Corporate Finance Ch 9 (Just Short Answers)
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1. 58. Briefly explain
the difference between company
and project cost
of capital.
If a firm is considering projects that have the same risk as
the firm, then the company cost of
capital is the same as the project cost of capital. But if the
firm is considering projects which
have risks different from the company then the project cost
of capital becomes relevant.
2. 59. Briefly explain
how the use of
single company
cost of capital to
evaluate projects
might
lead to erroneous
decisions.
If the firm is considering projects with differing risk characteristics, the firm will reject lowrisk
projects and accept high-risk projects. In reality low - risk
projects should be discounted
at a lower rate and high-risk projects at a higher discount
rate to account for differing risks.
3. 60. Discuss why
one might use an
industry beta to
estimate a company's cost of
capital.
Generally, an industry beta can be estimated more precisely than a company's beta. This is
similar to the estimate of the beta of a portfolio is more
precise than the estimate of the beta of
a single stock. The estimated industry cost of capital must
be suitably adjusted before using
for company's cost of capital. For example, differences in
the capital structure of the firm and
the industry.
4. 61. Briefly explain
how a firm's cost
of equity is estimated using the
capital asset pricing
model (CAPM).
The first step is to estimate the beta of the firm's common
stock by regressing the returns on
the stock on the market returns using historical data. Expected stock return is estimated using
CAPM [E(R) = rf + (beta)( rm - rf)]. Expected return is the
estimate of the firm's cost of equity.
5. 62. Briefly exGenerally, the value used for the risk-free rate is the
plain what value short-term Treasury bill rate.
should be used
for the risk-free
interest rate.
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6. 63. Briefly describe the factors that determine asset betas.
Asset betas are determined by the cyclical nature of the
cash flows. Generally, cyclical firms
have higher betas. Operating leverage also affects the
asset beta of a firm. Firms with high
fixed costs tend to have higher asset betas.
7. 64. Briefly discuss the certainty equivalent approach to estimating the NPV
of a project.
In the certainty equivalent approach, certainty equivalent
cash flows are discounted at the
risk-free rate to calculate the NPV of a project. First risky
cash flows have to be converted to
certainty equivalent cash flows by using individual risk
factors. One advantage of this method
is that the risk adjustment is separated from the time value
of money. Conceptually this is a
more sensible method than the risk adjusted discount rate
method. But estimating certainty
equivalent cash flows could be cumbersome.
8. 65. Briefly discuss the risk adjusted discount
rate approach to
estimating the
NPV of a
project.
The risk adjusted discount rate approach uses the discount
rate to adjust for both risk and the
time value of money. The main advantage of this approach
is simplicity. Risky project cash
flows are discounted using risk adjusted discount rates
(higher rates) to calculate the NPV of a
project.
9. 66. Why do firms
with large cash
flow betas also
have high asset
betas?
There is a strong correlation between the risk of the assets
of a firm and the risk of the firm's
earnings. As such high asset betas lead to high cash flow
betas.
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1. Briefly explain whether investors should expect a
higher return from holding portfolio A versus portfolio
B under the CAPM. Assume that both portfolios are
fully diversified.
Because systematic risk (measured by beta) is
equal to 1.2 for
both portfolios, an
Portfolio A: Systematic risk (Beta) 1.2 , Specific risk investor would exfor each individual security high
pect the SAME
RATE OF REPortfolio B: Systematic risk (Beta)1.2, Specific risk for TURN from both
each individual security Very Low
portfolios A and
B. Moreover, since
both portfolios are
well-diversified, it
doesn't matter if
the specific risk
of individual securities is high or low.
The firm-specific
risk has been diversified away for
both.
2. Liquidity is a risk factor that __________.
A. Has yet to be
accurately measured and incorporated into portfolio
management
3. The CAPM applies to....
all portfolios and
individual securities
4. According to CAPM, fairly priced securities...
have zero alphas
a. have positive betas
b. have zero alphas
c. have negative betas
d. have positive alphas
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5. Capital Asset Pricing Theory asserts that portfolio re- b. systematic risk
turns are best explained by...
a. economic factors
b. systematic risk
c. specific risk
d. diversification
6. Liquidity is a factor that ________________.
has yet to be accurately measured
and incorporated
into portfolio management
7. Standard deviation and beta both measure risk, but
they are different in that...
beta measures
only systematic
risk while standard
deviation is a measure of total risk
8. Which of the following is not an example of common d. real options pricCAPM applications?
ing
a. capital budgeting
b. portfolio evaluation
c. risk management
d. real options pricing
9. The stock market follows a...
b. submartingale
a. nonrandom walk
b. submartingale
c. predictable pattern that can be exploited
d. nonrandom walk and predictable pattern that can
be exploited
10. In an efficient market the correlation coefficient be- c. zero
tween stock returns for two non-overlapping time periods should be...
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a. positive and large
b. positive and small
c. zero
d. negative and small
11. Proponents of the EMH advocate...
a. an active trading strategy
b. investing in a index fund
c. a passive investment strategy
d. B and C
B and C
- investing in a index fund
- a passive investment strategy
12. If you believe in the _________________ form of the c. semistrong
EMH, you believe that stock prices reflect all information that can be derived by examining market trading
data such as the history of past stock prices of trading
volume.
a. semistrong
b. strong
c. weak
d. all of these
13. The risk-free rate is 7 percent. The expected market B. sell short stock
rate of return is 15 percent. If you expect stock X with X because it is
a beta of 1.3 to offer a rate of return of 12 percent, you overpriced
should...
A. buy stock X because it is overpriced
B. sell short stock X because it is overpriced
C. sell stock short X because it is underpriced
D. buy stock X because it is underpriced
E. none of these, as the stock is fairly priced
12% < 7% +
1.3(15% - 7%)
= 17.40%; therefore, stock is overpriced and should
be shorted
14. Assume that a security is fairly priced and has an
C. 1
expected rate of return of 0.13. The market expected
rate of return is 0.13 and the risk-free rate is 0.04. The
beta of the stock is
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A. 1.25
B. 1.7
C. 1
D. 0.95
E. none of these
15. Your opinion is that CSCO has an expected rate of
return of 0.15. It has a beta of 1.3. The risk-free rate is
0.04 and the market expected rate of return is 0.115.
According to the Capital Asset Pricing Model, this
security is
A. underpriced
B. overpriced
C. fairly priced
D. Cannot be determined from data provided
E. None of the options
A. Underpriced
16. ABCD Inc. has a beta of 2. The annualized market
return yesterday was 13%, and the riskfree rate is
currently 5%. You observe that ABCD Inc. had an annualized return yesterday of 15%. Assuming that markets are efficient and CAPM is the right model, this
suggests that:
A. bad news about
ABCD Inc. was
announced yesterday.
15% > 4% +
1.3(11.5% - 4%) =
13.75%; therefore,
the security is underpriced.
Abnormal return =
15% - (5% +
A. bad news about ABCD Inc. was announced yester- 2 (8%)) = -6.0%.
day.
A negative abnorB. good news about ABCD Inc. was announced yes- mal return sugterday.
gests that there
C. no news about ABCD Inc. was announced yester- was firm-specific
day.
bad news.
D. interest rates rose yesterday.
E. expected inflation fell yesterday.
17. Event studies are used to test the market efficiency B. after an event =
hypothesis. In an efficient market we expect that the 0
change in the cumulative abnormal return (CAR)
A. after an event > 0
B. after an event = 0
C. at an event > 0
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D. at an event = 0
E. before an event > 0
F. before an event = 0
18. A company reports its annual earnings during normal
trading hours. Earnings are 70% lower than the year
before. In an efficient market, the stock's abnormal
return that day:
E. depends on the
market's expectations prior to the
announcement
A. is probably zero, because of efficiency
B. is probably zero, because the return is only observed over a single day
C. is probably positive
D. is probably negative
E. depends on the market's expectations prior to the
announcement
F. none of the above
19. Proponents of the EMH think technical analysts
A. should focus on relative strength.
B. should focus on resistance levels.
C. should focus on support levels.
D. should focus on financial statements.
E. are wasting their time.
F. none of the above
20.
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E. are wasting
their time.
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The semistrong form of the efficient market hypothe- B. Fully reflect all
sis asserts that stock prices:
publicly available
information
A. Fully reflect all historical price information
Public informaB. Fully reflect all publicly available information
tion constitutes
semi-string effiC. Fully reflect all relevant information including insid- ciency, while the
er information
addition of private
information leads
D. May be predictable
to strong form efficiency
21. A "random walk" occurs when:
A. Stock price changes are random but predictable
B. Stock prices respond slowly to both new and old
information
C. Future price changes are uncorrelated with past
price changes
C. Future price
changes are uncorrelated with
past price
changes
A random walk reflects no other information and is
thus random.
D. Past information is useful in predicting future
prices
22. The risk-free rate is 7 percent. The expected market sell short the stock
rate of return is 15 percent. If you expect stock X with X because it is
a beta of 1.3 to offer a rate of return of 12 percent, you overpriced
should
12% < 7% +
A. buy stock X because it is overpriced
1.3(15% - 7%)
B. sell short stock X because it is overpriced
= 17.40%; thereC. sell stock short X because it is underpriced
fore, stock is overD. buy stock X because it is underpriced
priced and should
E. none of these, as the stock is fairly priced
be shorted.
23. Is it possible to have an asset with an expected return Yes.
lower than the risk-free rate?
This asset would
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provide protection
from bad states of
the economy, acting like an insurance asset
24. Name and briefly explain 2 applications of CAPM.
1. Event Studies: This application looks at and
tests whether an
event positively or
negatively impacts
a stocks' price.
CAPM is used to
look at the stock
prices in relation
to market fluctuations.
2. Portfolio Management: The
CAPM model allows investors to
manage their portfolios by ensuring that there is
a good relationship between market risk and expected return.
25. __________ focus more on past price movements of technical analysts
a firm's stock than on the underlying determinants of
future profitability.
A. Credit analysts
B. Fundamental analysts
C. Systems analysts
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D. Technical analysts
E. Specialists
26. Studies of negative earnings surprises have shown
that there is
A. a negative abnormal return on the day that negative
earnings surprises are announced.
B. a positive drift in the stock price on the days following the earnings surprise announcement.
C. a negative drift in the stock price on the days following the earnings surprise announcement.
D. a negative abnormal return on the day that negative
earnings surprises are announced and a positive drift
in the stock price on the days following the earnings
surprise announcement.
E. a negative abnormal return on the day that negative
earnings surprises are announced and a negative drift
in the stock price on the days following the earnings
surprise announcement.
E. a negative abnormal return on
the day that negative earnings surprises are announced and a
negative drift in the
stock price on the
days following the
earnings surprise
announcement.
27. The weather report says that a devastating and unex- drop immediately
pected freeze is expected to hit Florida tonight, during
the peak of the citrus harvest. In an efficient market
one would expect the price of Florida Orange's stock
to
A. drop immediately.
B. remain unchanged.
C. increase immediately.
D. gradually decline for the next several weeks.
E. gradually increase for the next several weeks
28. Explain the "Joint Hypothesis" problem.
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Joint hypothesis
refers to the test
of EMH and the
asset pricing model. The problem
is that the EMH
cannot be reject-
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ed because any
attempts to test
EMH involves the
use of an asset pricing model
(e.g. CAPM), and
therefore it is not
possible to measure abnormal returns without assuming a model.
In other words, for
any rejection of the
EMH, it can be argued that the model used is not the
"right" model.
29. Provide two types of interpretations of anomalous
Data mining
data, which are both consistent with market efficiency.
Risk based explanation (example,
size anomaly may
be explained by
risk)
Cost based explanation (it could
be costly to trade
based on this
anomaly)
30. Conventional (Standard) finance theory assumes in- rational; irrational
vestors are _______, and behavioral finance assumes
investors are _______.
31. An investor has her money segregated into checkmental accounting
ing, savings, and investments. The allocation among
the categories is subjective, yet the investor spends
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freely from the checking account and not the others.
This behavior can be explained as
A.loss aversion
B. mental accounting
C.overreaction
D. none of the above
32. Which of the following is considered a sentiment indi- short interest
cator?
A. a 200-day moving average
B. short interest
C. credit balances in brokerage accounts
D. relative strength
E. none of the above
33. If the utility you derive from your next dollar of wealth loss aversion
increases by less than a loss of a dollar reduces it,
you are exhibiting __________.
A. loss aversion
B. regret avoidance
C. mental accounting
D. framing bias
E. none of the above
34. Which pricing model provides no guidance concern- the multifactor
ing the determination of the risk premium on factor APT
portfolios?
A. The multifactor APT
B. The CAPM
C. Both the CAPM and the multifactor APT
D. Neither the CAPM nor the multifactor APT
E. None of these are true statements.
35. The risk-free rate is 3 percent. The expected market buy stock X berate of return is 11 percent. If you expect stock X with cause it is under
a beta of 0.85 to offer a rate of return of 10.5 percent, priced
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you should:
A. buy stock X because it is underpriced
B. buy stock X because it is overpriced
C. sell short stock X because it is overpriced
D. sell stock short X because it is underpriced
E. none of the above
10.5% > 3% +
0.85(11% - 3%) =
9.80%
36. You have a job interview for an equity portfolio anpassive managealyst. You are not sure if this position will include
ment
technical or fundamental analysis. Just before the
interview, you overheard that the firm believes that
markets are semi-strong efficient. This implies that the
position is most likely for:
A. Technical analysis
B. Fundamental analysis
C. Active management
D. Passive management
E. You cannot tell
37. According to the semi-strong form the efficient market Fully reflect all
hypothesis (EMH), stock prices____________
publicly available
information
A. Are predictable B.
Fully reflect all historical price and volume information
C. Fully reflect all information
D. Fully reflect all publicly available information
E. None of the above
38. Leinweber (1997) searched through a United Nations
database and discovered that, historically, "the single
best predictor of the Standard & Poor's 500 stock
index was butter production in Bangladesh." This is
an example of:
A. Joint hypothesis
B. Coincident indicators
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data snooping
This does not
make any sense,
and this is a potential issue in APT
like factor models.
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C. Demand shock
D. Data snooping
E. None of the above
39. A company reports its annual earnings during normal
trading hours. Earnings are 26.28% lower than the
year before. In an efficient market, the stock's abnormal return that day:
depends on the
market's expectations prior to the
announcement
A. is probably zero, because of efficiency
B. is probably zero, because the return is only observed over a single day
C. is probably positive
D. is probably negative
E. depends on the market's expectations prior to the
announcement
F. none of the above
40. The beta for a portfolio that is a Market-value weighted B. 1.
portfolio of all the assets in the economy has a beta
of:
A. 0.5
B. 1.
C. -1.
D. 0.
E. None of the above
41. What is the expected return of a negative-beta securi- Lower than the
ty?
risk-free rate of return
A. The market rate of return
B. A negative rate of return
C. Zero rate of return
D. The risk-free rate of return
E. Lower than the risk-free rate of return
42. HOHOHO Inc. has a beta of 1.1. The annualized mar- good news about
ket return yesterday was -2%, and the riskfree rate
HOHOHO Inc. was
is currently 5%. You observe that HOHOHO Inc. had
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an annualized return yesterday of 0%. Assuming that announced yestermarkets are efficient and CAPM is the right model, this day
suggests that:
A. bad news about HOHOHO Inc. was announced yesterday.
B. good news about HOHOHO Inc. was announced
yesterday.
C. no news about HOHOHO Inc. was announced yesterday.
D. interest rates rose yesterday.
E. expected inflation fell yesterday.
43. Limits of arbitrage include: Page 5 of 11
all of the above
A. Fundamental Risk
B. Implementation Costs
C. Model Risk
D. All of the above
44. The arbitrage pricing theory (APT) differs from the
Recognizes multicapital asset pricing model (CAPM) because the APT: ple systematic risk
factors
A. Puts more emphasis on market risk
B. Minimizes the importance of diversification
C. Recognizes multiple unsystematic risk factors
D. Recognizes multiple systematic risk factors
45. Fama and French have suggested that many marrisk premiums
ket anomalies can be explained as manifestations of
____________.
A. regulatory effects
B. high trading costs
C. information asymmetry
D. risk premiums
46. Bill and Shelly are friends. Bill invests in a portfolio Shelly will have
of hot stocks that almost all his friends are invested more regret over
in. Shelly invests in a portfolio that is totally different the loss than Bill
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from the portfolios of all her friends. Both Bill's and
Shelly's stocks fall 15%. According to regret theory,
____________________________________.
Shelly will have
more regret as
she is following
A. Bill will have more regret over the loss than Shelly a totally different
B. Shelly will have more regret over the loss than Bill strategy. Bill would
C. Bill and Shelly will have equal regret over their
feel better as he
losses
is as unsuccessD. Bill's and Shelly's risk aversion will increase in the ful as most of his
future
friends.
47. Most people would readily agree that the stock market strong-form effiis not _________.
cient
A. weak-form efficient
B. semistrong-form efficient
C. strong-form efficient
D. efficient at all
48. People buying lotteries is most likely consistent with: prospect theory
A. Traditional Finance Page 6 of 11
B. Perfect Rationality
C. Prospect Theory
49. Which of the following is not an example of typical
CAPM applications?
real options pricing
A. Capital Budgeting
B. Portfolio Evaluation
C. Portfolio Management
D. Real Options pricing
E. Risk Management
50. Information processing
1.1 Forecasting errors
1.2 Overconfidence
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1.3 Conservatism
1.4 Sample-size
and representativeness
51. behavioral bias:
2.1 Framing: mental bias
2.2 Mental accounting: look at
money differently
based on where
it comes from
(spend a bonus)
2.3 Regret avoidance: investors
can't admit a bad
decision
2.4 Affect
2.5 Prospect theory: if given the
option, people prefer certain gains
rather than the
prospect of larger gains with more
risk
52. compare APT and CAPM
APT applies to
well diversified
portfolios and not
necessarily to individual stocks
ª With APT it is pos15 / 19
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sible for some individual stocks to be
mispriced - not lie
on the SML
ª APT is more general in that it gets
to an expected return and beta relationship without
the assumption of
the market portfolio
ª APT can be extended to multifactor models\
ª CAPM applies
to all assets. Individual assets and
portfolio. Only risk
factor is the market risk factor (Rm
- Rf).
ª CAPM is an equilibrium model.
53. Assumptions APT
1. Security returns
can be described
by a factor model
2. There are sufficient securities to
diversity away idiosyncratic risk
3. Well-functioning
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security markets
do not allow for the
persistence of arbitrage opportunities
54. CAPM Assumptions
individual behavior:
- investors are rational, mean-variance optimizers
- their planning
horizon in a single
period
- investors have
homogenious expectations
market structure:
- all assets are
publicly traded,
short positions are
aloud, and investors can borrow or lend at a
common risk-free
rate
- all info publicly
available
- no taxes
- no transition
costs
55. Security A has a beta of 1.0 and an expected return of
12%. Security B has a beta of 0.75 and an expected
return of 11%. The risk-free rate is 6%. Is there any
arbitrage opportunity? Explain the arbitrage opportunity that exists; explain how an investor can take
advantage of it. Hint: Use CAPM
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An arbitrage opportunity occurs
if: 1. Profit >
0 2. With zero
investment AND
3. Zero risk. (in
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a CAPM "world",
this means Beta
= 0) Page 9
of 11 There are
two approaches to
solve this problem
that are equivalent (you only need
one to get full
credit). i. There is
an arbitrage opportunity, this can
be seen by looking at CAPM for
both securities. If
we calculate the
Rm: Estimate Rm
according to asset
A: E(Ri) = Rf +
Bi (Rm-Rf) 12% =
6% + 1x(Rm-6%),
then Rm would be
12% Estimate Rm
according to asset
B: E(Ri) = Rf + Bi
(Rm-Rf) 11% = 6%
+ 0.75x(Rm-6%),
then Rm would
be 12.67% Since
Rm according to A
and B differ, then
there is an arbitrage opportunity.
This is, B is underpriced relative to
A. So, you need to
Long B and Short
A Long B: E(Rb)
= 11% Beta(B)
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=0.75 Wb=1 Short
A: Wa = -0.75
and borrow Rf,
this is Wrf=-0.25
E(Ra+Rf) = -0.75
x 12% -0.25 x6%
= -10.5% Beta
(A+Rf) = -0.75x1
-0.25x0 = -0.75
Thus, there is an
arbitrage opportunity: Beta (portfolio) = 0, i. E(Rportfolio) = +0.5% >0
ii. 5˜5Š
AND
= 5Îiii.
Beta (portfolio) =
0, ii. By inspection, you need to
Long B and Short
A Long B: E(Rb)
= 11% Beta(B)
=0.75 Wb=1 Short
A: Wa = -0.75
and borrow Rf,
this is Wrf=-0.25
E(Ra+Rf) = -0.75
x 12% -0.25 x6%
= -10.5% Beta
(A+Rf) = -0.75x1
-0.25x0 = -0.75
Thus, there is an
arbitrage opportunity: Beta (portfolio) = 0, i. E(Rportfolio) = +0.5% >0 ii.
5˜5Š
AND
= 5Îiii. Beta
(portfolio) = 0,
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Applied Corporate Finance
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1. 5-1 Rationale for
using multiple
discount rates
(3):
1) Discount rates should reflect the opportunity cost of
capital/the risk of the investment.
2) project expected returns should be judged in comparison to returns that could be generated from investments
in publicly traded stocks and bonds with equivalent risk.
3) Using a Single Discount Rate Results in Bias Towards
Risk
2. 5-1 Rationale for
using multiple
discount rates:
-elaborate on
project expected
returns should
be judged in
comparison to
returns that
could be generated from investments in publicly
traded stocks
and bonds with
equivalent risk.
-Less risky investments (cash flows resembling the cash
flows of a portfolio of bonds) will have an opportunity cost
of capital that is lower than more risky investments (cash
flows resembling the cash flows of a portfolio of stocks).
3. 5-1 Rationale for
using multiple
discount rates:
-elaborate on Using a Single Discount Rate Results in Bias Towards Risk
-When a single discount rate (firm WACC) is used, the firm
will tend to take on investment projects that are relatively
risky (Project B), which appear to be attractive because
they generate an IRR that exceed the firm's WACC.
-The firm will tend to pass up investment projects that are
relatively safe (Project A), but which generate an IRR that
is less than the firm's WACC.
-This bias in favor of high-risk projects will make the firm
riskier over time.
4. 5-1 Benefits
to using a
single discount rate--because multiple
A manager who benefits personally from a project being
accepted has incentives to put the investment proposal
in the most favorable light possible (using optimistic CF
forecasts and understating risk). When discount rates are
discretionary, it opens up the possibility that "favored" or
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discount rates
more persuasive managers will be able to use artificially
may result in in- low discount rates for their projects
fluence costs...
What are these? extra time and effort is spent:
-Project advocate: justifying a lower discount rate
-Managers evaluating the project: determining extent of
the bias
Using a single discount rate for all projects may increase
perception of fairness, improve employee morale, and
improve one source of influence cost.
5. 5-1 Incentive
problems that
arise with managerial discretion
can be mitigated
how (2)?
Multiple discount rates should be used when risk attributes
of projects varies widely:
-Firms operating in different lines of business
-Firms operating in different countries
6. 5-2 Method: Firm
WACC
-Description:
-Advantages (3):
-Disadvantages
(2):
-When to Use (2):
-description: Estimate the WACC for the firm as an entity
and use it as the discount rate on ALL projects. Approximately 6 out of 10 firms use a single, companywide discount rate to evaluate investment projects.
Incentive problems that arise with managerial discretion
can be mitigated how?
-Systematic and verifiable cost of capital estimation
-Discount rates tied to outside market forces
-Advantages (3):
1) is a familiar concept ot most business executives
2) Minimizes estimation costs, as there is only one costs
of capital calculation for the firm
3) does not create influence cost issues
-Disadvantages (2):
1) does not adjust discount rates for differences in project
risk
2) does not provide for flexibility in adjusting for differences
in project debt capacities
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-When to Use (2):
1) projects are similar in risk to the firm as a whole
2) when using multiple discount rates creates significant
influence costs
7. 5-2 Method: Divisional WACC
-Description:
-Advantages (3):
-Disadvantages
(4):
-When to Use (2):
-Description: Estimate WACC for individual business units
or divisions of the firm. Use these estimates as the only
discount rates within each division. Divisions defined either by geographical regions or industry lines of business.
-Advantages (2):
1) Uses division-level risk to adjust discount rates for individual projects. Differences between divisions are based
on the systematic risk within each division.
2) entails minimal influence costs within divisions
3) Minimizes time and effort.
-Disadvantages (4):
1) does not capture intra-division risk differences in projects
2) does not account for differences in project debt capacities within divisions. Most investments are financed using
corporate finance, which means that the debt used to
finance the investment comes from corporate debt issues
that are guaranteed by the corporation as a whole. Determining the appropriate discount rate for a project under
these circumstances can be somewhat more challenging,
as the cost of financing the project cannot be directly
identified.
3) potential influence costs associated with the choice of
discount rates across divisions
4) difficult to find single-division firms to proxy for divisions
-When to Use (2):
1) individual projects within each division have similar risks
and debt capacities
2) discount rate discretion creates significant influence
costs within divisions but not between divisions
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8. 5-2 Method:
Project-specific
WACC: Project
financing
-Description:
-Advantages (1):
-Disadvantages
(3):
-When to Use (2):
-Description: Estimate WACC for each individual project,
using the capital costs associated with the actual financing
package for the project. Project is financed using non-recourse debt and the project is the sole source of collateral.
-Advantages (1):
1) Provides a unique discount rate that reflects the risks
and financing mix of the project.
-Disadvantages (3):
1) Market proxies for project risk may be difficult to find.
2) Creates the potential for high influence costs as managers seek to manipulate to get their pet projects accepted.
3) Capital structure weights are problematic, as equity
value of the project is unobservable.
-When to Use (2):
1) The project is financied with nonrecourse debt.
2) The costs of administering multiple discount rates are
not too great.
9. 5-2 Method:
Project-specific
WACC: Project
financing
-Description:
-Advantages (1):
-Disadvantages
(4):
-When to Use (1):
-Description: Estimate WACC for each individual project,
using the capital costs associated with the debt capacity
of the project.
-Advantages (1):
1) Provides a unique discount rate that reflects the risks
and financing mix of the project.
-Disadvantages (4):
1) Market proxies for project risk may be difficult to find.
2) Creates the potential for high influence costs as managers seek to manipulate to get their pet projects accepted.
3) Capital structure weights are problematic, as equity
value of the project is unobservable.
4) Project debt capacity must be allocated because it is
not readily observed.
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-When to Use (1):
1) The project is of such significane that it has a material
impact on the firm's debt capacity.
10. 5-3 Hurdle rates In practice firms tend to discount cash flow using discount
are what?
rates, often referred to as hurdle rates, which exceed the
appropriate cost of capital for the project being evaluated.
-It's not unusual to see corporate hurdle rates as high as
15% for firms with WACCs, as well as project WACCs, as
low as 10%.
Firms generally require that accepted projects have a
substantial NPV cushion, or margin of safety.
-Most managers would consider an NPV cushion of 0.2%
of the project's initial expenditure to be too small.
11. 5-3 Mutually exclusive projects
effect on cost of
capital
For firms that have constraints limiting the number of
projects that can be accepted, the opportunity cost of
capital reflects the return on alternative investments that
may have to be passed up.
-For example, suppose a firm is choosing between two
projects that are of equivalent risk. Suppose that the first
project can generate an expected internal rate of return of
18%. If taking the second project precludes taking the first
project, then the appropriate opportunity cost of capital
that should be used to evaluate the second project is 18%,
not the cost of capital.
12. 5-3 How do high
hurdle rates provide incentives
to project sponsors?
Requiring high hurdle rates may signal that firms have
good investment opportunities, which may have the side
benefit of motivating project sponsors to find better projects.
-For example, if top management sets a corporate hurdle
rate at 12%, project sponsors may be happy to propose
a project with an internal rate of return of 13%. However,
with a 15% hurdle rate, the project sponsor will need to
put in more effort and negotiate harder with suppliers and
strategic partners to come up with an investment plan that
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meets the higher hurdle.
-J.P. Morgan estimates that the current median WACC of
S&P 500 firms is 8.5%.
-Median reported hurdle rate of S&P 100 companies: 18%.
13. 5-3 Why has low- 1) Low cost of debt =/= low cost of capital
er cost of debt
-Cost of equity has remained stable. If firms are primarily
not led to more capitalized with equity, as in U.S., WACC has not dropped.
investment (2)?
2) Low cost of capital =/= low hurdle rates
-Firms maintain hurdle rates that are materially higher
than their estimated cost of capital.
-Many firms believe that interest rates are artifically low
and likely to rebound soon.
14. 5-3 Managing the
correct "buffer"
in hurdle rates. 3
aspects to take
into consideration.
The buffer should capture
-The fact that new projects are riskier than the firm's
assets in place today
-The need to generate some return over the cost of capital
to create value
-The desire to compensate for "cash flow projection inflation"; that is, the fact that cash flow forecasts are often too
high.
15. 5-3 Hurdle rates
influence corporate strategy in 5
ways:
1) choice of investments
2) capital structure
3) modes of growth
4) shareholder distribution policies
5) risk management
16. 8-1 Relative valu- Uses market comparables: It is a technique used to value
ation is what?
businesses, business units, and other major investments.
-Assumes similar assets should sell at similar prices.
The reliability of -Relative valuation should be used to complement DCF
this method re- analysis
lies solely on
what?
The reliability of this method of valuation depends on the
ability to identify publicly traded stocks that are "comparaDCF models es- ble" to the company we are valuing.
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timate what kind
of value of a
DCF models estimate the "intrinsic" value of a firm. Price
firm compared to multiples value a firm "relative" to how similar firms are
price multiples? valued by the market at the moment. An asset expensive
on an intrinsic value basis may be "cheap" on a price
multiple basis.
17. 8-1 The method
of comparables
involves using a
what? Doing this
evaluates what?
The method of comparables involves using a price multiple
to evaluate whether an asset is relatively fairly valued,
relatively undervalued, or relatively overvalued in relation
to a benchmark value of the multiple.
18. 8-1 The economic rationale underlying
the method of
comparables is
what?
the law of one price—the economic principle that two
identical assets should sell at the same price.
What is the most
widely used approach for analysts reporting
valuation judgments on the basis of price multiples?
The method of comparables is perhaps the most widely
used approach for analysts reporting valuation judgments
on the basis of price multiples.
If we may find that an asset is undervalued relative to a
comparison asset or group of assets, and we may expect
the asset to outperform the comparison asset or assets
on a relative basis.
-However, if the comparison asset or assets themselves
are not efficiently priced, the stock may not be undervalued—it could be fairly valued or even overvalued (on an
absolute basis).
If we may find
that an asset is
undervalued relative to a comparison asset or
group of assets,
and we may expect the asset to
what?
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19. 8-1 What are the Step 1: Identify similar or comparable investments and
4 steps in relative recent market prices for each.
valuation?
Step 2: Calculate a "valuation metric" for use in valuing the
asset.
Step 3: Calculate an initial estimate of value.
Step 4: Refine or tailor your
initial valuation estimate to the specific characteristics of
the investment.
20. 8-1
-What is the most
common application of the
relative valuation
technique?
What are the 3
key points necessary to consider
in relative valuation?
21. 8-2 What is the
connection between DCF valuation and relative
valuation?
Most common application of this method is the valuation
of commercial and residential real estate.
1) Identification of appropriate comps is paramount.
2) The initial estimate must be tailored to the investment's
specific attributes.
3) The specific metric used as the basis for the valuation
can vary from one application to another.
Capitalization rate is the reciprocal of the multiple used to
value the property.
-Perpetual cash flow: $100 per year
-Discount rate: 20%
-The capitalization rate is 1/5 = .20
Value = 100/.2 = 500
Value = 100 x (1/.2)
= 100 x (5)
= 500
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(1/.2=reciprocal)
(5=multiple)
22. 8-2
When is the
cap rate larger
than the discount
rate? When is it
smaller? When is
the cap rate and
discount rate the
same?
the cap rate is less than the discount rate when cash flows
are expected to grow, and it exceeds the discount rate
when cash flows are expected to shrink or decline over
time. Only when there is zero anticipated growth in future
cash flows are the discount rate and the capitalization rate
equal to one another.
The difference between the discount rate and the capitalization rate increases with the growth rate anticipated in
future cash flows.
The difference
between the discount rate and
the capitalization
rate increases
with what?
23. 8-2 What is the
Gordon Growth
Model? How can
you transform
this into a multiple model and
find the multiple?
The Gordon Growth Model formula is as follows:
Value = [CF(0)x(1+g)] / (k-g)
Example:
Value = [100 x (1.05)]/(.2-.05)
= 700
You can transform this into a multiple model and find the
multiple by:
Value = 100 x [1.05/(.2-.05)]
= 100 x 7
= 700
Because the multiple is equal to 7, the cap rate is 1/7 or
14.29%, which is less than the 20% discount rate.
24. 8-2 How are op- Investments with higher operating leverage will experierating leverage ence more volatility in its operating income in response to
and investment changes in revenues.
risk related?
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Compare the fixed costs of an asset to its revenue:
-Building B has higher fixed costs than Building A relative
to revenues, so Building B's operating leverage is substantially higher than Building A; we expect its operating
income to be more volatile in response to changes in rental
revenues.
25. 8-3 If two buildings are not perfectly comparable, is it possible
to use comparable analysis?
Even though the two buildings are not perfectly comparable, it is still possible to use an adjusted comparable
analysis, based on the sale price of Building A, to value
Building B.
-Dig more deeply into the determinants of their cash flows.
--Decomposition of each building's NOI into revenue and
maintenance-cost multipliers; this helps us analyze how
each component of NOI influences the values of the two
buildings.
26. 8-3 How do you
decompose an
NOI into revenue
and maintenance
cost multipliers?
Building Vallue
= NOI x NOI multiple
= (Rental Rev. x Rev. Mult.)
- (Maint. Costs x Maint. Mult.)
Building Value
= NOI / NOI cap rate
= (Rental Rev./Rev. cap rate)
- (Maint Costs/Maint Cap rate)
Get the cap rates by finding the invesrse of the multiples
in the first equation.
Since both buildings cost the same to maintain, it seems
reasonable to use identical cap rates for the maintenance
costs. Moreover, since we have assumed that rent revenues for each building are similar in terms of both growth
and risk, a single revenue cap rate is reasonable to apply to the rents from both buildings. If the ratio of rents
to expenses were the same for both buildings (resulting
in identical operating leverage), then these assumptions
would imply that cap rates for each building would also be
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identical. However, as we will show, when two buildings
differ in their operating leverage, they will generally differ
in their overall cap rates, even when they have the same
revenue and maintenance cap rates. The decomposition
method we illustrate here allows the analyst to compare
buildings that differ only in their operating leverage. If
Buildings A and B differ on more than this dimension,
additional analysis is required.
27. 8-4 What is the
most popular approach used by
business professionals to estimate a firm's enterprise value?
EBITDA Multiples
Analysts generally view EBITDA as a crude measure of
a firm's cash flow, and thus view EBITDA multiples as
roughly analogous to the cash flow multiples used in real
estate. Sometimes viewing EBITDA as CF is good and
sometimes it's not.
How do analysts generally
view EBITDA?
28. 8-4
What is enterprise value?
Enterprise value of a firm is defined as the sum of the
values of the firm's interest-bearing debt and its equity
minus the firm's cash balance on the date of the valuation.
What is Firm Val- Firm Value is all debt + the market value of common equity
ue?
Enterprise Value
Enterprise Value = Owner's Equity
formula
+ (InterestBearing Debt - Cash)
29. 8-4
Net debt refers to the firm's interest-bearing liabilities less
What is net Debt? cash.
Once you calculate a firm's
Enterprise Value,
what next?
Compare the firm's enterprise value to its EBITDA to get
an EBITDA multiple.
-On August 1, 2005, Airgas's EBITDA was $340 million
and its enterprise value was $2,955,995,000; this results
in an EBITDA multiple for Airgas of 8.69x.
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30. 8-4
When a firm is a
potential acquistion candidate
and is privately owned, what
is the thought
process about
valuing it (given
that we know the
firm's EBITDA).
After our initial
valuation, what
next?
Once firms express interest in buying a company, they
have to sign a confidentiality agreement. At that point,
the private company can release its EBITDA and other
financial information to the interested firms.
Because it is privately owned, a potential acquirer cannot
observe its market value. However, the acquirer can use
similar firms that are publicly traded to infer an enterprise
value for Helix by using the appropriate EBITDA valuation
ratio. Once an enterprise value is estimated, we can then
back out the equity value using the Enterprise Value formula.
After our initial valuation, what next?
-careful assessment of our valuation and refining our value
to the specific firm we are examining. In other words,
we consider the need to make adjustments to both the
EBITDA and the EBITDA multiple used in Step 1.
31. 8-4
EBITDA is not always a good estimate of free cash flow:
1) Difference between EBITDA
1) EBITDA is a before-tax measure and does not include
and FCF is?
expenditures for new capital equipment (CAPEX) and
does not account for changes in working capital (NWC).
2) Why is FCF
2) FCF is often more volatile than EBITDA because it
oftentimes more includes consideration for new investments in CAPEX and
volatile than
NWC, which are discretionary to varying degrees and vary
EBITDA?
over the business cycle.
-In years when large capital investments are being made,
3) Why not use a EBITDA significantly overstates the firm's free cash flow,
FCF multiple?
and vice versa.
3) Why not use a FCF Multiple? Too volatile since it reflects
4) So then undiscretionary expenditures for capital investments and
der what circum- working capital that can change dramatically from year to
stances is EBIT- year. However, EBITDA only measures the earnings of the
DA a good mea- firm's assets already in place, it ignores the value of the
sure of FCF?
firm's new investments.
4) Good for mature companies with CFs that are easy
to predict and that stay relatively stable. Enterprise value
won't work well for a high growth, unpredictable company.
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If CAPEX is bouncing all over the place, you want to go
back to firm free CF because it picks up the day to day
changes
32. 8-5 To reflect differences
in risk characteristics and
growth opportunities, EBITDA
multiples should
be adjusted for
(3):
Examples:
1) Onetime transaction with a
customer, which
contributed to
EBITDA but is not
likely to be repeated in future
years
2) Extraordinary
write-offs
1) Variations in operating leverage; differences in profit
margins
2) Differences between fixed and variable operating costs
-Firms that incur higher levels of fixed operating costs but
lower variable costs will experience more volatile swings in
profits as their sales rise and fall over the business cycle.
3) Differences in expected growth rates
Example 1: make a downward adjustment to EBITDA
Example 2: make an upward adjustment
-Asset write-downs
-Restructuring charges
-Start-up costs expensed
-Profits & losses from asset sales
-Change in accounting estimates or principles
-Gain (loss) from discontinued operations
-Strikes
-LIFO liquidations
-Catastrophes such as natural disasters or accidents
-Product recalls
Other possible nonrecurring
items:
33. 8-5
Adjusting for liquidity discounts
and control premiums:
What price will a buyer will be willing to pay for a company?
It depends.
1) A purely financial buyer (a private equity investor or
hedge fund) is likely to expect a liquidity discount.
-20-30% liquidity discount for privately held firms:
-Private companies often sell at a discount to their publicly
traded counterparts since they cannot be sold as easily.
2) A strategic buyer that can realize synergies by acquiring
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and controlling the investment may be willing to pay a
control premium.
-30%+ control premium for strategic acquisition
-When there are benefits (or synergies) from control valuations often feature control premiums, which can enhance
the value of an acquisition target by 30% or more.
34. 8-6
A high P/E ratio
predicts that?
A high P/E ratio predicts that the firm will have high growth
in the future. Low P/E is a value stock—price is less about
the future and more about where the company is today.
Low P/E predicts Size affects earnings! When using P/E multiples, use simthat?
ilar-sized companies!
Does size of
company affect
earnings?
35. 8-6
1) A stable-growth firm is one that is expected to grow
1) What is a sta- indefinitely at a constant rate.
ble-growth firm?
2) use Gordon growth model:
2) How to value
a stable-growth P(0)
firm? Equation? = Div(1+g)/(k-g)
=[(EarningsPerShare)(1-b)(1+g)] / (k-g)
b: retention ratio, or the fraction of firm earnings that the
firm retains, implying that (1 - b) is the fraction of firm
earnings paid in dividends
g: growth rate of these dividends
k: the required rate of return on the firm's equity.
36. 8-6
Well-positioned
firms with
competitive
advantages,
intellectual
It is the combination of the amount by which r exceeds
k, and the fraction of firm earnings that can be profitably
reinvested each year (1 - b) that determines the firm's P/E
ratio. Under these assumptions, we can express a firm's
dividend growth rate as the product of its retention rate,
b, and the rate of return it can provide on newly invested
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property,
patents, and
managerial
expertise are
able to generate
both higher rates
of return on new
investment, as
well as
opportunities to
reinvest more of
their earnings.
capital, r.
P/E Multiple
=[(1-b)(1+g)] / (k-g)
=[(1-b)(1+br)] / (k-br)
g turns into (b)(r), because it is based on its retention rate,
b, and the rate of return it can provide on newly invested
capital, r.
Equation to calculate P/E multiple:
37. 8-6 drawbacks to 1) EPS can be negative. The P/E ratio does not make
the P/E ratio (3): economic sense with a negative denominator.
2) The components of earnings that are on-going or recurrent are most important for this method.
-Earnings often have volatile, transient components, making application of this method difficult.
3) Management can "manage earnings" and distort earnings per share.
-Distortions can affect the comparability of P/E ratios
across companies.
38. 8-7
-What approach
plays an important role in the
pricing of IPOs?
-Are IPOs usually placed at a discount or premium?
The lead underwriter determines an initial estimate of
a range of values for the issuer's shares. The estimate
typically is the result of a comparables valuation analysis.
Underwriters like to price the IPO at a discount, typically
10% to 25%, to the price the shares are likely to trade on
the market. Underwriters argue that this helps generate
good after-market support for the offering.
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39. 9-1
-The 2 step Approach
-Most often way
to find enterprise -Steps are:
value is?
1) Company cash flows are forecasted for a limited number of years called the planning period and are discounted
-What are the
to present value
steps?
2) The estimate present value of all remaining cash flows
is called the terminal value
-What is the
equation?
-Equation:
Enterprise Value = PV of the Planning Period CFs + PV of
-What are the two Terminal Value
ways to estimate
terminal value? There are two ways to estimate terminal value:
1) A perpetuity approach (using the Gordon growth model)
2) A multiples approach (using EBITDA multiples)
Note: Terminal value often represents more than 50% of
enterprise value
40. 9-1
-what is one
problem with using WACC based
approaches to
enterprise value?
-What is another approach
to enterprise value that solves
this problem?
This approach reveals how what
influences what?
41. 9-1
-What is the hy-
-WACC based approaches to enterprise value are widely
used but do not take into consideration changes to capital
structure over time
-The adjusted present value (APV) approach provides an
improvement over traditional WACC approaches because
it reveals how the company's financing decisions influence
enterprise value
-Hybrid valuation combines DCF analysis with relative
valuation
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brid approach to
enterprise valua- -Steps:
tion?
1) The present value of planning period cash flows are
discounted using the traditional DCF approach
-What are the 3 2) Terminal value is calculated using an EBITDA multiple
steps?
and end-of-planning period EBITDA
3) The present value of the terminal value is added to the
present value of planning period cash flows to estimate
enterprise value
42. 9-1
-How is using
EBITDA to calculate terminal value beneficial?
-Using EBITDA to calculate terminal value is beneficial
because it ties the analysis of distant cash flows back to
recent market transactions involving similar firms
-EBITDA multiple and Gordon growth model should generate very similar terminal value estimates when there are
-When should
no extraordinary capital expenditures or investments in net
the EBITDA mul- working capital
tiple and Gordon growth model generage very
similar terminal
value estimates?
