, an American call option on a non-dividend-paying stock always exceeds its
intrinsic value. However, this is not true for a European call option on a non-dividend-paying
stock.
Before maturity, the price of any call option on a non-dividend-paying stock always exceeds
its intrinsic value.
If the present value of the dividend payment is high enough, the time value of a European call
option can be negative, implying that its price could be less than its intrinsic value.
It is optimal to exercise an American call option on a dividend paying stock early.
Leverage can raise a firm's expected earnings per share and its return on equity.
Leverage can increase a firm's volatility of earnings per share and the riskiness of
its equity.
A leveraged recapitalization will not change the firm's stock price.
Homemade leverage makes the capital structure of a firm irrelevant.
Accounting
Creditors are external users
Taxing authorities are external users
Management is an internal user
All of the following are transactions that should be recorded in the accounting system : The
payment of an expense with cash, The investment of cash by the owner, The collection of an
account receivable for services previously rendered but NOT the hiring of an employee
Production overhead cost in a food processing company: The cost of renting the factory
building, The salary of the factory manager, depreciation of equipment located in the
materials store.
Within the relevant range, fixed costs depend on the amount of resources acquired
If actual output is lower than budgeted output, total variable costs are expected to be lower
than the original budget
Absorption costing refers to the process of absorbing the overhead costs of departments into
products
Weighted average method is a unit-costing method that mergers prior-period work and costs
with current-period work and costs
Marginal costing means a system where only variable manufacturing costs are allocated to
products
Preparation of the indicated budgets => Sales budget, production budget, budgeted balance
sheet`
The standard cost of a product is the planned unit cost of products produced in a period
Cost accounting is mainly concerned with cost accumulation for inventory valuation to meet
requirements of external reporting and internal profit measurement
Total variable cost will change in relation to the activity level, and the variable cost per unit
remains unchanged in relation to the activity level
The accounting entry for jobs that have been completed includes a credit to work in progress
control account
In periods of increasing purchase prices, Fifo will result in lower cost of sales than Lifo
Both variable and absorption costing systems treat non-manufacturing costs as
period costs
Manufacturing fixed costs are assigned to products with an absorption costing
System
Total profits over the life of the business will be the same for both systems
Decreasing its total fixed costs, increasing the selling price per unit, increasing contribution
margin per unit will decrease break-even point but NOT increasing the variable cost