43. 9-1
1) Risks of cash flows do not change over time
-Using the tradi- 2) Company maintains a steady capital structure
tional WACC ap- -Often a constant discount rate is inconsistent with proproach to enjected changes to capital structure
terprise valu-Examples: LBO's, Planned M&A activity, future stock
ation requires
buy-back plans
some assumptions which are
difficult to justify,
specifically (2):
44. 9-2
Enterprise Value
(APV approach)
equation:
Enterprise Value (APV Approach)
= Value of the unlevered FCFs (planning period)
+ Value of Interest Tax Savings (planning period)
+ terminal value
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45. 9-2
-By unlevering
cash flow, the
APV approach
decomposes total enterprise value into what 2
types of values?
The APV approach decomposes total enterprise value
into these 2 values:
1) value from unlevered equity FCF
2) value from financing
This enables the impact of financing on enterprise value
to become evident.
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1. the cost of capital used in capital budgeting should True
reflect the average cost of the various sources of
investor supplied funds a firm uses to acquire assets.
T/F
2. the reason why retained earnings have a cost equal True
to rs is because investors think they can (expect too)
earn rs on investments with the same risk as the firms
common stock, and if the firm does not think that it
can earn rs on the earnings that it retains it should
pay those earnings out to tis investors , thus the cost
of retained earnings is based on the opportunity cost
principle T/F
3. The text identifies three methods for estimating
True
the cost of common stock from retained earnings: the CAPM method, the DCF method, and the
bond-yield-plus-risk-premium method. Since we cannot be sure that the estimate obtained with any of
these methods is correct, it is often appropriate to
use all three methods, then consider all three estimates, and end up using a judgmental estimate when
calculating the WACC. t/f
4. the lower the firms tax rate, the lower will be its after False, the lower the
tax cost of debt and also its WACC other things held tax rate, the higher
constant. T/F
the firms after tax
cost of debt.
5. for a typical firm, which of the following sequences is
correct? all rates are after taxes, and assume that the
firm operates at its target capital structure. a.
rs > re > rd > WACC.
b.
re > rs > WACC > rd.
c.
WACC > re > rs > rd.
d.
rd > re > rs > WACC.
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ANSWER: B. Note
that the question already says that "all
rates are after taxes." Thus, you can
think of the cost of
debt, rd, as being
rd(1-T).
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e.
WACC > rd > rs > re.
6. . Duval Inc. uses only equity capital, and it has two
equally-sized divisions. Division A's cost of capital
is 10.0%, Division B's cost is 14.0%, and the corporate (composite) WACC is 12.0%. All of Division A's
projects are equally risky, as are all of Division B's
projects. However, the projects of Division A are less
risky than those of Division B. Which of the following
projects should the firm accept?
a.
A Division B project with a 13% return.
ANSWER: C
Division A should
accept only projects with returns
greater than 10%,
and Division B
should accept only
projects with returns greater than
14%. Only option C
meets this criterion.
b.
A Division B project with a 12% return.
c.
A Division A project with an 11% return.
d.
A Division A project with a 9% return.
e.
A Division B project with an 11% return.
7. Norris Enterprises, an all-equity firm, has a beta of
2.0. The chief financial officer is evaluating a project
with an expected return of 14%, before any risk adjustment. The risk-free rate is 5%, and the market risk
premium is 4%. The project being evaluated is riskier
than the firm's average project, in terms of both its
beta risk and its total risk. Which of the following
statements is CORRECT?
ANSWER:
D. Statement D is
correct. Here is the
proof: First, you
find the required return for an average project. Using
the CAPM, we get
rs = 5% + 4%(2.0)
a.
= 5% + 8% =
The project should definitely be accepted because 13%. Now adjust
its expected return (before any risk adjustments) is for risk. Required
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greater than its required return.
return for risky projects = 13% + 3% =
b.
16%. Project return
The project should definitely be rejected because its = 14% < risk-adexpected return (before risk adjustment) is less than justed rs = 16%.
its required return.
Thus, the project
should be rejected
c.
Riskier-than-average projects should have their expected returns increased to reflect their higher risk.
Clearly, this would make the project acceptable regardless of the amount of the adjustment.
d.
The accept/reject decision depends on the firm's
risk-adjustment policy. If Norris' policy is to increase
the required return on a riskier-than-average project
to 3% over rs, then it should reject the project.
e.
Capital budgeting projects should be evaluated solely on the basis of their total risk. Thus, insufficient
information has been provided to make the accept/reject decision.
8. You were hired as a consultant to Giambono Company, whose target capital structure is 40% debt, 15%
preferred, and 45% common equity. The after-tax cost
of debt is 6.00%, the cost of preferred is 7.50%, and
the cost of retained earnings is 12.00%. The firm will
not be issuing any new stock. What is its WACC?
a.
8.93%
b.
7.59%
c.
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ANSWER: A
Weights
Costs
Debt
40%
6.00%
Preferred
15%
7.50%
Common
45%
12.00%
WACC = wd × rd ×
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6.96%
(1 T) + wp × r p +
wc × rs
d.
7.68%
8.93%
e.
6.69%
9. To help finance a major expansion, Castro Chemical
Company sold a noncallable bond several years ago
that now has 20 years to maturity. This bond has a
9.25% annual coupon, paid semiannually, sells at a
price of $1,025, and has a par value of $1,000. If the
firm's tax rate is 40%, what is the component cost of
debt for use in the WACC calculation? Do not round
your intermediate calculations.
a.
4.45%
b.
5.93%
c.
5.39%
ANSWER: C
Coupon rate
9.25%
Periods/year
2
Maturity (yr)
20
Bond price
$1,025.00
Par value
$1,000
Tax rate
40%
Calculator inputs:
N = 20 × 2
40
PV = Bond's price
-$1,025.00
PMT = (Coupon
rate × Par) / 2
$46.25
FV = Par = Maturity
value
$1,000
Calculator output:
I/YR, semiannual
rate
4.49%
Annual rate = 2 ×
d.
6.09%
e.
4.69%
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(I/YR) = Before-tax
cost of debt
8.98%
After-tax cost of
debt = rd(1 - T)
5.39%
10. You were hired as a consultant to Quigley Company, ANSWER: D
whose target capital structure is 35% debt, 10% pre- Tax rate = 40%
ferred, and 55% common equity. The interest rate on
new debt is 6.50%, the yield on the preferred is 6.00%,
the cost of retained earnings is 14.75%, and the tax
rate is 40%. The firm will not be issuing any new stock.
What is Quigley's WACC? Round final answer to two
decimal places. Do not round your intermediate cal- Weights
culations.
BT Costs
AT Costs
a.
Product
12.19%
Debt
35%
b.
6.50%
8.36%
3.90%
1.365%
c.
Preferred
9.17%
10%
6.00%
d.
6.00%
10.08%
0.60%
Common
55%
14.75%
14.75%
8.1125%
WACC
100%
10.08%
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11. Assuming that their NPVs based on the firm's cost of
capital are equal, the NPV of a project whose cash
flows accrue relatively rapidly will be more sensitive
to changes in the discount rate than the NPV of a
project whose cash flows come in later in its life.
a.
True
b.
False
ANSWER: False.
It's the backloaded
projects (the ones
whose cash flows
come later in the
life of the project)
that are more sensitive to changes in
the discount rate.
This means that
as the WACC increases, the NPV
of those projects
drops more sharply
(the slope of the
NPV profile will be
steeper).
12. . Conflicts between two mutually exclusive projects ANSWER: True
occasionally occur, where the NPV method ranks one
project higher but the IRR method puts the other one
first. In theory, such conflicts should be resolved in
favor of the project with the higher NPV.
a.
True
b.
False
13. other things held constant an increase in the cost of false, The cost of
capital will result in a decrease in a projects IRR. T/F capital does not affect the IRR. However, an increase in
the cost of capital
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makes it less likely that a business
will decide to accept a project, as
we only accept a
project when IRR >
WACC.
14. The NPV method's assumption that cash inflows are True
reinvested at the cost of capital is generally more reasonable than the IRR's assumption that cash flows
are reinvested at the IRR. This is an important reason
why the NPV method is generally preferred over the
IRR method.
a.
True
b.
False
15. Projects C and D are mutually exclusive and have
normal cash flows. Project C has a higher NPV if the
WACC is less than 12%, whereas Project D has a
higher NPV if the WACC exceeds 12%. Which of the
following statements is CORRECT?
ANSWER: A
The NPV profiles
cross at 12%. To
the left, or at lower discount rates,
C has the higher
a.
NPV, so its slope
Project D probably has a higher IRR.
is steeper, causing its profile to hit
b.
the X axis sooner.
Project D is probably larger in scale than Project C. This means that C
has the lower IRR,
c.
hence D has the
Project C probably has a faster payback.
higher IRR.
d.
Project C probably has a higher IRR.
e.
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The crossover rate between the two projects is below
12%.
16. Which of the following statements is CORRECT?
a.
The IRR method appeals to some managers because
it gives an estimate of the rate of return on projects
rather than a dollar amount, which the NPV method
provides.
b.
The discounted payback method eliminates all of the
problems associated with the payback method.
c.
When evaluating independent projects, the NPV and
IRR methods often yield conflicting results regarding
a project's acceptability.
d.
To find the MIRR, we discount the TV at the IRR.
e.
A project's NPV profile must intersect the X-axis at
the project's WACC.
ANSWER: A. B
is wrong because
the discounted payback method still
doesn't take into
account what happens after the payback period (it
ignores post-payback cash flows,
thus it doesn't tell
you about wealth
maximization). C is
wrong because for
independent projects, NPV and IRR
never conflict. D
is wrong because
we actually use the
WACC when finding out the MIRR
(we take the cash
inflows and compound them at the
WACC to obtain
our TVs, or terminal values). E is
wrong because the
NPV profile intersects the X-axis at
the IRR.
17. . Anderson Systems is considering a project that has ANSWER: D
the following cash flow and WACC data. What is the WACC:
project's NPV? Note that if a project's projected NPV 11.00%
is negative, it should be rejected.
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WACC:
11.00%
Year
0
1
2
3
Cash flows
-$1,000
$500
$500
$500
NPV = 0221.86
A step-by-step
overview of how to
input things into a
financial calculator
(this is for the Texas
Instruments BA II
Plus, but it should
be relatively similar across any calculator): The first
step is to input the
cash flows, which
you'll do in the cash
flow register. Press
the "CF" button in
the second row
from the top, second button from the
left. It will display
"CFo," which will
prompt you to input the Year 0 cash
flow. In this problem that is -$1,000
(it's a cash outflow, so make sure
Year
0
1
2
3
Cash flows
-$1,000
$500
$500
$500
a.
259.57
b.
257.35
c.
241.82
d.
221.86
e.
195.23
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you don't forget
the negative sign!).
Next, press "ENTER" then press
the down arrow. Now you'll
see "C01" which
prompts you to input the Year 1
cash flow. Input
that, then press
ENTER, then press
the down arrow
again. Now you'll
see "F01 = 1.0".
That's fine. Don't
worry about that.
You want all the
F's to be set to
1 (that's the default). Press down
arrow again and
you'll see "C02". Input the Year 2 cash
flow and press ENTER. Press the
down arrow twice
until you get to
"C03" and then input the Year 3 cash
flow. Press ENTER again. Press
the down arrow to
make sure there's
no further cash flow
information saved
in the calculator (this is only
a 3-year project).
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Once the cash
flows are entered
correctly, press the
"NPV" button (directly to the right
of the "CF" button). Now you'll be
prompted to enter
an "I", so here you'll
input the WACC (input it as a percent, don't convert to a decimal. For instance,
if the WACC is
11%, input "11"
in the calculator,
DON'T input ".11").
Once you input the
WACC, press ENTER. Then press
the down arrow.
Now you'll see
"NPV = ..." It will
either read "NPV =
0" or "NPV = whatever info it saved
from the most recent problem you
did". Either way,
remember to finish up the problem
by pressing compute, which is the
"CPT" button all the
way at the top left.
Once you do that,
it will display "NPV
= whatever the an11 / 22
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swer to this question is". If you did
everything correctly, you'll see "NPV =
221.8574".
18. net working capital is defined as current assets divid- false, Net working
ed by current liabilities . T/F
capital is current
assets minus current liabilities (CA /
CL is the current ratio)
19. An increase in any current asset must be accompa- ANSWER:
nied by an equal increase in some current liability. False
The balance sheet
a.
must balance (asTrue
sets must equal liabilities plus equib.
ty), so an increase
False
in current assets
must be accompanied by a corresponding increase
in current liabilities,
long-term liabilities,
and/or equity.
20. The three alternative current asset investment poli- True
cies discussed in the text differ regarding the size of
current asset holdings.
a.
True
b.
False
21. The concept of permanent current assets reflects the True
fact that some components of current assets do not
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shrink to zero even when a business is at its seasonal
or cyclical low. Thus, permanent current assets represent a minimum level of current assets that must
be financed.
a.
True
b.
False
22. Although short-term interest rates have historically
averaged less than long-term rates, the heavy use of
short-term debt is considered to be an aggressive
current asset financing strategy because of the inherent risks of using short-term financing.
a.
True
b.
False
23. . If a firm takes actions that reduce its days sales
outstanding (DSO), then, other things held constant,
this will lengthen its cash conversion cycle (CCC) and
cause a deterioration in its cash position.
a.
True
ANSWER:
True
Using short-term financing exposes
you to certain risks,
such as the chance
that interest rates
may rise. Also,
there's no guarantee that the loan
would be renewed.
ANSWER:
False
Reducing DSO
would actually
shorten the cash
conversion cycle
and improve the
cash position.
b.
False
24. Other things held constant, if a firm "stretches" (i.e., ANSWER:
delays paying) its accounts payable, this will length- False
en its cash conversion cycle (CCC).
Delaying paying
accounts payable
a.
will increase the
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True
payables deferral
period, thus shortening the cash conversion cycle.
b.
False
25. Other things held constant, which of the following will ANSWER:
cause an increase in net working capital?
c
Selling profitable
a.
merchandise on
Cash is used to buy marketable securities.
credit would increase accounts
b.
receivable, thus inA cash dividend is declared and paid.
creasing net working capital.
c.
Merchandise is sold at a profit, but the sale is on
credit.
d.
Long-term bonds are retired with the proceeds of a
preferred stock issue.
e.
Missing inventory is written off against retained earnings.
26. Firms generally choose to finance temporary current A
assets with short-term debt because
a.
matching the maturities of assets and liabilities reduces risk under some circumstances, and also because short-term debt is often less expensive than
long-term capital.
b.
short-term interest rates have traditionally been more
stable than long-term interest rates.
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c.
a firm that borrows heavily on a long-term basis is
more apt to be unable to repay the debt than a firm
that borrows short term.
d.
the yield curve is normally downward sloping.
e.
short-term debt has a higher cost than equity capital.
27. Helena Furnishings wants to reduce its cash conver- ANSWER:
sion cycle. Which of the following actions should it b
take?
Option A is wrong
because it would
a.
result in an inIncrease average inventory without increasing sales. creased inventory
conversion period,
b.
which would inTake steps to reduce the DSO.
crease the CCC
(increased invenc.
tory leads to
Start paying its bills sooner, which would reduce the lower inventory
average accounts payable but not affect sales.
turnover since inventory turnover
d.
is Sales/Inventory.
Sell common stock to retire long-term bonds.
This would lead
to the inventoe.
ry conversion peSell an issue of long-term bonds and use the proriod being longer,
ceeds to buy back some of its common stock.
since the formula
for inventory conversion period is
Days per year/Inventory Turnover).
Option C is wrong
because reducing
the average A/P
would decrease its
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payables deferral
period, thus increasing its CCC.
Options D and E
would have no effect on the CCC.
28. Which of the following is NOT a capital component accounts payable
when calculating the weighted average cost of capital
(WACC) for use in capital budgeting?
a. Long-term debt.
b. Preferred stock.
c. Common stock.
d. Retained earnings.
e. Accounts payable
29. For a typical firm, which of the following sequences e
is CORRECT? All rates are after taxes, and assume
that the firm operates at its target capital structure.
a. WACC > rd > rs > re.
b. rs > re > rd > WACC.
c. rd > re > rs > WACC.
d. WACC > re > rs > rd.
e. re > rs > WACC > rd.
30. Duval Inc. uses only equity capital, and it has two
d
equally-sized divisions. Division A's cost of capital
is 10.0%, Division B's cost is 14.0%, and the corporate (composite) WACC is 12.0%. All of Division A's
projects are equally risky, as are all of Division B's
projects. However, the projects of Division A are less
risky than those of Division B. Which of the following
projects should the firm accept?
a. A Division B project with a 12% return.
b. A Division A project with a 9% return.
c. A Division B project with an 11% return.
d. A Division A project with an 11% return.
e. A Division B project with a 13% return
31.
c
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LaPango Inc. estimates that its average-risk projects
have a WACC of 10%, its below-average risk projects
have a WACC of 8%, and its above-average risk projects have a WACC of 12%. Which of the following
projects (A, B, and C) should the company accept?
a. Project A, which is of average risk and has a return
of 9%.
b. Project C, which is of above-average risk and has
a return of 11%.
c. Project B, which is of below-average risk and has
a return of 8.5%.
d. None of these projects should be accepted.
e. All of these projects should be accepted
32. If a typical U.S. company correctly estimates its
e
WACC at a given point in time and then uses that
same cost of capital to evaluate all projects for the
next 10 years, then the firm will most likely
a. become less risky over time, and this will maximize
its intrinsic value.
b. continue as before, because there is no reason to
expect its risk position or value to change over time
as a result of its use of a single cost of capital.
c. become riskier over time, but its intrinsic value will
be maximized.
d. accept too many low-risk projects and too few
high-risk projects.
e. become more risky and also have an increasing
WACC. Its intrinsic value will not be maximized
33. Which of the following statements is CORRECT?
e
a. Since the money is readily available, the after-tax
cost of retained earnings is usually much lower than
the after-tax cost of debt.
b. All else equal, an increase in a company's stock
price will increase its marginal cost of retained earnings, rs.
c. All else equal, an increase in a company's stock
price will increase its marginal cost of new common
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equity, re.
d. When calculating the cost of preferred stock, a
company needs to adjust for taxes, because preferred stock dividends are deductible by the paying
corporation.
e. If a company's tax rate increases but the YTM on
its noncallable bonds remains the same, the after-tax
cost of its debt will fall.
34. Which of the following statements is CORRECT?
b
a. Although some methods used to estimate the
cost of equity are subject to severe limitations, the
CAPM is a simple, straightforward, and reliable model that consistently produces accurate cost of equity estimates. In particular, academics and corporate finance people generally agree that its key inputs—beta, the risk-free rate, and the market risk
premium—can be estimated with little error.
b. Surveys indicate that the CAPM is the most widely
used method for estimating the cost of equity. However, other methods are also used because CAPM
estimates may be subject to error, and people like to
use different methods as checks on one another. If all
of the methods produce similar results, this increases the decision maker's confidence in the estimated
cost of equity.
c. The bond-yield-plus-risk-premium approach to estimating the cost of equity may not always be accurate, but it has the advantage that its two key inputs,
the firm's own cost of debt and its risk premium,
can be found by using standardized and objective
procedures.
d. The DCF model is generally preferred by academics and financial executives over other models for
estimating the cost of equity. This is because of the
DCF model's logical appeal and also because accurate estimates for its key inputs, the dividend yield
and the growth rate, are easy to obtain.
e. The DCF model is preferred by academics and
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finance practitioners over other cost of capital models because it correctly recognizes that the expected
return on a stock consists of a dividend yield plus an
expected capital gains yield.
35. O'Brien Inc. has the following data: rRF = 5.00%; RPM c
= 6.00%; and b = 0.70. What is the firm's cost of equity
from retained earnings based on the CAPM?
a. 10.58%
b. 11.41%
c. 9.20%
d. 6.90%
e. 9.02%
36. Assume that you are a consultant to Broske Inc., and b
you have been provided with the following data: D1
= $0.67; P0 = $45.00; and g = 8.00% (constant). What
is the cost of equity from retained earnings based on
the DCF approach?
a. 10.15%
b. 9.49%
c. 11.10%
d. 7.59%
e. 8.63%
37. Several years ago the Jakob Company sold a $1,000 a
par value, noncallable bond that now has 20 years
to maturity and a 7.00% annual coupon that is paid
semiannually. The bond currently sells for $875, and
the company's tax rate is 25%. What is the component
cost of debt for use in the WACC calculation? Do not
round your intermediate calculations.
a. 6.22%
b. 5.92%
c. 4.92%
d. 4.33%
e. 5.02%
38. Conflicts between two mutually exclusive projects true
occasionally occur, where the NPV method ranks one
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project higher but the IRR method puts the other one
first. In theory, such conflicts should be resolved in
favor of the project with the higher NPV.
a. Trueb. False
39. The internal rate of return is that discount rate that
equates the present value of the cash outflows (or
costs) with the present value of the cash inflows.
a. Trueb. False
true
40. Which of the following statements is CORRECT? As- d
sume that the project being considered has normal
cash flows, with one outflow followed by a series of
inflows.
a. A project's NPV is found by compounding the cash
inflows at the IRR to find the terminal value (TV), then
discounting the TV at the WACC.
b. The lower the WACC used to calculate it, the lower
the calculated NPV will be.
c. If a project's NPV is greater than zero, then its IRR
must be less than zero.
d. If a project's NPV is less than zero, then its IRR
must be less than the WACC.
e. The NPV of a relatively low-risk project should be
found using a relatively high WACC.
41. Which of the following statements is CORRECT?
e
a. One defect of the IRR method versus the NPV is
that the IRR does not take account of the time value
of money.
b. One defect of the IRR method versus the NPV is
that the IRR does not take account of the cost of
capital.
c. One defect of the IRR method versus the NPV is
that the IRR values a dollar received today the same
as a dollar that will not be received until sometime in
the future.
d. One defect of the IRR method versus the NPV is
that the IRR does not take account of cash flows over
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a project's full life.
e. One defect of the IRR method versus the NPV is
that the IRR does not take proper account of differences in the sizes of projects.
42. Which of the following statements is CORRECT?
e
a. The discounted payback method recognizes all
cash flows over a project's life, and it also adjusts
these cash flows to account for the time value of
money.
b. The regular payback method was, years ago, widely
used, but virtually no companies even calculate the
payback today.
c. The regular payback method recognizes all cash
flows over a project's life.
d. The regular payback does not consider cash flows
beyond the payback year, but the discounted payback
overcomes this defect.
e. The regular payback is useful as an indicator of a
project's liquidity because it gives managers an idea
of how long it will take to recover the funds invested
in a project.
43. Assume a project has normal cash flows. All else
e
equal, which of the following statements is CORRECT?
a. A project's discounted payback increases as the
WACC declines.
b. A project's regular payback increases as the WACC
declines.
c. A project's MIRR is unaffected by changes in the
WACC.
d. A project's IRR increases as the WACC declines.
e. A project's NPV increases as the WACC declines
44. Which of the following statements is CORRECT?
c
a. The internal rate of return method (IRR) is generally regarded by academics as being the best single
method for evaluating capital budgeting projects.
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b. The modified internal rate of return method (MIRR)
is generally regarded by academics as being the best
single method for evaluating capital budgeting projects.
c. The net present value method (NPV) is generally regarded by academics as being the best single
method for evaluating capital budgeting projects.
d. The discounted payback method is generally regarded by academics as being the best single
method for evaluating capital budgeting projects.
e. The payback method is generally regarded by academics as being the best single method for evaluating
capital budgeting projects.
45. Which of the following statements is CORRECT?
b
a. We cannot draw a project's NPV profile unless we
know the appropriate WACC for use in evaluating the
project's NPV.
b. An NPV profile graph is designed to give decision
makers an idea about how a project's contribution to
the firm's value varies with the cost of capital.
c. An NPV profile graph shows how a project's payback varies as the cost of capital changes.
d. An NPV profile graph is designed to give decision
makers an idea about how a project's risk varies with
its life.
e. The NPV profile graph for a normal project will
generally have a positive (upward) slope as the life
of the project increases.
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Topic 6: APV
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1. The value of a
the sum of the value of the firm's debt and the firm's equity.
firm is defined to
be
V=B+S
If the goal of the firm's management is to make the firm
as valuable as possible, then the firm should pick the
debt-equity ratio that makes the pie as big as possible.
2. Modigiliani and theoretically, a firm's value is always the same under difMiller (MM) argue ferent capital structures.
that
Note that this theory relies on a list of assumptions!
3. Assumptions of Homogeneous Expectations
the M&M Model Homogeneous Business Risk Classes
Perpetual Cash Flows
Perfect Capital Markets:
Perfect competition
Firms and investors can borrow/lend at the same rate
Equal access to all relevant information
No transaction costs
No taxes
4. Adjusted Present APV = NPV + NPVF
Value Approach
The value of a project to the firm can be thought of as the
value of the project to an unlevered firm (NPV) plus the
present value of the financing side effects (NPVF).
5. The project
NPV < 0
would be rejected if
6. APV Example
APV valuation slide 7-9
7. WACC Method
APV valuation slide 10-14
8. A Comparison of Both approaches attempt the same task: valuation in the
the APV and
presence of debt financing.
Guidelines:
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WACC Approach- Use WACC if the firm's target debt-to-value ratio applies
es
to the project over the life of the project.
Use the APV if the project's level of debt is known/changing over the life of the project.
9. Refer to Valuation with APV approach handout
10. APV Equation
APV = NPV - NPV pf tax shield flotation cost + NPV of
Loan
11. NPV Equation
= Initial outlay + PV of Depr tax shield + PV after-tax
EBITDA
12. NPV pf tax
= flotation costs - sum(PV pf tax shield from flotation cost)
shield from flotation cost
13. NPV of Loan
= loan - PV of repayment of debt - sum(PV of after-tax
interest)
14. What is a Lever- is the purchase of a firm by outsider investors using large
aged Buyout?
amounts of debt to finance the purchase
Usually, LBOs are undertaken by private equity (PE) firms
that specialized in these transactions.
These PE firms are often referred to as sponsors, because
they in effect sponsor or propose the deal.
After the acquisition, equity securities are no longer publically traded, though the debt and preferred stocks may by
publically traded.
15. Why LBO?
Sponsors are seeking high returns on their invested equity, less concerned about the intrinsic value of the company.
LBO allows private equity firms to acquire a company by
paying a small portion of the total purchase price.
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PE funds typically have a 10-year life, so sponsors ideally
seek to invest and exist a target company within that time
frame.
16. Think of an LBO buying a house with a mortgage - you have a down paymodel like
ment (the equity in an LBO) and the mortgage (the debt
used to finance an LBO).
17. Exit strategies in- Acquired by another corporation (strategic buyer)
clude
IPO
Secondary buyout
18. Riskiness of LBO financial distress cost
May lead to corporation bankruptcy
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Finance Test Chapter 18
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1. Valuation Models 1) WACC
(2)
2) Adjusted Present Value (APV)
2. Assumptions be- •The project has average risk
ing taken
•The firm's debt-equity ratio is constant
=> the WACC remains constant over time
•Corporate taxes are the only imperfection
3. WACC Method
Because the WACC incorporates the tax savings from
debt, we can compute the levered value of an investment,
by discounting its future free cash flow using the WACC.
V(@ time 0 of a Levered Firm)
=Present value of FCF (using WACC to discount)
4. Debt Capacity
The amount of debt at a particular date that is required to
maintain the firm's target debt-to-value ratio!
Let,
• d = target debt-to-value ration
• Vt = Value of firm at time t
then,
Debt Capacity at time t, Dt, is
= d * Vt
5. Summary of
WACC Method
1. Determine the free cash flow of the investment.
2) Compute the weighted average cost of capital.
3) Compute the value of the investment, including the tax
benefit of leverage, by discounting the free cash flow of
the investment using the WACC.
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• The WACC can be used throughout the firm as the
companywide cost of capital for new investments that are
of comparable risk to the rest of the firm and that will not
alter the firm's debt-equity ratio.
6. Adjusted Present A valuation method to determine the levered value of an
Value Method
investment by first calculating its unlevered value and then
adding the value of the interest tax shield!
V(L)
= V(U) +PV(Interest Tax Shield)
7. Step 1 of APV
method
1): calculate the value of the free cash flows using the
project's cost of capital if it were financed without leverage.
Using Pre-tax WACC !
R(pre-tax wacc)
= [E/(E+D)]*Re + [D/(E+D)]*Rd
8. Step 2 of APV
method
2): Value PV of Interest Tax Shield
Interest paid in year t
= Rd * D(@ time t-1)
Interest Tax Shield
= Interest Paid * Corporate Tax Rate
___________________________
When the firm maintains a target leverage ratio, its future
interest tax shields have similar risk to the project's cash
flows, so they should be discounted at the project's unlevered cost of capital
Get PV using Ru= Rwacc
9.
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Summary of APV 1). Determine the investment's value without leverage.
method
2). Determine the present value of the interest tax shield.
a. Determine the expected interest tax shield. b. Discount
the interest tax shield.
3). Add the unlevered value to the present value of the
interest tax shield to determine the value of the investment
with leverage.
10. Advantages of
APV
• It can be easier to apply than the WACC method when
the firm does not maintain a constant debt-equity ratio.
•The APV approach also explicitly values market imperfections and therefore allows managers to measure their
contribution to value.
•We can easily extend the APV approach to include other
market imperfections such as financial distress, agency,
and issuance costs.
11. Project Based
Cost of Capital
In the real world, a specific project may have different
market risk than the average project for the firm...
______________________________
A) Assume two firms are comparable
B) Assuming that both firms maintain a target leverage
ratio, the unlevered cost of capital for each competitor can
be estimated by calculating their pretax WACC.
1) Find Ru for each firm
2) Take average of the Ru's
C) With this rate in hand we can use APV approach.
• To use WACC, we need to estimate the project's equity
cost of capital, which depends on the incremental debt the
company will take on as a result of the project.
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D) Solve for firm's Re by using the average Ru we found
E) The firm's WACC can now be estimated
12. Comparison of
Methods
• Typically, the WACC method is the easiest to use when
the firm will maintain a fixed debt-to-value ratio over the
life of the investment.
• For alternative leverage policies, the APV method is
usually the simplest approach.
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Chapter 19 Short Answer
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1. Discuss the advantages and limitations of
using the weighted average cost of capital as
a discount rate to evaluate capital budgeting
projects.
WACC is relatively simple to calculate and use.
It has the disadvantage in that it applies only to
projects that have a business risk the same as the
firm's. It also implies that the debt-equity ratio is
held constant. It can be used when debt-ratio is
known. The value of the debt need not be known. It
automatically takes into the tax-shield effect of debt.
2. Which is the most often used method by
managers to make decisions?
The after-tax weighted average cost of capital
(WACC) method is the most often used method
in practice. It is because it is conceptually easy to
understand and communicate. It relates well with
the NPV and IRR methods. It is also used for valuing
businesses.
3. Briefly explain how
The value of a business can be estimated by calWACC can be used for culating the present value of free cash flows (FCF)
valuing a business.
generated by a firm using WACC as the discounts
rate for the life of the firm. FCF is estimated by
adding profits after taxes, depreciation, investments
in fixed assets, and investments in working capital.
From a practical point of view, FCFs are estimated
for a few years and the present value of the horizon value is calculated using a reasonable constant
growth rate for the rest of the years. The value of the
firm is the present value of free cash flows plus the
present value of the horizon value.
4. Briefly explain how
the beta of equity of
a firm changes with
changes in debt-equity ratio when taxes are
considered.
The equity beta of a firm increases linearly with
changes in debt-equity ratio. This is modified by
the tax factor. The exact relationship is obtained
by combining capital asset pricing model and
Modigliani-Miller proposition II with taxes. The relationship is given by:
bE = bA + (1 - TC)(bA - bD)(D/E)
5. Briefly explain how the The rate of return on equity of a firm increases
rate of return on equity linearly with changes in debt-equity ratio. This is
of a firm changes with modified by the tax factor. The exact relationship is
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changes in debt-equi- obtained by combining capital asset pricing model
ty ratio when taxes are and Modigliani-Miller proposition II with taxes. The
considered.
relationship is given by:
rE = rA + (1 - TC)(rA - rD)(D/E)
6. Under what circumstances would it be
better to use the Adjusted Present Value
approach?
The APV approach is better if there are many side
effects to financing. For example, if a firm is getting
a subsidized loan for a project then the APV method
should be used. It is used when the amount of debt
is known.
7. Briefly explain how
APV can be used for
valuing a business.
The value of a business can be estimated by calculating the present value of free cash flows (FCF)
generated by a firm using opportunity cost of capital
as the discounts rate for the life of the firm. This
gives the base-case NPV. Business debt levels, interest, and interest tax shields are calculated. If the
debt levels are fixed, then the interest tax shields are
discounted at the borrowing rate to get the present
value of interest tax shields. The value of the firm
is the base-case NPV plus the present value of
interest tax shields.
8. What discount rate
should be used for
calculating the present
value of safe, nominal
cash flows?
The discount rate used for finding the present value
of safe, nominal cash flows is the after-tax cost
of debt. This present value is also the value of an
equivalent loan that can be paid off using the cash
flows.
9. What method would
Generally, international projects have numerous
you use for evaluating and important side effects like special contracts with
international projects? governments, suppliers, and customers. They also
have special project financing packages. All these
effects can be explicitly considered by using the
APV method.
10. What are some of the
additional factors that
have to be considered when analyzing
Sometimes international projects have additional
features, like special contracts with suppliers, customers, or governments, that provide guarantees.
These guarantees are valuable for the firm and
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an international project? Briefly explain.
11. "Urbanrenewalcanbeaccomplishedbytheprovisionofgovernmenttaxandloanincentivestobusiness,
despite the existence
of negative NPV
projects." Explain why
this is true.
should be added to the APV. Sometimes governments impose special restrictions. These restrictions generally decrease the value of the project to
the firm. The value of the restrictions are subtracted
from the APV.
Investments may have a negative NPV in the absence of other incentives. When the government
provides a financial incentive, in the form of subsidies, tax breaks, or low interest loans, the APV of the
project may increase. If the increase is enough, the
NPV may become positive and the firm might make
the investment. This could cause economic development in areas that would not otherwise receive
investments. The risk, however, is that the eventual
elimination of the incentives may cause urban blight
to return.
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B3 Capital Asset Pricing Model
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1. Capital Asset
Pricing Model
(CAPM) is a common framework used to understand the
relation between risk and expected return.
- used to determine how much return investors require for
an investment given its systematic risk (beta)
- often used to measure a firm's cost of equity capital
2. CAPM formula
measures an investment's expected return on an investment, given the level of market risk and sensitivity of the
investment relative to the market;
a function of three market conditions:
- Risk-free rate of return (Rf)
- Market risk premium (Rm Rf)
- Beta (²)of the investment, which measures the investment's sensitivity to changes in the market, systematic risk
Ke = Investment's required rate of return or Cost of Equity
Capital
Ke=Rf+²(RmRf)
3. risk-free rate
typically refers to the current rate of return on a risk-free
security such as U.S. Treasury bill, T-bond
- time value
4. market rate of re- is expected return of the broader stock market such as the
turn
S&P 500 or Dow Jones Industrial Average. It is used to
calculate a market risk premium (Rm Rf).
5. market risk premium
(Rm Rf). The "premium" refers to the amount of return expected from the market above and beyond the return that
could be earned from a risk-free security. The premium is
the additional return to compensate investors for bearing
greater risk.
- varies in direct proportion to the beta in the market
6. security market
line
a positively sloped straight line displaying the relationship
between expected return and beta
- a graphical representation of CAPM, betas - horizontal
ax, RRR - vertical; SML starts with Rf => beta=0
- provides a benchmark for evaluating the relative merits
of portfolio investments
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- all investments in a portfolio should plot along a sloping
line
7. Beta
indicates how much, and in what direction, a rational investor expects an investment to move given a 1% change
in the market.
8. Beta = 0
indicates a fixed return with no sensitivity to market
changes, in other words, no systematic risk.
- An example: U.S. T-bills, whose value does not change
based on stock market changes.
9. Beta > 1
- indicates more systematic risk than the market. A stock
with a beta of 1.5 is expected to increase 1.5% if the
market increases 1.0%.
- Technology stocks often have a beta greater than 1.
10. Beta < 1
- indicates less systematic risk than the market. A stock
with a beta of 0.5 is expected to increase 0.5% if the
market increases 1.0%.
- Utility companies often have a beta less than 1.
11. Beta = 1
- indicates the same systematic risk as the market. A stock
with a beta of 1.0 is expected to increase 1.0% if the
market increases 1.0%.
- An index fund that tracks the S&P 500 would have a beta
close to 1.0.
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1. Consider the
Capital Asset
Pricing Model
(CAPM). What are
the main assumptions of the
model? What is
the Capital Market Line (CML)?
What is the Security Market Line
(SML)?
The Capital Asset Pricing (CAPM) model is a theory
whereby the equilibrium rates of return on all risky assets
are a function of their covariance with the market portfolio.
It is a model that is used to determine the expected rate
of return on a security based on its risk
characteristics. It describes the relationship that holds between systematic risk and expected return for assets, in
particular stocks. Systematic risks are market risks that
cannot be diversified away, such as interest rates. All the
portfolios that optimally combine the risk-free rate of return
and the market portfolio of risky assets are represented.
The CAPM model tells us that the return on a security
is equal to the risk-free rate plus a market risk premium
multiplied by the market relative risk factor for the security
measured as beta.
CAPM Equation: rb = rf +5ý
b (r˜ - rf)
The main assumption underlying CAPM is that the capital
market is perfect and:
¢ There are no transaction costs or taxes involved in buying
or selling securities in the capital market
¢ All the information about the securities in the market is
freely available to all investors
¢ All investors can borrow or lend any amount of money at
a given interest rate
¢ All investments mature in one period
¢ Investors are risk averse and make decisions using the
mean variance rule (i.e. investors seek to maximise their
expected return for a given amount of risk)
The Capital Market Line represents portfolios that optimally combine risk and return. It is a straight line passing
through the risk-free rate of return and the expected rate
of return on the market portfolio. Risk is measured by
the standard deviation on the horizontal axis. The rate
of return is on the vertical axis. Under CAPM, investors
will choose a position on this capital market line at the
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equilibrium, by borrowing or lending at the risk-free rate,
as this will maximise their return for a given level of risk.
It optimally combines risk and return and leads to an
efficient portfolio. The slope of the CML is the sharpe ratio
of the market portfolio. It can be stated that an investor
should buy assets if the sharpe ratio is above the CML,
and sell if below the CML.
The equation of the CML:
r“ =5_5S
r˜ +
5_5S)/
Ã̃[(
“]
5
where 5_
“ is the expected return on an asset/portfolio
5_5S
is the risk free rate
r˜ is the expected market return
Ã̃is the standard deviation of the market returns
“ is the standard deviation of the asset/portfolio returns
5
CML Graph:
-x-axis: Volatility
-y-axis: Expected return
-Upward sloping line
-Line starts at rf
-Mark the Market portfolio on the line at some point (Ã̃, r˜)
-Mark r˜ -5_5S
The Security Market Line (SML) is derived from the CML.
While the CML shows the rates of return for a specific
portfolio, the SML represents the market's risk and return
at a given time, and shows the expected returns of individual assets. And while the measure of risk in the CML
is the standard deviation of returns (total risk), the risk
measure in the SML is systematic risk, or beta. The SML
is a line which measures the relationship between beta
(or systematic risk) and a firm's expected rate of return.
Securities that are fairly priced will plot on the CML and
SML. Securities that plot above the CML or the SML are
generating returns that are too high for the given risk and
are under-priced. Securities that plot below CML or the
SML are generating returns that are too low for the given
risk and are over-priced.
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Beta is a measure of a security's sensitivity to market
movements or systematic risk
b = Cov(rb, r˜)/Var(r˜)
5ý
This formula represents the covariance of the security
relative to the variance of the market. By definition, the 5ý
of the market is 1.
-The SML equation is:
rb =5_5S
r˜ 5_5S)
+ 5ý(
where rb is the expected return on an asset,
5_5S
is the risk free rate,
r˜ is the expected market return
SML Graph
-x-axis: Beta
-y-axis: Expected Return
-Upward sloping line
-Starts at rf
-Mark the Market portfolio on the line at some point (1, r˜)
2. CAPM
-The Capital Asset Pricing (CAPM) model is a theory
whereby the equilibrium rates of return on all risky assets
are a function of their covariance with the market portfolio.
-It is a model that is used to determine the expected rate
of return on a security based on its risk characteristics.
-It describes the relationship that holds between systematic risk and expected return for assets.
-Systematic risks are market risks that cannot be diversified away, such as interest rates.
-All the portfolios that optimally combine the risk-free rate
of return and the market portfolio of risky assets are represented.
-The CAPM model tells us that the return on a security
is equal to the risk-free rate plus a market risk premium
multiplied by the market relative risk factor for the security
measured as beta.
3. CAPM Assumptions
The main assumption underlying CAPM is that the capital
market is perfect and:
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¢ There are no transaction costs or taxes involved in buying
or selling securities in the capital market
¢ All the information about the securities in the market is
freely available to all investors
¢ All investors can borrow or lend any amount of money at
a given interest rate
¢ All investments mature in one period
¢ Investors are risk averse and make decisions using the
mean variance rule (i.e. investors seek to maximise their
expected return for a given amount of risk)
4. SML Graph
-x-axis: Expected Return
-y-axis: Beta
-Upward sloping line
-Starts at rf
-Mark the Market portfolio on the line at some point (1, r˜)
5. CML
-The Capital Market Line represents portfolios that optimally combine risk and return.
-It is a straight line passing through the risk-free rate
of return and the expected rate of return on the market
portfolio.
-Risk is measured by the standard deviation on the horizontal axis. The rate of return is on the vertical axis.
-Under CAPM, investors will choose a position on this
capital market line at the equilibrium, by borrowing or
lending at the risk-free rate, as this will maximise their
return for a given level of risk.
-It optimally combines risk and return and leads to an
efficient portfolio.
-The slope of the CML is the sharpe ratio of the market
portfolio.
-It can be stated that an investor should buy assets if the
sharpe ratio is above the CML, and sell if below the CML.
-The equation of the CML:
r“ =5_5S
r˜5_5S)/
+Ã̃5
“][(
where 5_
“ is the expected return on an asset/portfolio
5_5S
is the risk free rate
r˜ is the expected market return
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Ã̃is the standard deviation of the market returns
“ is the standard deviation of the asset/portfolio returns
5
CML Graph:
-x-axis: Volatility
-y-axis: Expected return
-Upward sloping line
-Starts at rf
-Mark the Market portfolio on the line at some point (Ã̃, r˜)
-Mark r˜ -5_5S
6. SML
-The Security Market Line (SML) is derived from the CML.
-While the CML shows the rates of return for a specific
portfolio, the SML represents the market's risk and return
at a given time, and shows the expected returns of individual assets.
-The measure of risk in the SML is the systematic risk, or
beta.
-The SML is a line which measures the relationship between beta (or systematic risk) and a firm's expected rate
of return.
-Securities that are fairly priced will plot on the CML and
SML.
-Securities that plot above the CML or the SML are generating returns that are too high for the given risk and are
under-priced.
-Securities that plot below CML or the SML are generating returns that are too low for the given risk and are
over-priced.
-Beta is a measure of a security's sensitivity to market
movements or systematic risk
b = Cov(rb, r˜)/Var(r˜)
5ý
This formula represents the covariance of the security
relative to the variance of the market. By definition, the 5ý
of the market is 1.
-The SML equation is:
rb =5_5S
r˜ 5_5S)
+ 5ý(
where rb is the expected return on an asset,
5_5S
is the risk free rate,
r˜ is the expected market return
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SML Graph
-x-axis: Expected Return
-y-axis: Beta
-Upward sloping line
-Starts at rf
-Mark the Market portfolio on the line at some point (1, r˜)
7. SML Equation
-The SML equation is:
rb =5_5S
r˜ 5_5S)
+ 5ý(
where rb is the expected return on an asset,
5_5S
is the risk free rate,
r˜ is the expected market return
8. CML Graph
-x-axis: Volatility
-y-axis: Expected return
-Upward sloping line
-Starts at rf
-Mark the Market portfolio on the line at some point (Ã̃, r˜)
-Mark r˜ -5_5S
9. Beta
-A measure of a security's sensitivity to market movements or systematic risk
-It measures the riskiness of stock i relative to the risk of
the market
5ý how
= risky asset i is/ how risky the stock market is
b = Cov(rb, r˜)/Var(r˜)
5ý
-By definition, the 5ý
of the market is 1.
-A share with a beta of 1 tends to move by a similar
percentage to the market; one with a beta of 2 tends to
move up or down
-5ý > amplifies
1
the overall movements of the market
-0 < 5ý <tend
1 to move in the same direction as the market
but not so far
-E.g. Tesco had a beta of 1.36 which means on average
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when the market raises/falls by 1%, Tesco's price will
rise/fall by 1.36%
10. CML Equation
r“ =5_5S
r˜5_5S)/
+Ã̃5
“][(
11. CAPM Equation
rb = rf +5ý
b (r˜ - rf)
Expected returns on an asset = risk free rate of return
return + the risk adjustment
12. Explain how the
CAPM provides a
simple rationale
for the following
portfolio strategy:
• Diversify your
holdings of risky
assets according
to the proportions of the market
portfolio;
• Mix this portfolio with the
risk free asset to
achieve a desired
risk-return combination
-CAPM is a theory whereby the equilibrium rates of return
on all risky assets are a function of their covariance with
the market portfolio.
-If an investor buys a portfolio of assets in proportion to the
market weightings (otherwise known as passive investing
or indexing) of some broad market index like the S&P500,
the MSCI global index; the FTSE 100, an investor will by
definition earn a market return (r˜).
-If all the investors capital is invested within this portfolio,
full exposure to the market conveys that they will neither
under nor outperform the market.
-From the CAPM model, r˜ symbolises the return from
complete investment in the market portfolio, also having
a 57
of 1.
-The risk level an investor is willing to take may alter the
value
of beta. For example, putting all their money into risk free
assets and none to the market portfolio, would earn a
return of 5“5‡
with a 57
of 0. This shows that the market will
generate varying returns dependent upon the percentage
of the portfolio invested in the market.
-A 57
of ½ implies a 50/50 portfolio, meaning the portfolio
return will be equal to the average of the risk-free rate and
the market return.
-A portfolio with a 57 could
> 5Ï be achieved if the investor was
more
of a risk taker, they could borrow money to invest in the
market and this would therefore give an expected return
that is higher than the market return.
-This strategy can be used alongside their tolerance to risk
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to determine where on the SML return they wish to be and
the percentage of the portfolio to invest in the market.
13. Systematic Risk -Systematic risk (market/covariant/undiversifiable risk) is
the risk that cannot be diversified away.
-It is the risk that faces every firm in the economy and is
due to market conditions (interest rates/inflation rate/business cycles etc).
-Example: A firm's earnings are positively correlated with
business cycles, so if there is a recession all firms' earnings are negatively affected
14. Non-systematic
Risk
-Specific/idiosyncratic/diversifiable risk
-Risk that can be eliminated by diversification
Four components:
-Management risk - the risk that the managers running
the firm are incompetent and lead the firm into insolvency.
It is quite high in new firms with untried and untested
managers.
-Business risk - the risk from the asset side of the firm's
balance sheet. It is the risk that the firm will not generate
sufficient sales of revenue to finance the fixed costs of its
operations.
-Financial risk - the risk from the liability side of the firm's
balance sheet. It is the risk that the firm will not generate
enough sales revenue to finance the
fixed-charge liabilities on the balance sheet.
-Collateral Risk - the risk that investors face if they have
poor collateral and claims to the assets of the firm and
behind other investors.
15. The following describes the mean
returns and betas of stocks A, B
and C:
Arbitrage Pricing Theory (APT) is a multi-factor asset pricing model. It is based on the concept that an asset's
returns can be predicted using the linear relationship between the asset's expected return and a number of macroeconomic variables that capture systematic risk.
Stock A Mean Re- Inherent to the arbitrage pricing theory is the belief that
turn (%): 4.6
mispriced securities can represent short-term, risk-free
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Stock B Beta:
0.86
Stock B Mean Return (%): 10
Stock B Beta:
0.74
Stock C Mean Return (%): 11.2
Stock C Beta:
0.71
Determine the arbitrage portfolio
with zero investment and a zero
beta. Is there
room for arbitrage profit?
profit opportunities. APT differs from the more conventional CAPM, which uses only a single factor.
With APT, all securities (and all portfolios) sit on the Security Market Line (SML). An arbitrage portfolio can be
created by selling (or buying) an undervalued asset and
buying (or selling) a portfolio of other assets with the same
beta and then closing out the position later to realise a
profit. So, in APT, any asset or portfolio with the same beta
should give the same expected return. Arbitrage opportunities may exist if this does not hold true.
In this question, we can see that the mean returns and
betas of stocks A, B and C do not fit the linear relationship
as shown in the market equilibrium because as the expected returns increase, the beta decreases, as opposed to
increasing as the SML would suggest. Therefore, implying
the existence of an arbitrage portfolio.
Graph
-x-axis: Mean Return
-y-axis: Beta
-Plot points from the question - use dotted lines and label
on the axis
-The basic idea behind the APT model is that investors
can create a zero-beta portfolio with zero net investment.
-To create an arbitrage portfolio with zero investment and
zero beta, two conditions need to be satisfied:
1) For zero investment: 5e
b = 0, where5e
b is the weight of5V5a
security
2) For zero beta: b
5ý= 0, where5e
5e
b is the weight of5V5a
security and
b is the5ý
5ý
of 5V5a
security
Therefore, to construct the portfolio, we have to solve 2
equations:
A + 5e55 + 5e56 = 0
5e
0.865e54 + 0.745e55 + 0.715e56 = 0
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As illustrated in the graph, it is evident that stock A is the
most overvalued stock since its expected return is low,
compared to its volatility. Therefore, we assume that this
is a stock to sell (short). The weighting we give for this
portfolio is 5e54 = 1
-1 + 5e55 + 5e56 = 0
5e55 + 5e56 = 1
5e55 = 1 5e56
-0.86 + 0.745e55 + 0.715e56 = 0
0.745e55 + 0.715e56 = 0.86
0.74(1 5e56) + 0.715e56 = 0.86
0.74 0.745e56 + 0.715e56 = 0.86
0.035e56 = 0.12
5e56 = 4
Sub 5e56 into
= -45e55 =
to1find:
5e56
5e55 = 1 (4)
5e55 = 5
The arbitrage portfolio comprises of
1) Buying stock B and
2) Selling stock A (20% of investment amount) and stock
C (80% of investment amount)
The criteria is satisfied, since:
1. The sum of the weightings is 1 0.2 0.8 = 0 (zero
investment)
2. The beta of portfolio is (1 0.74 ) + (0.2 0.86) + (0.8
0.71) = 0 (zero beta)
Through the implementation of this strategy, the expected
arbitrage profit can be calculated by b
5_, whereby5e
5e
b is the
weight of security 5V
and 5_5V
is the expected return of the
security b .
If in equilibrium, it would give a value of zero.
(1 0.1) + (0.2 0.046) + (0.8 11.2%) = 0.0012 = 0.12%
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The above workings demonstrate that even when an arbitrage profit is available, the figure is very small and
due to transactions costs not being accounted for in the
calculations this potentially further undermines how if this
is a significant this profit is .
16. 2017/18
Through the implementation of this strategy, the expected
arbitrage profit can be calculated by b
5_, whereby5e
5e
b is the
weight of security 5V
and 5_5V
is the expected return of the
security b .
If in equilibrium, it would give a value of zero.
(1 0.1) + (0.2 0.046) + (0.8 11.2%) = -0.001492
-0.001492 X 100 = -14.92%
The above workings demonstrate that there is no room
17. Expected Arbitrage Profit
5_, whereby5e
b
5e
b is the weight of security5V
and 5_5V
is the expected
return of the security b
18. To create a port- -The basic idea behind the APT model is that investors
folio with zero
can create a zero-beta portfolio with zero net investment.
investment and
zero beta
-To create an arbitrage portfolio with zero investment and
zero beta, two conditions need to be satisfied:
1) For zero investment: 5e
b = 0, where5e
b is the weight of5V5a
security
2) For zero beta: b
5ý= 0, where5e
5e
b is the weight of5V5a
security and
b is the5ý
5ý
of 5V5a
security
19. APT
-Arbitrage Pricing Theory (APT) is a multi-factor asset
pricing model.
-It is based on the concept that an asset's returns can
be predicted using the linear relationship between the
asset's expected return and a number of macroeconomic
variables that capture systematic risk.
-With APT, all securities (and all portfolios) sit on the
Security Market Line (SML). An arbitrage portfolio can be
created by selling (or buying) an undervalued asset and
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buying (or selling) a portfolio of other assets with the same
beta and then closing out the position later to realise a
profit. So, in APT, any asset or portfolio with the same beta
should give the same expected return. Arbitrage opportunities may exist if this does not hold true.
20. Draw the decision tree describing the situation that the Your
Bank faces if it
does not implement the credit check. What is
the expected return to each loan
that is offered?
-Decision tree has two branches: loan is paid back (0.8) or
loan is defaulted (0.2)
Payoff: 18% return if loan is paid back so r = 0.18
Payoff: 100% loss if loan is defaulted so r = -1
Expected return on each loan offered:
5_= (0.8 0.18) + (0.2 1) = 0.056 = 5.6%
5]
b
21. Draw the decision tree describing the situation that the
Your Bank faces
if it implements the credit
check. Would you
recommend the
bank to go ahead
and implement
the credit check?
If so, why? How
valuable is the
information contained in the
credit check to
Your Bank?
-First decision tree section: CREDIT CHECK - Favourable
(0.8) or Unfavourable (0.2)
-Second decision tree section (no probabilities) : LOAN
DECISION - Granted or Not granted
-Third decision tree section: When the loan is granted,
PAYMENT - Loan repaid or Not repaid
-Calculate the payoffs of each outcome by taking away
the cost of implementing the check from the return figures
given in the question
-Calculate the expected return on a favourable credit
check
-Calculate the expected return on an unfavourable credit
check
-Total these to get the expected return when a credit check
is implemented
-Compare this figure to the expected return without a
credit check to see if it is worth implementing
22. 2015/16 3. Capi- -Sub rf = 6, rm = 0.14 and the different betas into the the
tal Asset Pricing CAPM equation
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Model
(a) The Betas of
four stocks in
a perfect capital
market are as follows:
²A = -1 ²B = 0 ²C = 1
²D = 2
Assume that the
market is in equilibrium, that the
returns on the
risk-free asset is
6% and that the
expected return
on the "market
portfolio" is 14%.
Calculate the expected returns
on
shares A, B, C
and D.
23. 2015/16 3. Capital Asset Pricing
Model
(b) Assume a perfect capital market in which investors are constrained to holding portfolios
that consist
of a single risky
asset and the
riskless asset. In
equilibrium the
following relationship between
-CAPM Equation: rb = rf +5ý
b (r˜ - rf)
-Define CAPM: The Capital Asset Pricing (CAPM) model
is a theory whereby the equilibrium rates of return on all
risky assets are a function of their covariance with the
market portfolio. It is a model that is used to determine the
expected rate of return on a security based on its risk characteristics. It describes the relationship that holds between
systematic risk and expected return for assets. Systematic
risks are market risks that cannot be diversified away, such
as interest rates.
-CML equation is used
-Equate the slopes of the CML and find rf
The Capital Asset Pricing (CAPM) model is a theory
whereby the equilibrium rates of return on all risky assets
are a function of their covariance with the market portfolio.
It describes the relationship that holds between systematic
risk and expected return for assets, in particular stocks.
Systematic risks are market risks that cannot be diversified away, such as interest rates.
Under CAPM, investors will choose a position on this capital market line at the equilibrium, by borrowing or lending
at the risk-free rate, as this will maximise their return for
a given level of risk. Therefore the risk-free rate (rf) is the
rate of interest in this market.
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two risky securities i and j holds:
Security i Security j
Exp. ret. (%) 18 25
Standard Dev.
(%) 8 12
What is the rate
of interest in this
market?
In equilibrium, the two securities i and j must be on the
same CML.
The equation of the CML is
r“ =5_5S
r˜5_5S)/
+Ã̃5
“][(
where 5_
“ is the expected return on an asset/portfolio
5_5S
is the risk free rate
r˜ is the expected market return
Ã̃is the standard deviation of the market returns
“ is the standard deviation of the asset/portfolio returns
5
The slope of the Capital Market Line(CML) is the Sharpe
Ratio of the market portfolio.
In equilibrium:
(r˜5_5S)/
Ã̃= (r˜5_5S)/
Ã̃
(0.18 - rf)/0.08 = (0.25 - rf)/0.12
Solve for rf
rf = 0.04
4%
24. Investment strat- An investor can reduce risk through investing in a diverse
egy past paper range of investments, where the returns of these investq?
ments are not highly correlated. The benefits of diversification only hold true if the
securities within a portfolio are not perfectly correlated.
An investor can reduce risk through investing in a diverse
range of investments, where the returns of these investments are not highly correlated. The benefits of diversification only hold true if the
securities within a portfolio are not perfectly correlated.
The diversified portfolio will include a mix of asset types
and investment vehicles in an attempt to limit exposure to
any single asset or risk.The positive performance of some
investments will neutralise the negative performance of
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others. For example, mutual funds are a portfolio of stocks
of many different companies.
Diversification can eliminate non-systematic/specific/idiosyncratic risk. However, diversification cannot eliminate
systematic (market/covariant/undiversifiable risk). This is
the risk that faces every firm in the economy and is due
to market conditions (interest rates/inflation rate/business
cycles etc). For example, a firm's earnings are positively
correlated with business cycles, so if there is a recession
all firms' earnings are negatively affected
Providing the rate of return on these stocks are not strongly correlated, the portfolio will have a lower variance than
any of the individual stocks. As the number of stocks in
the portfolio increases, the portfolio's variance decreases,
portraying the benefits in having a more diversified portfolio.
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1. 4) The target capital structure is the desired optimal Answer: TRUE
mix of debt and equity financing that most firms attempt to achieve and maintain.
2. 5) The cost of capital is the rate of return a firm must Answer: TRUE
earn on investments in order to increase the firm's
value.
3. 6) The cost of capital is used to decide whether a pro- Answer: TRUE
posed corporate investment will increase or decrease
a firm's stock price.
4. 7) The cost of capital reflects the cost of funds over Answer: TRUE
the long run measured at a given point in time, based
on the best information available.
5. 8) The cost of capital acts as a major link between a Answer: TRUE
firm's long-term investment decisions and the wealth
of the firm's owners as determined by the market
value of their shares.
6. 12) The cost of capital is a dynamic concept and it is Answer: TRUE
affected by economic and firm-specific factors such
as business risk and financial risk.
7. 14) The ________ is the rate of return that a firm
Answer: B
must earn on its investments in order to maintain the
market value of its stock.
A) yield to maturity
B) cost of capital
C) internal rate of return
D) modified internal rate of return
8. 15) The ________ is the rate of return required by the Answer: C
market suppliers of capital in order to attract their
funds to the firm.
A) yield to maturity
B) internal rate of return
C) cost of capital
D) modified internal rate of return
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9. 16) The cost of capital reflects the cost of funds
Answer: C
________.
A) that makes the net present value of a project equal
zero
B) at a given point in time
C) over a long-run time period
D) at current book values
10. 17) Although a firm's existing mix of financing
Answer: B
sources may reflect its target capital structure, it is
ultimately ________.
A) the internal rate of return that is relevant for evaluating the firm's future investment opportunities
B) the marginal cost of capital that is relevant for
evaluating the firm's future investment opportunities
C) the risk-free rate of return that is relevant for evaluating the firm's future investment opportunities
D) the risk-free rate of return that is relevant for evaluating the firm's future financing opportunities
11. 18) The ________ is a weighted average of the cost of Answer: C
funds which reflects the interrelationship of financing
decisions.
A) internal rate of return
B) sunk cost
C) cost of capital
D) risk-free rate
12. 19) The ________ is the firm's desired optimal mix of Answer: D
debt and equity financing.
A) book value
B) market value
C) cost of capital
D) target capital structure
13. 20) The cost to a firm of each type of capital is depen- Answer: D
dent upon ________.
A) the risk-free rate of bonds plus the business risk of
the firm
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B) the risk-free rate of each type of capital plus the
business risk of the firm
C) the risk-free rate of each type of capital plus the
financial risk of the firm
D) the risk-free rate of each type of capital plus the
business risk and the financial risk of the firm
14. 21) In order to recognize the interrelationship beAnswer: C
tween financing and investments, a firm should use
________ when evaluating an investment.
A) the least costly source of financing
B) the most costly source of financing
C) the weighted average cost of all financing sources
D) the current opportunity cost
15. 22) The four basic sources of long-term funds for a Answer: D
firm are ________.
A) current liabilities, long-term debt, common stock,
and preferred stock
B) current liabilities, long-term debt, common stock,
and retained earnings
C) long-term debt, paid-in capital in excess of par,
common stock, and retained earnings
D) long-term debt, common stock, preferred stock,
and retained earnings
16. 23) Which of the following is true of long-term funds? Answer: C
A) They provide an easy way to reduce financing costs
because they are relatively cheaper than short-term
funds.
B) They are a type of investment fund which invests
in money market investments of high quality and low
risk.
C) They are the sources that supply the financing necessary to support a firm's capital budgeting activities.
D) They are the funds available to a business on the
basis of inventory held and require detailed inventory
tracking.
17.
Answer: B
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24) Which of the following is a source of long-term
funds?
A) commercial paper
B) retained earnings
C) factoring
D) money market instruments
18. 2) The marginal cost of capital is a relevant cost of
Answer: TRUE
capital for evaluating a firm's future investment opportunities.
19. 3) Generally, the order of cost, from the least expen- Answer: D
sive to the most expensive, for long-term capital of a
corporation is ________.
A) new common stock, retained earnings, preferred
stock, long-term debt
B) common stock, preferred stock, long-term debt,
short-term debt
C) preferred stock, new common stocks, common
stock, retained earnings
D) long-term debt, preferred stock, retained earnings,
new common stock
20. 4) Generally the least expensive source of long-term Answer: C
capital is ________.
A) retained earnings
B) preferred stock
C) long-term debt
D) common stock
21. 1) In general, floatation costs include two components, underwriting costs and administrative costs.
Answer: TRUE
22. 2) Flotation costs reduce the net proceeds from the
sale of a bond whether sold at a premium, at a discount, or at its par value.
Answer: TRUE
23. 3) The net proceeds used in calculation of the cost of Answer: TRUE
long-term debt are funds actually received from the
sale after paying for flotation costs and taxes.
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24. 4) When the net proceeds from sale of a bond equal Answer: TRUE
its par value, the before-tax cost would just equal the
coupon interest rate.
25. 5) From a bond issuer's perspective, the IRR on a
Answer: TRUE
bond's cash flows is its cost to maturity, from the
investor's perspective, the IRR on a bond's cash flows
is the yield to maturity (YTM).
26. 9) A tax adjustment must be made in determining the Answer: A
cost of ________.
A) long-term debt
B) common stock
C) preferred stock
D) retained earnings
27. 10) The ________ from the sale of a security are the Answer: C
funds actually received from the sale after ________.
A) gross proceeds, adding the after-tax costs
B) gross proceeds, reducing the flotation costs
C) net proceeds, reducing the flotation costs
D) net proceeds, adding the after-tax costs
28. 13) The before-tax cost of debt for a firm, which has
a marginal tax rate of 40 percent, is 12 percent. The
after-tax cost of debt is ________.
A) 4.8 percent
B) 6.0 percent
C) 7.2 percent
D) 12 percent
Answer: C
29. 14) The specific cost of each source of long-term
Answer: D
financing is based on ________ and ________ costs.
A) before-tax, historical
B) after-tax, historical
C) before-tax, book value
D) after-tax, current
30.
Answer: B
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15) When determining the after-tax cost of a bond, the
face value of the issue must be adjusted to the net
proceeds amounts by considering ________.
A) the risks
B) the flotation costs
C) the approximate returns
D) the taxes
31. 19) Debt is generally the least expensive source of
Answer: C
capital. This is primarily due to ________.
A) the fixed interest payments
B) the priority of claims on assets and earnings in the
event of liquidation
C) the tax deductibility of interest payments
D) the secured nature of a debt obligation
32. 1) Since preferred stock is a form of ownership, it has Answer: TRUE
no maturity date.
33. 4) The cost of preferred stock is typically higher than Answer: TRUE
the cost of long-term debt (bonds) because the cost
of long-term debt (interest) is tax deductible.
34. 5) The cost of preferred stock is the ratio of the pre- Answer: TRUE
ferred stock dividend to a firm's net proceeds from the
sale of the preferred stock.
35. 1) The cost of common stock equity may be measured Answer: TRUE
using either the constant-growth valuation model or
the capital asset pricing model.
36. 2) The constant-growth model uses the market price Answer: TRUE
as a reflection of the expected risk-return preference
of investors in the market place.
37. 3) The cost of common stock equity capital represents Answer: TRUE
the return required by existing shareholders on their
investment.
38.
Answer: TRUE
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4) The cost of retained earnings is always lower than
the cost of a new issue of common stock due to the
absence of flotation costs when financing projects
with retained earnings.
39. 5) A firm can retain more of its earnings if it can
Answer: TRUE
convince its stockholders that it will earn at least their
required return on the reinvested funds.
40. 7) The cost of retained earnings is generally higher Answer: TRUE
than both the cost of debt and cost of preferred stock.
41. 8) One measure of the cost of common stock equity Answer: TRUE
is the rate at which investors discount the expected
common stock dividends of the firm to determine its
share value.
42. 11) Using the Capital Asset Pricing Model (CAPM), the Answer: TRUE
cost of common stock equity is the return required by
investors as compensation for a firm's nondiversifiable risk.
43. 12) Use of the capital asset pricing model (CAPM) in Answer: TRUE
measuring the cost of common stock equity differs
from the constant-growth valuation model in that it
directly considers the firm's risk as reflected by beta.
44. 13) When the constant-growth valuation model is
Answer: TRUE
used to find the cost of common stock equity capital,
it can easily be adjusted for flotation costs to find the
cost of new common stock, the capital asset pricing
model (CAPM) does not provide a simple adjustment
mechanism.
45. 14) The cost of new common stock is normally greater Answer: TRUE
than any other long-term financing cost.
46. 18) According to the CAPM, the required return of an Answer: TRUE
asset is the sum of risk-free rate of return and beta
times the risk premium.
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47. 19) The cost of equity for Tangshan Mining would be Answer: TRUE
18.00 percent if the expected return on U.S. Treasury
Bills is 5.00 percent, the market risk premium is 10.00
percent, and the firm's beta is 1.3.
48. 21) The cost of common stock equity is ________.
Answer: B
A) the cost of the guaranteed stated dividend expected by the stockholders
B) the rate at which investors discount the expected
dividends of the firm to determine its share value
C) the after-tax cost of the interest obligations
D) the historical cost of floating the stock issue
49. 22) The cost of common stock equity may be estimat- Answer: C
ed by using the ________.
A) yield curve
B) break-even analysis
C) Gordon model
D) DuPont analysis
50. 23) The cost of common stock equity may be estimat- Answer: B
ed by using the ________.
A) yield curve
B) capital asset pricing model
C) break-even analysis
D) DuPont analysis
51. 24) The cost of retained earnings is ________.
Answer: C
A) less than the cost of debt
B) equal to the cost of a new issue of common stock
C) equal to the cost of common stock equity
D) irrelevant to the investment/financing decision
52. 25) A corporation has concluded that its financial risk Answer: D
premium is too high. In order to decrease this, the firm
can ________.
A) increase the proportion of long-term debt to decrease the cost of capital
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crease the cost of capital
C) decrease the proportion of common stock equity to
decrease financial risk
D) increase the proportion of common stock equity to
decrease financial risk
53. 26) The constant-growth valuation model is based on Answer: D
the premise that the value of a share of common stock
is ________.
A) the sum of the dividends and expected capital
appreciation
B) determined based on an industry standard P/E multiple
C) determined by using a measure of relative risk
called correlation coefficient
D) equal to the present value of all expected future
dividends
54. 27) In calculating the cost of common stock equity, Answer: D
the model which describes the relationship between
the required return and the nondiversifiable risk of the
firm is ________.
A) the constant-growth model
B) the NPV model
C) the variable growth model
D) the capital asset pricing model
55. 28) A firm has a beta of 1.2. The market return equals Answer: D
14 percent and the risk-free rate of return equals 6
percent. The estimated cost of common stock equity
is ________.
A) 6 percent
B) 7.2 percent
C) 14 percent
D) 15.6 percent
56. 29) One major expense associated with issuing new Answer: D
shares of common stock is ________.
A) coupon payment
B) sunk cost
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C) overvaluation
D) underpricing
57. 30) One of the circumstances in which the Gordon
Answer: D
growth valuation model for estimating the value of a
share of stock should be used is ________.
A) declining dividends
B) an erratic dividend stream
C) the lack of data on dividend payments
D) a steady growth rate in dividends
58. 33) Using the capital asset pricing model, the cost
of common stock equity is the return required by
investors as compensation for ________.
A) the specific risk of a firm
B) a firm's unsystematic risk
C) price volatility of the stock
D) a firm's nondiversifiable risk
Answer: D
59. 35) In comparing the constant-growth model and the Answer: B
capital asset pricing model (CAPM) to calculate the
cost of common stock equity, ________.
A) the CAPM ignores risk, while the constant-growth
model directly considers risk as reflected in the beta
B) the CAPM directly considers risk as reflected in
the beta, while the constant-growth model uses the
market price as a reflection of the expected risk-return
preference of investors
C) the CAPM directly considers risk as reflected in the
beta, while the constant growth model uses dividend
expectations as a reflection of risk
D) the CAPM indirectly considers risk as reflected in
the market return, while the constant growth model
uses dividend expectations as a reflection of risk
60. 36) In calculating the cost of common stock equity, Answer: C
________.
A) the use of the capital asset pricing model (CAPM)
is often preferred, because the data required are more
readily available
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B) the use of the CAPM is preferred, because it directly
considers risk and the effect of inflation on the stock
prices
C) the use of the constant-growth valuation model is
often preferred, because the data required are more
readily available
D) the use of the constant-growth valuation model is
often preferred, because it has a stronger theoretical
foundation
61. 40) The cost of new common stock financing is higher Answer: A
than the cost of retained earnings due to ________.
A) flotation costs and underpricing
B) flotation costs and overpricing
C) flotation costs and commission costs
D) commission costs and overpricing
62. 41) Since retained earnings are viewed as a fully sub- Answer: A
scribed issue of additional common stock, the cost of
retained earnings is ________.
A) less than the cost of new common stock equity
B) equal to the cost of new common stock equity
C) greater than the cost of new common stock equity
D) not related to the cost of new common stock equity
63. 42) Which of the following is a reason for a firm to
Answer: D
underprice new issues?
A) When the market is in equilibrium, additional demand for shares can be achieved only at a higher
price.
B) When additional shares are issued, each share's
percent of ownership in a firm is diluted, thereby justifying a higher share value.
C) When additional shares are issued, each share's
percent of ownership in a firm is concentrated, thereby justifying a lower share value.
D) When the market is in equilibrium, additional demand for shares can be achieved only at a lower price.
64.
Answer: TRUE
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1) The weighted average cost that reflects the interrelationship of financing decisions can be obtained by
weighing the cost of each source of financing by the
target proportion in a firm's capital structure.
65. 2) The weighted average cost of capital (WACC) re- Answer: TRUE
flects the expected average future cost of capital over
the long run.
66. 4) A firm may face increase in the weighted average Answer: TRUE
cost of capital either when retained earnings have
been exhausted or due to increases in debt, preferred
stock, and common equity costs as additional new
funds are required.
67. 5) In computing the weighted average cost of capital, Answer: TRUE
the historical weights are either book value or market
value weights based on actual capital structure proportions.
68. 7) In computing the weighted average cost of capital, Answer: TRUE
from a strictly theoretical point of view, the preferred
weighing scheme is target market value proportions.
69. 9) Weights that use accounting values to measure the Answer: TRUE
proportion of each type of capital in a firm's financial
structure are called book value weights.
70. 11) Target weights are either book value or market val- Answer: TRUE
ue weights based on a firm's desired capital structure
proportions.
71. 13) The weights used in weighted average cost of
capital must be ________.
A) greater than 50%
B) nonnegative
C) less than zero
D) zero
Answer: B
72.
Answer: D
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14) The preferred capital structure weights to be used
in the weighted average cost of capital are ________.
A) book value weights
B) nominal weights
C) historic weights
D) target weights
73. 17) As the need for capital increases beyond the opti- Answer: B
mum capital structure, the cost of debt financing will
________ the firm's weighted average cost of capital.
A) increase, lowering
B) increase, raising
C) decrease, lowering
D) decrease, raising
74. 18) When discussing weighing schemes for calculat- Answer: A
ing the weighted average cost of capital, ________.
A) market value weights are preferred over book value
weights and target weights are preferred over historical weights
B) book value weights are preferred over market value
weights and target weights are preferred over historical weights
C) book value weights are preferred over market value weights and historical weights are preferred over
target weights
D) market value weights are preferred over book value weights and historical weights are preferred over
target weights
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1. 113. Management of Kelly, Inc. uses
CAPM to calculate the estimated cost of
common equity. Which of the following
would reduce the firm's estimated cost of
common equity?
a. A reduction in the risk-free rate.
b. An increase in the firm's beta.
c. An increase in expected inflation.
d. An increase in the risk-free interest
rate.
113. (a) The requirement is to
identify the factor that affects the
calculation of the cost of equity
using CAPM.
Answer (a) is correct because
a reduction in the risk-free rate
would reduce the required return demanded by stockholders.
Answers (b), (c), and (d) are incorrect because an increase in
these items would cause the estimated cost of common equity
to increase.
2. **114. In general, it is more expensive for
a company to
finance with equity than with debt because
114. (b) The requirement is to
identify the reason why it is
more expensive to finance with
equity than with debt. Answer
(b) is correct because equity
a. Long-term bonds have a maturity date holders are subject to more risk
and must,
than debt holders. Therefore,
therefore, be repaid in the future.
they require a higher rate of reb. Investors are exposed to greater risk turn.
with equity
capital.
c. The interest on debt is a legal obligation.
d. Equity capital is in greater demand
than debt capital.
3. 115. Which of the following is not a characteristic of the
capital asset pricing model for estimating
the cost of equity?
115. (d) The requirement is to
identify the item that does
not describe a characteristic of
the capital asset pricing model. Answer (d) is correct bea. The model is simple to understand and cause CAPM does not include
implement.
the stock's market price in its
b. The model can be applied to all firms. computation. Answers (a), (b),
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c. The model does not rely on any divi- and (c) are incorrect because
dend assumptions
they are all characteristics of
or growth of dividends.
CAPM method.
d. It is based upon the stock's actual market price.
4. 116. Management of Terra Corp. is attempting to estimate
the firm's cost of equity capital. Assuming that the firm
has a constant growth rate of 5%, a forecasted dividend of
$2.11, and a stock price of $23.12, what
is the estimated cost of common equity
using the dividend-yield plus-growth approach?
a. 9.1%
b. 14.1%
c. 15.6%
d. 12.3%
116. (b) The requirement is to
apply the dividend-yield plusgrowth approach to calculate
the cost of common equity.
The formula for estimated cost
of common equity is equal
to the expected dividend divided
by the stock price plus the
growth rate. Therefore, the correct answer is (b) because
the estimated cost of equity is
14.1% [(2.11/23.13) + 5%].
5. 117. If nominal interest rates increase
substantially but
expected future earnings and dividend
growth for a firm over the long run are not
expected to change, the firm's stock price
will
117. (b) The requirement is to
identify the impact of an
increase in nominal interest
rates on a company's share
price.
Answer (b) is correct because
an increase in the nominal
a. Increase.
interest rate would mean that inb. Decrease.
vestors would expect a higher
c. Stay constant.
return on all investments. If the
d. Change, but in no determinable direc- stock earnings and dividend
tion.
growth is unchanged, the stock
price will decrease.
6. 118. Assume that two companies, Com- 118. (a) The requirement is to
pany X and Company Y, are alike in all
identify the impact of
respects, except the market value of the investor expectations on stock
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outstanding common shares of Company price. Answer (a) is correct
X is greater than the market value of Com- because if investors expect a
pany Y shares. This may indicate that
higher dividend growth rate, the
market value of the common
a. Company X's investors expect higher shares will be greater.
dividend growth
than Company Y's investors.
Answer (b) is incorrect because
b. Company X's investors expect lower if investors expect a lower dividividend growth
dend
than Company Y's investors.
growth rate, the market value of
c. Company X's investors have longer ex- common shares will be lower.
pected holding
Answers (c) and (d) are incorperiods than Company Y's investors.
rect because holding periods
d. Company X's investors have shorter are
expected holding
not related to the market value
periods than Company Y's investors.
of common shares.
7. 119. Which of the following methods explicitly recognizes a
firm's risk when determining the estimated cost of equity?
a. Capital asset pricing model.
b. Dividend-yield-plus-growth model.
c. Bond-yield-plus model.
d. Return on equity.
119. Answer (a) The requirement is to identify the technique that explicitly considers
risk in calculating the firm's estimated cost of equity. Answer
(a) is correct because CAPM is
the only technique that explicitly considers risk in the form
of the firm's beta. Beta measures the relationship between
the price volatility of the market
as a whole and the price volatility of the individual stock.
Answers (b) and (c) are incorrect because they do not directly
incorporate the firm's risk in the
calculation of the estimated cost
of equity. Answer (d) is incorrect because it is not utilized to
determine the estimated cost of
equity.
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8. 120. Assume a firm is expected to pay a 120. (c) The requirement
dividend of $5.00 per share this year. The is to use the divifirm along with the dividend is expected dend-yield-plus-growth- rate apto grow at a rate of 6%. If the current
proach to calculate the estimatmarket price of the stock is $60 per share, ed cost of equity. The estimatwhat is the estimated cost of equity?
ed cost of equity is equal to the
dividend divided by the price of
a. 8.3%
the stock + the growth rate. Acb. 6.0%
cordingly, answer (c) is correct
c. 14.3%
because the estimated cost of
d. 12.0%
equity is equal to 14.3% [($5 ÷
$60) + 6%].
9. 121. The bond-yield-plus approach to estimating the cost of common equity involves adding a risk premium of 3% to 5%
to the firm's
a. Cost of short-term debt.
b. Cost of long-term debt.
c. Return on assets.
d. Return on equity.
121. (b) The requirement is to
identify how the bond-yield- plus
approach to estimating the cost
of equity is applied.
Answer (b) is correct because
the bond-yield-plus approach involves adding a risk premium of
3% to 5% to the interest rate of
the firm's long-term debt.
Answers (a), (c), and (d) are
incorrect because they involve
items that are not components
of the formula.
10. **122. In practice, dividends
122. (a) The requirement is to
identify the characteristic
a. Usually exhibit greater stability than
of typical dividend policies. Anearnings.
swer (a) is correct because
b. Fluctuate more widely than earnings. management is hesitant to
c. Tend to be a lower percentage of earn- decrease dividends. Therefore,
ings for mature
they
firms.
are more stable than earnings.
d. Are usually changed every year to reflect earnings
Answer (b) is incorrect because
changes.
they do not fluctuate more wide4 / 13
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ly than earnings. Answer (c) is
incorrect because dividends
tend to be higher for mature
firms.
Answer (d) is incorrect because
dividends are usually not
changed every year.
11. Items 123 and 124 are based on the following information:
Martin Corporation
STATEMENT OF FINANCIAL POSITION
December 31, 2012
(Dollars in millions)
Assets:
Current assets $ 75
Plant and equipment 250
Total assets: $325
Liabilities and shareholders' equity
Current liabilities $ 46
Long-term debt (12%) 64
Common equity:
Common stock, $1 par 10
Additional paid in capital 100
Retained earnings 105
Total liabilities and shareholders' equity
$325
Additional data
+The long-term debt was originally issued at par ($1,000/bond) and is currently
trading at $1,250 per bond.
+Martin Corporation can now issue debt
at 150 basis points over US Treasury
bonds.
+The current risk-free rate (US Treasury
bonds) is 7%.
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123. (c) The requirement is to
calculate the current net
cost of debt. The current cost of
debt before tax is 8.5% (7%
Treasury bond rate + 1.5%), and
the cost of debt after tax
is 5.1% [8.5% × (1 - 40% tax
rate)].
Therefore, the correct answer is
(c).
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+Martin's common stock us currently
selling at $32 per share.
+The expected market return is currently
15%.
+The beta value for Martin is 1.25.
+Martin's effective corporate income tax
rate is 40%
**123. Martin Corporation's current net
cost of debt is
a. 5.5%
b. 7.0%
c. 5.1%
d. 8.5%
12. Items 123 and 124 are based on the following information:
Martin Corporation
STATEMENT OF FINANCIAL POSITION
December 31, 2012
(Dollars in millions)
Assets:
Current assets $ 75
Plant and equipment 250
Total assets: $325
Liabilities and shareholders' equity
Current liabilities $ 46
Long-term debt (12%) 64
Common equity:
Common stock, $1 par 10
Additional paid in capital 100
Retained earnings 105
Total liabilities and shareholders' equity
$325
Additional data
+The long-term debt was originally is6 / 13
124. (d) The requirement is to
calculate the cost of capital using CAPM. The CAPM formula
is Cost of capital =
Risk free rate + (Market rate Risk-free rate) × Beta.
In this case, the estimated cost
of equity is equal to
17% [7% + (15% - 7%) × 1.25].
Thus, the answer is (d).
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sued at par ($1,000/bond) and is currently
trading at $1,250 per bond.
+Martin Corporation can now issue debt
at 150 basis points over US Treasury
bonds.
+The current risk-free rate (US Treasury
bonds) is 7%.
+Martin's common stock us currently
selling at $32 per share.
+The expected market return is currently
15%.
+The beta value for Martin is 1.25.
+Martin's effective corporate income tax
rate is 40%
**124. Using Capital Asset Pricing Model
(CAPM) Martin Corporation's current cost
of common equity is
a. 8.75%
b. 10.00%
c. 15.00%
d. 17.00%
13. *Items 125 and 126 are based on the fol- 125. (a) The requirement is to
lowing information:
calculate the weighted -average cost of capital. The weightDQZ Telecom is considering a project for ed-average cost of capital is dethe coming yearthat will cost $50 million. termined by summing the cost
DQZ plans to use the following combiof each funding source weightnation of debt and equity to finance the ed by its percentage of the
investment.
total. In this case, the funds
+Issue $15 million of 20-year bonds at a received from the debt are
price at a price of 101, with a coupon rate equal to 99% (101% - 2%) ×
of 8%, and flotation costs of 2% of par. $15,000,000, or $14,850,000,
+Use $35 million of funds generate from and the funds from equity is $35
earnings.
million, the amount of retained
earnings. Therefore, total fundThe equity market is expected to earn
ing is $49,850,000.
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12%. US Treasury bonds are currently
yielding 5%. The beta coefficient for DQZ
is estimated to be .60. DQZ is subject to
an effective corporate income tax rate of
40%.
The weighted-average cost
of capital is equal to
($14,850,000/$49,850,000) ×
7% +
($35,000,000/$49,850,000) ×
12% = 10.50%.
**125. Assume that the after-tax costs of
debt is 7% and the cost of equity is 12%. Thus, the answer is (a).
Determine the weighted-average cost of
capital.
a. 10.50%
b. 8.50%
c. 9.50%
d. 6.30%
14. *Items 125 and 126 are based on the fol- 126. (a) The requirement is to
lowing information:
use the capital asset pricing
model to compute the cost of
DQZ Telecom is considering a project for equity (expected return of equity
the coming yearthat will cost $50 million. holders). The CAPM formula is
DQZ plans to use the following combiCost of equity =
nation of debt and equity to finance the Risk-free interest rate + (Market
investment.
rate - Risk-free interest rate) ×
+Issue $15 million of 20-year bonds at a Beta.
price at a price of 101, with a coupon rate
of 8%, and flotation costs of 2% of par. Therefore, the expected return
+Use $35 million of funds generate from =
earnings.
9.2% [5% + (12% - 5%) × .60],
or answer (a).
The equity market is expected to earn
12%. US Treasury bonds are currently
yielding 5%. The beta coefficient for DQZ
is estimated to be .60. DQZ is subject to
an effective corporate income tax rate of
40%.
**126. The Capital Asset Pricing Model
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(CAPM) computes the expected return on
a security by adding the risk-free rate
of return to the incremental yield of the
expected market return that is adjusted
by the company's beta. Compute DQZ's
expected rate of return.
a. 9.20%
b. 12.20%
c. 7.20%
d. 12.00%
15. *127. When calculating the cost of capital, 127. (b) The requirement is to
the cost assigned to retained earnings specify the cost of capital
should be
assigned to retained earnings.
Answer (b) is correct because
a. Zero.
newly issued or "external" comb. Lower than the cost of external com- mon equity is more costly than
mon equity.
retained earnings because the
c. Equal to the cost of external common company incurs issuance costs
equity.
when raising new funds.
d. Higher than the cost of external common equity.
Answer (a) is incorrect because
the cost of retained earnings is
the rate of return stockholders
require on retained equity capital. The opportunity cost of retained funds will be positive.
Answer (c) is incorrect because
retained earnings will always be
less costly than external equity
financing because earnings retention does not involve the payment of issuance costs. Answer
(d) is incorrect because
the cost is lower as described
above.
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16. 128. According to the Capital Asset Pric- 128. (c) The requirement is to
ing Model (CAPM) the relevant risk of a identify the relevant risk of a sesecurity is its
curity according to CAPM. Answer (c) is correct because sysa. Company-specific risk.
tematic risk is the component of
b. Diversifiable risk.
the total risk of a security that
c. Systematic risk.
cannot be eliminated through did. Total risk.
versification and is relevant to
valuation.
Answer (a) is incorrect because
"company-specific" risk can be
eliminated through portfolio diversification and is not relevant
to the valuation of the security.
Answer (b) is incorrect because
"diversifiable" risk can be eliminated through portfolio diversification and is not relevant to the
valuation of the security. Answer
(d) is incorrect because only the
systematic component of total
risk is relevant to security valuation.
17. **129. Hi-Tech Inc. has determined that it
can minimize its weighted-average cost
of capital (WACC) by using a debt/ equity
ratio of 2/3. If the firm's cost of debt is 9%
before taxes, the cost of equity is estimated to be 12% before taxes, and the
tax rate is 40%, what is the firm's WACC?
a. 6.48%
b. 7.92%
c. 9.36%
d. 10.80%
129. (c) The requirement is to
calculate the weighted-average
cost of capital (WACC). Answer
(c) is correct because the
WACC is calculated as 9.36%
{2/5 × [9% × (1 - 40%)]} + (3/5
× 12%).
Answers (a), (b), and (d) are incorrect because they represent
inaccurate computations of the
cost of the financing.
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18. Items 130 through 132 are based on the 130. (b) Answer (b) is correct
following information:
because the weighted average
cost of capital is calculated as
A new company requires $1 million of fi- follows:
nancing and is considering two arrange- = (Weight of equity) × (Cost of
ments as shown in the table below.
equity) + (Weight of debt)
× (Before-tax cost of debt) × (1 Arrangement
Tax rate)
Amount of equity raised
= (.7) × (.12) + (.3) × (.08) × (1 Amount of debt financing
.3) = .084 + .0168 = 10%
Before-tax cost of debt
#1; $700,000; $300,000; 8% per annum
Answer (a) is incorrect because
#2; $300,000; $700,000; 10% per annum 8% is the cost of equity before
tax. Answer (c) is incorrect beIn the first year of operations, the compa- cause this solution uses the beny is expected to have sales revenues of fore-tax cost of debt rather than
$500,000, cost of sales of $200,000, and the after-tax cost of debt. Angeneral and administrative expenses of swer (d) is incorrect because
$100,000. The tax rate is 30%, and there 12% is the cost of equity.
are no other items on the income statement.
All earnings are paid out as dividends at
year-end.
130. If the cost of equity were 12%, then
the weightedaverage cost of capital under Arrangement #1, to the nearest full
percentage point, would be
a. 8%
b. 10%
c. 11%
d. 12%
19. Items 130 through 132 are based on the 131. (d) The requirement is to
following information:
identify the true statement
about the financing alternatives.
A new company requires $1 million of fi- Answer (d) is correct because
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nancing and is considering two arrange- taxes payable will be higher unments as shown in the table below.
der Arrangement #1 because
with lower interest expense, taxArrangement
able income will be higher.
Amount of equity raised
Amount of debt financing
Under Arrangement #1, interest
Before-tax cost of debt
expense will be $300,000
#1; $700,000; $300,000; 8% per annum
(.08) = $24,000, while under
#2; $300,000; $700,000; 10% per annum Arrangement #2, interest expense will be $700,000 (.10) =
In the first year of operations, the compa- $70,000 per annum. Answer (a)
ny is expected to have sales revenues of is incorrect because expected
$500,000, cost of sales of $200,000, and gross margin is unaffected by
general and administrative expenses of the choice of financing arrange$100,000. The tax rate is 30%, and there ment. Answer (b) is incorrect
are no other items on the income state- because the degree of operatment.
ing leverage is not affected by
the method of financing. Answer
All earnings are paid out as dividends at (c) is incorrect because interyear-end.
est expense will be higher under
Arrangement #2.
131. Which of the following statements
comparing the two
financing arrangements is true?
a. The company will have a higher expected gross
margin under Arrangement #1.
b. The company will have a higher degree
of operating
leverage under Arrangement #2.
c. The company will have higher interest
expense under
Arrangement #1.
d. The company will have higher expected
tax expense
under Arrangement #1.
20.
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Items 130 through 132 are based on the 132. (a) The requirement is to
following information:
calculate the return on equity
and the debt ratio. Answer (a) is
A new company requires $1 million of fi- correct because return on equinancing and is considering two arrange- ty is calculated as net income
ments as shown in the table below.
divided by the amount of equity invested. The debt ratio is
Arrangement
the amount of debt financing diAmount of equity raised
vided by total assets. CalculaAmount of debt financing
tions of the two ratios for both
Before-tax cost of debt
financing arrangements are as
#1; $700,000; $300,000; 8% per annum
follows:
#2; $300,000; $700,000; 10% per annum # 1; # 2
Sales revenue $500,000;
In the first year of operations, the compa- $500,000
ny is expected to have sales revenues of Cost of sales 200,000; 200,000
$500,000, cost of sales of $200,000, and General & admin. expense
general and administrative expenses of 100,000; 100,000
$100,000. The tax rate is 30%, and there Interest expense 24,000;
are no other items on the income state- 70,000
ment.
Taxable income $176,000;
$130,000
All earnings are paid out as dividends at Tax payable (30%) 52,800;
year-end.
39,000
Net income $123,200; $91,000
132. The return on equity will be <List A> Equity invested 700,000;
and the debt ratio will be <List B> un300,000
der Arrangement #2, as compared with
Arrangement #1.
Return on eqList A; List B
uity 123,200/700,000;
91,000/300,000
a. Higher Higher
17.6%; 30.3%
b. Higher Lower
c. Lower Higher
Debt ratio 300,000/1,000,000;
d. Lower Lowe
700,000/1,000,000
.3 .7
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1. Portfolio risk is a
weighted average of
the relevant risks of
the different stocks in
the portfolio.
2. The principal way value is increased is by invest- projects that earn
ing in
more than their cost of
capital.
3. A project's future cash flows can be forecasted
and that those cash flows can be
discounted to find their
present value.
Then if the PV of
the future cash flows
exceeds the project's
cost, the firm's value
will increase if the project is accepted.
However, we need a
discount rate to find
the PV of these future cash flows, and
that discount rate is
the firm's cost of capital.
4. When you finish this chapter, you should be able • Estimate the costs of
to:
different capital components—debt, pre• Explain why the weighted average cost of capital ferred stock,
(WACC) is used in capital budgeting.
retained earnings, and
common stock.
• Combine the different component costs
to determine the firm's
WACC.
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These concepts are
necessary to understand the firm's capital
budgeting process.
5. 10-1 An Overview of the Weighted Average
Cost of Capital (WACC)
When calculating the
WACC, our concern is with capital
Table 10.1 shows Allied Food Product's balance that must be providsheet as presented in Chapter 3, with three addi- ed by investors—intertions:
est-bearing debt, preferred stock, and com(1) the actual capital supplied by investors (banks, mon equity.
bondholders, and stockholders), calculated using
the accounting-based book values;
Accounts payable and
accruals, which arise
(2) the market values of the investor-supplied cap- spontaneously when
ital; and
capital budgeting projects are undertaken,
(3) the target capital structure that Allied plans to are not included as
use in the future.
part of investor-supplied capital because
they do not
come directly from investors.
6. 10-1 An Overview of the Weighted Average
Cost of Capital (WACC) - continued
The market value of
equity is the number of shares of stock
Looking at column 1 of Table 10.1, we see that
outstanding multiplied
using the accounting-based book values, Allied's by the current stock
capital consists of 47.8% debt and 52.2% equity. price.
Allied's investors are more concerned about the
current market value of the company's debt and
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Recall from Chapter 3
that Allied has 50 mil-
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equity, which are shown in column 2 of Table 10.1. lion shares of comTo keep things relatively simple, we assume that mon stock outstandthe market value of Allied's debt is equal to its
ing, and the combook value (i.e., we assume that its average out- pany's stock currently
standing debt is trading at its par value).
trades at $23.06 per
share, which means
that the market value
of its equity is $1.153
billion.
Because the market
value of its equity exceeds the book
value of its equity,
we see that Allied's
market-based capital
structure has a higher
percentage of equity
(57.3%) than the capital structure that was
calculated using its accounting-based book
values (52.2%).
7. Although these market-based numbers are a useful starting point, what ultimately matters is the
target capital structure, which refers to how Allied
plans to
raise capital to fund its future projects.
The mix of debt, preferred stock, and
common equity the
firm plans to raise to
fund its future projects.
As we will see, there
is an optimal capital
structure—one where
the percentages of
debt, preferred stock,
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and common equity
maximize the firm's
value.
As shown in column
3 of Table 10.1, Allied Food has concluded that its target capital structure should include 45% debt, 2%
preferred stock, and
53% common equity;
and in the future it
plans to raise capital in
those proportions.
8. Capital Components
one of the types of
capital used by firms to
raise funds
The particular types of
capital used by the
firm—that is, its debt,
preferred stock, and
common equity.
9. The cost of each component is called its compo- These costs are then
nent cost;
combined to form a
weighted average cost
for example, Allied can borrow money at 10%, so of capital, which is
its component cost of debt is 10%.
used in the firm's capital budgeting analysis.
Throughout this chapter, we concentrate on
the three major capital
components.
The following symbols
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identify the cost
and weight of each:
10. rd = interest rate on the firm's new debt = before-tax component cost of debt.
It can be found in several ways, including
calculating the yield to
maturity on the firm's
currently outstanding
bonds.
11. rd (1-T) = after-tax component cost of debt, where rd(1 - T) is the debt
T is the firm's marginal tax rate.
cost used to calculate
the weighted average
cost of capital.
As we shall see, the
after-tax cost of debt
is lower than its before-tax cost because
interest is tax deductible.
12. rp = component cost of preferred stock, found as Preferred dividends
the yield investors expect to earn on the preferred are not tax deductible;
stock.
hence, the before- and
after-tax costs of preferred are equal.
13. rs = component cost of common equity raised by It is the rs developed
retaining earnings, or internal equity.
in Chapters 8 and 9
and defined there as
the rate of return that
investors require on a
firm's common stock.
Most firms, once they
have become well established, obtain all
of their new equity
as retained earnings;
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hence, rs
is their cost of all new
equity.
14. re = component cost of external equity, or common As we will see, re is
equity raised by issuing new stock.
equal to rs plus a factor that reflects the
cost of issuing new
stock.
Note, though, that established firms such
as Allied Food rarely
issue new stock;
hence, re is rarely a
relevant consideration
except for very young,
rapidly growing firms.
15. wd, wp, wc = target weights of debt, preferred
stock, and common equity (which includes retained earnings, internal equity, and new common
stock,
external equity).
The weights are the
percentages of the different types of capital
the firm plans to use
when it raises capital
in the future.
Target weights may
differ from actual current weights.
16. Weighted Average Cost of Capital (WACC)
the firm's weighted average, or overall, cost
of capital
We assume at this
point that all new
common equity is
raised as retained
earnings, as is true
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for most companies;
hence, the cost of
common equity is rs:
Note that only debt
has a tax adjustment
factor, (1 - T).
As discussed in the
next section, this is because interest on debt
is tax deductible, but
preferred dividends
and the returns on
common stock (dividends and capital
gains) are not.
17. Before-Tax Cost of Debt, rd
The interest rate the
firm must pay on new
debt.
Firms can estimate
rd by asking their
bankers what it will
cost to borrow or
by finding the yield
to maturity on their
currently outstanding
debt (as we
illustrated in Chapter
7).
18. After-Tax Cost of Debt, rd(1-T)
The relevant cost of
new debt, taking into
We use the after-tax cost of debt in calculating the account the tax deWACC because we are interested in maximizing ductibility of interest;
the value of the firm's stock, and the stock price used to calculate the
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depends on after-tax cash flows.
WACC.
Because we are concerned with after-tax cash
flows and because cash flows and rates of return
should be calculated on a comparable basis, we
adjust the
interest rate downward due to debt's preferential
tax treatment.
This is the interest rate
on new debt, rd,
less the tax savings
that result because
interest is tax deductible:
In effect, the government pays part of the
cost of debt because
interest is tax
deductible.
19. We are interested in the cost of new debt because capital budgeting deciour primary concern with the cost of capital is its sions.
use in
For example, would
a new machine earn
a return greater than
the cost of the capital
needed to acquire the
machine?
The rate at which the
firm has borrowed in
the past is irrelevant
when answering this
question because we
need to know the cost
of new capital.
For these reasons,
the yield to maturity on outstanding debt
(which reflects current
market conditions) is a
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better measure of the
cost of debt than the
coupon rate.
20. Cost of Preferred Stock, rp
The rate of return investors require on the
firm's preferred stock;
rp is calculated as
the preferred dividend,
Dp, divided by the current price, Pp.
This preferred stock
would be sold directly to a group of hedge
funds, so no flotation costs would be
incurred. If significant
flotation costs were involved, the cost of the
preferred should be
adjusted upward, as
we explain in a later
section.
21. As we can see from Equation 10.3, calculating the a specified maturity
cost of preferred stock is easy.
date and we described
how to calculate the
This is particularly true for traditional "plain vanil- expected return on
la" preferred that pays a fixed dividend in perpe- these issues.
tuity. However, in Chapter 9, we noted that some
preferred issues have
Also, preferred stock
may include an option
to convert to common
stock, which adds another layer of complexity.
We leave these more
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complicated situations
for advanced classes.
Finally, note that no tax
adjustments
are made when calculating rp because preferred dividends, unlike interest on debt,
are not tax deductible,
so no tax savings are
associated with preferred stock.
22. Cost of Retained Earnings, rs
the rate of return required by stockholders
Similarly, the cost of common equity is based on on a firm's common
the rate of return that investors require on the
stock
company's common stock.
Note, though, that
new common equity is
raised in two ways:
(1) by retaining some
of the current year's
earnings
(2) by issuing new
common stock.
We use the symbol rs
to designate the cost
of retained earnings
23. Cost of New Common Stock, re
The cost of external
equity; based on the
Some have argued that retained earnings should cost of retained earnbe "free" because they represent money that is ings, but increased for
"left over" after dividends are paid.
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Although it is true that no direct costs are associ- mon stock.
ated with retained earnings, this capital still has a
cost, an
Therefore, once firms
opportunity cost.
get beyond the
start-up stage, they
normally obtain all of
their new equity by retaining earnings.
24. The firm's after-tax earnings belong to its
stockholders.
• Bondholders are
compensated by interest payments;
• preferred stockholders, by preferred dividends.
But the net earnings
remaining after paying
interest and preferred
dividends
belong to the common stockholders, and
these earnings serve
to compensate them
for the use of their capital.
25. When managers make this decision, they should
recognize that there is an opportunity cost involved—stockholders could have received the
earnings as dividends and invested this money in
other stocks, in bonds, in real estate, or in anything else.
Therefore, the firm needs to
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earn at least as much
on any earnings retained as the stockholders could earn
on alternative investments of comparable
risk.
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26. What rate of return can stockholders expect to
earn on equivalent-risk investments?
First, recall from Chapter 9 that stocks are
normally in equilibrium, with
expected and required
rates of return equal:
r^s = rs.
Therefore, if the firm
cannot invest retained
earnings to earn at
least rs, it should pay
those funds to its
stockholders and let
them invest
directly in stocks or
other assets that will
provide that return.
27. We can employ the techniques developed
in Chapters 8 and 9 to produce reasonably good
estimates of the cost of equity from retained earnings.
Thus, we can write
the following equation
and estimate rs using
the left term, the right
term, or both terms:
• To begin, recall that if a stock is in equilibrium,
its required rate of return, rs, must be equal to its The left term is based
expected rate of return, r^s.
on the capital asset
pricing model (CAPM)
• Further, its required return is equal to a risk-free as discussed in Chaprate, rRF, plus a risk premium, RP, whereas the ex- ter 8, and the right
pected return on the stock is its expected dividend term is based on
yield, D1/P0, plus its expected growth rate, g.
the discounted dividend model as developed in Chapter 9.
28. CAPM APPROACH
Step 1: Estimate the
risk-free rate, rRF.
The most widely used method for estimating the We generally use the
cost of common equity is the capital asset pricing 10-year Treasury bond
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model (CAPM) as developed in Chapter 8.
rate as the measure
of the risk-free rate,
Here are the steps used to find rs (cost of retained but some analysts use
earnings):
the short-term Treasury bill rate.
Step 2: Estimate the
stock's beta coefficient, bi, and use it as
an index of the stock's
risk. The i signifies the
ith company's beta.
Step 3: Estimate the
market risk premium.
Recall that the market risk premium is the
difference between the
return that investors
require on an average
stock and the risk-free
rate.
Step 4: Substitute the
preceding values in
the CAPM equation to
estimate the
required rate of return
on the stock in question:
Example
Assume that in today's
market,
• rRF = 5.6%
• the market risk premium is RPM = 5 0%,
• and Allied's beta is
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1.48.
rS = 5.6% +
(5.0%)(1.48)
= 13%
29. Although the CAPM appears to produce an accurate, precise estimate of rs, several potential
problems exist.
First, as we saw in
Chapter 8, if a firm's
stockholders are not
well diversified, they
may be concerned
with stand-alone risk
rather than just market risk. In that case,
the firm's true investment risk would not
be measured by its
beta and the CAPM
estimate would understate the correct value
of rs.
Further, even if the
CAPM theory is valid,
it is hard to obtain
accurate estimates of
the required inputs because:
(1) there is controversy about whether
to use long-term
or short-term Treasury
yields for rRF.
(2) It is hard to estimate the beta that
investors expect the
company to have in
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the future.
(3) It is difficult to estimate the proper market risk premium.
30. Bond yield plus risk premium approach
Bond yield + Risk Premium
Empirical studies suggest that the risk premium
on a firm's stock over its own bonds generally
An estimate of the cost
ranges from 3 to 5 percentage points.
of common equity that
is produced by sumFirms with risky, low-rated, and consequently high ming the before-tax
interest-rate debt also have risky, high-cost equity; cost of debt and a risk
and the procedure of basing the cost of equity on premium that captures
the firm's own readily observable debt cost utilizes the additional yield on
this logic.
a company's stock relative to its bonds. The
Although this method does not produce a precise additional yield is often
cost of equity, it should "get us in the right ball- estimated using historpark."
ical spreads between
bond yields and stock
yields.
31. Discounted Cash Flow (DCF) aka
Dividend Yield + Growth Rate
1. For companies that are expected to remain in
business indefinitely, the cash flows are
the dividends (10.6 formula)
Method of calculating
present value by discounting future cash
flows
• It is easy to calculate
the dividend yield; but
2. Here P0 is the current stock price, Dt is the
because stock prices
dividend expected to be paid at the end of Year t, fluctuate, the yield
and rs is the required rate of return.
varies from day to day,
If dividends are expected to grow at a constant
which leads to fluctuarate, as we saw in Chapter 9, Equation 10.6 retions in the DCF cost
duces to this important formula: (10.7 formula)
of equity.
3. We can solve for rs to obtain the required rate of • Also, it is difficult
return on common equity, which for the marginal to determine the prop15 / 25
GS FIN 304 CH 10 The Cost of Capital
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investor is also equal to the expected rate of return:
er growth rate. If past
growth rates in earnings and dividends
Thus, investors expect to receive a dividend yield, have been relatively
D1 P0, plus a capital gain, g, for a total expected stable, and if investors
return of r^s; and in equilibrium, this expected
expect a continuation
return is also equal to the required return, rs.
of past trends, g may
be based on the firm's
historic growth rate.
However, if the company's past growth has
been abnormally high
or low due to a unique
situation or because
of general economic
fluctuations, investors
will not project historical growth rates into
the future. In this case,
which applies to Allied,
g must be obtained in
some other manner.
32. Discounted Cash Flow (DCF) aka
Dividend Yield + Growth Rate (continued)
Therefore, someone
estimating
a firm's cost of eqSecurity analysts regularly forecast growth rates uity can obtain anfor earnings and dividends, looking at such fac- alysts' forecasts and
tors as projected sales, profit margins, and com- use them as a proxy
petition.
for the growth expectations of investors in
general. Then he or
she can combine this
g with the current dividend yield to estimate
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r^s:
Again, note that this
estimate of r^s is
based on the assumption that g is expected
to remain constant in
the future. Otherwise,
we must use an average of expected future
rates.
33. AVERAGING THE ALTERNATIVE ESTIMATES
Also, we recognize
that our final estimate
In our examples, Allied's estimated cost of eqwill almost certainly be
uity was 13.0% by the CAPM, 14.0% by the
incorrect to some exbond-yield-plus-risk premium method, and 13.7% tent.
by the DCF method.
Therefore, we always
provide a range and
state that in our judgment, the cost of equity is within that range.
For Allied, we used a
range of 13% to 14%.
34. Flotation Costs
the transaction cost incurred when a firm
raises funds by issuing
a particular type of security
So if a firm does plan
to issue new stock,
these costs should not
be ignored.
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When firms use investment bankers to
raise capital, two approaches can be used
to account for flotation
costs.
35. Add flotation costs to a project's cost
add this sum to the initial investment
cost.
One approach to handling flotation costs, found
as the sum of the flotation costs for the debt,
preferred, and common stock used to finance the Because the investproject, is to
ment cost is increased, the project's
expected rate of return
is reduced.
For example, consider
a 1-year project with
an initial cost (not including flotation costs)
of $100 million.
After 1 year, the project is expected to
produce an inflow of
$115 million. Therefore, its expected rate
of return is
$115/$100 - 1 = 0.15 =
15.0%.
However, if the project
requires the company
to raise $100 million of
new capital and incur
$2 million of flotation
costs, the total upfront
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cost will rise to $102
million, which will lower the expected rate of
return to $115/$102 - 1
= 0.1275 = 12.75%.
36. Increase the Cost of Capital
The DCF approach
can be used to esThe second approach involves adjusting the cost timate the effects of
of capital rather than increasing the project's in- flotation costs. Here
vestment cost.
is the equation for
the cost of new comIf the firm plans to continue using the capital in the mon stock, re (formula
future, as is generally true for equity, this second 10.9)
approach theoretically will be better.
Here F is the percentThe adjustment process is based on the following age flotation cost relogic. If there are flotation costs, the issuing firm quired to sell the new
receives only a portion of the capital provided
stock, so
by investors, with the remainder going to the un- P0( 1 - F ) is the
derwriter. To provide investors with their required net price per share rerate of return on the capital they contributed, each ceived by the compadollar the firm actually receives must "work hard- ny.
er"; that is, each dollar must earn a higher rate of
return
than the investors' required rate of return.
37. Flotation Cost, F
the percentage cost of
issuing new common
stock
38. Flotation Cost Adjustment
The amount that must
be added to rs to
account for flotation
costs to find re.
39. WHEN MUST EXTERNAL EQUITY BE USED?
However, if a firm has
more good
Because of flotation costs, dollars raised by sell- investment opportuni19 / 25
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ing new stock must "work harder" than dollars
raised by retaining earnings.
40. Retained Earnings Breakpoint
ties than can be financed with retained
earnings plus the debt
and preferred stock
supported by those retained earnings, it may
need to issue new
common stock.
the amount of capital
raised beyond which
new common stock
must be issued
Formula:
Addition to retained
earnings for year
Equity Fraction
Example:
Allied's addition to
retained earnings in
2017 is expected to be
$66 million
Its target capital
structure consists of
45% debt, 2% preferred, and 53% equity. Therefore, its retained earnings breakpoint for 2017 is as follows:
= 66M
.53
= 124.5M
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To prove that this
is correct, note that
a capital budget of
$124.5 million could
be financed as
• 0.45($124.5) = $56M
of debt,
• 0.02($124.5) =
$2.5M of pref. stock,
and • 0.53 ($124.5)=
$66 million of equity raised from retained
earnings.
41. Composite, or Weighted Average, Cost of Capital, Equation 10.1, preWACC
sented earlier, can be
used to calculate its
Allied's target capital structure calls for 45% debt, WACC when all of
2% preferred stock, and 53% common equity.
the new common equity comes from retained
Earlier we saw that
earnings:
• its before-tax cost of debt is 10.0%;
• its after-tax cost of debt is rd(1 - T) = 10%
Under these condi(0.6)=6.0%;
tions, every dollar of
• its cost of preferred stock is 10.3%;
new capital that Al• its cost of common equity from ret. earnings = lied raises would con13.5%; • and its marginal tax rate is 40%.
sist of 45 cents of debt
with an after-tax cost
of 6%, 2 cents of preferred stock with a cost
of 10.3%, and 53 cents
of common equity from
additions to retained
earnings with a
cost of 13.5%.
The average cost of
each whole dollar, or
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the WACC, would be
10.1%.
If, instead, Allied had
to issue new common
stock, its WACC would
be slightly higher because of the additional
flotation costs:
42. Factors That Affect the WACC
Factors that the Firm
Can Control
The cost of capital is affected by a number of
A firm can directly affactors. Some are beyond the firm's control, but fect its cost of capital in
others can be influenced by its financing and in- three primary ways:
vestment decisions.
(1) by changing its
capital structure,
Factors that the Firm Cannot Control
Other things held con1. interest rates in the economy,
stant, an increase in
2. the general level of stock prices, and
the target debt ra3. tax rates.
tio tends to lower the
WACC (and vice versa
if the debt
ratio is lowered) because the after-tax
cost of debt is lower
than the cost of equity.
However, other things
are not likely to remain
constant.
(2) by changing its dividend payout ratio, and
(3) by altering its capital budgeting decision
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jects with more or less
risk than projects previously undertaken.
43. Adjusting the Cost of Capital for Risk
Figure 10.1 illustrates
the trade-off between
Thus, the cost of capital is a "hurdle rate"—a
risk and the cost of
project's expected rate of return must "jump the capital.
hurdle" for it to be accepted.
• Firm L is in a low-risk
business and has a
Moreover, investors require higher returns on
WACC of 8%.
riskier investments. Consequently, companies
• Firm A is an averthat are raising capital to take on risky projects will age-risk business with
have higher costs of capital than companies that a WACC of 10%,
are investing in safer projects.
whereas
• Firm H's business is
exposed to greater risk
and consequently has
a WACC of 12%.
Thus, Firm L will accept a typical project if its expected
return is above 8%.
Firm A's hurdle rate is
10%, whereas the corresponding hurdle rate
for Firm H is 12%.
44. However, different projects often have different
risks, even for a given firm. Therefore, each project's hurdle rate should reflect the risk of the project, not the risk associated with the firm's average
project as reflected in its composite WACC.
23 / 25
However, it would be
a mistake to use this
10%WACC for either
division.
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For example, assume that Firm A (the average-risk
firm with a composite WACC of 10%) has two divisions, L and H. Division L has relatively little risk,
and if it were operated as a separate firm, its WACC
would be 7%. Division H has higher risk, and its
divisional cost of capital is 13%. Because the two
divisions are of equal size, Firm A's composite
WACC is calculated as 0.50(7%) + 0.50(13%) = 10%.
45. Some Other Problems with Cost of Capital Estimates
A number of issues related to the cost of capital
have not been mentioned or were glossed over in
this chapter. These topics are covered in advanced
finance courses, but they deserve mention now to
alert you to potential dangers and to provide
a preview of some matters covered in advanced
courses.
To see this point, assume that Division L
is considering a relatively low-risk project
with an expected return of 9%, and Division H is considering a
higher-risk project with
an expected return of
11%.
2. Privately owned
firms. Our discussion
of the cost of equity focused on publicly owned corporations, and we have
concentrated on the
rate of return required
by public stockholders.
However, there is a serious question about
how to measure the
cost of equity for a
firm whose stock is not
traded.
1. Depreciation-generated funds. The largest single source of capital for many firms is depreciation, yet we have not discussed how the cost of
this capital is
determined. In brief, depreciation cash flows can
either be reinvested or returned to investors
3. Measurement prob(stockholders and creditors). The cost of depre- lems. We cannot
ciation generated funds is thus an opportunity
overemphasize the
cost; and it is approximately equal to the WACC practical difficulties
from retained earnings, preferred stock, and debt. encountered when esTherefore, we
timating the cost of eqcan ignore it in our estimate of the WACC.
uity. It is very difficult to
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obtain
good input data for the
CAPM, for g and for
the risk premium in the
formula.
4. Costs of capital
for projects of differing risk. We touched
briefly on the fact that
different projects can
differ in risk and thus
in their required rates
of return. However, it is
difficult to measure a
project's risk.
5. Capital structure
weights. In this chapter, we took as given
the target capital structure and used it to calculate the WACC. As
we shall see in Chapter 13, establishing the
target capital structure
is a major task in itself.
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1. Katie owns 100 shares of ABC stock. Which one of
C. Cost of Equity
the following terms is used to refer to the return that
Katie and the other shareholders require on their investments in ABC?
2. Lester lent money to the corner store by purchasing B cost of debt
bonds issued by the store. The rate of return that he
and the other lenders require is referred to as the
3. The weighted average cost of capital is defined as the The cost of equiweighted average of a firms
ty ended after tax
cause of debt
4. Farmer supply is considering opening a clothing
E. Pure Play Apstore, which would be a new line of business for the proach
firm. Management has decided to use the cost of capital of a similar clothing store as the discount rate that
should be used to evaluate the proposed expansion.
Which one of the following terms is used to describe
the approach Farmer supply is taking to establish an
appropriate discount rate for the project?
5. Kate is the CFO of a major firm and has the job of
C. Subjective Apassigning discount rates to each project that is under proach
consideration. Kids method of doing this is to assign
and incrementally higher rate as the risk level of the
project increases over that of the current firm. Likewise she assigns lower rates as the risk level declines.
Which one of the following to purchase is Kate using
to assign the discount rates?
6. Ted is trying to decide what cost of capital he should D. Risk level of the
assigned to a project. Which one of the following
project
should be his primary consideration in this decision?
7. Blackstone furnaces wants to build a new facility. The D. The nature of
cost of capital for this investment is primarily depend- the investment
ed upon which one of the following?
8.
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Which one of the following statements is correct relat- C. The annual dived to the dividend growth model approach to comput- idend used in the
ing the cost of equity?
computation must
be for year one if
you are using today's stock price
to compute the return.
9. A firm has a return on equity of 12.4% according to the C. The arithmetic
dividend growth model and a return of 18.7% accord- average of 12.4%
ing to the capital asset pricing model. The market rate and 18.7%
of return is 13.5% which really should the firm use as
the cost of equity when computing the firms WACC?
10. Which one of the following features are advantages of D. I and II only
the dividend growth model?
I. Easy to understand
II. Model simplicity
III. Constant dividend growth rate
IV.Models applicability to all common stocks
11. Which of the following are weaknesses of the dividend D. II and IV only
growth model?
I. market risk premium fluctuations
II. lack of dividends for some firms
III. reliance on historical beta
IV. sensitivity of model to dividend growth rate
12. In an efficient market, the cost of equity for a risky
E. Increases in difirm does which one of the following according to the rect relation to the
security market line?
stock's systematic
risk
13. Which of the following will increase the cost of equity B. III only
for a firm with a beta of 1.1?
I. decrease in the security's beta
II. decrease in the market risk premium
III. decrease in the risk-free rate
IV. increase in the risk-free rate
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14. Which one of the following will increase the cost of
equity, all else held constant?
A. Increase in the
dividend growth
rate
15. All else constant, which of the following will increase C. I and IV only
the aftertax cost of debt for a firm? I. increase in the
yield to maturity of the firm's outstanding debt
II. decrease in the yield to maturity of the firm's outstanding debt
III. increase in the firm's tax rate
IV. decrease in the firm's tax rate
16. Which one of the following is the pre-tax cost of debt? C. Weighted average yield-to-maturity on the firm's
outstanding debt
17. Which one of the following will decrease the aftertax B. Increase in tax
cost of debt for a firm?
rates
18. All else constant, an increase in a firm's cost of debt: B. will result in
an increase in the
firm's cost of capital.
19. The cost of preferred stock:
D. is equal to
the stock's dividend yield.
20. Which one of the following statements is correct?
B. The cost of preferred stock is unaffected by the issuer's tax rate.
21. Which one of the following will affect the capital struc- C. Increase in the
ture weights used to compute a firm's weighted aver- market value of
age cost of capital?
the firm's common
stock
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22. The aftertax cost of which of the following are affected B. II and IV only
by a change in a firm's tax rate?
I. preferred stock
II. debt
III. equity
IV. capital
23. Which one of the following statements is correct con- D. The repurchase
cerning capital structure weights?
of preferred stock
will increase the
weight of debt.
24. Which one of the following statements is correct?
A. A firm may
Assume the pre-tax cost of debt is less than the cost change its capof equity.
ital structure if
the government
changes its tax
policies.
25. Which one of the following represents the rate of re- D. Weighted averturn a firm must earn on its assets if it is to maintain age cost of capital
the current value of its securities?
26. Which one of the following statements is accurate for E. A reduction in
a levered firm?
the risk level of a
firm will tend to decrease the firm's
WACC.
27. Which one of the following statements is correct, all B. A decrease in
else held constant?
a firm's WACC will
increase the attractiveness of the
firm's investment
options.
28. A firm has a cost of equity of 13 percent, a cost of
D. Increasing the
preferred of 11 percent, and an aftertax cost of debt of firm's beta
6 percent. Given this, which one of the following will
increase the firm's weighted average cost of capital?
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29. All else constant, the weighted average cost of capital A. the firm's bonds
for a risky, levered firm will decrease if:
start selling at
a premium rather
than at a discount.
30. A firm that uses its weighted average cost of capital B. increase the risk
as the required return for all of its investments will: level of the firm
over time.
31. Old Town Industries has three divisions. Division X
has been in existence the longest and has the most
stable sales. Division Y has been in existence for five
years and is slightly less risky than the overall firm.
Division Z is the research and development side of
the business. When allocating funds, the firm should
probably:
B. assign the highest cost of capital
to division Z because it is most
likely the riskiest of
the three
divisions.
32. A firm uses its weighted average cost of capital to
evaluate the proposed projects for all of its varying
divisions. By doing so, the firm:
A. automatically
gives preferential
treatment in the allocation of funds to
its riskiest division.
33. Kurt, who is a divisional manager, continually brags D. Kurt's division is
that his division's required return for its projects is less risky than the
one percent lower than the return required for any
other divisions.
other division of the firm. Which one of the following
most likely contributes the most to the lower rate
requirement for Kurt's division?
34. Which one of the following is the primary determinant C. Level of risk
of an investment's cost of capital?
35. The cost of capital for a project depends primarily on D. How the project
which one of the following?
uses its funds
36. Marine Expeditors has three divisions. Division A is
the core of the business and represents 80 percent
of the firm's operations. Division B is involved only
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with contractual short-term projects and therefore
has about 8 percent less risk than division A. Division
C develops and markets new products and is
about 12 percent riskier than division A and about
equal in size to division B. The manager of division
A has suggested that the operations of his division
be increased by 10 percent next year. The proposed
project should probably be assigned a required return
that is equal to _____ percent of the firm's weighted
average cost of capital.
37. Which one of the following is most apt to cause a
C. She learns the
wise manager to increase a project's cost of capital? project is riskiAssume the firm is levered.
er than previously
believed.
38. Boone Brothers remodels homes and replaces win- B. Ace Builders'
dows. Ace Builders constructs new homes. If Boone cost of capital
Brothers considers expanding into new home construction, it should evaluate the expansion project using which one of the following as the required return
for the project?
39. You need to use the pure play approach to assign
D. Firm operations
a cost of capital to a proposed investment. Which
one of the following characteristics should you most
concentrate on as you search for an appropriate pure
play firm?
40. When using the pure play approach for a proposed E. best matches
investment, a firm is primarily seeking a rate of return the risk level of
which:
the proposed investment.
41. Derek's is a brick-and-mortar toy store. The firm is
C. A toy store that
considering expanding its operations to include Inter- only sells online
net sales. Which one of the following would be the best
firm to use in a pure play approach to analyzing this
proposed expansion?
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42. Kelly's uses the firm's weighted average cost of capi- C. Risk level of protal (WACC) as the required return for some of its pro- ject
jects. For other projects, the firms uses a rate equal
to WACC plus 1 percent, while another set of projects
is assigned rates equal to WACC minus some amount.
Which one of the following factors should be the key
factor the firm uses to determine the amount of the
adjustment it will make when assigning the project a
discount rate?
43. A firm has multiple divisions of similar nature, yet
varying degrees of risk. Which one of the following
would be the most appropriate, yet relatively easy,
means of assigning discount rates to each of its proposed investments?
C. Assign every
project a rate
equal to the firm's
WACC plus or minus a subjective
adjustment
44. The computation of which one of the following reE. Subjective cost
quires assigning every proposed investment to a par- of capital
ticular risk class?
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1.
59. Explain the term "primary market.
When new shares of common stocks are sold
in the market to raise capital, it is called a
primary market transaction. A good example of
a primary market transaction is the IPO (Initial
Public Offering)
2.
55. State the important differences between investment decisions and financing decisions
Generally, investment decisions have positive NPVs, while financing decisions have
zero NPV. Mostly, investment decisions are
irreversible while financing decisions are reversible. Investment decisions are made in
factor markets while financing decisions are
made in financial markets
3.
56. Briefly explain why,
in a competitive securities market,successive
price changes are random.
In a competitive market, prices reflect all
available information. The only reason prices
change is because of new information. By definition new information arrives randomly. Therefore security prices change randomly.In a competitive market, prices reflect all available information. The only reason prices change is
because of new information. By definition new
information arrives randomly. Therefore security prices change randomly.
4.
5.
57. List the three forms of • Weak-form efficiency
market efficiency and ex- •Semi-strong form efficiency
plain the basis for it.
•Strong form efficiency
These distinctions are based on the level of information reflected in the security
prices. Weak-form efficiency deals with historical prices. Semi-strong form deals with publicly
available information that also includes historical information. Lastly, strong-form which includes all information.
6.
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58. State the strong form of Security prices reflect all the information that is
market efficiency.
available to the investors.
7.
64. How does the random Random walk theory relies upon the concept
walk theory explain market of a normal or lognormal distribution pattern
crashes?
for stocks. This requires that the stock price
gains and losses reflect a normal distribution.
For this to occur, there must, on rare occasion,
be large movements in stock prices in either direction. Thus, a large drop in stock prices must
occur for the movement to truly be random
8.
63. List the six lessons of
market efficiency.
9.
62. Briefly discuss some of Behavioral finance studies have focused on
the important findings of three important areas: (1) limits to arbitrage,
behavioral finance studies. (2) attitudes toward risk, and (3) beliefs about
probabilities. Arbitrage is defined as a strategy
that exploits market inefficiency and generates
superior returns if and when the prices return
to efficient market prices or equilibrium prices.
If arbitrage is not powerful enough to drive
all prices to equilibrium levels, it will result in
mispricing. This is caused by investors' attitude towards risk and the way the investors
assess probabilities. This has led to the development of "prospect theory." Most investors
List the six lessons of market efficiency.
•
Markets have no memory
•
Trust market prices
•
Read the entrails
•
There are no financial illusions
•
The Do-it yourself alternative
•
Seen one stock, seen them all.
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are either too conservative or overconfident. In
other words, investors are not 100% rational
100% of the time. Thus behavioral finance provides new interpretations of some long-standing puzzles and anomalies.
10. 59. State the weak form of Security prices reflect the information conmarket efficiency and its tained in the record of past prices. This implies
implications.
that prices will follow a random walk. It is impossible to make consistently superior profits
by studying past returns.
Type: Medium
11. 60. State the semi-strong
form of market efficiency
and its implications.
Security prices reflect all publicly available information. If markets are efficient in this sense,
then prices will adjust immediately to public
announcements.
12. 61. What are puzzles and
anomalies?
Puzzles and anomalies are abnormal behavior
of stocks that apparently contradict the efficient market hypothesis. There are quite a few
of them. For example, stocks of small firms
have provided abnormally high returns compared to stocks of large firms.
13. 72. Briefly explain how
"Beta" of a stock can be estimated graphically
"beta" of a stock is estimat- by plotting the market returns on the x-axis and
ed.
the corresponding stock returns on the y-axis.
The slope of the resulting linear graph is the
"beta" estimate for the stock.
14. 73. Briefly explain what
"beta" of a stock means.
For each additional 1% change in the market
return, the return on the stock on the average changes by "beta" times 1%. For example
the beta of IBM is 1.59, then for additional
1% change in the market return is expected
change the returns on the IBM stock by 1.59%.
15.
"Beta" is a measure of market risk. It is also
called relative measure of risk as it measures
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74. Discuss the importance risk relative to the market risk. Beta is useful as
of "beta" as a measure of a measure of risk in the context of well-diversirisk.
fied portfolios. It measures the risk contribution
of a single security to the portfolio risk.
16. 75. Briefly explain the difference between beta as a
measure of risk and variance as a measure of risk.
Variance measures the total risk of a security
and is a measure of stand-alone risk. Total
risk has both unique risk and market risk. In
a well-diversified portfolio, unique risks tend to
cancel each other out and only the market risk
is remaining. Beta is a measure of market risk
and is useful in the context of a well-diversified
portfolio. Beta measures the sensitivity of the
security returns to changes in market returns.
Market portfolio has a beta of one and is considered the average risk.
17. 76. Briefly explain how in- The risk of a well-diversified portfolio depends
dividual securities affect on the market risk of the securities included
portfolio risk.
in the portfolio. Portfolio beta is the weighted
average of individual security betas included in
the portfolio.
18. 77. What is the beta of a
portfolio with a large number of randomly selected
stocks?
The beta of a portfolio with a large number of
randomly selected stocks is equal to one. The
standard deviation of such a portfolio is equal
to the standard deviation of the market.
19. 78. How can individual in- One of the simplest ways for individual investor
vestors diversify?
to diversify is to buy shares in a mutual fund
that holds a diversified portfolio.
20. 79. Briefly explain the con- If the capital market establishes a value PV(A)
cept of value additivity.
for asset A and PV(B) for asset B the market
value of the firm that holds both these assets
is: PV(AB) = PV(A) + PV(B). This logic can
be extended for any number of assets. Value
additivity is also applicable to cash flows. We
can add the present values of two cash flows
and get the present value of the combined
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cash flows. It can be stated as follows: PV(A +
B) = PV(A) + PV(B) and PV(A + B + C) = PV(A)
+ PV(B) + PV(C) This idea can be extended for
any number of cash flows.
21. 80. Explain why international stock may have high
standard deviation but low
betas.
Beta is traditionally measured relative to the
S&P 500 index. As such, there may be very
little statistical relationship between the S&P
500 and an international stock. If these two
assets are independent of one another there
is little chance they will have a statistically significant covariance. With a low covariance, by
definition, the stock will have a low beta. This
could occur even if the standard deviation of
the beta is very high.
22. 72. Explain the term market Market risk is that part of the risk that is asrisk.
sociated with market-wide variations. Investors
cannot eliminate market risk. All the risk in a
well-diversified portfolio is market risk. Beta is
a measure of market risk.
23. 73. Briefly explain the term Security market line (SML) is the straight-line
"security market line."
plot of "beta" on the x-axis and expected return
on investment on y-axis. This straight line joins
two benchmark investments: Risk-free rate on
the y-axis and the market portfolio, which has a
beta of one. It provides the risk-return tradeoff
for any security. In equilibrium all securities
should plot on SML. It is used for comparing
investments with different risk characteristics.
24. 74. Briefly explain the "cap- The relationship, that in a competitive market,
ital asset pricing model." the expected risk premium on a security varies
in direct proportion to beta is called the capital
asset pricing model (CAPM). It is expressed
as:
25. 75. Where would under
Under priced securities would plot above the
priced and overpriced se- SML and overpriced securities would plot be5 / 26
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curities plot on the SML
(security market line)?
low the SML. These conditions do not last
long in a competitive market. As investors start
buying the under priced securities, their prices
will increase and would be forced to move
towards the SML. Investors would sell the overpriced securities thereby forcing their prices
down and again these securities would move
towards the SML. In equilibrium all securities
will plot on the SML.
26. 76. Briefly explain the
The three-factor model was developed by
Fama-French Three-Factor Fama and French and is an empirical model.
Model.
They have identified three factors that explain
the security risk premium better. The three
factors are: Market factor, Size factor, and
Book-to-market factor.
27. 77. Briefly discuss how you
would use Fama-French
three-factor model to estimate the cost of equity for
a firm.
The three factors considered are: (1) market
factor, (2) size factor, and (3) book-to-market
value factor.•Estimate the risk premiums for
each factor.•Estimate the factor sensitivities.
Use the following model to estimate the expected equity returns on the stock.
28. 78. Explain why growth mutual funds are worse investments than taking out
a second mortgage on a
home and investing in the
market index.
The growth mutual fund is usually riskier than
the market portfolio. It is well below the security
market line and is not producing an efficient
risk return trade off. While difficult to accept,
a second mortgage permits the investor to
create a leveraged investment in the tangency
portfolio. This generates a return that is on the
security market line and has a higher return
given the same level of risk as the growth fund.
As such, the investor can earn a better risk
return trade off than with the growth fund. True,
this is a very risky investment, but it is better
than the growth fund. Investors often fail to
realize the risk of the growth fund.
29.
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58. Briefly explain the dif- If a firm is considering projects that have the
ference between company same risk as the firm, then the company cost of
and project cost of capital. capital is the same as the project cost of capital. But if the firm is considering projects which
have risks different from the company then the
project cost of capital becomes relevant.
30. 59. Briefly explain how the
use of single company cost
of capital to evaluate projects might lead to erroneous decisions.
If the firm is considering projects with differing
risk characteristics, the firm will reject low-risk
projects and accept high-risk projects. In reality low - risk projects should be discounted at
a lower rate and high-risk projects at a higher
discount rate to account for differing risks.
31. 60. Discuss why one might
use an industry beta to estimate a company's cost of
capital.
Generally, an industry beta can be estimated
more precisely than a company's beta. This is
similar to the estimate of the beta of a portfolio
is more precise than the estimate of the beta of
a single stock. The estimated industry cost of
capital must be suitably adjusted before using
for company's cost of capital. For example,
differences in the capital structure of the firm
and the industry.
32. 61. Briefly explain how a
firm's cost of equity is estimated using the capital asset pricing model (CAPM).
The first step is to estimate the beta of the
firm's common stock by regressing the returns
on the stock on the market returns using historical data. Expected stock return is estimated
using CAPM [E(R) = rf + (beta)( rm- rf )]. Expected return is the estimate of the firm's cost
of equity.
33. 62. Briefly explain what val- Generally, the value used for the risk-free rate
ue should be used for the is the short-term Treasury bill rate.
risk-free interest rate.
34. 63. Briefly describe the fac- Asset betas are determined by the cyclical
tors that determine asset nature of the cash flows. Generally, cyclical
betas.
firms have higher betas. Operating leverage
also affects the asset beta of a firm. Firms
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with high fixed costs tend to have higher asset
betas.
35. 64. Briefly discuss the certainty equivalent approach
to estimating the NPV of a
project.
In the certainty equivalent approach, certainty
equivalent cash flows are discounted at the
risk-free rate to calculate the NPV of a project.
First risky cash flows have to be converted
to certainty equivalent cash flows by using
individual risk factors. One advantage of this
method is that the risk adjustment is separated
from the time value of money. Conceptually
this is a more sensible method than the risk
adjusted discount rate method. But estimating
certainty equivalent cash flows could be cumbersome.
36. 65. Briefly discuss the risk
adjusted discount rate approach to estimating the
NPV of a project.
The risk adjusted discount rate approach uses
the discount rate to adjust for both risk and the
time value of money. The main advantage of
this approach is simplicity. Risky project cash
flows are discounted using risk adjusted discount rates (higher rates) to calculate the NPV
of a project.
37. 66. Why do firms with large There is a strong correlation between the risk
cash flow betas also have of the assets of a firm and the risk of the firm's
high asset betas?
earnings. As such high asset betas lead to high
cash flow betas.
38. 60. Explain the term "sec- When already issued stocks are traded in the
ondary market."
market, it is called a secondary market transaction. Most transactions in the stock market
are secondary market transactions.
39. 61. Briefly explain the ma- There are two types of exchanges that are
jor types of exchanges
prevalent in the USA. They are auction marprevalent in the USA.
kets and dealer markets. The New York Stock
Exchange is an example of an auction market.
Here specialists act as auctioneers and match
up would-be buyers and sellers. The Nasdaq is
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an example of a dealer market. In the case of
a dealer market all trades take place between
a group of dealers and the investors. Dealer
markets are also active in trading many other
types of financial instruments such as bonds.
40. 62. Briefly explain the
The rate of return expected by the investors
term "market capitalization in common stocks is called the market capitalrate."
ization rate. It is also called the cost of equity
capital. For a constant growth stock it is the dividend yield plus the growth rate in dividends.
41. 63. Discuss the general
The value of a common stock is the present
principle in the valuation of value of all the dividends received by owning
a common stock.
the stock discounted at the market capitalization rate or the cost of equity. This is called the
discounted cash flow (DCF) method.
42. 64. Briefly explain the
assumptions associated
with the constant dividend
growth formula.
There are two important assumptions that are
necessary for the formula to work correctly.
First assumption is that the growth rate in dividends is constant. The second assumption is
that the discount rate is greater than the growth
rate in dividends.
43. 50. Briefly explain the cash Bonds provide two types of cash flows: interest
flows associated with a
payments and the principal payment. Interest
bond to the investor.
payments occur each period, usually annually
or semi-annually. Periodic interest payments
are also called coupon payments. Thus this
forms an annuity. Principal payment occurs at
the time of maturity of the bond and is a lump
sum payment.
44. 51. Briefly explain the term The yield to maturity is the single discount rate
"yield to maturity."
that is used to calculate the present value of
cash flows received from buying a bond. It is
used for calculating the bond value. Conceptually it is the same as the internal rate of
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return (IRR). It is also stock-in-trade of any
bond dealer.
45. 52. What is the relationship Interest rates and bond prices are inversely
between interest rates and related. High interest rates cause bond prices
bond prices?
to fall and vice-versa. For a given change in
interest rates, prices of long-term bonds fluctuate more than for short-term bonds. Similarly, for a given change in interest rates low
coupon bond prices fluctuate more than for
high coupon bonds.
46. 53. Discuss the concept of Duration can be thought of as the weighted avduration.
erage time of a bond's cash flow. The weights
are determined by the present value factors.
Duration is expressed in units of time. Duration
is an important concept for two reasons. First,
the volatility of a bond is directly related to
its duration. Second, one way to hedge interest rate risk is through a strategy of duration
matching.
47. 54. Briefly discuss the con- Volatility is calculated as Duration/ (1 + yield).
cept of volatility.
Bonds with longer duration also have greater
volatility. Bond's volatility is directly related to
duration. Volatility is also the slope of the curve
relating the bond price to the interest rate.
48. 55. Briefly explain what is
meant by "the term structure of interest rates."
The term structure of interest rates is the plot
of interest rates on the y-axis and the maturity
on the x-axis. It is also called the yield curve.
It shows how interest rates and maturity are
related. Economists have developed several
theories to explain the shape of the yield curve.
49. 56. Briefly explain the expectations theory.
This theory postulates that the current forward
rates are the expected value of the corresponding future spot rates.
50.
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57. What is the relationship The exact relationship is given by: (1 + nominal
between real and nominal rate ) = (1 + real rate) * (1 + expected Inflation
rates of interest?
rate). It can also be written as: nominal rate =
real rate + Inflation rate + (real rate) * (Inflation
rate)
51. 58. Define the term, "real in- Real interest rate is the inflation adjusted nomterest rate."
inal interest rate. We do not observe it directly.
The relationship between the two is given by:
1 + r nominal = (1 + real rate)(1 + inflation
rate). (An approximate formula that works for
low values is: r nominal = r real rate + Inflation
rate)
52. 59. What are TIPs?
Briefly explain. TIPs(Treasury Inflation-Protected Securities) are issued by the U.S. Treasury. The U.S. Treasury began issuing TIPs in
1997. These are also known as Inflation-indexed bonds. The real cash flows on TIPs
are fixed, but the nominal cash flows, which
includes interest and principal, are increased
as the Consumer Price Index (CPI) increases.
Thus the buying power of the lender in protected.
53. 60. What is the relationship A forward rate is the internal rate of return
between spot and forward derived from the future value of bonds given
rates?
spot rates from two different maturity bonds.
54. 91. What are the three ele- The value of a convertible bond is determined
ments of convertible bond by straight bond value, conversion value and
value?
the option value. Value of a convertible bond
= Higher of [Straight bond value, conversion
value] + Option value. The straight bond value
and the conversion values provide the floor for
the convertible bond value.
55. 92. Briefly explain what is
meant by "force conversion?"
If the conversion value is greater than the call
price and bond is called, then the call is said
to force conversion. Obviously, bondholders
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would convert the bonds to realize the higher
conversion value.
56. 93. Explain why firms issue Smaller and more risky firms generally issue
convertible debt.
convertibles. Convertibles are useful when investors have difficulty in assessing the risk of
a company's debt. They also diminish the possible conflicts of interest between bondholder
and stockholder.
57. 94. Explain the differences The main differences are: warrants are usubetween warrants and con- ally issued as a part of a private placement;
vertibles.
warrants can be detached and sold separately;
warrants may be issued on their own; warrants
are exercised for cash; warrants and convertibles are subject to different tax rules.
58. 95. Discuss the differences
between publicly issued
bonds and private placements.
Mainly, there are three differences. First, publicly issued bonds must be registered with the
SEC, while private placements need not. Second, publicly issued bonds are highly standardized, while private placements are tailor-made for the firms involved. Third, the restrictions placed on the issuer are much more
stringent with private placements.
59. 96. Briefly explain project
financing.
Project financing refers to debt financing that
is largely a claim against the cash flow from a
particular project rather than against the firm
as a whole. Project financing is used for power, communication and transportation projects.
This is also used extensively in developing
countries.
60. 97. What are LYONs?
LYONs (Liquid yield option notes) are an innovation in bond design. They are puttable,
callable, convertible and carry zero-coupon interest rate.
61.
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98. What are reverse
floaters?
Reverse floaters are floating-rate bonds that
pay a higher rate of interest when other rates of
interests fall and a lower rate when other rates
rise.
62. 100. Explain why the follow- This phrase is false for many reasons. While
ing phrase is true or false. the issuance of a guarantee does not involve
"Government loan guaran- an upfront cost, it does transfer value and risk.
tees are costless methods A loan guarantee adds value to the recipients.
for the government to help By providing a guarantee the firm will assume
troubled firms."
more risk than the capital markets would otherwise allow it to take. The transfer of risk to the
government and the subsequent reduced risk
aversion of the firm, may increase the chance
of a payout by the government. The intervention of the government prevents capital markets from assigning proper risk adjusted prices
to firm assets.
63. 66. Briefly describe the left- If the dividends are taxed at a higher rate than
ists' point of view on divi- capital gains, firms should pay the lowest cash
dends and taxes.
dividends. By shifting their distribution policy,
corporations can transform dividends into capital gains. Leftists generally favor low dividend
payout.
64. 67. Briefly explain how cur- Tax rate on capital gains tax rate is 20%, while
rent tax laws favor capital for taxable income it is much higher. Tax laws
gains?
favor capital gains in another way. Taxes on
dividends have to be paid immediately. But,
taxes on capital gains can be deferred until the
shares are sold and capital gains realized. The
longer the shareholders wait, less the present
value of capital gains liability.
65. 68. Briefly describe the
Middle-of-the-roaders hold that a firm's value
middle-of-the-roaders' po- is not affected by its dividend policy.
sition.
66.
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69. Briefly explain how
shareholders' returns are
taxed twice in the United
States?
Shareholders' returns are taxed at the corporate level as corporate tax, and at the shareholders level as either income tax or capital
gains tax.
67. 70. Briefly describe the "im- In the imputation tax system, shareholders are
putation tax system."
taxed on dividends, but they receive a tax deduction, which is equal to their share of the
corporate tax that the company has paid. This
is followed in Australia.
68. 73. A retiree believes that
investing in a non-dividend
paying growth firm, that requires the periodic sale of
stock for income, will eventually lead to a loss of all
shares. Explain the flaw in
this logic.
A growth firm, by definition, we have an increasing share price. Over time the firm will
either have stock splits to maintain a stock
price within a certain trading range or the price
will go up substantially over time. In the case
of stock splits, the retiree will get an ever increasing number of shares. In the case of an
increasing share price, the retiree will need to
liquidate an ver decreasing quantity of shares.
In either case, the share will not disappear
any faster than they would through dividend
payments
69. 76. Briefly explain how
EPS-Operating Income
analysis helps determine
the capital structure of a
firm?
The plot of EPS - operating income at a specified amount of debt will provide the break-even
income. If the firm's income is above the
break-even point debt financing is preferred
and below that equity financing is preferred.
In this method expected level of operating income will determine whether debt financing
should be used or equity financing be used.
70. 77. State and explain MM's The expected rate of return on the common
Proposition II.
stock of a levered firm increases in proportion to the debt-equity ratio, stated in market
values. rE = rA + (D/E) * (rA - rD). As the
debt-equity ratio increases the cost of equity
increases; the cost of debt and the weighted
average cost of capital remain constant. This
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also implies that the beta of the firm's equity
also increases in the same manner.
71. 78. Briefly explain how
changes in debt-equity ratio impacts on the beta of
the firm's equity?
There is a linear relationship between the equity beta of a firm and its debt-equity ratio.
It is obtained by combining Modigliani-Miller
proposition II with the capital asset pricing
model (CAPM). The relationship is given by:
bE= bA + (D/E)(bA- bD). Many times bD(beta
of debt) is zero. Then the relationship is written
as: bE= [1 + (D/E)](bA).
72. 79. Briefly describe the tra- The traditional view of the debt policy states
ditional position on capital that moderate amounts of debt increase the
structure.
expected return on equity, but when the firm
borrows too much the expected return on equity declines. The weighted average cost of
capital declines initially at low levels of debt
and later increases at higher levels of debt.
Hence, there is an optimal capital structure for
a firm.
73. 80. Under what circumBriefly discuss. MM's proposition I is violated
stances would MM's propo- when the firm, by imaginative design of its
sition is violated?
capital structure, is able to offer some financial
service that meets the needs of a particular
clientele. Either the service must be new and
unique or the firm must find a way to provide
some existing service more cheaply than other
firms or financial intermediaries is able to provide. Therefore, smart financial managers look
for an unsatisfied clientele, investors who need
a particular type of financial instrument but
because of market imperfections are unable to
get it or get it cheaply.
74. 81. Discuss a successful
example of corporations
trying to add value through
innovative financing.
Citicorp was the first to issue floating rate
notes whose interest payments changed with
changes in short term interest rates. The success of the issue suggests that Citicorp was
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able to add value through financing, by meeting an unmet need of the investors.
75. 82. State the generalized Modigliani-Miller proposition I states that
version of Modigliani-Miller changes in capital structure does not affect
proposition I.
the value of a firm. MM's proposition I is an
extremely general result. Any change in the
capital structure of the firm can be duplicated or "undone" by the investors at no cost.
The investors need not pay extra for borrowing indirectly (by holding shares in a levered
firm) when they can borrow just as easily and
cheaply on their own account. It applies equally to trade-offs of any choice of financial instruments. For example, the choice between
long-term debt and short-term debt would also
not affect the value of the firm. Generally, the
choice between issuing preferred stock, common stock, or some combination of the two
should not have any effect on the overall value
of the firm. It also applies to the mix of debt
securities issued by the firm. The choices of
long-term versus short-term, secured versus
unsecured, senior versus subordinated, and
convertible and nonconvertible debt all should
not have any effect on the overall value of the
firm.
76. 83. Explain why the cost of
equity and the cost of debt
are concave upward at high
levels of debt.
As firm's take on higher levels of debt, the risk
of default increases. Default risk requires a risk
premium for investors. Since the risk of both
debt and equity not getting paid increases,
the premium also increases. Thus, both issues
require an ever increasing risk premium.
77. 68. What is the relative tax
advantage of debt when
corporate and personal
taxes are considered?
The relative tax advantage of debt can be stated as: (1 - TP)/[(1 - TC)(1 - TPE)] Suppose all
equity income is in the form of dividends then
TPE= TP, the relative tax advantage of debt is:
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1/(1 - TC) In case (1 - TP) = (1 - TC)(1 - TPE),
the relative tax advantage is zero.
78. 69. State how the present value of tax shield
is changed when personal
taxes are included.
Miller developed a modified form of proposition
I by including personal taxes on equity income
and interest income. These could be different
from corporate taxes. VL= VU+ [(1 - (1 - TC)(1
- TPE)/(1 - TP)](D) Where: TC = Corporate tax
rate, TPE= personal tax rate on income from
equity and TP = personal tax rate on interest
income.
79. 70. How does
Modigliani-Miller's proposition I is modified when
taxes and financial distress
costs are considered?
Financial distress occurs when bondholder
contracts are broken or fulfilled with great difficulty. Financial distress could lead to bankruptcy. Financial distress is costly. This is reflected
in the market value of the levered firm. Value of
a levered firm = Value of an equivalent unlevered firm + PV(tax shield) - PV(cost of financial
distress)
80. 71. Briefly explain bankruptcy costs.
There are direct and indirect costs to bankruptcy. Direct costs include legal and administrative costs of liquidation or reorganization.
Indirect costs of financial distress include impaired ability to conduct business and increased agency costs. Agency costs associated with managerial actions under the threat of
bankruptcy are: risk shifting, under-investment
or refusal to invest more equity, and milking the
property.
81. 72. Discuss some examples of the conflicts of
interest that may arise
between bondholders and
stockholders when a firm is
in financial distress.
When a firm is in distress, the shareholders
are interested in protecting the value of their
securities and hence take actions that might
decrease the value of the firm and hence reduce the debtholders' wealth. Some examples
of such actions are risk shifting, refusing to
contribute equity capital, milking the assets,
playing for time and bait and switch.
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82. 73. Briefly explain the
trade-off theory of capital
structure.
A firm's debt-equity decision can be thought
of as a trade-off between interest tax shields
and the costs of financial distress. These two
interact to provide an optimal capital structure
for a firm. This is called the trade-off theory.
83. 74. Explain the pecking or- This theory is based on the observation that, in
der theory of capital struc- general, managers know more about the firm's
ture.
prospects, risks, and values than do outsiders.
This asymmetric information affects the choice
between internal and external financing and
between new issues of debt and equity. The implication is that firms prefer internal financing
to external financing. When firms are propelled
to go for external financing it prefers debt to
equity.
84. 75. Explain the impact of
government loan guarantees on corporate financing.
The capital markets naturally punish firms for
excess use of debt via default and bankruptcy. Firms naturally will turn away from debt
financing and back towards equity financing.
Intervention in the capital markets by the government to provide loan guarantees to firms
on the brink of failure works in the opposite
direction by encouraging further leveraging.
85. 78. Briefly explain how the
beta of equity of a firm
changes with changes in
debt-equity ratio when taxes are considered.
The equity beta of a firm increases linearly
with changes in debt-equity ratio. This is modified by the tax factor. The exact relationship
is obtained by combining capital asset pricing
model and Modigliani-Miller proposition II with
taxes. The relationship is given by: bE = bA +
(1 - TC)(bA- bD)(D/E)
86. 79. Briefly explain how the
rate of return on equity of a
firm changes with changes
in debt-equity ratio when
taxes are considered.
The rate of return on equity of a firm increases
linearly with changes in debt-equity ratio. This
is modified by the tax factor. The exact relationship is obtained by combining capital asset
pricing model and Modigliani-Miller proposition
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II with taxes. The relationship is given by: rE =
rA + (1 - TC)(rA - rD)(D/E)
87. 80. Under what circumstances would it be better
to use the Adjusted Present Value approach?
The APV approach is better if there are many
side effects to financing. For example, if a firm
is getting a subsidized loan for a project then
the APV method should be used. It is used
when the amount of debt is known.
88. 81. Briefly explain how APV The value of a business can be estimated by
can be used for valuing a calculating the present value of free cash flows
business.
(FCF) generated by a firm using opportunity
cost of capital as the discounts rate for the
life of the firm. This gives the base-case NPV.
Business debt levels, interest, and interest tax
shields are calculated. If the debt levels are
fixed, then the interest tax shields are discounted at the borrowing rate to get the present
value of interest tax shields. The value of the
firm is the base-case NPV plus the present
value of interest tax shields.
89. 82. What discount rate
should be used for calculating the present value of
safe, nominal cash flows?
The discount rate used for finding the present
value of safe, nominal cash flows is the after-tax cost of debt. This present value is also
the value of an equivalent loan that can be paid
off using the cash flows.
90. 83. What method would you Generally, international projects have numeruse for evaluating interna- ous and important side effects like special contional projects?
tracts with governments, suppliers, and customers. They also have special project financing packages. All these effects can be explicitly
considered by using the APV method.
91. 84. What are some of the
additional factors that have
to be considered when analyzing an international project?
Briefly explain. Sometimes international projects have additional features, like special contracts with suppliers, customers, or governments, that provide guarantees. These guarantees are valuable for the firm and should
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be added to the APV. Sometimes governments
impose special restrictions. These restrictions
generally decrease the value of the project
to the firm. The value of the restrictions are
subtracted from the APV.
92. 85. "Urban renewal can be
accomplished by the provision of government tax
and loan incentives to business, despite the existence
of negative NPV projects."
Explain why this is true.
Investments may have a negative NPV in the
absence of other incentives. When the government provides a financial incentive, in the form
of subsidies, tax breaks, or low interest loans,
the APV of the project may increase. If the
increase is enough, the NPV may become positive and the firm might make the investment.
This could cause economic development in
areas that would not otherwise receive investments. The risk, however, is that the eventual
elimination of the incentives may cause urban
blight to return.
93. 51. Briefly explain the relationship between accounting standards and the legal
traditions.
Generally, companies from countries with English or Scandinavian legal traditions provide
more accounting information and have higher accounting standards than companies from
countries with French or German legal traditions.
94. 52. What are the three basic The three basic financial statements are the
financial statements?
balance sheet, the income statement, and the
sources and uses of funds.
95. 53. How are "uses and
Sources and uses of funds are calculated as
sources" of funds are cal- follows: Total uses of funds = Investment in net
culated?
working capital + investment in fixed assets +
dividends paid to shareholders Total sources
of funds = operating cash flow + new issues of
long-term debt + new issues of equity
96. 54. What are the common The ratios commonly used to measure liquidity
ratios used to measure liq- are the current ratio, quick ratio, and cash ratio.
uidity of a firm?
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97. 55. Briefly explain the dif- There are five categories of financial ratios.
ferent categories of finan- They are: leverage ratios, liquidity ratios, efcial ratios.
ficiency ratios, profitability ratios, and market
value ratios.
98. 56. What are the primary
reasons for a company to
use debt in its capital structure?
Companies use debt for two main reasons:
(a) debt is less expensive due to the tax-deductibility of interest charges, and (b) the use
of debt does not dilute shareholders' equity
position.
99. 57. Discuss the DuPont
system.
The DuPont system is a quick way of looking
at the performance of a firm or a division. ROA
and ROE can be thought of as comprising of
several ratios and hence provide some useful
information about the interaction of these ratios.
100. 58. Why is liquidity relevant?
Firms have a need to convert assets into cash
quickly. This is necessary to meet short term
obligations. Without liquidity, even the most
short term loans could force a company into
bankruptcy.
101. 77. Briefly explain how individuals can adjust their
preferences for current and
future consumption.
Individuals can adjust their preferences for
consumption by borrowing or lending in the
financial market. The appropriate balance between present and future consumption that
each individual will choose depends on personal preferences. But individuals with different preferences can adjust their preferences
using financial market
102. 91. Briefly explain the term Discount rate is the rate of return used for
"discount rate."
discounting future cash flows to obtain the present value. The discount rate can be obtained
by looking at the rate of return, an equivalent
investment opportunity in the capital market.
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103. 92. Intuitively explain the If you have $100 today, you can invest it and
concept of the present val- start earning interest on it. On the other hand,
ue.
if you have to make a payment of $100 one
year from today, you do not need to invest $100
today but a lesser amount. The lesser amount
invested today plus the interest earned on it
should add up to $100. The present value of
$100 one year from today at an interest rate of
10% is $90.91. [PV = 100/1.1 = 90.91]
104. 93. State the "net present
value rule."
Invest in projects with positive net present values. Net present value is the difference between the present value of future cash flows
from the project and the initial investment.
105. 94. Briefly explain the con- If the future cash flows from an investment are
cept of risk.
not certain then we call it a risky cash flow.
That means there is an uncertainty about the
future cash flows or future cash flows could be
different from expected cash flows. The degree
of uncertainty varies from investment to investment. Generally, uncertain cash flows are
discounted using a higher discount rate than
certain cash flows. This is only one method of
dealing with risk. There are many ways to take
risk into consideration while making financial
decisions.
106. 95. State the "rate of return Invest as long as the rate of return on the
rule."
investment exceeds the rate of return on equivalent investments in the capital market.
107. 96. Discuss why a dollar
tomorrow cannot be worth
less than a dollar the day
after tomorrow.
If a dollar tomorrow is worth less than a dollar
a day after tomorrow, it would be possible to
earn a very large amount of money through
"money machine" effect. This is only possible,
if someone else is losing a very large amount
of money. These conditions can only exist for
a short period of time, and cannot exist in
equilibrium as the source of money is quickly
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exhausted. Thus a dollar tomorrow cannot be
worth less than a dollar the day after tomorrow.
108. 97. Define the term "perpe- A perpetuity is defined as the same cash flow
tuity."
occurring each year forever.
109. 98. Describe how you
would go about finding the
present value of any annuity given the formula for the
present value of a perpetuity.
The present value of any annuity can be
thought of as the difference between two perpetuities one payment stating in year-1 (immediate) and one starting in year (n + 1) (delayed). By calculating difference between the
present values of these two perpetuities today
we can find the present value of an annuity.
110. 99. What is the difference between simple interest and compound interest?
When money is invested at compound interest,
each interest payment is reinvested to earn
more interest in subsequent periods. In the
simple interest case, the interest is paid only
on the initial investment.
111. 100. Briefly explain, "continuous compounding."
As frequency of compounding increases, the
effective rate on an investment also increases.
In case of continuous compounding the frequency of compounding is infinity. In this case,
the nature of the function also changes. The
effective interest rate is given by (er - 1), where
the value of e = 2.718. e is the base for natural
logarithms
112. 66. Briefly discuss capital There are two types of capital rationing; soft
rationing.
rationing imposed by the company and hard
rationing imposed by the capital markets. Capital rationing results in the firm foregoing some
positive NPV projects thereby reducing a firm's
value.
113. 67. Briefly explain the term Management uses soft rationing to get bet"soft rationing".
ter financial control over investment decisions.
Soft rationing is imposed by the management
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on a temporary basis and not by capital markets.
114. 68. Briefly explain the term A firm faces hard rationing when it cannot raise
"hard rationing."
more money in the capital markets. It is also
be indicative of market imperfections. Market
imperfections do not invalidate the NPV rule as
long as the shareholders of the firm have access to well-functioning capital markets so that
their portfolio choice is not restricted. The NPV
rule is undermined when imperfections restrict
shareholders' portfolio choice. Generally, hard
rationing is rare for corporations in the U.S.A.
115. 69. When calculating a
weighted average profitability index should you
apply an index of 0 to left
over money?
The NPV of money that is not invested is zero.
If the NPV is zero the profitability index is zero.
Thus, the math leads to a PI of zero for left
over money. Additionally, money not invested
cannot be assumed to have created value.
116. 68. Define the term cash
flow for a project.
Cash flow for a project is the net income plus
depreciation. Cash flows are always estimated
on an after-tax basis.
117. 69. What are some of the
important points to remember while estimating the
cash flows of a project?
Estimate after-tax cash flows on an incremental basis.• Include all incidental effects.•
Include working capital requirements.• Include opportunity costs.• Do not include sunk
costs.•Take inflation into consideration in a
consistent manner.
118. 70. Briefly explain how inflation is treated consistently while estimation the
project NPV.
There are two ways to treat inflation consistently in the estimation of NPV of a project. If
the discount rate is stated in nominal terms,
then consistency requires that project cash
flows also be estimated in nominal terms. This
might involve using different inflation rates for
different components of cash flow. If the discount rate is stated in real terms then real cash
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tency rule is: discount nominal cash flows at a
nominal discount rate and discount real cash
flows at a real discount rate.
119. 71. Briefly explain the
acronym MACRS.
MACRS is short for Modified Accelerated Cost
Recovery System. This is the result of the Tax
Reform Act of 1986. It is based on a combination of double declining method and straight
line depreciation methods. In this system, assets are classified into several classes like
3-year class, 5-year class etc. Tax depreciation
allowed under each asset class is provided in a
Table format. It uses mid-year convention and
hence an asset under 3-year class has depreciation for four years, and etc. The alternative
is to use the straight-line depreciation method.
120. 72. Briefly discuss how taxes are taken into consideration in countries like
Japan.
In Japan and all of the European Community
countries, it is not possible to separate tax accounts reported to the government and those
reported to shareholders. They must be same.
In some countries it is not possible to use the
accelerated depreciation.
121. 73. What are some of the
additional factors that have
to be considered while estimating cash flows in other
countries and currencies?
•Currency of the cash flow should be relevant
to the project•Use an appropriate inflation rate
for the project• Use the relevant tax rate and
depreciation method for the project• Use the
appropriate discount rate for the project
122. 74. How do you comProjects with different lives are compared aspare projects with different suming that the projects are repeated to inlives?
finity, called replacement chains. The replacement chains are analyzed using equivalent annual costs (EAC) or adjusted NPVs (adjusted
for differences in project lives).
123. 75. Briefly explain how the The decision to replace an existing machine is
decision to replace an ex- done for economic or technological reasons or
isting machine is made?
for both. For this equivalent annuity approach
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is used. As long as the benefits exceed equivalent annual costs replacing old machine with
a new one, the decision will be a sound one.
124. 76. Briefly explain how the Many managers assume that the marginal cost
cost of excess capacity is of excess capacity is zero and encourage emtaken into consideration. ployees to use up the excess capacity. This
may not be a very sound way to utilize excess capacity. If we use the equivalent annual
cost (EAC) approach cost of excess capacity
can be estimated easily. Indiscriminate use of
excess capacity may result in replacing the
existing machine with a new machine sooner.
This is the cost of excess capacity and must
be taken into consideration.
125. 77. Briefly explain the difference between an equivalent annual cost and an
equivalent annual annuity.
The technique of equivalent annual cash flows
can be employed for evaluating cost saving projects or projects that generate positive
NPVs. When used to evaluate cost savings
projects the term equivalent annual cost is
used and we seek to minimize this number.
When looking at positive NP
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1. 58. Briefly explain
the difference between company
and project cost
of capital.
If a firm is considering projects that have the same risk as
the firm, then the company cost of
capital is the same as the project cost of capital. But if the
firm is considering projects which
have risks different from the company then the project cost
of capital becomes relevant.
2. 59. Briefly explain
how the use of
single company
cost of capital to
evaluate projects
might
lead to erroneous
decisions.
If the firm is considering projects with differing risk characteristics, the firm will reject lowrisk
projects and accept high-risk projects. In reality low - risk
projects should be discounted
at a lower rate and high-risk projects at a higher discount
rate to account for differing risks.
3. 60. Discuss why
one might use an
industry beta to
estimate a company's cost of
capital.
Generally, an industry beta can be estimated more precisely than a company's beta. This is
similar to the estimate of the beta of a portfolio is more
precise than the estimate of the beta of
a single stock. The estimated industry cost of capital must
be suitably adjusted before using
for company's cost of capital. For example, differences in
the capital structure of the firm and
the industry.
4. 61. Briefly explain
how a firm's cost
of equity is estimated using the
capital asset pricing
model (CAPM).
The first step is to estimate the beta of the firm's common
stock by regressing the returns on
the stock on the market returns using historical data. Expected stock return is estimated using
CAPM [E(R) = rf + (beta)( rm - rf)]. Expected return is the
estimate of the firm's cost of equity.
5. 62. Briefly exGenerally, the value used for the risk-free rate is the
plain what value short-term Treasury bill rate.
should be used
for the risk-free
interest rate.
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6. 63. Briefly describe the factors that determine asset betas.
Asset betas are determined by the cyclical nature of the
cash flows. Generally, cyclical firms
have higher betas. Operating leverage also affects the
asset beta of a firm. Firms with high
fixed costs tend to have higher asset betas.
7. 64. Briefly discuss the certainty equivalent approach to estimating the NPV
of a project.
In the certainty equivalent approach, certainty equivalent
cash flows are discounted at the
risk-free rate to calculate the NPV of a project. First risky
cash flows have to be converted to
certainty equivalent cash flows by using individual risk
factors. One advantage of this method
is that the risk adjustment is separated from the time value
of money. Conceptually this is a
more sensible method than the risk adjusted discount rate
method. But estimating certainty
equivalent cash flows could be cumbersome.
8. 65. Briefly discuss the risk adjusted discount
rate approach to
estimating the
NPV of a
project.
The risk adjusted discount rate approach uses the discount
rate to adjust for both risk and the
time value of money. The main advantage of this approach
is simplicity. Risky project cash
flows are discounted using risk adjusted discount rates
(higher rates) to calculate the NPV of a
project.
9. 66. Why do firms
with large cash
flow betas also
have high asset
betas?
There is a strong correlation between the risk of the assets
of a firm and the risk of the firm's
earnings. As such high asset betas lead to high cash flow
betas.
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1. The law of one price,
which implies
that the price of a security should equal the present value of the expected cash flows an investor
will receive from owning it
2. To value a stock, we need expected cash flows an investor will receive and
to know the
the appropriate cost of capital with which to discount those cash flows
3. The law of one price im- determine the expected cash flows an investor
plies that to value any se- will receive from owning it. Thus, we begin our
curity, we must
analysis of stock valuation by considering the
cash flows for an investor with a one-year investment horizon.
4. There are two potential
sources of cash flows
from owning a stock.
First, the firm might pay out cash to its shareholders in the form of a dividend. Second, the
investor might gen-erate cash by choosing to sell
the shares at some future date.
5. The equity cost of capital is the expected return of other investments availfor the stock
able in the market with equivalent risk to the firm's
shares.
6. for an investor to be will- receive at least as much today as the present
ing to sell the stock, she value she would receive if she waited to sell next
must
year:
7. The stock's dividend
yield
is the
expected annual dividend of the stock divided by
its current price. The dividend yield is the percentage return the investor expects to earn from the
dividend paid by the stock
8. The capital gain the investors will earn on the
stock
is the difference between the expected sale price
and purchase price for the stock, P1 - P0. We
divide the capital gain by the current stock price to
express the capital gain as a percentage return,
called the capital gain rate.
9.
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The sum of the dividend The total return is the expected return that the
yield and the capital gain investor will earn for a one-year investment in the
rate is called the total re- stock.
turn of the stock.
10. the stock's total return
should equal the equity
cost of capital. In other
words, the expected total return of the stock
should equal
the expected return of other investments available
in the market with equivalent risk
11. The price of the stock is the present value o f the expected future diviequal to
dends it will pay
12. the simplest forecast for grow at a constant rate forever
the firm's future dividends states that stye
will
13. According to the Constant dividend growth
model
the value of the firm depends on the dividend level
for the coming year, divided by the equity cost of
capital adjusted by the expected growth rate of
dividends
14. Increasing growth may
require
investment and money spent on investment cannot be used to pay dividends
15. What determines the rate If we define a firm's dividend payout rate as the
of growth of a firm's divi- fraction of its earnings that the firm pays as divdends?
idends each year, then we can write the firm's
dividend per share at dateWhat determines the
rate of growth of a firm's dividends? If we define
a firm's dividend payout rate as the fraction of
its earnings that the firm pays as dividends each
year, then we can write the firm's dividend per
share at date
16.
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Thus the firm can increase its dividend in
three ways:
1. It can increase its earnings (net income). 2. It
can increase its dividend payout rate.
3. It can decrease its shares outstanding.
17. A firm can do one of two It can pay them out to investors, or it can retain
things with its earnings: and reinvest them. By investing more today, a firm
can increase its future earnings and dividends.
18. Change in Earnings =
New Investment * Return on New In
19. New investment =
earnings x retention rate
20. Earnings Growth rate =
change in earnings / earnings = retention rate x
return on new investment
21. sustainable growth rate
the rate at which it can grow using only refined
earnings
22. cutting the firm's divistock price if, and only if, the new investments
dend to increase invest- have a positive NPV
ment will raise the
23. The dividend-discount
model values the
stock based on a forecast of the future dividends
paid to shareholders. But unlike a Treasury bond,
where the future cash flows are known
with virtual certainty,
24. Forecasting dividends
requires
forecasting the firm's earnings, dividend payout
rate, and future share count. But future earnings
depend on interest expenses (which in turn depend on how much the firm borrows), and the
firm's share count and dividend payout rate depend on whether the firm uses a portion of its
earnings to repurchase shares.
25. we outline two alternative approaches to valuing the firm's shares
that avoid some of the
First, we consider the total payout model, which
allows us to ignore the firm's choice between
dividends and share repurchases. Then, we consider the discounted free cash flow model, which
focuses on the cash flows to all of the firm's
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difficulties of the dividend-discount model.
26. share repurchase
investors, both debt and equity holders, allowing
us to avoid estimating the impact of the firm's
borrowing decisions on earnings.
the firm uses excess cash to buy back its
own stock. Share repurchases have two consequences for the dividend-discount model. First,
the more cash the firm uses to repurchase
shares, the less it has available to pay dividends.
Second, by repurchasing shares, the firm decreases its share count, which increases its earnings and dividends on a per-share basis
27. An alternative method
all of the firm's equity, rather than a single share.
that may be more reliable
when a firm repurchases
shares is the total payout
model, which values
28. Discounted free cash
determining the total value of the firm to all inflow model goes one step vestors-both equity and debt holders
further and begins by
29. enterprise value =
market value of equity + debt - cash
30. The enterprise value is
the
value of the firm's underlying business, unencumbered by debt and separate from any cash or
marketable securities.
31. The advantage of the dis- allows us to value a firm without explicitly forecounted free cash flow casting its dividends, share repur-chases, or its
model is that it
use of debt.
32. How can we estimate a
firm's enterprise value?
To estimate the value of the firm's equity, we
computed the present value of the firm's total
payouts to equity holders. Likewise, to estimate a
firm's enterprise value, we compute the present
value of the free cash flow (FCF) that the firm
has available to pay all investors, both debt and
eq-uity holder
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33. net investment =
capital expenditures - depreciation
34. net investment as invest- support the firm's growth, above and beyond the
ment intended to
level needed to maintain the firm's existing capital.
35. free cash flow measures cash generated by the firm before any payments
the
to debt o r equity holders are considered
36. Firm's weighted average the average cost of capital the firm must pay to all
cost of capital is
of its investors, both debt and equity holders.
(We can also interpret the WACC as reflecting the
average risk of all of the firm's investments.)
37. Because the firm's free
cash flow is equal to
the sum of the free cash
flows from the firm's current and future investments, we can interpret
the firm's enterprise value as the
total NPV that the firm will earn from continuing its
existing projects and initiat-ing new ones. Hence,
the NPV of any individual project represents its
contribution to the firm's enterprise value. To maximize the firm's share price, we should accept
projects that have a positive NPV
38. The value of the stock
is determined by the present value of its future dividends. We can
estimate the total market capitalization of the
firm's equity from the
present value of the
firm's total payouts,
which includes dividends
and share repurchases.
Finally, the present value of the firm's free cash
flow, which is the cash the firm has available to
make payments to equity or debt holders, determines the firm's enterprise value.
39. method of comparable
Finally, the present value of the firm's free cash
flow, which is the cash the firm has available to
make payments to equity or debt holders, determines the firm's enterprise value.
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40. A firm's P/E ratio is
equal to the share price divided by its earnings
per share
41. We can adjust for differ- value in terms of a valuation multiple, which is a
ences in scale between ratio of the value to some measure of the firm's
firms by expressing their scale.
42. forward P/E, which is
the P/E multiple computed based on its forward
earnings (expected earnings over the next twelve
months).
We can also compute a firm's trailing P/E ratio
using trailing earnings (earnings over the prior 12
months). For valuation purposes, the forward P/E
is generally preferred, as we are most concerned
about future earnings. We can also compute a
firm's trailing P/E ratio using trailing earnings
(earnings over the prior 12 months). For valuation
purposes, the forward P/E is generally preferred,
as we are most concerned about future earnings.
43. because it represents
the total value of the
firm's underlying business rather than just the
value of equity, using the
enter-prise value is advantageous if we want to
compare firms with different amounts of leverage
Because the enterprise value represents the entire value of the firm before the firm pays its debt,
to form an appropriate multiple, we divide it by a
measure of earnings or cash flows before interest
payments are made
44. a key shortcoming of the that it does not take into account the important
comparables approach is differences among firms.
Another limitation of comparables is that they only
provide information regarding
the value of the firm relative to the other firms in
the comparison set.
45. Using a valuation multi- discounted cash flow methods of valuation.
ple based on comparables is best viewed as a
"shortcut" to the
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46. discounted cash flow
(DCF) methods have the
advantage that they
allow us to incorporate specific information
about the firm's profitability, cost of capital,
or future growth potential, as well as perform
sensitivity analysis.
Because the true driver of value for any firm is its
ability to generate cash flows for its investors, the
discounted cash flow methods have the potential
to be more accurate and insightful than the use
of a valu-ation multiple
47. If information were available that indicated that
buying a stock had a positive NPV, investors with
that information would
choose to
buy the stock; their attempts to purchase it would
then drive up the stock's price. By a similar logic,
investors with information that selling a stock had
a positive NPV would sell it and the stock's price
would fall
48. The idea that competition
among investors works
to eliminate all positive
NPV trading opportunities is referred to as the
efficient markets hypothesis. It implies that securities will be fairly priced, based on their future
cash flows, given all information that is available
to investor
49. If stocks are fairly valued -focus on NPV and free cash flow
according to the models -avoid accounting illusions
we have described, then -use financial transactions to support investment
the value of the firm is
determined by the cash
flows that it can pay to its
investors. This result has
several key implications
for corporate managers:
50. An arbitrage opportunity situation in which two securities (or portfolios)
is a
with identical cash flows have different prices.
51. The efficient markets hy- returns
pothesis, that the NPV of
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investing in securities is
zero, is best expressed in
terms of
52. When the NPV of invest- present value of its expected cash flows when
ing is zero, the price of discounted at a cost of capital that reflects its risk
every security equals the
53. the growth rate of the
the growth rate of earnings, not earnings per
firm's total payout is gov- share
erned by
54. When a firm has leverage reliable to sue the discounted free cash flow modit is more
el
55. Stock prices aggregate if our valuation disagrees with the stock's market
the information of many price, it is most likely an indication that our asinvestors. Therefore
sumptions about the firm's cash flows are wrong.
56. In an efficient market, to maximizing the present value of the free cash flow
raise the stock price cor- from the firm's investments, rather than accountporate managers should ing consequences or financial policy
focus on
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1. True or False: The value of a company is equal to
the present value of its expected future cash flows,
discounted for timing and risk.
True
2. Which of the following is NOT a step in discounted
cash flow valuation?
Estimate the current ratio
Forecast expected cash flows
Estimate the discount rates
Calculate the enterprise value of a company
Calculate the per share price of a stock
Estimate the current ratio
3. Which of the following is NOT necessary to project
free cash flow to the firm?
Beta
Revenue Growth
Operating Profit Margin
Beta
Working Capital Investment
Tax Rate
4. True or False: Using a higher risk-free rate in your
WACC calculation will yield a lower value in a discounted cash flow analysis.
True
5. Discounted cash flow is a type of ______ analysis.
Fundamental
Modern portfolio theory
Fundamental
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Technical
Capital markets
Interest rate
6. Who would be most likely to value a stock based on Fundamental Anathe Discounted Cash Flow valuation technique?
lyst
Technical Analyst
Fundamental Analyst
Day Trader
All of the Above
None of the Above
7. Who determines the stock price of a company?
The Market
Management
Board of Directors
Investment Banks
The Market
The Government
8. True or False: The value of a stock is equal to the
present value of its earnings.
False
9. Which of the following would NOT increase the intrin- Higher working
sic value of a Stock with all else constant?
capital as a % of
sales
Higher working capital as a % of sales
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Higher Revenue Growth Rate
Lower Beta
Lower risk free interest rate
Lower Tax Rate
10. True or False: With all fundamentals the same, a tech False
company will have a higher valuation than a non-tech
company.
11. Which would stock would be the best buying oppor- Stock D
tunity?
Stock A: intrinsic value - $40, price - $45
Stock B: intrinsic value - $60, price - $40
Stock C: intrinsic value - $100, price - $90
Stock D: intrinsic value - $40, price - $20
Stock E: intrinsic value - $40, price - $60
Stock A
Stock B
Stock C
Stock D
Stock E
12. True or False: If a company's earnings are in line with False
expectations, the stock price will increase significantly.
13. Which of the following would cause a stock's price to Company ABC
increase?
losing $5 million in
the quarter versus
Company ABC losing $10 million in the quarter versus expectations of a
expectations of a $5 million loss
$10 million loss
Company ABC reporting a revenue growth rate of
10%, in line with expectations
Company ABC reporting an operating profit margin of
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15% versus expectations of 20%
Company ABC losing $5 million in the quarter versus
expectations of a $10 million loss
Company ABC reporting an operating profit margin of
10%, in line with expectations
14. Given the following, calculate the intrinsic value per $10.43
share of Company XYZ's stock:
Corp. Value - $26 million
Bonds Outstanding - $10 million
ST Liabilities - $350 thousand
LT Growth Rate - 6%
Beta - 1.2
Shares Outstanding - 1.5 million
$24.23
$17.33
$11.06
$10.43
$12.52
15. With all else constant, which would result in a lower Lower Profit Marintrinsic value per share of a company's stock?
gins
Lower Market Risk Premium
Lower Investment as % of Revenue
Higher Revenue Growth
Lower Profit Margins
Lower Risk Free Rate
16. An increase in _________ risk in the market place was Systematic
a major factor is the latest financial crisis.
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Systematic
Unsystematic
Interest rate
Reinvestment
Inflation
17. In the long run, stock returns are influenced by growth Earnings
in _________.
Earnings
Interest rates
Inflation
Risk
Supply and demand
18. In a WACC calculation, which of the following measures risk?
Beta
Risk free rate
Market return
Beta
CAPM
Debt to equity ratio
19. Which is definitely true regarding stock valuation?
If interest rates decline and risk increases, the value
5/6
If risk increases
and interest rates
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of a stock will increase
rise, the value of a
stock will decrease
If expectations of future cash flows decline and risk
decreases, the value of a stock will decrease
If expectations of future cash flows increase and interest rates rise, the value of a stock will increase
If risk increases and interest rates rise, the value of a
stock will decrease
If risk decreases and interest rates fall, the value of a
stock will decrease
20. _________ analysis tends to be more a short-term
trading approach to buying and selling stocks.
Modern portfolio theory
Fundamental
Technical
Discounted cash flow
Cost of capital
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Technical
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1. Intrinsic value: high confidence in
your model means?
high confidence means the market
price will converge to the intrinsic value over time
2. Intrinsic value: number of analysts
the more analysts the less the misspricing
3. Present value models
· estimate value as present value of
expected future benefits
· future benefits are cash distributed
to shareholders (dividend discount
model), or cash available to shareholders after meeting the necessary
capital expenditure and working capital expenses
4. Multiplier models
· estimate intrinsic value based on
a multiple of some fundamental variable
· either stock price/ earnings, or
sales, book value, cash flow
5. Asset-based valuation models
· estimate the value of equity as the
value of assets less the value of liabilities
· book values of assets and liabilities
are typically adjusted to their fair values when using these models
6. Three types of cash dividends
· regular cash dividends- are paid out
on a constant basis. a stable or increasing dividend is viewed as a sign
of financial stability
· special dividends- are one time
cash payments when the situation is
favorable
· liquidating dividend- distributed to
shareholders when a company goes
out of business
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7. Stock dividend
· Company distributes additional
shares instead of cash
· since the market value of equity
is unaffected, stock dividends aren't
relevant for valuation purposes
8. Share Repurchase
a transaction in which a firm uses
cash to buy back its own stock
· companies choose to engage in
share repurchase instead of cash
dividends to support share prices,
to have flexibility in the amount and
timing of cash distribution, when tax
rates on capital gains are lower than
tax rates on dividends, and to offset
the impact of employee stock options
9. dividend payment chronology
· the dividend payment schedule is
as follows
· declaration date -> ex dividend date
(cut-off date on or after which buyers of a stock aren't eligible for the
dividend) -> Holder of record date
(record of shareholders who are eligible to receive the dividend is made)
-> payment date
10. Dividend Discount Model
Discounted cash-flow model which
states that today's stock price equals
the present value of all expected future dividends
· according to DDM, the intrinsic value of a stock is the present value
of future dividends plus the present
value of terminal value
11. Free Cash Flow to Equity
Cash flow that would be available for
distribution to common shareholders;
= Cash Flow from Operations - Fixed
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Capital Investment + Debt Issued Debt Repaid
12. preferred stock valuation
· For a non callable, nonconvertible
perpetual preferred share paying a
level dividend and assuming a constant required rate of return, the value is given by the equation V= D/r
· where V equals present value of
the perpetuity; D equals dividend; R
equals rate of return
13. Gordon Growth Model
· One disadvantage of the DDM is
that it's difficult to accurately estimate the amount of dividends for a
long period of time
· the Gordon growth model simplifies
this by assuming that dividends grow
indefinitely at a constant rate
·v=D/R-G
14. · Assumptions of the Gordon growth · dividends are the correct metric to
model
use for valuation purposes
· dividend growth rate is continuous
· required rate of return is constant
throughout the life of the security
· dividend growth rate is less than
required rate of return
15. When is it not appropriate to use the · if the company is currently not payGordon growth model?
ing a dividend as it may reinvest
earnings
· if the company isn't profitable
enough to currently pay a dividend
16. What happens to the value if dividend · when dividend value increases, nuvalue increases?
merator increases
· If the payout ratio increases, retention rate decreases and the value of
G decreases, denominator increas3 / 11
Estimated Value and Market Price
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es
· as a result, the impact on value if
dividend is increased cannot be determined with certainty
17. price multiple
· Price multiple is a ratio that uses
a company's share price with some
monetary flow/value for evaluating
the relative worth of a company's
stock
18. Enterprise Value (EV)
· Used as an alternative measure for
equity
· it measures the market value of the
whole company (debt and equity)
· enterprise value= market value of
debt + market value of equity + market value of preferred stock - cash
and investments
· An enterprise value model relates
a firm's enterprise value (the market
value of its outstanding equity and
debt securities minus its cash and
marketable securities holdings) to its
EBITDA, operating earnings, or revenue
19. When is EV/EBITDA used?
· when earnings are negative making
PE useless, EBITDA is usually positive
· for comparing companies with significant differences in capital structure
· to evaluate the cost of a takeover
20. Asset-Based Valuation
Estimates the value of the firm's assets; does not reflect the value of the
firm as a going concern.
· Asset based valuation uses the estimates of the market or the fair value
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of the company's assets and liabilities
· this method is appropriate for companies that have low proportion of
intangible or off the book assets
· often used for valuing private enterprises
21. A company last paid a $1.00 diviD0 (1 + g) / P0 + g = k
dend, the current market price of the 1.00 (1.05) / 20 + 0.05 = 10.25%.
stock is $20 per share and the dividends are expected to grow at 5 percent forever. What is the required rate
of return on the stock?
22. Beth Knight, CFA, and David Royal, You can select the correct answer
CFA, are independently analyzing the without calculating the share values.
value of Bishop, Inc., stock. Bishop Royal is using a shorter period of
paid a dividend of $1 last year. Knight supernormal growth and a higher reexpects the dividend to grow by 10% quired rate of return on the stock.
in each of the next three years, afBoth of these factors will contribute
ter which it will grow at a constant to a lower value using the multistage
rate of 4% per year. Royal also exDDM.
pects a temporary growth rate of 10%
followed by a constant growth rate
of 4%, but he expects the supernormal growth to last for only two years.
Knight estimates that the required return on Bishop stock is 9%, but Royal
believes the required return is 10%.
Royal's valuation of Bishop stock is
approximately:
A)$5 greater than Knight's valuation.
B)$5 less than Knight's valuation.
C)equal to Knight's valuation.
23. If an analyst estimates the intrinsic
value for a security that is different
from its market value, the analyst
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B.
In general, an analyst can be more
confident about an estimate of intrin-
Estimated Value and Market Price
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should most likely take an investment position based on this difference if:
A)many analysts independently evaluate the security.
B)the model used is not highly sensitive to its input values.
C)the security lacks a liquid market
and trades infrequently.
sic value if the model used is not
highly sensitive to changes in its inputs. If a large number of analysts
follow a security, its market value is
more likely to be a reliable estimate
of its intrinsic value. A security that
does not trade frequently or in a liquid market may remain mispriced for
an extended time, and thus may not
result in a profit within the investment
horizon even if the analyst's estimate
of intrinsic value is correct.
24. An argument against using the
price-to-earnings (P/E) valuation approach is that:
A)research shows that P/E differences are significantly related to
long-run average stock returns.
B)earnings power is the primary determinant of investment value.
C)earnings can be negative.
C.
Negative earnings render the P/E ratio useless. Both remaining factors
increase the usefulness of the P/E
approach.
25. The earnings multiplier model, derived from the dividend discount
model, expresses a stock's P/E ratio
(P0/E1) as the :
A)expected dividend in one year divided by the difference between the
required return on equity and the expected dividend growth rate.
B)expected dividend payout ratio divided by the sum of the expected dividend growth rate and the required
return on equity.
C)expected dividend payout ratio divided by the difference between the
required return on equity and the expected dividend growth rate.
Starting with the dividend discount
model P0 = D1/(ke - g), and dividing both sides by E1 yields: P0/E1 =
(D1/E1)/(ke - g)
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Thus, the P/E ratio is determined by:
The expected dividend payout ratio
(D1/E1).
The required rate of return on the
stock (ke).
The expected growth rate of dividends (g).
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26. Regarding the estimates required in
the constant growth dividend discount model, which of the following
statements is most accurate?
A)Dividend forecasts are less reliable than estimates of other inputs.
B)The model is most influenced by
the estimates of "k" and "g."
C)The variables "k" and "g" are easy
to forecast.
B.
The relationship between "k" and "g"
is critical - small changes in the difference between these two variables
results in large value fluctuations.
27. Which of the following is NOT an ad- B.
vantage of using price-to-book value Book values are NOT very meaning(PBV) multiples in stock valuation? ful for firms in service industries.
A)Book value is often positive, even
when earnings are negative.
B)Book values are very meaningful
for firms in service industries.
C)PBV ratios can be compared
across similar firms if accounting
standards are consistent.
28. An analyst gathered the following
data:
An earnings retention rate of 40%.
An ROE of 12%.
The stock's beta is 1.2.
The nominal risk free rate is 6%.
The expected market return is 11%.
Assuming next year's earnings will
be $4 per share, the stock's current
value is closest to:
A)$45.45.
B)$33.32.
C)$26.67.
Dividend payout = 1 - earnings retention rate = 1 - 0.4 = 0.6
RS = Rf + ²(RM - Rf) = 0.06 + 1.2(0.11
- 0.06) = 0.12
g = (retention rate)(ROE) =
(0.4)(0.12) = 0.048
D1 = E1 × payout ratio = $4.00 × 0.60
= $2.40
Price = D1 / (k - g) = $2.40 / (0.12 0.048) = $33.32
29. A firm has an expected dividend pay- Expected dividend = $4.50 × 0.50 =
out ratio of 50%, a required rate of
$2.25
return of 12% and a constant growth
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rate of 6%. If earnings for the next
Value today = $2.25 / (0.12 - 0.06) =
year are expected to be $4.50, the
$37.50
value of the stock today is closest to:
A)$33.50.
B)$37.50.
C)$39.75.
30. Holding all else equal, if the beta of
a stock increases, the stock's price
will:
A)be unaffected.
B)decrease.
C)increase.
When the beta of a stock increases,
its required return will increase. This
increases the discount rate investors
use to estimate the present value of
the stock's future cash flows, which
decreases the value of the stock.
31. If a firm's growth rate is 12% and its
dividend payout ratio is 30%, its current return on equity (ROE) is closest
to:
A)40.00%.
B)17.14%.
C)36.00%.
g = (RR)(ROE)
g / RR = ROE
0.12 / (1 - 0.30) = 0.12 / 0.70 = 0.1714
or 17.14%
32. Given the following information,
compute price/book value.
Book value of assets = $550,000
Total sales = $200,000
Net income = $20,000
Dividend payout ratio = 30%
Operating cash flow = $40,000
Price per share = $100
Shares outstanding = 1000
Book value of liabilities = $500,000
Book value of equity = $550,000 $500,000 = $50,000
Market value of equity =
($100)(1000) = $100,000
Price/Book = $100,000/$50,000 =
2.0X
33. Witronix is a rapidly growing U.S.
company that has increased free
cash flow to equity and dividends at
an average rate of 25% per year for
the last four years. The present value
model that is most appropriate for
estimating the value of this company
B.
A multistage model is the most appropriate model because the company is growing dividends at a higher
rate than can be sustained in the
long run. Though the company may
be able to grow dividends at a high-
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Estimated Value and Market Price
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is a:
A)Gordon growth model.
B)multistage dividend discount model.
C)single stage free cash flow to equity model.
er-than-sustainable 25% annual rate
for a finite period, at some point dividend growth will have to slow to
a lower, more sustainable rate. The
Gordon growth model is appropriate
to use for mature companies that
have a history of increasing their dividend at a steady and sustainable
rate. A single stage free cash flow to
equity model is similar to the Gordon
growth model, but values future free
cash flow to equity rather than dividends
34. If all other factors remain unchanged, B.
which of the following would most
likely reduce a company's price/earnings ratio?
A)The dividend payout ratio increases, and the dividend growth rate increases.
B)The required rate of return increases, and the dividend payout ratio decreases.
C)The dividend growth rate increases, and the required rate of return
decreases.
35. Free Cash Flow to the Firm (FCFF)
Cash Flow available for distribution
to all investors (stockholders & debt
holders)
CFO + int(1-t) - fixed capital investment
or
36. A valuation model based on the cash
flows that a firm will have available
to pay dividends in the future is best
characterized as a(n):
A.
Free cash flow to equity represents
a firm's capacity to pay future dividends. A free cash flow to equity
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A)free cash flow to equity model.
B)free cash flow to the firm model.
C)infinite period dividend discount
model.
model estimates the firm's FCFE for
future periods and values the stock
as the present value of the firm's future FCFE per share.
37. A stock has a steady 5% growth rate First solve for D5: D5 = (D1)(1 + g)n
in dividends. The required rate of re- = $1(1.05)4 = $1.216
turn for stocks of this risk class is
P0 = 1/(0.150.05)=10
15%. The stock is expected to pay
P4=10(1.05)^4=$12.16
a $1 dividend this coming year. The
expected value of the stock at the end
of the fourth year is:
A)$14.21.
B)$16.32.
C)$12.16.
38. A company's required return on equity is 15% and its dividend payout
ratio is 55%. If its return on equity
(ROE) is 17% and its beta is 1.40, then
its sustainable growth rate is closest
to:
A)6.75%.
B)7.65%.
C)9.35%.
Growth rate = (ROE)(Retention Ratio)
= (0.17)(0.45)
= 0.0765 or 7.65%
39. Net income= $1,000,000
Total equity= $5,000,000
Total assets= $10,000,000
Dividend payout ratio= 40%
Based on the sustainable growth
model, the most likely forecast of the
company's future earnings growth
rate is:
A)12%.
B)8%.
C)6%.
g = (RR)(ROE)
RR = 1 - dividend payout ratio = 1 0.4 = 0.6
ROE = NI / Total Equity = 1,000,000
/ 5,000,000 = 1 / 5 = 0.2
40. What is the value of a preferred stock B.
that is expected to pay a $5.00 annual $5.00/0.08 = $62.50.
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dividend per year forever if similar
risk securities are now yielding 8%?
A)$60.00.
B)$62.50.
C)$40.00.
41. basis points below the bond yield.
The price of the preferred is closest
to:
A)$90.91.
B)$80.00.
C)$5.00.
Preferred stock yield (Kp) = bond
yield - 0.75% = 6.25% - 0.75% =
5.5%
Value = dividend / Kp = $5 / 0.055 =
$90.91.
42. A stock has a required rate of return of 15%, a constant growth rate of
10%, and a dividend payout ratio of
45%. The stock's price-earnings ratio
should be:
A)4.5 times.
B)3.0 times.
C)9.0 times.
P/E = D/E1/ (k - g)
D/E1 = Dividend Payout Ratio = 0.45
k = 0.15
g = 0.10
P/E = 0.45 / (0.15 - 0.10)
= 0.45 / 0.05 = 9
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1. (1) Ownership
(2) Dividend
(3) Are not
Common stock
represents the *(1)
*position in a firm
and is valued as
the present value of its expected future *(2)
*stream. Common
stock dividends
*(3) * specified
by contract—they
depend on the
firm's earnings.
Two models are
used to estimate
a stock's intrinsic value: the discounted dividend
model and the
corporate valuation model.
2. Discounted dividend
The __________
model values a
common stock as
the present value
of its expected future cash flows at
the firm's required
rate of return on
equity. Variations
of this model are
used to value
constant growth
stocks, zero
growth stocks,
and non-constant
growth stocks.
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3. (1) Corporate valuation
(2) Free-cash flows
The *(1) *model
is an alternative
model used to value a firm, especially one that does
not pay dividends
or is privately held.
This model calculates the firm's *(2)
*, and then finds
their present values at the firm's
weighted average
cost of capital to
determine a firm's
value.
4. D
Which of the following statements
is correct?
a. The only difference between
the discounted dividend and corporate valuation
models is the expected cash flow
stream. Expected
future dividends
are the cash flow
stream in the discounted dividend
model and expected free cash flows
are the cash flow
stream in the corporate valuation
model. Both models use the same
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discount rate to
calculate the present value of the
cash flow stream.
b. The discounted dividend model
is especially suited
for valuing companies that are privately held.
c. The only difference between
the discounted dividend and corporate valuation
models is the discount rate used to
calculate the present value of the
cash flow stream.
The discount rate
used in the discounted dividend
model is the firm's
required rate of
return on equity, while the discount rate used in
the corporate valuation model is the
firm's weighted average cost of capital. Both models
use the same expected cash flow
stream in the discounting process.
d. There are actually two dif3 / 55
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ferences between
the discounted dividend and corporate valuation
models: the expected cash flow
stream and the
discount rate used
in the models are
different. The discounted dividend
model calculates
the firm's stock
price as the present value of
the expected future dividends at
the firm's required
rate of return on
equity, while the
corporate valuation model calculates the firm's
stock price as the
present value of
the expected free
cash flows at the
firm's weighted average cost of equity.
5. (1) equal to
(2) below
(3) an infinite
(4) start-up
(5) mature
The value of a
share of common
stock depends on
the cash flows it
is expected to provide, and those
flows consist of
the dividends the
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investor receives
each year while
holding the stock
and the price the
investor receives
when the stock
is sold. The final
price includes the
original price paid
plus an expected
capital gain. The
actions of the marginal investor determine the equilibrium stock price.
Market equilibrium
occurs when the
stock's price is *(1)
*its intrinsic value.
If the stock market
is reasonably efficient, differences
between the stock
price and intrinsic value should
not be very large
and they should
not persist for very
long. When investing in common stocks, an
investor's goal is
to purchase stocks
that are undervalued (the price is
*(2) *the stock's intrinsic value) and
avoid stocks that
are overvalued.
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The value of a
stock today can be
calculated as the
present value of
*(3) *stream of dividends:
This is the generalized stock valuation model. We
will now look at
3 different situations where we
can adapt this
generalized model
to each of these
situations to determine a stock's intrinsic value:
1. Constant
Growth Stocks;
2. Zero Growth
Stocks;
3. Nonconstant
Growth Stocks.
Constant Growth
Stocks:
For many companies it is reasonable to predict
that dividends will
grow at a constant
rate, so we can
rewrite the generalized model as
follows:
This is known
as the con6 / 55
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stant growth model or Gordon model, named after
Myron J. Gordon who developed and popularized it. There are
several conditions
that must exist
before this equation can be used.
First, the required
rate of return, rs,
must be greater
than the long-run
growth rate, g.
Second, the constant growth model is not appropriate unless a
company's growth
rate is expected
to remain constant in the future.
This condition almost never holds
for *(4) *firms, but
it does exist for
many *(5) *companies.
6. E
Which of the
following assumptions would
cause the constant growth stock
valuation model to
be invalid?
a. The growth rate
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is zero.
b. The growth rate
is negative.
c. The required
rate of return is
greater than the
growth rate.
d. The required
rate of return is
more than 50%.
e. None of the
above assumptions would invalidate the model.
7. Current price = P hat 0 = = D0 (1 + g)/(rs - g)
= $1.60(1.03)/(0.09 - 0.03)
= $1.648/0.06 = $27.47 per share
8. Vp = Dp/rp
Vp = $1.80/0.10 = $18.00
Hubbard Industries just paid a
common dividend,
D0, of $1.60. It
expects to grow
at a constant rate
of 3% per year.
If investors require a 9% return
on equity, what is
the current price
of Hubbard's common stock? Round
your answer to the
nearest cent. Do
not round intermediate calculations.
$ _____ per share
Zero Growth
Stocks:
The constant
growth model is
sufficiently general
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to handle the case
of a zero growth
stock, where the
dividend is expected to remain constant over time. In
this situation, the
equation is: P hat 0
= D / Rs
Note that this is
the same equation developed in
Chapter 5 to value a perpetuity,
and it is the same
equation used to
value a perpetual preferred stock
that entitles its
owners to regular,
fixed dividend payments in perpetuity. The valuation
equation is simply the current dividend divided by
the required rate of
return.
Quantitative Problem 2: Carlysle
Corporation has
perpetual preferred stock outstanding that pays
a constant annual
dividend of $1.80
at the end of each
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year. If investors
require an 10% return on the preferred stock, what
is the price of
the firm's perpetual preferred stock?
Round your answer to the nearest cent. Do not
round intermediate calculations. $
______ per share.
9. Picture on phone
01234
rs=9.5%
gs = 15% gs = 15% gs = 15% gn = 6%
D1 = 1.2650 D2 = 1.4548 D3 = 1.6730 D4 = 1.7733
= 50.6669*
52.3398
*The horizon value is calculated as $1.6730
(1.06)/(0.095 - 0.06) = $50.66686.
Using your financial calculator, enter the following
data: CF0 = 0, CF1 = 1.2650, CF2 = 1.4548, CF3 =
52.33983, and I/YR = 9.5; and solve for NPV = = $42.23.
It's important to realize that D0 is not included in the
stock's value today because the dividend has already
been paid. Note that D4 is calculated only to determine
the horizon value . To include D4 in the valuation is
to double count this dividend because it is already included in the horizon value. Also, note that the horizon
value should be discounted in Year 3 and not Year 4.
The horizon value is the present value of all dividends
received during the constant growth period. In this
problem, the horizon value is equal to the present
value at Year 3 of all dividends received in Year 4 and
thereafter.
10 / 55
Nonconstant
Growth Stocks:
For many companies, it is not appropriate to assume that dividends will grow
at a constant rate.
Most firms go
through life cycles where they
experience different growth rates
during different
parts of the cycle. For valuing
these firms, the
generalized valuation and the constant growth equations are combined to arrive
at the nonconstant growth valuation equation:
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Basically, this
equation calculates the present
value of dividends
received during
the nonconstant
growth period and
the present value
of the stock's horizon value, which
is the value at the
horizon date of all
dividends expected thereafter.
Quantitative Problem 3: Assume today is December
31, 2013. Imagine Works Inc. just
paid a dividend of
$1.10 per share at
the end of 2013.
The dividend is expected to grow at
15% per year for 3
years, after which
time it is expected
to grow at a constant rate of 6%
annually. The company's cost of equity (rs) is 9.5%.
Using the dividend
growth model (allowing for nonconstant growth),
what should be
the price of the
company's stock
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today (December
31, 2013)? Round
your answer to the
nearest cent. Do
not round intermediate calculations.
$ _____ per share
10. Calculate next year's FCF:
FCF1 = EBIT(1 - T) + Depreciation - (Gross capital
expenditures + ”Net operating working capital)
FCF1 = $450 + $65 - ($110 + $20) = $385 million
The recognition
that dividends
are dependent on
earnings, so a
reliable dividend
Calculate the value of the firm today:
forecast is based
VFirm = $385,000,000/(0.086 - 0.045) =
on an underly$9,390,243,902.44
ing forecast of the
firm's future sales,
Calculate the market value of the firm's equity today: costs and capital
MVE = VFirm - (MV of debt and equity)
requirements, has
MVE = $9,390,243,902.44 - $2,850,000,000 =
led to an alterna$6,540,243,902.44
tive stock valuation
approach, known
Calculate the firm's current price per share:
as the corporate
P0 = $6,540,243,902.44/180,000,000 = $36.33
valuation model.
The market value
of a firm is equal
to the present value of its expected future free cash
flows:
Free cash flows
are generally forecasted for 5 to 10
years, after which
it is assumed that
the final forecasted free cash flow
will grow at some
long-run constant
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rate. Once the firm
reaches its horizon date, when
cash flows begin to grow at a
constant rate, the
equation to calculate the continuing
value of the firm at
that date is:
Discount the free
cash flows back at
the firm's weighted average cost
of capital to arrive at the value
of the firm today.
Once the value of
the firm is calculated, the market value of debt
and preferred are
subtracted to arrive at the market value of equity.
The market value
of equity is divided by the number
of common shares
outstanding to estimate the firm's
intrinsic per-share
value.
We present 2 examples of the corporate valuation
model. In the first
problem, we assume that the firm
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is a mature company so its free
cash flows grow at
a constant rate. In
the second problem, we assume
that the firm has a
period of nonconstant growth.
Quantitative Problem 1: Assume today is December
31, 2013. Barrington Industries expects that its 2014
after-tax operating
income (EBIT(1
- T)) will be
$450 million and
its 2014 depreciation expense will
be $65 million.
Barrington's 2014
gross capital expenditures are expected to be $110
million and the
change in its net
operating working
capital for 2014
will be $20 million. The firm's free
cash flow is expected to grow at
a constant rate of
4.5% annually. Assume that its free
cash flow occurs
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at the end of each
year. The firm's
weighted average
cost of capital is
8.6%; the market value of the
company's debt is
$2.85 billion; and
the company has
180 million shares
of common stock
outstanding. The
firm has no preferred stock on its
balance sheet and
has no plans to
use it for future
capital budgeting projects. Using the corporate
valuation model, what should
be the company's stock price
today (December
31, 2013)? Round
your answer to
the nearest cent.
Do not round intermediate calculations. $ ______
per share
11. Calculate FCF6:
FCF6 = $55.6 (1.05) = $58.38 million
Calculate the firm's continuing value at Year 5:
CV5 = FCF6/(WACC - gFCF)
CV5 = $58.38/(0.12 - 0.05) = $834.00 million
15 / 55
We present 2 examples of the corporate valuation
model. In the first
problem, we assume that the firm
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is a mature comCalculate the firm's value today:
pany so its free
Using your financial calculator, enter the following
cash flows grow at
data: CF0 = 0, CF1 = -22.54, CF2 = 38.1, CF3 = 44, CF4 = a constant rate. In
51.1, CF5 = 55.6 + 834.00 = 889.60, and I/YR = WACC = the second prob12. Then, solve for NPV = Firm value = $578.82 million. lem, we assume
that the firm has a
Calculate the market value of the firm's equity:
period of nonconMVE = $578.82 - $24 = $554.82 million
stant growth.
Quantitative ProbCalculate the firm's current price per share:
lem 2: Hadley
P0 = $554,824,322.29/21,000,000 = $26.42
Inc. forecasts the
False statement
year-end free cash
flows (in millions)
shown below.
Year 1 2 3 4 5
FCF -$22.54
$38.1 $44 $51.1
$55.6
The weighted average cost of capital is 12%, and
the FCFs are expected to continue growing at a
5% rate after Year
5. The firm has
$24 million of market-value debt, but
it has no preferred stock or any
other outstanding
claims. There are
21 million shares
outstanding. What
is the value of the
stock price today
(Year 0)? Round
your answer to the
16 / 55
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nearest cent. Do
not round intermediate calculations.
$_____ per share
According to the
valuation models
developed in this
chapter, the value
that an investor assigns to a share
of stock is dependent on the length
of time the investor
plans to hold the
stock.
The statement
above is_____.
Conclusions:
Analysts use both
the discounted
dividend model
and the corporate
valuation model
when valuing mature, dividend-paying firms; and they
generally use the
corporate model
when valuing divisions and firms
that do not pay
dividends. In principle, we should
find the same intrinsic value using
either model, but
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differences are often observed.
Even if a company is paying steady
dividends, much
can be learned
from the corporate model; so analysts today use
it for all types
of valuations. The
process of projecting future financial
statements can reveal a great deal
about a company's
operations and financing needs.
Also, such an
analysis can provide insights into
actions that might
be taken to increase the company's value; and for
this reason, it is integral to the planning and forecasting process.
12. D0 = $3.75; g1-3 = 12%; gn = 3%; D1 through D5 = ? Weston CorporaD1 = D0(1 + g1) = $3.75(1.12) = $4.2000 H $4.20
tion just paid a
D2 = D0(1 + g1)(1 + g2) = $3.75(1.12)2 = $4.7040 H $4.70dividend of $3.75
D3 = D0(1 + g1)(1 + g2)(1 + g3) = $3.75(1.12)3 = $5.2685 a share (i.e., D0
H $5.27
= $3.75). The divD4 = D0(1 + g1)(1 + g2)(1 + g3)(1 + gn) =
idend is expect$3.75(1.12)3(1.03) = $5.4265 H $5.43
ed to grow 12%
D5 = D0(1 + g1)(1 + g2)(1 + g3)(1 + gn)2 =
a year for the
$3.75(1.12)3(1.03)2 = $5.5893 H $5.59
next 3 years and
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then at 3% a year
thereafter. What is
the expected dividend per share
for each of the
next 5 years?
Round your answers to two decimal places.
13. D1 = $3.9; g = 6%; rs = 19%; Current value per share = Tresnan Brothers
?
is expected to pay
3.9 / (0.19 - 0.06) = $30.00
a $3.9 per share
dividend at the end
of the year (i.e., D1
= $3.9). The dividend is expected
to grow at a constant rate of 6%
a year. The required rate of return on the stock,
rs, is 19%. What is
the stock's current
value per share?
Round your answer to two decimal places.
14. P0 = $27; D0 = $2; g = 9%; P hat 1 = ?; rs = ?
A) P hat 1 = P0 (1 + g) = 27(1.09) = $29.43
B) Rs = D1 / P0 + g = (2 x 1.09) / 27 + 0.09 = 17.07%
19 / 55
Holtzman Clothiers's stock currently sells for $27
a share. It just paid
a dividend of $2
a share (i.e., D0
= $2). The dividend is expected
to grow at a constant rate of 9% a
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year.
A) What stock
price is expected
1 year from now?
Round your answer to two decimal places.
B) What is the required rate of return? Round your
answer to two decimal places. Do
not round your intermediate calculations.
15. a . The horizon date is the date when the growth rate
becomes constant. This occurs at the end of Year 2. =
II
b. 0 1 2 3
rs = 16%
gs = 18% gs = 18% gn = 3%
1 1.18 1.3924 1.434172
11.03 = 1.434172 / (0.16-0.03)
The horizon, or continuing, value is the value at the
horizon date of all dividends expected thereafter. In
this problem it is calculated as follows:
(1.3924 x 1.03) / (0.16 - 0.03) = 11.03
c. The firm's intrinsic value is calculated as the sum
of the present value of all dividends during the supernormal growth period plus the present value of the
terminal value. Using your financial calculator, enter
the following inputs: CF0 = 0, CF1 = 1.18, CF2 = 1.3924
+ 11.03 = 12.42, I/YR = 16, and then solve for NPV =
$10.25.
20 / 55
Holt Enterprises
recently paid a
dividend, D0, of
$1.00. It expects to
have non-constant
growth of 18% for
2 years followed by
a constant rate of
3% thereafter. The
firm's required return is 16%.
A) How far away is
the horizon date?
I. The terminal, or
horizon, date is
the date when the
growth rate becomes constant.
This occurs at the
beginning of Year
2.
II. The terminal,
or horizon, date
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is the date when
the growth rate becomes constant.
This occurs at the
end of Year 2.
III. The terminal, or
horizon, date is infinity since common stocks do not
have a maturity
date.
IV. The terminal,
or horizon, date is
Year 0 since the
value of a common
stock is the present value of all future expected dividends at time zero.
V. The terminal,
or horizon, date
is the date when
the growth rate
becomes non-constant. This occurs
at time zero.
B) What is the
firm's horizon, or
continuing, value?
Round your answer to two decimal places. Do
not round your intermediate calculations.
C) What is the
firm's intrinsic value today, P0?
Round your an21 / 55
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swer to two decimal places. Do
not round your intermediate calculations.
16. The firm's free cash flow is expected to grow at a
constant rate, hence we can apply a constant growth
formula to determine the total value of the firm.
Firm value = FCF1/(WACC - gFCF)
= $125,000,000/(0.13 - 0.03)
= $1,250,000,000.00
To find the value of an equity claim upon the company
(share of stock), we must subtract out the market
value of debt and preferred stock. This firm happens to
be entirely equity funded, so this step is unnecessary
here. Hence, to find the value of a share of stock, we
divide equity value (or in this case, firm value) by the
number of shares outstanding.
Scampini Technologies is expected to generate $125 million in
free cash flow next
year, and FCF is
expected to grow
at a constant rate
of 3% per year indefinitely. Scampini has no debt
or preferred stock,
and its WACC is
13%. If ScampiEquity value per share = Equity value/Shares outni has 40 million
standing
shares of stock
= $1,250,000,000.00/40,000,000
outstanding, what
= $31.25
is the stock's value
Each share of common stock is worth $31.25, accord- per share? Round
ing to the corporate valuation model
your answer to two
decimal places.
Each share of
common stock is
worth $_____, according to the corporate valuation
model.
17. E
The required returns of Stocks
X and Y are rX
= 10% and rY
= 12%. Which of
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the following statements is CORRECT?
a. Stock Y must
have a higher dividend yield than
Stock X.
b. The stocks must
sell for the same
price.
c. If Stock Y
and Stock X have
the same dividend
yield, then Stock Y
must have a lower expected capital gains yield than
Stock X.
d. If Stock X
and Stock Y have
the same current dividend and
the same expected dividend growth
rate, then Stock
Y must sell for a
higher price.
e. If the market
is in equilibrium,
and if Stock Y has
the lower expected dividend yield,
then it must have
the higher expected growth rate.
18. E - Assuming that the book value of debt is close to its Based on the cormarket value, the total market value of the company porate valuation
is:
model, Gray En23 / 55
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Total Market Value = Total value of operation + Value of
nonoperating assets
TMV = $1,150
Value of Equity = Total MV - (Long + Short-term debt
+preferred stock)
Value of Equity = $1,150 - (120 + 300 + 50) = 680
Stock price per share = Value of equity / stock outstanding
Stock price per share = $680/ 30 million = $22.67
tertainment's total corporate value is $1,150 million. The company's balance sheet
shows $120 million of notes
payable, $300 million of long-term
debt, $50 million
of preferred stock,
$180 million of
retained earnings,
and $800 million of
total common equity. If the company has 30 million
shares of stock
outstanding, what
is the best estimate of its price
per share?
a. $26.07
b. $17.68
c. $22.44
d. $18.81
e. $22.67
19. a. Horizon value = (41 x 1.07) / (0.14 - 0.07) = 43.87/0.07 Dozier Corpora= $626.71 million
tion is a fast-growb. See picture on phone - Using a financial calculator, ing supplier of ofenter the following inputs: CF0 = 0; CF1 = -22; CF2 = fice products. An19; CF3 = 667.71; I/YR = 14; and then solve for NPV = alysts project the
$446.01 million
following free cash
c. Total value t=0 = $446.01 million.
flows (FCFs) durValue of common equity = $446.01 - $97 = $349.01
ing the next 3
million.
years, after which
Price per share = 349.01 / 14 = $24.93
FCF is expected to
grow at a constant
24 / 55
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7% rate. Dozier's
WACC is 14%.
Year 0 1 2 3
FCF ($ millions)
NA - 22 19 41
A) What is Dozier's horizon, or
continuing, value?
(Hint: Find the value of all free
cash flows beyond
Year 3 discounted back to Year
3.) Round your answer to two decimal places. Enter your answer in
millions. For example, an answer
of $13,550,000
should be entered
as 13.55.
B) What is the
firm's value today?
Round your answer to two decimal places. Enter your answer in
millions. For example, an answer
of $13,550,000
should be entered
as 13.55.
C) Suppose Dozier has $97 million of debt and
14 million shares
of stock outstand25 / 55
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ing. What is your
estimate of the
price per share?
Round your answer to two decimal places. Write
out your answer
completely. For example, 0.00025
million should be
entered as 250.
20. A
Which of the following statements
is CORRECT?
a. The stock valuation model, P0
= D1/(rs g), can
be used to value
firms whose dividends are expected to decline at a
constant rate, i.e.,
to grow at a negative rate.
b. The constant
growth model cannot be used for a
zero growth stock,
where the dividend is expected
to remain constant
over time.
c. The price of a
stock is the present value of all expected future dividends, discounted at the dividend
26 / 55
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growth rate.
d. If a stock has
a required rate of
return rs = 12%
and its dividend is
expected to grow
at a constant rate
of 5%, this implies
that the stock's
dividend yield is
also 5%.
e. The constant
growth model is often appropriate for
evaluating start-up
companies that do
not have a stable
history of growth
but are expected to reach stable
growth within the
next few years.
21. A - Statement a is true, because if the required return
for Stock A is higher than that of Stock B, and if the
dividend yield for Stock A is lower than Stock B's, the
growth rate for Stock A must be higher to offset this.
"If Stock A has a lower dividend yield than Stock B,
its expected capital gains yield must be higher than
Stock B's" is true, because if the required return for
Stock A is higher than that of Stock B, and if the
dividend yield for Stock A is lower than Stock B's, the
growth rate for Stock A must be higher to offset this.
27 / 55
Stocks A and B
have the same
price and are
in equilibrium, but
Stock A has the
higher required
rate of return.
Which of the following statements
is CORRECT?
a. If Stock A has
a lower dividend
yield than Stock
B, its expected
capital gains yield
must be higher
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than Stock B's.
b. Stock B must
have a higher dividend yield than
Stock A.
c. If Stock A has
a higher dividend
yield than Stock
B, its expected
capital gains yield
must be lower than
Stock B's.
d. Stock A must
have a higher dividend yield than
Stock B.
e. Stock A must
have both a higher dividend yield
and a higher capital gains yield than
Stock B.
22. D
If markets are in
equilibrium, which
of the following
conditions will exist?
a. Each stock's
expected return
should equal its
realized return as
seen by the marginal investor.
b. All stocks should
have the same realized return during the coming
year.
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c. The expected
and required returns on stocks
and bonds should
be equal.
d. Each stock's
expected return
should equal its required return as
seen by the marginal investor.
e. All stocks should
have the same expected return as
seen by the marginal investor.
23. D
The preemptive
right is important to shareholders because it
a. will result in
higher dividends
per share.
b. protects bondholders, and thus
enables the firm to
issue debt with a
relatively low interest rate.
c. is included
in every corporate
charter.
d. protects the current shareholders
against a dilution
of their ownership
interests.
e. allows man29 / 55
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agers to buy additional shares below the current
market price.
24. D - The following calculations show that "A's expected
dividend is $0.75 and B's expected dividend is $1.20"
is correct. The others are all wrong.
AB
Price $25 $40
Expected growth 7% 9%
Expected return 10% 12%
A = P0= D1/(r - g) = D1= P0(r) - P0(g) = $0.75
B = P0= D1/(r - g) = D1= P0(r) - P0(g) = $1.20
30 / 55
Stocks A and B
have the following data. Assuming the stock market is efficient
and the stocks
are in equilibrium,
which of the following statements is
CORRECT?
AB
Price $25 $40
Expected growth
7% 9%
Expected return
10% 12%
a. The two stocks
should have the
same expected
dividend.
b. B's expected
dividend is $0.75.
c. The two stocks
could not be in
equilibrium with
the numbers given
in the question.
d. A's expected
dividend is $0.75
and B's expected
dividend is $1.20.
e. A's expected
dividend is $0.50.
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25. B
Two constant
growth stocks are
in equilibrium,
have the same
price, and have
the same required
rate of return.
Which of the following statements
is CORRECT?
a. The two stocks
must have the
same dividend
yield.
b. If one stock has
a higher dividend
yield, it must also
have a lower dividend growth rate.
c. The two stocks
must have the
same dividend
growth rate.
d. If one stock has
a higher dividend
yield, it must also
have a higher dividend growth rate.
e. The two stocks
must have the
same dividend per
share.
26. A - Growth rate 5.25%
Years in the future 5
Stock price $35.25
P5 = P0(1 + g)^5 = $45.53
Whited Inc.'s stock
currently sells for
$35.25 per share.
The dividend is
projected to increase at a con31 / 55
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stant rate of 5.25%
per year. The required rate of return on the stock,
rs, is 11.50%.
What is the stock's
expected price 5
years from now?
a. $45.53
b. $39.15
c. $52.81
d. $47.80
e. $40.06
27. B
What is the expected return for
MP?
Economy ---------Probability ---------MP
Recession ---------0.1 ----------17.0%
Below avg --------0.2 ---------- -3.0%
Average ---------0.4 ---------- 10.0%
Above avg ---------0.2 ----------25.0%
Boom ----------- 0.1
---------- 38.0%
A. 12.4%
B. 10.5%
C. 9.8%
D. 5.5%
E. 1.0%
28. D
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What is the standard deviation for
MP, given expected return of 10.5%
Economy ---------Probability ---------MP
Recession ---------0.1 ----------17.0%
Below avg --------0.2 ---------- -3.0%
Average ---------0.4 ---------- 10.0%
Above avg ---------0.2 ----------25.0%
Boom ----------- 0.1
---------- 38.0%
A. 20%
B. 0%
C. 13.2%
D. 15.2%
E. 18.8%
29. E
Which one below
would yield most
diversification for a
portfolio?
A. Correlation = 1
B. Correlation =
0.8
C. Correlation =
0.5
D. Correlation = 0
E. Correlation =
-0.1
30. C
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Stocks A and B
each have an expected return of
15%, a standard
deviation of 20%,
and a beta of
1.2. The returns
on the two stocks
are positively correlated, but the
correlation coefficient is only 0.6.
You have a portfolio that consists
of 50% Stock A
and 50% Stock B.
Which of the following statements
is CORRECT?
A. The portfolio's
standard deviation
is greater than
20%.
B. The portfolio's
standard deviation
is equal to 20%.
C. The portfolio's
standard deviation
is less than 20%.
31. A - ri = rRF + (rM - rRF)bi
Niendorf Corporation's stock has
a required return
of 12.00%, the
risk-free rate is
5.50%, and the
market risk premium is 5.00%. Now
suppose there is
34 / 55
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a shift in investor
risk aversion, and
the market risk
premium increases by 2.00%. What
is Niendorf's new
required return?
(Step 1: find beta;
Step 2: use beta to
calculate ri)
A. 14.6%
B. 14.0%
C. 8.1%
D. 7.5%
32. A
You are given the
following returns
on the Market and
on Stock A. Calculate Stock A's beta
coefficient. (Market as X variable,
Stock as Y variable)
Year ---------- Market ---------- Stock
A
2001 ----------20% ----------35%
2002 ---------- -5
---------- -15
2003 ---------- 40
---------- 45
2004 ---------- 25
---------- 40
2005 ---------- 10
---------- 10
A. 1.43
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B. 1.23
C. 1.03
D. 1.33
E. 1.13
33. B
Stocks A and B
each have an expected return of
15%, a standard
deviation of 20%,
and a beta of
1.2. The returns
on the two stocks
are positively correlated, but the
correlation coefficient is only 0.6.
You have a portfolio that consists
of 50% Stock A
and 50% Stock B.
Which of the following statements
is CORRECT?
A. The portfolio's
beta is greater
than 1.2
B. The portfolio's
beta is equal than
1.2
C. The portfolio's
beta is less than
1.2
34. D
Consider the following information
for three stocks, A,
B, and C. The returns on the stocks
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are positively but
not perfectly correlated with one
another, i.e., the
correlation coefficients are all between 0 and 1.
Stock ----- Expected Return ----Standard Deviation ----- Beta
Stock A: ---- 10%
----- 20% ----- 1.0
Stock B: ---- 10 ---20 ---- 1.0
Stock C: ---- 12 ---20 ---- 1.4
Portfolio AB has
half of its funds
invested in Stock
A and half invested in Stock
B. Portfolio ABC
has one third of
its funds invested in each of the
three stocks. The
risk-free rate is
5%, and the market is in equilibrium, so required
returns equal expected returns.
Which statement
is CORRECT?
A. Portfolio ABC
has a standard deviation of 20%.
B. Portfolio AB's
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coefficient of variation is greater than
2.0.
C. Portfolio AB's
required return >
the required return
on Stock A.
D. Portfolio ABC's
expected return is
10.67%.
E. Portfolio AB has
a standard deviation of 20%
35. B
The risk-free rate
is 6%; Stock A has
a beta of 1.0; Stock
B has a beta of
2.0, and the market risk premium,
rm-rRF, is positive.
Which of the following statements
is correct?
A. If the risk-free
rate increases but
the market risk
premium stays unchanged, Stock
B's required return
will increase by
more than Stock
A's.
B. If Stock A's
required return is
11%, the market
risk premium is
5%.
C. Stock B's re38 / 55
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quired rate of return is twice that of
Stock A.
D. If the risk-free
rate remains constant but the market risk premium
increases, Stock
A's required return
will increase by
more than Stock
B's.
E. If Stock B's
required return is
11%, the market
risk premium is
5%.
36. C
Which of the following statements
is CORRECT?
A. A two-stock
portfolio will always have a lower beta than a
one-stock portfolio.
B. A two-stock
portfolio will always have a lower
standard deviation
than a one-stock
portfolio.
C. A portfolio that
consists of 40
stocks that are
not highly correlated with "the market" will proba39 / 55
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bly be less risky
than a portfolio
of 40 stocks that
are highly correlated with the market.
D. A stock with
a higher standard
deviation must
also have a higher
beta.
E. If portfolios are
formed by randomly selecting
stocks, a 10-stock
portfolio will always have a lower beta than a
one-stock portfolio
37. D
Market equilibrium
for a stock would
imply which of the
following?
a. Historical return
in last year = expected return in
the coming year
b. Historical return
in the last year =
required return in
the coming year
c. Historical return
= required return =
expected return
d. Required return
= expected return
38. C - r = 3% + (5% x 1.5) = 10.5%
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The Lashgari
Company's beta is
1.5; the market risk
premium is 5%,
and the risk-free
rate is 3%. What is
the company's required rate of return?
a. 3.0%
b. 7.5%
c. 10.5%
d. 15%
39. A - Pc = bi / rs - g = 0.75 / (0.105 - 0.05) = 13.64
41 / 55
The Lashgari
Company is expected to pay a
dividend of $0.75
per share at the
end of the year,
and that dividend
is expected to
grow at a constant rate of 5%
per year in the future. The company's beta is 1.5; the
market risk premium is 5%, and
the risk-free rate is
3%. What is the
company's current
stock price? (Hint:
find required rate
of return first and
then stock price.)
a. 13.64
b. 11.33
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c. 10.50
d. 7.50
40. C is correct answer
The Lashgari
A: expected return will be 10.5%, equal to required
Company is exreturn, if the market is in equilibrium.
pected to pay a
B: required rate of return rs= rRF + b * MRP = 0.03 + dividend of $0.75
1.5*0.05 = 0.105
per share at the
C: for constant dividend growth, the price grows at end of the year,
constant rate of dividend growth "g" = 5% as given. and that dividend
D: dividend yield + capital gains yield = 10.5%, while is expected to
capital gains yield = g = 5% for constant growth model. grow at a constant
So dividend yield = 5.5%.
rate of 5% per year
E: stock price actually grows at constant rate 5%.
in the future. The
Stock price is NOT constant.
company's beta is
1.5; the market risk
premium is 5%,
and the risk-free
rate is 3%. Which
of the statement is
correct?
a. The expected
return on the stock
is 5% a year.
b. The stock's required return must
be equal to 5%.
c. The stock's price
one year from now
is expected to be
5% higher.
d. The stock's dividend yield is 5%.
e. The price of the
stock is expected
to remain constant
in the future due
non-constant dividend growth.
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41. D
Horizon value at time 3, P3 = D4/(rs-g)
D4 = D3*(1+0.07) = D0*(1+0.29)^3*(1+0.07) = 6.317;
where D0=2.75. Remember last dividend means D0.
So P3 = 6.137/(0.12-0.07) = 126.33
42. C
Current stock price is discounted sum of D1, D2,
D3+P3
D1 = D0*1.29 = 3.5475
D2 = D1*1.29 = 4.5763
D3 = D2*1.29 = 5.9034
P3 = 126.33 from previous question
Tapley Tank Company's last dividend was $2.75.
The dividend
growth rate is expected to be constant at 29% for 3
years, after which
dividends are expected to grow at a
rate of 7% forever.
Tapley's required
return (rs) is 12%.
What will Tapley's
stock price be in
3 yrs (horizon value)?
a. 80.94
b. 97.93
c. 118.07
d. 126.33
Tapley Tank Company's last dividend was $2.75.
The dividend
growth rate is expected to be constant at 29% for 3
years, after which
Register CFs as CF0 =0; C01 = 3.5475, F01 = 1; C02 = dividends are ex4.5763, F01 = 1; C03 = 5.9034 + 126.33 =132.2334, F01 pected to grow at
= 1;
a rate of 7% forWith discount rate I = rs =12, NPV = 100.94
ever. Tapley's required return (rs)
is 12%. What is
Tapley's current
stock price?
a. 80.94
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b. 90.94
c. 100.94
d. 110.94
43. C
FCF1 = 26
g = 0.085
WACC=rs = 0.11
Value of Firm = FCF1/(rs -g) = 26/(0.11-0.085) = 1,040
Stock value = (Firm's value - Debt value )/# of shares
= (1040 - 200)/30 = 28
44.
44 / 55
You must estimate
the intrinsic value
of Gallovits
Technologies'
stock. Gallovits's
end-of-year free
cash flow (FCF) is
expected to be
$26 million, and it
is expected to
grow at a constant
rate of 8.5% a
year thereafter.
The company's
WACC (discount
rate) is 11%.
Gallovits has
$200 million of
long-term debt
plus preferred
stock, and there
are 30 million
shares of
common stock
outstanding. What
is Gallovits's
estimated intrinsic
value per share of
common stock?
a. 26
b. 27
c. 28
d. 30
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A
If your company
plans to take over
First find out horizon value, P3 = FCF4/(rs-g) =
the company with
FCF3*1.06/(rs-g) = 20*1.06/(0.10-0.06) =530
cash flows of -10,
10, 20 for next
Register CFs as CF0 =0; C01 = -10, F01 = 1; C02 = 10, three years and
F01 = 1; C03 = 20 + 530 =550, F01 = 1;
with a long-run
With discount rate I = rs =10, NPV = 412.40
growth rate of 6%,
how much your
company should
pay for the target
company assuming WACC = 10%?
R = 10%, g = 6%
after year 3
a. 412.40
b. 414.39
c. 398.20
d. 416.94
45. A - $45.14
Required return 11.0%
Short-run growth rate 27.5%
Long-run growth rate 6.0%
Last dividend (D0) $1.25
Year 0 1 2 3 4
Dividend $1.2500 $1.5938 $2.0320 $2.5908 $2.7463
Horizon value = P3 = D4/(rS - g4) = 54.9258
Total CFs $1.5938 $2.0320 $57.5166
PV of CFs $1.4358 $1.6492 $42.0557
Price = Sum of PVs = $45.14
45 / 55
Huang Company's
last dividend was
$1.25. The dividend growth rate
is expected to be
constant at 27.5%
for 3 years, after which dividends are expected to grow at a rate
of 6% forever. If the
firm's required return (rs) is 11%,
what is its current
stock price?
a. $45.14
b. $36.11
c. $40.63
Chapter 9 PRE, HW, and Clicker Questions
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d. $41.08
e. $52.36
46. B - $32.61
D1 $0.75
rS 10.5%
g 8.2%
P0 = D1/(rS - g) $32.61
A stock is expected to pay a dividend of $0.75 at
the end of the
year. The required
rate of return is
rs = 10.5%, and
the expected constant growth rate is
g = 8.2%. What is
the stock's current
price?
a. $38.80
b. $32.61
c. $27.39
d. $29.02
e. $27.07
47. D - $15.45
D0 $1.50
rS 14.1%
g 4.0%
D1 = D0(1 + g) = $1.56
P0 = D1/(rS - g) $15.45
A stock just paid
a dividend of D0
= $1.50. The required rate of return is rs = 14.1%,
and the constant
growth rate is g
= 4.0%. What is
the current stock
price?
a. $19.15
b. $18.84
c. $12.82
d. $15.45
e. $12.97
48. A - $46.11
FCF1 $24.50
You must estimate
the intrinsic value
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Constant growth rate 7.0%
WACC 10.0%
Debt & preferred stock $125
Shares outstanding 15
Total firm value = FCF1/(WACC - g) = $816.67
Less: Value of debt & preferred -$125.00
Value of equity $691.67
Number of shares 15
Value per share = Equity value/Shares = $46.11
49. C - $1,289
FCF3 $55.00
g 5.5%
WACC 10.0%
FCF4 = FCF3(1 + g) = $58.0250
HV3 = FCF4/(WACC - g) = $1,289
of Noe Technologies' stock. The
end-of-year free
cash flow (FCF1)
is expected to
be $24.50 million,
and it is expected
to grow at a constant rate of 7.0%
a year thereafter.
The company's
WACC is 10.0%,
it has $125.0 million of long-term
debt plus preferred
stock outstanding,
and there are
15.0 million shares
of common stock
outstanding. What
is the firm's estimated intrinsic value per share of
common stock?
a. $46.11
b. $47.96
c. $34.58
d. $38.27
e. $40.12
Misra Inc. forecasts a free cash
flow of $55 million
in Year 3, i.e., at t
= 3, and it expects
FCF to grow at
a constant rate of
5.5% thereafter. If
the weighted aver-
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age cost of capital
(WACC) is 10.0%
and the cost of
equity is 15.0%,
what is the horizon, or continuing,
value in millions at
t = 3?
a. $1,212
b. $1,186
c. $1,289
d. $1,083
e. $1,148
50. D - "The stock's price one year from now is expected
to be 5% above the current price" is true, because the
stock price is expected to grow at the dividend growth
rate.
48 / 55
If a stock's dividend is expected
to grow at a constant rate of 5%
a year, which of
the following statements is CORRECT? The stock
is in equilibrium.
a. The expected
return on the stock
is 5% a year.
b. The stock's required return must
be equal to or less
than 5%.
c. The stock's dividend yield is 5%.
d. The stock's
price one year
from now is expected to be 5%
above the current
price.
e. The price of the
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stock is expected
to decline in the future.
51. D - $3,500
FCF0 $250
g 5.0%
WACC 12.5%
FCF1 = FCF0(1 + g) = $262.50
Total corporate value = FCF1/(WACC - g) = $3,500.00
Mooradian Corporation's free cash
flow during the
just-ended year (t
= 0) was $250 million, and its FCF is
expected to grow
at a constant rate
of 5.0% in the future. If the weighted average cost of
capital is 12.5%,
what is the firm's
total corporate value, in millions?
a. $2,695
b. $4,130
c. $3,850
d. $3,500
e. $3,255
52. E - $1.22
Stock price $29.00
Required return 11.50%
Growth rate 7.00%
P0 = D1/(rS - g), so D1 = P0(rS - g) = $1.3050
Last dividend = D0 = D1/(1 + g) $1.22
Goode Inc.'s stock
has a required
rate of return of 11.50%,
and it sells for
$29.00 per share.
Goode's dividend
is expected to
grow at a constant
rate of 7.00%.
What was the last
dividend, D0?
a. $0.95
b. $1.37
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c. $1.38
d. $1.06
e. $1.22
53. B - "Each stock's expected return should equal its
required return as seen by the marginal investor" is
true, because if the expected return does not equal the
required return, then markets are not in equilibrium
and buying/selling will occur until the expected return
equals the required return.
If markets are in
equilibrium, which
of the following
conditions will exist?
a. The expected and required
returns on stocks
and bonds should
be equal.
b. Each stock's
expected return
should equal its required return as
seen by the marginal investor.
c. All stocks
should have the
same expected return as seen by the
marginal investor.
d. Each stock's
expected return
should equal its
realized return as
seen by the marginal investor.
e. All stocks
should have the
same realized return during the
coming year.
54. B - Note that P0 = $2/(0.15 + 0.05) = $10. That price is A stock is exexpected to decline by 5% each year, so P1 must be pected to pay a
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$10(0.95) = $9.50. Therefore, "The company's expect- year-end dividend
ed stock price at the beginning of next year is $9.50" of $2.00, i.e., D1
is correct, while all the others are false.
= $2.00. The dividend is expected to decline at
a rate of 5% a
year forever (g =
-5%). If the company is in equilibrium
and its expected
and required rate
of return is 15%,
which of the following statements is
CORRECT?
a. The constant
growth model cannot be used because the growth
rate is negative.
b. The company's expected
stock price at the
beginning of next
year is $9.50.
c. The company's expected capital gains yield is
5%.
d. The company's
current stock price
is $20.
e. The company's dividend yield
5 years from now
is expected to be
10%.
55.
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B - P1 = P0(1 + g) = $54. Therefore, "The stock price The expected reis expected to be $54 a share one year from now" is turn on Natter Corcorrect. All the other answers are false. P1 = $54.00 poration's stock is
14%. The stock's
dividend is expected to grow at a
constant rate of
8%, and it currently sells for $50
a share. Which of
the following statements is CORRECT?
a. The current dividend per share is
$4.00.
b. The stock price
is expected to be
$54 a share one
year from now.
c. The stock's dividend yield is 7%.
d. The stock price
is expected to be
$57 a share one
year from now.
e. The stock's dividend yield is 8%.
56. E - 6.96%
Pref. quarterly dividend $1.00
Annual dividend = Qtrly dividend × 4 = $4.00
Preferred stock price $57.50
Nom. required return = Annual dividend/Price = 6.96%
52 / 55
Carter's preferred
stock pays a dividend of $1.00 per
quarter. If the price
of the stock is
$57.50, what is its
nominal (not effective) annual rate of
return?
a. 6.75%
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b. 5.84%
c. 8.56%
d. 7.03%
e. 6.96%
57. E - $28.77
Stock price $24.50
Growth rate 5.50%
Years in the future 3
P3 = P0(1 + g)3 = $28.77
Reddick Enterprises' stock currently sells for $24.50
per share. The dividend is projected to increase at
a constant rate of
5.50% per year.
The required rate
of return on the
stock, rS, is 9.00%.
What is the stock's
expected price 3
years from today?
a. $31.65
b. $24.45
c. $33.66
d. $26.76
e. $28.77
58. A - 5.95%
Expected dividend (D1) $1.25
Stock price $27.50
Required return 10.5%
Dividend yield 4.55%
Growth rate = rS - D1/P0 = 5.95%
Gray Manufacturing is expected to
pay a dividend of
$1.25 per share
at the end of
the year (D1 =
$1.25). The stock
sells for $27.50
per share, and its
required rate of
return is 10.5%.
The dividend is
expected to grow
at some constant
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rate, g, forever.
What is the equilibrium expected
growth rate?
a. 5.95%
b. 6.07%
c. 5.54%
d. 6.01%
e. 6.91%
59. a. Horizon value = (50 x 1.07) / (0.16 - 0.07) = $594.44
million
b. 0 1 2 3 4
WACC = 16%
gn = 7%
-13 32 50 53.5
$-11.2069 x 1/1.16
23.7812 x 1/(1.16)2
Vop3 = 594.44
412.8683 x 1/(1.16)3 644.44
Dantzler Corporation is a fast-growing supplier of office products. Analysts project the
following free cash
flows (FCFs) during the next 3
years, after which
FCF is expected to
grow at a constant
7% rate. Dantzler's
WACC is 16%.
$425.4426
Using a financial calculator, enter the following inputs:
CF0 = 0; CF1 = -13; CF2 = 32; CF3 = 644.44; I/YR = 16; Year 0 1 2 3
and then solve for NPV = $425.44 million.
FCF ($ millions) $13 $32 $50
c. Total valuet=0 = $425.44 million
a. What is Dantzler's horizon, or
Value of common equity = $425.44 - $37 = $388.44
continuing, value?
million
(Hint: Find the valPrice per share = 388.44/10 = $38.84
ue of all free
cash flows beyond
Year 3 discounted back to Year
3.) Round your answer to two decimal places. Enter your answer in
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millions. For example, an answer
of $13,550,000
should be entered
as 13.55.
b. What is the
firm's value today?
Round your answer to two decimal places. Enter your answer in
millions. For example, an answer
of $13,550,000
should be entered
as 13.55. Do not
round your intermediate calculations.
c. Suppose Dantzler has $37 million of debt and 10
million shares of
stock outstanding.
What is your estimate of the current
price per share?
Round your answer to two decimal places. Write
out your answer
completely. For example, 0.00025
million should be
entered as 250.
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1. Common stock represents
the ownership position in a firm and is valued as the present value of its expected
future dividend stream.
2. Common stock dividends
are not specified by contract they depend
on the firms earnings. Two models are used
to estimate a stocks intrinsic value: the discounted dividend model and the corporate
valuation model.
3. The discounted dividend
model values a common stock as the present value of its expected future cash flows
at the firms required rate of return on equity.
Variations of this model are used to value
constant growth stocks, zero growth stocks,
and nonconstant growth stocks
4. The corporate valuation model is an alternative model used to value a firm,
especially one that does not pay dividends
or is privately held. This model calculates
the firm's free cash flows and then finds
their present values at the firms weighted
average cost of capital to determine a firms
value.
5. There are actually two differences between the discounted
dividend and corporate valuation models:
the expected cash flow stream and the discount rate used in the models are different.
The discounted dividend model calculates
the firm's stock price as the present value of
the expected future dividends at the firm's
required rate of return on equity, while the
corporate valuation model calculates the
firm's stock price as the present value of
the expected free cash flows at the firm's
weighted average cost of equity.
6. The value of a share of common stock depends on
the cash flows it is expected to provide and
those flows consist of the dividends the investor receives each year while holding the
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stock and the price the investor receives
when the stock is sold. The final price includes the original price paid plus an expected capital gain. The actions of the marginal investor determine the equilibrium stock
price.
7. Market equilibrium occurs
when
the stocks price is equal to its intrinsic value.
If the stock market is reasonably efficient,
differences between the stock price and intrinsic value should not be very large and
they should not persist for very long.
8. When investing in common
stocks, an investors goal is
to purchase stocks that are undervalued
(the price is below the stocks intrinsic value)
and avoid stocks that are overvalued.
9. The value of a stock can be
calculated as
the present value of an infinite stream of
dividends
10. constant growth model or Gor- who developed and popularized it. There
don model, named after Myron are several conditions that must exist before
J. Gordon
this equation can be used. First, the required
rate of return, rs, must be greater than the
long-run growth rate, g. Second, the constant growth model is not appropriate unless
a company's growth rate is expected to remain constant in the future. This condition
almost never holds for start-up firms but it
does exist for many mature companies.
11. Hubbard Industries just paid
a common dividend, D0, of
$1.70. It expects to grow at a
constant rate of 2% per year.
If investors require a 10% return on equity, what is the current price of Hubbard's common stock? Round your answer to the nearest cent. Do
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not round intermediate calculations.
12. Facts about common stock
-represents ownership
-ownership implies control
-stockholders elect directors
-directors elect management
-mangements goal: maximize the stock
price
13. Intrinsic value and stock price -outside investors, corporate insiders and
analysts use a variety of approaches to estimate a stocks intrinsic value (Po)
-In equilibrium we assume that a stocks
price equals its intrinsic value
-Outsiders estimate intrinsic value to help
determine which stocks are attractive to buy
and/or sell
-Stocks with a price below(above) its intrinsic value are undervalued(overvalued)
14. Different approaches for esti- discounted dividend model
mating the intrinsic value of a corporate valuation model
common stock
P/E multiple approach
15. Discounted Dividend Model
value of a stock is the present value of the
future dividends expected to be generated
by the stock
16. Constant Growth Stock
a stock whose dividends are expected to
grow forever at a constant rate, g.
17. What happens if g>rs?
If g>rs the constant growth formula leads to
a negative stock price, which does not make
sense.
-the constant growth model can be used
only if :
rs >g
g is expected to be constant forever
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18. If rRF= 3%, rM= 8% and b=1.2 rs=rRF+ (rM-rRF)b
what is the required rate of re- =3% + (8%-3%)1.2
turn on the firms stock?
=9%
19. Supernormal Growth: What if
g=30% for 1 year, 20% for 1
year, and 10% for 1 year before
achieving long-run growth of
4%?
Can no longer use just the constant growth
model to find stock value
however the growth does become constant
after 3 years
20. Corporate Valuation Model
-also called the free cash flow method. Suggests the value of the entire firm equals the
present value of the firms free cash flows
-remember free cash flow is the firms after-tax operating income less the net capital
investment
21. Issues regarding the corporate valuation model
-often preferred to the discounted dividend
model, especially when considering number
of firms that dont pay dividends or when
dividends are hard to forecast
-similar to discounted dividend model, assumes at some point free cash flow will grow
at a constant rate
-Horizon value (HVN) represents value of
firm at the point that growth becomes constant
22. Firm multiple method
-analysts often use the following multiples to
value stocks: P/E, P/CF, P/Sales
-Example: based on comparable firms, estimate the appropriate P/E. Multiply this by
expected earnings to back out an estimate
of the stock price.
23. Equilibrium
where
expected return=required return
intrinsic value=market price
24.
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If preferred stock with an an- Vp=D/rp
nual dividend of $5 sells for $100=$5/rp
$100 what is the preferred
rp=$5/$100=.05=5%
stocks expected return?
25. Preferred stock is
a hybrid--it is similar to a bond in some
respects and to common stock in others
hybrid nature becomes apparent when we
try to classify preferred stock in relation to
bonds and common stock
Vp= the value of the preferred stock
Dp=the preferred dividend
rp=the required rate of return
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1. Which of the following statements is TRUE?
B. A stock's price
is the present valA. The Gordon Growth Model assumes constant divi- ue of its future
dend growth but implies that stock prices grow at a cash flows, namedifferent rate.
ly, its expected
B. A stock's price is the present value of its future
capital gains and
cash flows, namely, its expected capital gains and
dividends.
dividends.
C. Brokers buy and sell securities from their own inventory, while dealers bring buyers and sellers together to complete transactions.
D. Holders of common stock have greater voting
rights in corporate decisions than holders of preferred stock, but they have less voting rights than
creditors of the corporation.
2. Which of the following statements is FALSE?
D. Holders of
preferred stock
A. The Gordon Growth Model assumes constant divi- have greater votdend growth and implies that stock prices grow at the ing rights in corsame rate.
porate decisions
B. A stock's price is the present value of the expected than holders of
dividends and capital gains.
common stock.
C. Dealers buy and sell securities from their own inventory, while brokers bring buyers and sellers together to complete transactions.
D. Holders of preferred stock have greater voting
rights in corporate decisions than holders of common
stock.
3. Newly issued securities are sold to investors in which D. Primary
one of the following markets?
A. Proxy
B. Inside
C. Secondary
D. Primary
4.
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Which of the following statements is FALSE?
C. In the stock
market, the secA. The bid price is the price that a dealer is willing to ondary market is
pay for a security and is lower than the ask price.
the market where
B. Bonds trade less frequently than stocks.
new securities are
C. In the stock market, the secondary market is the originally sold to
market where new securities are originally sold to
investors by the isinvestors by the issuing company.
suing company.
D. Dividends received by corporations have a 70% to
100% exclusion from taxable income.
5. A broker is an agent who:
A. Trades on the floor of an exchange for himself or
herself.
B. Buys and sells from inventory.
C. Offers new securities for sale to dealers only.
D. Brings buyers and sellers together.
D. Brings buyers
and sellers together.
6. Fill in the blanks: Stock prices fall if investors either C. lower, higher
expect _________ growth rates or require _________
returns.
A. higher, higher
B. higher, lower
C. lower, higher
D. lower, lower
7. An agent who buys and sells securities from inventory B. Dealer
is called a:
A. Specialist
B. Dealer
C. Broker
D. Floor Trader
8. Which of the following statements is FALSE?
B. Lenders can exert control over
A. Unlike equity holders, debt holders are not owners a company's manB. Lenders can exert control over a company's man- agers by voting for
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agers by voting for its board of directors.
its board of direcC. A corporation cannot deduct its payments to pre- tors.
ferred shareholders before it pays taxes
D. Holders of convertible bonds can force bankruptcy
if their coupons are not paid
9. Which of the following statements is FALSE?
A. One reason why
the Average AcA. One reason why the Average Accounting Return counting Return is
is a flawed measure in making business decisions is a flawed measure
that it is based on cash flows.
in making busiB. IRR measures the dollar-weighted return on an in- ness decisions is
vestment.
that it is based on
C. In order to use the Payback Rule as a tool to deter- cash flows.
mine if an investment is acceptable, a manager needs
to provide a pre-specified limit of time for recouping
investment costs.
D. The Profitability Index measures the value created
per dollar invested, based on the time value of money.
10. If any, which of the following statements is FALSE?
C. NPV is the discounted present
A. NPV measures the value created by taking on an value of a project's
investment
expected future
B. NPV indicates how much a project will improve
accounting net inowner wealth
come at the reC. NPV is the discounted present value of a project's quired return, subexpected future accounting net income at the required tracting the initial
return, subtracting the initial investment
investment
D. None of the above statements is false
11. Which one of the following methods of analysis
is most similar to computing the return on assets
(ROA)?
A. Average accounting return
B. Payback
C. Internal rate of return
D. Profitability index
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A. Average accounting return
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12. The average accounting return method of analyzing B. Is similar to calprojects:
culating the Return on Assets.
A. Incorporates cash flows.
B. Is similar to calculating the Return on Assets.
C. Is difficult to estimate using information from accounting statements.
D. Should accept all projects with positive AAR.
13. Which of the following statements is FALSE?
A. The internal rate of return is defined as the discount
rate which results in a zero net present value for the
project.
B. The primary advantage to payback analysis is that it
biases companies to invest in long-term projects that
require large current expenditures on research and
development.
C. The average accounting return ignores cash flows
is most similar to computing the return on assets
(ROA).
D. The profitability index reflects the value created per
dollar invested.
14. Which of the following statements is TRUE?
B. The primary advantage to payback analysis is
that it biases companies to invest
in long-term projects that require
large current expenditures on research and development.
C. Managerial real
options can be
A. Opportunity costs are those values that have al- very valuable but
ready been incurred, cannot be recouped, and should difficult to meanot be considered in an investment decision.
sure, and ignoring
B. Under hard capital rationing, a business enforces them will undereslimits on investment budgets because it prefers not timate a project's
to raise financing from the capital markets.
true Net Present
C. Managerial real options can be very valuable but Value.
difficult to measure, and ignoring them will underestimate a project's true Net Present Value.
D. Forecasting risk is more troublesome when NPV
estimates are particularly large.
15.
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If any, which of the following does NOT have the po- D. All of the above
tential to increase the net present value of a proposed have the poteninvestment?
tial to increase the
NPV of a proposed
A. The ability to immediately shut down a project
investment
should the project become unprofitable
B. The ability to wait until the economy improves before making the investment
C. The option to increase production beyond that initially projected
D. All of the above have the potential to increase the
NPV of a proposed investment
16. Which of the following should not be included in the B. The amount
analysis of a proposed investment?
paid 4 years ago
for an existing
A. The current market value of an existing building to building to be used
be used in the project.
in the project.
B. The amount paid 4 years ago for an existing building to be used in the project.
C. The expected after-tax salvage value at the end of
a project of an existing building to be used in the
project.
D. The net working capital balance remaining at the
end of the project.
17. Which of the following statements is FALSE??
B. Under intense
competition, posiA. The impacts of estimation errors and forecasting tive NPV projects
risks are small when NPVs are large and positive.
are as common as
B. Under intense competition, positive NPV projects negative NPV proare as common as negative NPV projects.
jects.
C. Scenario analysis helps determine the reasonable
range of expectations for a project's outcome.
D. Sensitivity analysis helps identify the variable within a project that presents the greatest forecasting risk.
18. Which of the following statements is FALSE?
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A. Sensitivity
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A. Sensitivity analysis helps determine the reasonable
range of expectations for a project's outcome.
B. The impacts of estimation errors and forecasting
risks are small when NPVs are large and negative.
C. Under intense competition, positive NPV projects
are rare.
D. The error of commission, or Type 1 error NPV estimation, is the risk that a project will be accepted when
its true NPV is negative.
termine the reasonable range of
expectations for a
project's outcome.
19. Sensitivity analysis:
B. helps identify
the variable within
A. looks at the most reasonably optimistic and pes- a project that presimistic results for a project.
sents the greatest
B. helps identify the variable within a project that pre- forecasting risk.
sents the greatest forecasting risk.
C. is generally conducted prior to scenario analysis
just to determine if the range of potential outcomes is
acceptable.
D. illustrates how an increase in operating cash flow
caused by changing both the revenue and the costs
simultaneously will change the net present value for
a project.
20. Which of the following statements is FALSE?
C. Type 1 errors
occur when manA. Since errors of commission are often readily appar- agers reject proent, managers have a tendency to be cautious when jects whose true
evaluating new projects
NPVs are positive
B. Errors of omission can result in lost potential value
as much as errors of commission can destroy value.
C. Type 1 errors occur when managers reject projects
whose true NPVs are positive
D. Errors in projected cash flows create large forecasting risks when their net present values are particularly
small in magnitude.
21. Which of the following statements is FALSE?
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B. The average return is always less
FIN 310 Exam 2 Ch 7-12
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A. Over the long run, investments in small-comthan the geometric
pany stocks have had the largest return but also
return.
the most risk, when compared with large-company
stocks, bonds, and T-Bills.
B. The average return is always less than the geometric return.
C. Investors who hold bonds instead of stocks over
long horizons can be rational and relatively averse to
risk.
D. Unlike the capital gains yield, the dividend yield can
never be negative.
22. Which of the following statements is FALSE?
A. Over the long run, investments in small-company stocks have had the largest return but also
the most risk, when compared with large-company
stocks, bonds, and T-Bills.
B. The average return is always greater than the geometric return.
C. Investors who hold bonds instead of stocks over
long horizons can be rational and relatively averse to
risk.
D. Like the dividend yield, the capital gains yield can
never be negative.
23. Which of the following statements is TRUE?
D. Like the dividend yield, the
capital gains yield
can never be negative.
C. Efficient markets react to new
A. Efficient markets will protect investors from wrong information by inchoices if they do not diversify.
stantly adjusting
B. Consistent with efficient markets, stock prices
the price of a stock
reach equilibrium several times per week.
to its new fair marC. Efficient markets react to new information by in- ket value without
stantly adjusting the price of a stock to its new fair
any delay or overmarket value without any delay or overreaction.
reaction.
D. Weak form efficiency implies that all information is
reflected in stock prices.
24.
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Which of the following statements is TRUE?
A. It is better
to use Geometric
A. It is better to use Geometric Return than Average Return than AvReturn to forecast what the stock market over the next erage Return to
50 years
forecast what the
B. The return earned in an average year over a multi- stock market over
year period is known as the geometric return
the next 50 years
C. The compound return earned per year over a multiyear period is known as the arithmetic average return
D. The average return is always smaller than the geometric return
25. If the financial markets are semi-strong form efficient, B. only individuthen:
als with private
information have
A. only the most talented analysts can determine the a marketplace adtrue value of a security.
vantage.
B. only individuals with private information have a
marketplace advantage.
C. technical analysis provides the best tool to use to
gain a marketplace advantage.
D. no one individual has an advantage in the marketplace.
26. Which one of the following statements is TRUE?
A. The risk-free rate of return has a risk premium of
1.0.
B. The reward for bearing risk is called the standard
deviation.
C. Risks and expected return are inversely related.
D. The higher the expected rate of return, the wider the
distribution of returns.
D. The higher the
expected rate of
return, the wider
the distribution of
returns.
27. Under Munich, a footwear manufacturer, recently announced that they have just designed a new footwear
product which includes the latest technology. This
news is totally unexpected and viewed as a major advancement in the footwear industry. Which one of the
following reactions to this announcement indicates
C. The price of Under Munich's stock
suddenly increases, and then remains at that price.
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the market for New Labs stock is efficient?
A. The price of Under Munich doesn't change, but then
it increases one week after the announcement.
B. The price of all stocks quickly increase in value
and then all but Under Munich stock fall back to their
original values.
C. The price of Under Munich's stock suddenly increases, and then remains at that price.
D. The price of Under Munich's stock increases rapidly, and then settles back to its pre-announcement level.
28. Which of the following statements is TRUE?
A. If a portfolio has
a positive investA. If a portfolio has a positive investment in every
ment in every asasset, the standard deviation on the portfolio can be set, the standard
less than that on every asset in the portfolio.
deviation on the
B. Labor strikes and part shortages are examples of portfolio can be
market-wide systematic risks.
less than that on
C. Market-wide systematic risks can be significantly every asset in the
reduced by diversification.
portfolio.
D. Asset-specific unsystematic risks can be substantially reduced with less numerous and less correlated
assets in a portfolio.
29. Portfolio diversification eliminates which of the following?
D. Unsystematic
risk
A. Total investment risk
B. Reward for bearing risk
C. Market-wide risk
D. Unsystematic risk
30. Which of the following statements is FALSE?
A. Asset-specific
risks can be easA. Asset-specific risks can be easily diversified with ily diversified with
highly correlated assets in a portfolio
highly correlated
B. Asset-specific risks can be easily diversified with
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numerous assets in a portfolio
assets in a portfoC. Bearing risk is rewarded with higher expected re- lio
turns
D. Only market-wide risks, not asset-specific risks,
should earn rewards
31. Fill in the blanks: Standard deviation measures
______ risk, while beta measures ______ risk.
C. Total; market-wide
A. Asset-specific; market-wide
B. Market-wide; total
C. Total; market-wide
D. Total; asset-specific
32. Which one of the following represents the amount of D. Zero
compensation an investor should expect to receive
for accepting the unsystematic firm-specific risk associated with an individual security?
A. Security beta multiplied by the market rate of return
B. Market risk premium
C. Risk-free rate of return
D. Zero
33. Which of the following statements is TRUE?
A. By investing in varied and numerous assets, an
investor is able to virtually eliminate all asset-specific
risks in her portfolio, both easily and cheaply.
B. It is possible, but not very easy, for an investor to
control market-wide risks in his portfolio, and increases in these market-wide risks are costly because they
reduce expected returns.
C. The most important characteristic in determining
the expected return of a well-diversified portfolio is
the total variance risks of the individual assets in the
portfolio.
D. When a portfolio has a positive investment in every
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A. By investing in
varied and numerous assets, an investor is able to
virtually eliminate
all asset-specific
risks in her portfolio, both easily and
cheaply.
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one of its assets, its standard deviation cannot be less
than that on every asset in the portfolio.
34. Which of the following statements is FALSE?
A. The cost to a firm for capital funding equals the
expected return to the providers of those funds
B. A firm's cost of capital depends primarily on the
source of the funds, not the use
C. WACC is affected by market conditions including
interest rates, tax rates, and the market risk premium
D. A firm's WACC reflects the average risk of the existing projects undertaken by the firm
B. A firm's cost
of capital depends
primarily on the
source of the
funds, not the use
35. Which of the following statements is FALSE?
B. The cost of capital for a project
A. The cost of capital is the minimum required return depends primarily
to compensate financial investors.
on the source of
B. The cost of capital for a project depends primarily funds.
on the source of funds.
C. The cost of equity is the return required by equity
investors given the risk of the cash flows from the
firm.
D. A firm's WACC reflects the average risk of the existing projects undertaken by the firm.
36. A firm uses its weighted average cost of capital to
evaluate the proposed projects for all of its varying
divisions. By doing so, the firm:
A. Automatically gives preferential treatment in the
allocation of funds to its riskiest division
B. Encourages the division managers to only recommend their most conservative projects
C. Maintains the current risk level and capital structure of the firm
D. Automatically maximizes the total value created for
its shareholders
37. Which of the following statements is FALSE?
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A. Automatically
gives preferential
treatment in the allocation of funds to
its riskiest division
D. Due to its
lower priority and
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A. The cost of debt for bonds is the same as the yield
implied by their market quoted prices, except when
that promised yield is too high due, for example, to the
high default probabilities for junk bonds.
B. The cost of preferred stock equals its dividend yield
as a percent of the current price, rather than the preferred dividend as a percent of its stated liquidating
value, which is usually $100.
C. Judgment is typically required when estimating the
cost of equity, particularly when a company pays no
dividends and when its beta estimate is imprecise.
D. Due to its lower priority and greater risk, a firm's
cost of equity can sometimes be, and often is, less
that its after-tax cost of debt.
greater risk, a
firm's cost of equity can sometimes be, and often is, less that
its after-tax cost of
debt.
38. Which one of the following types of securities has no C - Common stock
priority in a bankruptcy proceeding?
A - Convertible bond
B - Senior debt
C - Common stock
D - Preferred stock
E - Straight bond
39. Which one of the following generally pays a fixed
D - cumulative predividend, receives first priority in a dividend payment, ferred
and maintains the right to a dividend payment, even if
that payment is deferred?
A - cumulative common
B - noncumulative common
C - noncumulative preferred
D - cumulative preferred
E - senior common
40. A specialist is a(n):
C - NYSE member
who functions as a
A - employee who executes orders to buy and sell for dealer for a limited
clients of his or her brokerage firm
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B - individual who trades on the floor of an exchange number of securifor his or her personal account
ties
C - NYSE member who functions as a dealer for a
limited number of securities
D - broker who buys and sells securities from a market
maker
E - trader who only deals with primary offerings
41. Inside quotes are defined as the:
C - lowest asked
and highest bid ofA - bid and asked prices presented by NYSE special- fers
ists
B - last bid and asked price offered to the market close
C - lowest asked and highest bid offers
D - daily opening bid and asked quotes
E - last traded bid and asked prices
42. Which one of the following defines the internal rate of B- discount rate
return for a project?
which results in a
zero net present
A- discount rate that creates a zero cash flow from
value for the proassets
ject
B- discount rate which results in a zero net present
value for the project
C- discount rate which results in a net present value
equal to the project's initial cost
D- rate of return required by the project's investors
E- the project's current market rate of return
43. Which one of the following indicates that a project is C- positive net preexpected to create value for its owners?
sent value
A- profitability index less than 1.0
B- payback period greater than the requirement
C- positive net present value
D- positive avg accounting rate of return
E- internal rate of return that is less than the requirement
44.
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Which one of the following is generally considered
to be the best form of analysis if you have to select
a single method to analyze a variety of investment
opportunities?
E- net present value
A- payback
B- profitability index
C- accounting rate of return
D- internal rate of return
E- net present value
45. Which one of the following methods of analysis ignores cash flows?
A-profitability index
B- net present value
C- avg accounting return
D- modified internal rate of return
E- internal rate of return
C- avg accounting
return
46. Which one of the following indicates that a project is A- profitability indefinitely acceptable?
dex greater than
1.0
A- profitability index greater than 1.0
B- negative net present value
C- modified internal rate return that is lower than the
requirement
D- zero internal rate of return
E- positive avg accounting return
47. Which one of the following is the primary advantage B- ease of use
of payback analysis?
A- incorporation of the time value
B- ease of use
C- research and development bias
D- arbitrary cutoff point
E- long term bias
48. Which one of the following statements is correct?
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B- the payback
method is biased
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A- the internal rate of return is the most reliable
towards short term
method of analysis for any type of investment deci- projects
sion
B- the payback method is biased towards short term
projects
C- the modified internal rate of return is the most
useful when projects are mutually exclusive
D- the avg accounting return is the most difficult
method of analysis to compute
E- the net present value method is only acceptable if
a project has conventional cash flows
49. The profitability index reflects the value created per
dollar:
A- invested
A- invested
B- of sales
C- of net income
D- of taxable income
E- of shareholders' equity
50. An investment has conventional cash flows and a
C- the net present
profitability index of 1.0. Given this, which one of the value is equal to
following must be true?
zero.
A- the internal rate of return exceeds the required rate
of return
B- the investment never pays back
C- the net present value is equal to zero.
D- the avg accounting return is 1.0
E- the net present value is greater than 1.0
51. The Blackwell Group is unable to obtain financing
C- hard rationing
for any new projects under any circumstances. Which
term best applies to this situation?
A- contingency planning
B- soft rationing
C- hard rationing
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D- sensitivity analysis
E- scenario analysis
52. Marcos Enterprises has three separate divisions. The A- soft rationing
firm allocates each division $1.5 million per yr for
capital purchases. Which one of the following terms
applies to this allocation process?
A- soft rationing
B- hard rationing
C- opportunity cost
D- sunk cost
E- strategic planning
53. Which one of the following have the potential to increase the net present value of a proposed investment?
E- I, II, III, and IV
I. ability to immediately shut down a project should the
project become unprofitable
II. ability to wait until the economy improves before
making the investment
III. option to place the investment on hold until a more
favorable discount rate becomes available
IV. option to increase production beyond that initially
projected
A- I only
B- I and IV only
C- II and III only
D- I, II, and IV only
E- I, II, III, and IV
54. Ignoring the option to wait:
A- may overestimate the internal rate of return on a
project
B- may underestimate the net present value of a project
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B- may underestimate the net present value of a project
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C- ignores the ability of a manager to increase output
after a project has been implemented
D- is the same as ignoring all strategic options
E- ignores the value of discontinuing a project early
55. Turner Industries started a new project three months E- option to exago. Sales arising from this project are all exceeding pand
expectations. Given this, which one of the following is
management most apt to implement?
A- option to wait
B- soft rationing
C- strategic option
D- option to abandon
E- option to expand
56. Which one of the following refers to the option to
expand into related businesses in the future?
A- strategic option
A- strategic option
B- contingency option
C- soft rationing
D- hard rationing
E- capital rationing option
57. Scenario analysis:
C- helps determine the reasonA- determines the impact a $1 change in sales has on able range of exthe internal rate of return
pectations for a
B- determines which variable has the greatest impact project's anticipaton a project's net present value
ed outcome
C- helps determine the reasonable range of expectations for a project's anticipated outcome
D- evaluates a project's net present value while sensitivity analysis evaluates a project's internal rate of
return
E- determines the absolute worst and absolute best
outcome that could ever occur.
58.
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Mark is analyzing a proposed project to determine
how changes in the variable costs per unit would
affect that project's net present value. What type of
analysis is Mark conducting?
A- sensitivity
analysis
A- sensitivity analysis
B- erosion planning
C- scenario analysis
D- cost benefit analysis
E- opportunity cost analysis
59. Which one of the following should be included in the D- I, II, and IV only
analysis of a proposed investment?
I. erosion effects
II. opportunity costs
III. sunk costs
IV. side effects
A- I only
B- II only
C- I and IV only
D- I, II, and IV only
E- I, II, III, and IV
60. The managers of HR Construction are considering
C- current market
remodeling plans for an old building the firm current- value of the buildly owns. The building was purchased 8 yrs ago for
ing
$689,000. Over the past 8 yrs, the firm rented out the
building and used the rent to pay off the mortgage. The
building is now owned free and clear and has a current market value of $898,000. The firm is considering
remodeling the building into a conference centre and
sandwich bar at an estimated cost of $1.7 million. The
estimated present value of the future income from this
centre is $2.9 million. Which one of the following defines the opportunity cost of the remodeling project?
A- initial cost of the building
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B- cost of the remodeling
C- current market value of the building
D- initial cost of the building plus the remodeling
costs
E- current market value of the building plus the remodeling costs
61. Valley Forge and Metal purchased a truck 5 yrs ago
for local deliveries. Which one of the following costs
related to this truck is the best example of a sunk
cost? Assume the truck has a usable life of 8 yrs
C- money spent
last month repairing a damaged
front fender
A- new tires that will be purchased this winter
B- costs of repairs needed so the truck can pass
inspection next month
C- money spent last month repairing a damaged front
fender
D- engine tune up that is scheduled for this afternoon
E- cost for a truck driver for the remainder of the
truck's useful life
62. Which one of the following terms is most commonly C- erosion
used to describe the cash flows of a new project
that are simply an offset of reduced cash flows for a
current project?
A- opportunity cost
B- sunk cost
C- erosion
D- replicated flows
E- pirated flows
63. Which one of the following terms refers to the best op- D- opportunity
tion that was foregone when a particular investment cost
is selected?
A- side effect
B- erosion
C- sunk cost
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D- opportunity cost
E- marginal cost
64. A cost that should be ignored when evaluating a pro- E- sunk
ject because the cost has already been incurred and
cannot be recouped is referred to as which type of
cost?
A- fixed
B- forgotten
C- variable
D- opportunity
E- sunk
65. Any changes to a firm's projected future cash flows C- incremental
that are caused by adding a new project are referred cash flows
to as which one of the following?
A- eroded cash flows
B- deviated projections
C- incremental cash flows
D- directly impacted flows
E- assumed flows
66. Semi-strong form market efficiency that states the
value of a security based on:
C- all publicly
available information
A- all public and private information
B- historical information only
C- all publicly available information
D- all publicly available information plus any data that
can be gathered from insider trading
E- random information with no clear distinction as to
the source of that information
67. If the financial markets are efficient then:
A- stock prices should remain constant
B- stock prices should increase or decrease slowly
as new events are analyzed and the information is
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E- stock prices
should only respond to unexpected news and
events
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absorbed by all the markets
C- an increase in the value of one security should be
offset by a decrease in the value of another security
D- stock prices will only change when an event actually occurs, not at the time the event is anticipated
E- stock prices should only respond to unexpected
news and events
68. New Labs just announced that it has received a patent
for a product that will eliminate all flu viruses. The
news is totally unexpected and viewed as a major
medical advancement. Which one of the following reactions to this announcement indicates the market for
New Labs stock is efficient?
C- the price of
New Labs stock
increases rapidly
to a higher price
then remains at
that price
A- the price of New Labs stock remains unchanged
B- the price of New Labs stock increases rapidly and
then settles back to its pre announcement level
C- the price of New Labs stock increases rapidly to a
higher price then remains at that price
D- all stocks quickly increase in value and then all but
New Labs stock fall back to their original values
E- the value of all stocks suddenly increase and then
level off at their higher values
69. Which one of the following categories has the
A- small company
widest frequency distribution of returns for the period stocks
1926-2008?
A- small company stocks
B- U.S. Treasury bills
C- long term government bonds
D- inflation
E- large company stocks
70. Which one of the following is the most apt to have
the largest risk premium in the future based on the
historical record for 1926-2008?
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D- small company
stocks
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A- U.S. Treasury bills
B- large company stocks
C- long term government debt
D- small company stocks
E- long term corporate debt
71. Over the period of 1926-2008:
A- the risk premium on large company stocks was
greater than the risk premium on small company
stocks
B- U.S. Treasury bills had a risk premium that was
slightly over 2 percent
C- the risk premium on long term government bonds
was zero percent
D- the risk premium on stocks exceeded the risk premium on bonds
E- U.S. Treasury bills had a negative risk premium.
D- the risk premium on stocks
exceeded the risk
premium on bonds
72. An efficient capital market is best defined as a market C- available inforin which security prices reflect which one of the fol- mation
lowing?
A- current inflation
B- a risk premium
C- available information
D- the historical arithmetic rate of return
E- the historical geometric rate of return
73. Which one of the following best describes an arithmetic avg return?
A- total return divided by ( N - 1), where N equals the
number of individual returns
B- avg compound return earned per year over a multiyear period
C- total compound return divided by the number of
individual returns
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D- return earned in
an avg year over a
multiyear period
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D- return earned in an avg year over a multiyear period
E- positive square root of the avg compound return
74. Which one of the following is defined as the avg com- A- geometric avg
pound return earned per year over a multiyear period? return
A- geometric avg return
B- variance of returns
C- standard deviation of returns
D- arithmetic deviation of returns
E- normal distribution of returns
75. Based on the capital asset pricing model, investors
are compensated based on which of the following?
D- I, III, and IV only
I. market risk premium
II. portfolio standard deviation
III. portfolio beta
IV. risk-free rate
A- I and III only
B- II and IV only
C- I, II, and III only
D- I, III, and IV only
E- I, II, III, and IV
76. Assume you own a portfolio of diverse securities
which are each correctly priced. Given this, the reward-to-risk ratio:
E- of each security must equal the
slope of the security market line.
A- for the portfolio must equal 1.0
B- for the portfolio must be less than the market risk
premium
C- for each security must equal zero
D- of each security is equal to the risk-free rate
E- of each security must equal the slope of the security market line.
77. The beta of a risky portfolio (assuming no borrowing E- the lowest indior short selling) cannot be less than ____ nor greater vidual beta in the
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than _______.
A- 0;1
B- 1; the market beta
C- the lowest individual beta in the portfolio; market
beta
D- the market beta; the highest individual beta in the
portfolio
E- the lowest individual beta in the portfolio; the highest individual beta in the portfolio
78. Portfolio diversification eliminates which one of the
following?
portfolio; the highest individual beta
in the portfolio
D- unsystematic
risk
A- total investment risk
B- portfolio risk premium
C- market risk
D- unsystematic risk
E- reward for bearing risk
79. The risk premium for an individual security is based D- systematic
on which one of the following types of risk?
A- total
B- surprise
C- diversifiable
D- systematic
E- unsystematic
80. Which one of the following best exemplifies unsystematic risk?
A- unexpected economic collapse
B- unexpected increase in interest rates
C- unexpected increase in the variable costs for a firm
D- sudden decrease in inflation
E- expected increase in tax rates
C- unexpected increase in the variable costs for a
firm
81. Which one of the following is an example of system- B- increase in conatic risk?
sumption created
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A- major layoff by a regional manufacturer of power
boats
B- increase in consumption created by a reduction in
personal tax rates
C- surprise firing of a firm's chief financial officer
D- closure of a major retail chain of stores
E- product recall by one manufacturer
by a reduction in
personal tax rates
82. Which one of the following is the slope of the security B- market risk premarket line?
mium
A- risk free rate
B- market risk premium
C- beta coefficient
D- risk premium on an individual asset
E- market rate of return
83. The security market line is a linear function which is E- expected return
graphed by plotting data points based on the relation- and beta
ship between which two of the following variables?
A- risk free rate and beta
B- market rate of return and beta
C- market rate of return and the risk free rate
D- risk free rate and the market rate of return
E- expected return and beta
84. The systematic risk principle states that the expected D- market risk
return on a risky asset depends only on which of the
following?
A- unique risk
B- diversifiable risk
C- asset specific risk
D- market risk
E- unsystematic risk
85. Which one of the following terms best refers to the C- diversification
practice of investing in a variety of diverse assets as
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a means of reducing risk?
A- systematic
B- unsystematic
C- diversification
D- security market line
E- capital asset pricing model
86. Which one of the following describes systematic risk? A- risk that affects
a large number of
A- risk that affects a large number of assets
assets
B- an individual security's total risk
C- diversifiable risk
D- asset specific risk
E- risk unique to a firm's management
87. Boone Brothers remodels homes and replaces win- B- Ace Builders'
dows. Ace Builders constructs new homes. If Boone cost of capital
Brothers considers expanding into new home construction, it should evaluate the expansion project using which one of the following as the required return
for the project?
A- Boone Brothers' cost of capital
B- Ace Builders' cost of capital
C- Avg of Boone Brothers' and Ace Builders' cost of
capital
D- Lower of Boone Brothers' or Ace Builders' cost of
capital
E- Higher of Boone Brothers' or Ace Builders' cost of
capital
88. Old Town Industries has three divisions. Division X
has been in existence the longest and has the most
stable sales. Division Y has been in existence for five
years and is slightly less risky than the overall firm.
Division Z is the research and development side of
the business. When allocating funds, the firm should
probably:
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B- assign the highest cost of capital
to division Z because it is most
likely the riskiest of
the three divisions
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A- require the highest rate of return from division X
since it has been in existence the longest.
B- assign the highest cost of capital to division Z
because it is most likely the riskiest of the three divisions
C- use the firm's WACC as the cost of capital for division Z as it provides analysis for the entire firm
D- use the firm's WACC as the cost of capital for
divisions A and B because they are part of revenue
producing operations of the firm
E- allocate capital funds amongst the divisions to
maintain the current capital structure of the firm.
89. A firm has a cost of equity of 13 percent, a cost of
D- increasing the
preferred of 11 percent, and an aftertax cost of debt of firm's beta
6 percent. Given this, which one of the following will
increase the firm's weighted average cost of capital?
A- increasing the firm's tax rate
B- issuing new bonds at par
C- redeeming shares of common stock
D- increasing the firm's beta
E- increasing the debt equity ratio
90. Which one of the following statements is correct, all B- a decrease in
else held constant?
a firm's WACC will
increase the atA- beta is used to compute the return on equity and tractiveness of the
the standard deviation is used to compute the return firm's investment
on preferred.
options
B- a decrease in a firm's WACC will increase the attractiveness of the firm's investment options
C- the aftertax cost of debt increases when the market
price of a bond increases
D- if you have both the dividend growth and the security market line's cost of equity, you should use the
higher of the two estimates when computing WACC
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E- WACC is only applicable to firms that issue both
common and preferred stock.
91. Which one of the following represent the rate of return D- weighted avera firm must earn on its assets if it is to maintain the age cost of capital
current value of its securities?
A- cost of equity
B- internal rate of return
C- aftertax cost of debt
D- weighted average cost of capital
E- debt equity ratio
92. The cost of preferred stock:
A- increases when a firm's tax rate decreased
B- is constant over time
C- is unaffected by changes in the market price.
D- is equal to the stock's dividend yield
E- increases as the price of the stock increases
D- is equal to
the stock's dividend yield
93. Which one of the following is the pre-tax cost of debt? C- weighted avg
yield to maturity
A- avg coupon rate on the firm's outstanding bonds on the firm's outB- coupon rate on the firm's latest bond issue
standing debt
C- weighted avg yield to maturity on the firm's outstanding debt
D- avg current yield on the firm's outstanding debt
E- annual interest divided by the market price per
bond for the latest bond issue
94. All else constant, which of the following will increase C- I and IV only
the aftertax cost of debt for a firm?
I. increase in the yield to maturity of the firm's outstanding debt
II. decrease in the yield to maturity of the firm's outstanding debt
III. increase in the firm's tax rate
IV. decrease in the firm's tax rate
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A- I only
B- I and III only
C- I and IV only
D- II and III only
E- II and IV only
95. Which of the following are weaknesses of the dividend D- II and IV only
growth model?
I. market risk premium fluctuations
II. lack of dividends for some firms
III. reliance on historial beta
IV. sensitivity of model to dividend growth rate
A- II only
B- I and II only
C- I and III only
D- II and IV only
E- I, II, III, and IV
96. Ted is trying to decide what cost of capital he should D- risk level of the
assign to a project. Which one of the following should project
be his primary consideration in this decision?
A- amount of debt used to finance the project
B- use, or lack thereof, of preferred stock to finance
the project
C- mix of funds used to finance the project
D- risk level of the project
E- length of the project's life
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Unit 3: Valuing Corporate Securities
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1. The dividend yield is calculated as follows
(dividend/closing stock
price)
2. The following are auction markets
NYSE, LSE, TSE
3. The expected rate of return or the cost of
equity capital:
Dividend yield + expected
rate of growth in dividends
4. Generally high growth stocks pay:
Low or no dividends
5. T or F: Most of the trading on the NYSE is in TRUE
ordinary common stocks.
6. T or F: All securities in an equivalent risk
TRUE
class are priced to offer the same expected
returns
7. T or F: The constant growth formula for stock FALSE
valuation does not work for a firm with a
negative growth rate (i.e., a declining growth
rate) in its dividend.
8. T or F: It is not possible to value a firm that FALSE
has a supernormal (variable) growth for the
first few years of its life.
9. T or F: One can use the discounted
cash-flow formulas that are used to value
common stocks. in order to value entire
businesses.
TRUE
10. T or F: An investor who uses a market order TRUE
instructs her brokerage firm to buy a given
quantity of shares at the best available price.
11. T or F: A stock's price is based on the expect- FALSE
ed present value, at the market capitalization
rate, of all the stock's future earnings.
12. Explain the terms secondary market
1/3
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When already issued stocks
are traded in the market, it
is called a secondary market transaction. Most transactions in the stock market
(e.g., trades on the NYSE
are secondary market transactions)
13. Briefly explain the term market capitalization The rate of return expected
rate
by the investors in common
stocks is called the market
capitalization rate. It is also
called the cost of equity capital. For a constant growth
stock it equals the dividend
yield + the expected growth
rate in dividends/
14. Briefly explain the assumptions associated There are two important aswith the constant dividend growth formula. sumptions that are necessary for the formula to work
correctly. The first assumption is that the expected
growth rate of dividends is
constant. The second assumption is that the discount
rate is greater than the expected growth rate in dividends.
15. Briefly explain how the formulas that are
The formulas that are used
used for valuing common stocks can also be to value common stocks can
used to value businesses.
also be used to value entire
businesses. In the case of
businesses, free cash flows
generated by the businesses are discounted. Typically, a two-stage DCF mod2/3
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el is used. Free cash flows
are forecasted out to a horizon and discounted to present value. Then a horizon
value is forecasted, discounted and added to the present
value of free cash flows. The
sum is the value of the business. This may look easy in
theory but is quite complicated in practice.
3/3
Module 3 Practice Answers
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1. Ottocell Motor Company just paid a diviD5 = (1.40) × (1.10) × (1.082)
dend of $1.40. Analysts expect its dividend × (1.052) = 1.98
to grow at a rate of 10% next year, 8% for the
following two years, and then a constant rate
of 5% thereafter.
What is the expected dividend per share at
the end of year 5?
2. The major secondary market for GE shares NYSE
is:
3. Otobai Motor Company just paid a dividend D5 = (1.40) × (1.183) ×
of $1.40. Analysts expect its dividend to
(1.052) = 2.54
grow at a rate of 18% for the next three years
and then a constant rate of 5% thereafter.
What is the expected dividend per share at
the end of year 5?
4. All securities in an equivalent risk class are True
priced to offer the same expected return.
5. A Wall Street Journal quotation for a company has the following values: Div: $1.12, PE:
18.3, Close: $37.22.
Calculate the approximate dividend payout
ratio for the company.
PE ratio = price per
share/earnings per share
Earnings per share =
(37.22)/18.3 = 2.03
Dividend payout = 1.12/2.03
= 0.55 = 55%
6. World-Tour Co. has just now paid a dividend P0 = (2.83 × 1.06)/(0.16 of $2.83 per share (D0); its dividends are
0.06) = 30
expected to grow at a constant rate of 6% per
year forever.
If the required rate of return on the stock is
16%, what is the current value of the stock,
after paying the dividend?
7. A large percentage of the total value of a
True
growth stock comes from the present value
of its growth opportunities.
1/6
Module 3 Practice Answers
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8. The valuation of a common stock today pri- its expected future dividends
marily depends on:
and its discount rate
9. The exchange-traded fund (ETF) that tracks QQQQ
the Nasdaq 100 index is called:
10. The following are auction markets EXCEPT: NASDAQ
London Stock Exchange
Nasdaq
New York Stock Exchange
Tokyo Stock Exchange
11. Deluxe Company expects to pay a dividend P0 = (2/1.15) + [(3 +
of $2 per share at the end of year 1, $3 per 32)/(1.152)] = $28.20
share at the end of year 2, and then be sold
for $32 per share at the end of year 2.
If the required rate of return on the stock is
15%, what is the current value of the stock?
12. Universal Air is a no-growth firm and has
EPS = DPS =
two million shares outstanding. It expects to 20,000,000/2,000,000 = $10
earn a constant $20 million per year on its per share
assets.
P0 = 10/0.10 = $100/share
If it has no debt, all earnings are paid out
as dividends, and the cost of capital is 10%,
calculate the current price per share of the
stock.
13. A stock's price is based on the expected
present value, at the market capitalization
rate, of all the stock's future earnings.
FALSE. Dividends not earnings.
14. An investor who uses a market order inTrue
structs her brokerage firm to buy a given
quantity of shares at the best available price.
15. The dividend yield reported on finance.yahoo.com is calculated as follows:
16.
2/6
Dividend/closing stock price
Module 3 Practice Answers
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Seven-Seas Co. just paid a dividend of $3
per share out of earnings of $5 per share.
If its book value per share is $40 and its
market price is $52.50 per share, calculate
the required rate of return on the stock.
17. In which of the following stock exchanges
are there specialists who act as auctioneers?
New York Stock Exchange
Frankfurt Stock Exchange
Tokyo Stock Exchange
London Stock Exchange
g = (1 - 0.6) (5/40) = .05, or
5%; r = [(3 × 1.05)/52.50] +
0.05 = 0.11 = 11%
New York Stock Exchange
18. One can estimate the dividend growth rate plow-back rate x the return
for a stable firm as:
on equity (ROE)
19. In which of the following exchanges does a II, III, and IV only
computer act as the auctioneer?
New York Stock Exchange
London Stock Exchange
Tokyo Stock Exchange
Frankfurt Stock Exchange
20. The cost of equity capital equals the divFalse
idend yield minus the growth rate in dividends for a constant dividend growth stock.
21. The return that is expected by investors from True
a common stock is also called its market
capitalization rate, or cost of equity capital.
22. Galaxy Air, previously a no-growth firm, has
two million shares outstanding. Until now,
it consistently earned $20 million per year
on its assets. (It has no debt and pays out
all earnings as dividends. Its cost of capital
is 10%.) Due to its newly appointed CEO,
Galaxy Air is now able to squeeze out 1% an3/6
(1 - .05) × EPS1 = DPS1 =
(20 × .95 × 1.01)/2 = $9.60
per share
P0 = 9.60/(0.10 - 0.01) =
$106.61/share.
Module 3 Practice Answers
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nual growth by plowing back 5% of earnings.
Calculate its stock price per share.
23. Company X has a P/E ratio of 10 and a stock EPS = 50/10 = $5
price of $50 per share.
Calculate earnings per share of the company.
24. River Co. just paid a dividend of $2 per share
out of earnings of $4 per share.
If its book value per share is $25 and its
stock is currently selling for $40 per share,
calculate the required rate of return on the
stock.
g = (1 - plow-back ratio) *
ROE
Plow-back ratio = 1 - dividend payout ratio
ROE = earnings (i.e., net income) / book value equity
g = (1 - 0.5)(4/25) = 0.08, or
8%
P0 = D1/*(r-g)
D1 = D0*(1+g)
Thus:
r = [(2 × 1.08)/40] + 0.08 =
13.4%
25. The In-Tech Co. just paid a dividend of $1 per
share. Analysts expect its dividend to grow
at 25% per year for the next three years and
then 5% per year thereafter.
If the required rate of return on the stock is
18%, what is the current value of the stock?
P = (1.25/1.18)
+ (1.5625/1.182)
+ (1.9531/1.183)
+ (2.0508/(0.18 0.05))/(1.183) = 12.97
26. The constant dividend growth formula P0 =
Div1/(r - g) assumes:
that dividends grow at a constant rate g,
forever
r>g
g is never negative
that dividends grow at a constant rate g forever
and
r>g
27. R&D Technology Corporation just paid a dividend of $0.50 per share. Analysts expect its
dividend to grow at 24% per year for the next
two years and then 8% per year thereafter.
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If the required rate of return in the stock is
16%, calculate the current value of the stock.
28. Casino Inc. expects to pay a dividend of $3 P0 = Div1/(r - g) = (3/(0.18 per share at the end of year 1 (D1) and these 0.06)) = 25
dividends are expected to grow at a constant
rate of 6% per year forever.
If the required rate of return on the stock is
18%, what is the current value of the stock
today?
29. One can use the discounted cash-flow for- True
mulas that are used to value common stocks
in order to value entire businesses.
30. Ocean Co. just paid a dividend of $2 per
share out of earnings of $4 per share.
If the book value per share is $25, what is the
expected growth rate in dividends (g)?
Sustainable growth = ROE x
plowback ratio
Payout ratio = 50%
Plowback ratio = 50%
g = (1 - 0.5)(4/25) = 0.08, or
8%
31. The growth rate in dividends is a function of ROE and the plowback ratio
two ratios. They are:
32. Lake Co. just paid a dividend of $3 per share g = (1 - 3/5)(5/40) = .05, or
out of earnings of $5 per share. If its book 5%
value per share is $40, what is the expected
growth rate in dividends?
33. Galaxy Air, previously a no-growth firm, has
two million shares outstanding. Until now,
it consistently earned $20 million per year
on its assets. (It has no debt and pays out
all earnings as dividends. Its cost of capital
is 10%.) Due to its newly appointed CEO,
Galaxy Air is now able to squeeze out 1% annual growth by plowing back 5% of earnings.
Calculate its stock price per share
5/6
(1 - .05) × EPS1 = DPS1 =
(20 × .95 × 1.01)/2 = $9.60
per share
P0 = 9.60/(0.10 - 0.01) =
$106.61/share.
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34. Will Co. is expected to pay a dividend of $2 r = [(D1/P0 ) + g] = (2/20) +
per share at the end of year 1(D1), and the 0.04 = 14%
dividends are expected to grow at a constant
rate of 4% forever.
If the current price of the stock is $20 per
share, calculate the expected return or the
cost of equity capital for the firm.
35. R&D Technology Corporation just paid a dividend of $0.50 per share. Analysts expect its
dividend to grow at 24% per year for the next
two years and then 8% per year thereafter.
If the required rate of return in the stock is
16%, calculate the current value of the stock.
6/6
P0 = [(0.5 × 1.24)/1.16]
+ [(0.5 × 1.242)/(1.162)] +
[(0.5 × 1.242 × 1.08)/(0.16 0.08)/(1.162))] = $8.82
Ch4
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1. The return that is expected by investors from a com- T
mon stock is also called its market capitalization rate,
or cost of equity capital
2. Generally high growth stocks pay:
low or no dividends
3. One can estimate the expected rate of return or the
cost of equity capital as follows
Dividend yield +
expected rate of
growth in dividends
4. A stock's price is based on the expected present val- F
ue, at the market capitalization rate, of all the stock's
future earnings
5. Michigan Co. just paid a dividend of $2.00 per share. DIV6=(2.00)*(1.20)^4*
Analysts expect future dividends to grow at 20% per
year for the next four years and then grow at 6% per
year thereafter. Calculate the expected dividend in
year 5.
6. The constant dividend growth formula P0 = Div1/(r - g) I and II only
assumes:
I) that dividends grow at a constant rate g, forever; II)
r > g; III) g is never negative
7. CK Company stockholders expect to receive a
year-end dividend of $5 per share and then immediately sell their shares for $115 dollars per share. If the
required rate of return for the stock is 20%, what is the
current value of the stock?
(120-x)/x = .20
Multiply both sides
by x
120-x=.20x
120=1.2x
x=100
or
P=(115+5)/1.2 =
100
8. For most firms, market value is usually greater than
book value.
1/3
T
Ch4
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9. A sole proprietorship is owned by:
one person
10. Which of the following organization forms for a busi- c corporation
ness does NOT avoid double taxation?
11. Which of the following organization forms accounts c corporation
for the most revenue?
12. Which of the following organization forms accounts sole proprietorship
for the greatest number of firms?
13. Consider the following prices from a McDonald's
Restaurant:
Big Mc Sandwich $2.99
Large Coke $1.39
Large Fry $1.09
5.47
A McDonald's Big Mac Extra Value Meal® consists of
a Big Mac Sandwich, Large Coke, and a Large Fry.
Assuming that there is a competitive market for McDonald's food items, at what price must a Big Mac
value meal sell to ensure the absence of an arbitrage
opportunity and uphold the law of one price?
14. Wesley Mouch's auto loan requires monthly payments 6.25
and has an effective annual rate of 6.43%. The APR on
this auto loan is closest to:
15. Which of the following statements is FALSE?
a)The law of one price implies that to value any security, we must determine the expected cash flows an
investor will receive from owning it.
b)If the current stock price were less than
P0= Div1 + P1/ 1 + rE,
it would be a negative NPV investment, and we would
expect investors to rush in and sell it, driving down
the stock's price.
2/3
b
Ch4
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c)The price of a share of stock is equal to the present
value of the expected future dividends it will pay.
d)The equity cost of capital for a stock is the expected
return of other investments available in the market
with equivalent risk to the firm's shares.
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Finance 325 Midterm: True/False Qs
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1. A firm's total asset value belongs entirely to the share- False
holders.
2. Accept a project if its rate of return > 0.
False
3. Accept a project if its NPV > 0.
True
4. Accept a project if its rate of return > opportunity cost True
of capital.
5. Reject a project if the NPV < 0.
True
6. An equal-payment home mortgage is an example of
an annuity.
True
7. There is an inverse relationship between bond prices True
and interest rates.
8. The price of long-term bonds fluctuates more than
the price of short-term bonds for a given change in
interest rates (assuming that the coupon rate is the
same for both).
True
9. There is a direct relationship between bond prices and False
interest rates.
10. The price of short-term bonds fluctuates more than
the price of long-term bonds for a given change in
interest rates (assuming that the coupon rate is the
same for both).
False
11. The yield to maturity on a bond is really its internal
rate of return.
True
12. The longer a bond's duration, the greater its volatility. True
13. U.S. Treasury bonds have almost zero default risk, but True
are subject to inflation risk.
14.
False
1/4
Finance 325 Midterm: True/False Qs
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Once a bond defaults, bondholders can no longer
receive any residual payment from the bond.
15. Corporate bond yields are generally higher than gov- True
ernment bond yields for bonds having the same
coupon rate and maturity.
16. Two bonds have the same maturity, risk rating, and True
face value, but have different coupon rates. The bond
with a lower coupon rate will have a longer duration.
17. All securities in an equivalent risk class are priced to True
offer the same expected return.
18. For most firms, market value is usually greater than
book value.
True
19. A stock's price is based on the expected present val- False
ue, at the market capitalization rate, of all the stock's
future earnings.
20. The return that is expected by investors from a com- True
mon stock is also called its market capitalization rate,
or cost of equity capital.
21. Your customer pays you $5,000 for product you've
False
previously invoiced and sold to him. You will debit
Accounts Receivable by $5,000 and your cash flow
will increase by $5,000 as a result of this transaction.
22. Suppose that, over the course of this semester, that True
the yields on U.S. Treasury bonds increase. The following statements regarding this event are all true:
- The prices of these securities will fall.
- People holding great amounts of U.S. Treasury bonds
in their portfolio will be disappointed.
- The job of the U.S. Secretary of the Treasury will
become more difficult since the U.S. treasury will have
to issue more bonds to finance a given size public
deficit
2/4
Finance 325 Midterm: True/False Qs
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23. If a bond's coupon rate is lower than its yield, then the False
bond price will be higher than its face value. (Assume
annual coupon payments.)
24. If a firm uses a single cutoff period for all projects, it True
is likely to accept too many short-lived projects.
25. If the firm uses the discounted-payback rule, it will
accept negative-NPV projects.
False
26. If a firm uses the discounted-payback rule, it will turn True
down positive-NPV projects.
27. The profitability index of a positive NPV project is
always positive.
True
28. The payback rule ignores all cash flows after the cut- True
off date.
29. The IRR rule states that firms should accept any pro- True
ject offering an internal rate of return in excess of the
cost of capital.
30. Accounting earnings from a firm's income statement, False
prepared according to generally accepted accounting
principles (GAAP), are typically the best data source
for calculating a project's NPV.
31. Sunk costs are bygones, i.e., they are unaffected by True
the decision to accept or reject a project. They should
therefore be ignored.
32. A financial analyst should include interest and dividend payments when calculating a project's cash
flows.
False
33. You should replace a machine when the EAC of con- True
tinuing to operate it exceeds the EAC of the new machine.
3/4
Finance 325 Midterm: True/False Qs
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34. Treasury bills typically provide higher average returns, both in nominal terms and in real terms, than
long-term government bonds.
False
35. The beta of a well-diversified portfolio is equal to the True
value weighted average beta of the securities included
in the portfolio.
36. A portfolio with a beta of one offers an expected return False
equal to the market risk premium.
37. Stocks with high standard deviations will necessarily False
also have high betas.
38. A risk premium generated by comparing stocks to
True
10-year U.S. Treasury bonds will be smaller than a
risk premium generated by comparing stocks to U.S.
Treasury bills.
39. The standard deviation of a two-stock portfolio gen- False
erally equals the value-weighted average of the standard deviations of the two stocks.
40. Diversification can reduce portfolio risk even in the
case when correlations across stock returns equal
zero.
4/4
True
Finance 325 Midterm: True/False Qs CHAPTER 4
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1. A firm's total asset value belongs entirely to the share- False
holders.
2. Accept a project if its rate of return > 0.
False
3. Accept a project if its NPV > 0.
True
4. Accept a project if its rate of return > opportunity cost True
of capital.
5. Reject a project if the NPV < 0.
True
6. An equal-payment home mortgage is an example of
an annuity.
True
7. There is an inverse relationship between bond prices True
and interest rates.
8. The price of long-term bonds fluctuates more than
the price of short-term bonds for a given change in
interest rates (assuming that the coupon rate is the
same for both).
True
9. There is a direct relationship between bond prices and False
interest rates.
10. The price of short-term bonds fluctuates more than
the price of long-term bonds for a given change in
interest rates (assuming that the coupon rate is the
same for both).
False
11. The yield to maturity on a bond is really its internal
rate of return.
True
12. The longer a bond's duration, the greater its volatility. True
13. U.S. Treasury bonds have almost zero default risk, but True
are subject to inflation risk.
14.
False
1/4
Finance 325 Midterm: True/False Qs CHAPTER 4
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Once a bond defaults, bondholders can no longer
receive any residual payment from the bond.
15. Corporate bond yields are generally higher than gov- True
ernment bond yields for bonds having the same
coupon rate and maturity.
16. Two bonds have the same maturity, risk rating, and True
face value, but have different coupon rates. The bond
with a lower coupon rate will have a longer duration.
17. All securities in an equivalent risk class are priced to True
offer the same expected return.
18. For most firms, market value is usually greater than
book value.
True
19. A stock's price is based on the expected present val- False
ue, at the market capitalization rate, of all the stock's
future earnings.
20. The return that is expected by investors from a com- True
mon stock is also called its market capitalization rate,
or cost of equity capital.
21. Your customer pays you $5,000 for product you've
False
previously invoiced and sold to him. You will debit
Accounts Receivable by $5,000 and your cash flow
will increase by $5,000 as a result of this transaction.
22. Suppose that, over the course of this semester, that True
the yields on U.S. Treasury bonds increase. The following statements regarding this event are all true:
- The prices of these securities will fall.
- People holding great amounts of U.S. Treasury bonds
in their portfolio will be disappointed.
- The job of the U.S. Secretary of the Treasury will
become more difficult since the U.S. treasury will have
to issue more bonds to finance a given size public
deficit
2/4
Finance 325 Midterm: True/False Qs CHAPTER 4
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23. If a bond's coupon rate is lower than its yield, then the False
bond price will be higher than its face value. (Assume
annual coupon payments.)
24. If a firm uses a single cutoff period for all projects, it True
is likely to accept too many short-lived projects.
25. If the firm uses the discounted-payback rule, it will
accept negative-NPV projects.
False
26. If a firm uses the discounted-payback rule, it will turn True
down positive-NPV projects.
27. The profitability index of a positive NPV project is
always positive.
True
28. The payback rule ignores all cash flows after the cut- True
off date.
29. The IRR rule states that firms should accept any pro- True
ject offering an internal rate of return in excess of the
cost of capital.
30. Accounting earnings from a firm's income statement, False
prepared according to generally accepted accounting
principles (GAAP), are typically the best data source
for calculating a project's NPV.
31. Sunk costs are bygones, i.e., they are unaffected by True
the decision to accept or reject a project. They should
therefore be ignored.
32. A financial analyst should include interest and dividend payments when calculating a project's cash
flows.
False
33. You should replace a machine when the EAC of con- True
tinuing to operate it exceeds the EAC of the new machine.
3/4
Finance 325 Midterm: True/False Qs CHAPTER 4
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34. Treasury bills typically provide higher average returns, both in nominal terms and in real terms, than
long-term government bonds.
False
35. The beta of a well-diversified portfolio is equal to the True
value weighted average beta of the securities included
in the portfolio.
36. A portfolio with a beta of one offers an expected return False
equal to the market risk premium.
37. Stocks with high standard deviations will necessarily False
also have high betas.
38. A risk premium generated by comparing stocks to
True
10-year U.S. Treasury bonds will be smaller than a
risk premium generated by comparing stocks to U.S.
Treasury bills.
39. The standard deviation of a two-stock portfolio gen- False
erally equals the value-weighted average of the standard deviations of the two stocks.
40. Diversification can reduce portfolio risk even in the
case when correlations across stock returns equal
zero.
4/4
True
Short answer questions
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1. Why do firms rely heavily on in- Internal funds, defined as depreciation
ternal funds?
plus retained earnings, make up a large
portion of funds invested by U.S. corporations each year. The main reason is the
cost of issuing new equity. The cost of issuing new equity is quite high, and corporations try to minimize these costs. The second reason might be to avoid the discipline
of the security market.
2. Indicate the major sources of fi- • common stock
nance available to corporations. • preferred stock
• debt, including bonds and convertible
bonds
3. Briefly explain the voting rights The common stockholders have a right
of shareholders.
to vote, either in person or by proxy, in
the election of directors to the board of
directors. Important decisions like mergers must be submitted for shareholder approval. Different classes of common stocks
can have different voting rights.
4. Briefly explain the two different
types of voting systems used
for the election of the board of
directors.
There are two different types of voting
that are used for electing boards of directors. The type used by a particular firm is
specified in the firm's articles of incorporation. According to a majority voting system,
each director is voted upon separately and
the stockholders can cast one vote per
share that they own. According to cumulative voting, all directors are voted upon
jointly and stockholders can, if they want
to, cast all their votes for just one candidate. Cumulative voting makes it easier for
a minority group of shareholders to elect
directors.
5.
1 / 16
Short answer questions
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Briefly discuss some of the fea- There are several important features that
tures that would increase the would increase the value of a corporate
value of a corporate bond.
bond. The most important ones are the
bond's convertible provision and the collateral associated with the bond. A conversion feature allows the bondholder to
exchange the bond for a predetermined
number of shares. The firm may also set
aside some of its assets specifically for
the protection of particular bondholders.
This is called collateral and such bonds
are called secured bonds. Both of these
features increase the value of bonds that
have them.
6. Briefly describe the different
types of financial markets.
Financial markets can be classified as
primary markets and secondary markets.
When corporations sell securities for the
first time, such a transaction is called
a primary market transaction. When already-issued securities are traded, such
transactions are called secondary market
transactions. Financial markets can also
be classified as organized exchanges and
over-the-counter (OTC) markets.
7. Briefly list the various functions • the payment mechanism
of financial institutions.
• borrowing and lending
• pooling risk
8. Explain how shareholders
might have lost control over
corporations, relative to managers, over the years.
There are many possible answers to this
question. The most relevant answer is a
simple disparity of resources. Managers
have access to the resources of the firm
and may use those resources to enact
changes in corporate governance rules
or laws to which they benefit. Other than
large institutional shareholders, most common stockholders have very little financial
2 / 16
Short answer questions
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incentive to lobby their interests considering the small size of their investment, compared to the overall size of the firm. This
is why most shareholder rights initiatives
are led by institutional investors or large
individual investors.
9. Briefly explain the term venture Equity investment in start-up private comcapital.
panies is commonly known as venture
capital. There are venture capital organizations that help provide venture capital to
deserving start-up firms. Some large technology firms like Intel and Sun Microsystems also provide venture capital to new
innovative firms.
10. Briefly explain the term initial
public offering (IPO).
When a firm issues securities to the public
for the first time, it is called an IPO. This
is an important decision on the part of
the firm as it involves disclosing a lot of
information to the public. Generally, IPOs
are underpriced.
11. Briefly explain the role of under- The underwriters are an integral part of
writers in the issuance of secu- the securities market. Underwriters have
rities.
the expertise and contacts necessary to
design and distribute the securities. Underwriters provide advice and guidance in
the preparation of the security issue, and
price it and sell it to investors.
12. What are some of the costs to
a firm associated with issuing
new securities?
The most important cost is the underwriter's spread, which can be as high
as 7% in the case of IPOs. In addition
there are other administrative costs like
preparing the registration statement and
prospectus; and consulting costs for management, legal, and accounting matters.
These can be substantial.
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13. Briefly explain the basic proce- The rules governing the sale of securidure for a new issue.
ties are derived from the Securities Act of
1933. The Securities and Exchange Commission (SEC) administers this act. The
board of directors of the firm should approve the issuance of the security to the
public. Next, the firm should file a registration statement with the SEC. The basic
intent of this statement is the disclosure of
information to the public. There is a 20-day
waiting period. The registration is automatic if the firm does not hear from the SEC. If
the SEC sends a letter of comment, which
generally requires disclosure of more information, then the 20-day waiting period
starts again after the firm has presented
the new information to the SEC. On the
21st day the firm can start selling the security to the public.
14. Explain the term winner's curse. The highest bidder in an auction is most
likely to have overestimated the value of an
object. Therefore buyers will on average
overpay. This problem is called winner's
curse.
15. Discuss the advantages of shelf • Securities can be issued in dribs and
registration.
drabs without incurring excessive transaction costs.
• Securities can be issued on short notice.
• Issuance of securities issues can be
timed to take advantage of market conditions.
• The issuing firms can make sure that
underwriters compete for business.
16. Briefly explain the term private When an entire issue of a security is sold
placement.
to a small group of investors, usually institutional investors, it is called a private
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placement. Private placements need not
be registered with the SEC. Also, Rule
144A allows large financial institutions to
trade unregistered securities among themselves.
17. Explain the need for a firewall Underwriters are in the business of sellbetween underwriters and ana- ing securities for issuing firms. Analysts
lysts.
provide advice to investors who purchase
securities. These relationships show that
the underwriter and analyst represent opposing parties in the same transaction. Accordingly, there is a need for the analyst to
be free from underwriter influence. If such
independence does not exist, the investor
may not get objective advice.
18. Briefly describe the sequence
of events of a firm's dividend
payment.
The board of directors sets the dividend
for a firm. The date on which the board of
directors announces the dividend is called
the declaration date. Dividends will be paid
to those who are registered shareholders
as of the record date. Two business days
prior to the record date is the ex-dividend
date. Shares bought on the ex-dividend
date or later do not come with the dividend.
Dividend checks are mailed to shareholders on the payment date.
19. Briefly discuss different ways in Firms that pay dividends typically pay a
which a firm can pay dividends regular cash dividend each quarter. Octo its shareholders.
casionally, firms pay extra or special dividends. Occasionally, firms declare stock
dividends. That is, shareholders receive
additional shares of stock instead of cash.
Many times firms might repurchase their
own stock. This is in lieu of paying dividends.
20.
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What information does a share Firms repurchase shares when they have
repurchase convey to inaccumulated cash that they are not able to
vestors?
invest profitably. Share repurchases may
indicate an underpriced stock. Share repurchase may also be used to signal management's confidence in the future of the
firm.
21. Describe Miller and Modigliani's Miller and Modigliani state that in a world
proposition on dividend irrele- without taxes, transaction costs, or other
vance.
market imperfections, the firm's choice of
dividend policy is irrelevant to the value of
the firm.
22. Rightists argue that increasing
a firm's dividend will increase
its value. Review some of the
key points in their assertion.
Investors prefer cash to capital gains as
cash dividends are certain and capital
gains are uncertain; many investors prefer
cash, as they need it for living expenses;
investors see the information contained
within dividend payments as objective evidence of a firm's good performance.
23. Briefly describe the leftists'
If dividends are taxed at a higher rate than
point of view on dividends and capital gains, firms should pay the lowest
taxes.
cash dividends. By shifting their distribution policy, corporations can transform dividends into capital gains. Leftists favor low
dividend payouts.
24. Briefly describe how current tax The current (2012) tax rate on long-term
laws favor capital gains.
capital gains is 20%, while marginal rates
for investors are usually much higher. Tax
laws also favor capital gains because capital gains taxes are deferred until the stock
is sold, at which point the gain is realized.
Taxes on dividends have to be paid immediately. The longer the shareholders defer
capital gains, the less the present value of
capital gains liability.
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25. Briefly describe the midMiddle-of-the-roaders hold that a firm's
dle-of-the-roaders' position on value is not affected by its dividend policy.
dividend policy.
26. A retiree believes that investing
in a nondividend paying growth
firm, which requires the periodic sale of stock for income, will
eventually lead to a loss of all
shares. Explain the flaw in this
logic.
A growth firm, by definition, will have an
increasing share price. Over time the firm
will either have stock splits to maintain a
stock price within a certain trading range
or the price will go up substantially over
time. In the case of stock splits, the retiree will get an ever increasing number of
shares. In the case of an increasing share
price, the retiree will need to liquidate a
decreasing quantity of shares. In either
case, the investor's investment will not disappear any faster than it would through
dividend payments.
27. Explain why, as a function of
the debt-equity ratio, the cost of
debt graph is concave at high
levels of debt.
As a firm takes on higher levels of debt,
the risk of default increases. Default risk
requires a risk premium for debt investors.
Thus, equity investors are shifting risk to
the debtholders.
28. State the law of conservation of The law of conservation of value states
value.
that the value of an asset is preserved
regardless of the nature of claims against
it.
29. Explain the concept of value ad- If we have two streams of cash flow, A and
ditivity.
B, the present value of A + B is equal to the
present value of A plus the present value
of B. The same idea holds when assets are
divided.
30. law of conservation of value.
can be applied to the choice of various
securities issued by a firm. For example, we could apply the law of conservation of value to the choice between issuing preferred stock, common stock, or
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some combination of the two. The law implies that the choice is irrelevant, assuming perfect capital markets, and that the
choice does not affect the firm's investment, borrowing, and operating policies.
The law also applies to the mix of debt
securities issued by the firm. The choices
of long-term versus short-term, secured
versus unsecured, senior versus subordinated, and convertible and nonconvertible
debt all should not have any effect on the
overall value of the firm.
31. Describe the break-even point, On a plot of EPS versus operating inas displayed on an EPS-operat- come graph, one can determine the speing income graph.
cific amount of debt at which the EPS of an
unlevered position will equal that of a levered position. If the firm's income is above
the break-even point, the levered position
will have higher EPS while below that the
unlevered position will have higher EPS.
32. State and explain MM's Proposi- The expected rate of return on the comtion II.
mon stock of a levered firm increases in
proportion to the debt-equity ratio, stated
in market values: rE = rA + (D/E) × (rA - rD).
As the debt-equity ratio increases, the cost
of equity increases while the cost of debt
and the weighted average cost of capital
remain constant. This also implies that the
beta of the firm's equity also increases in
the same manner. Proposition II assumes
no taxes.
33. Briefly explain how changes in There is a linear relationship between
the debt-equity ratio change the the firm's equity beta and its debt-equifirm's equity beta.
ty ratio. It can be obtained by combining Modigliani-Miller Proposition II with
the capital asset pricing model (CAPM).
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The relationship is given by: bE = bA +
(D/E)(bA - bD). For many firms, bD (beta of
debt) is close to zero. Then the relationship
is written as: bE = [1 + (D/E)](bA).
34. Briefly describe the traditional- The traditional view of debt policy states
ists' position on capital struc- that moderate amounts of debt increase
ture.
the expected return on equity, but not as
fast as proposed by M&M. Therefore, the
weighted average cost of capital declines
initially at low levels of debt and later increases at higher levels of debt. At high
levels of debt, the rate of return increases at a rate faster than that proposed by
M&M. Hence, there is an optimal capital
structure for a firm lying between these
two situations.
35. What circumstances violate
when the firm, by imaginative design of
MM's Proposition I? Briefly dis- its capital structure, is able to offer some
cuss.
financial service that meets the needs of a
particular clientele. Either the service must
be new and unique or the firm must find
a way to provide some existing service
more cheaply than other firms or financial
intermediaries are able to provide. Therefore, smart financial managers look for an
unsatisfied clientele, investors who need
a particular type of financial instrument
but because of market imperfections, are
unable to get it or get it cheaply.
36. State the generalized version of states that changes in capital structure do
Modigliani-Miller Proposition I. not affect the value of a firm. MM's Proposition I is an extremely general result. Any
change in the capital structure of the firm
can be duplicated or "undone" by investors
at no cost. Investors need not pay extra
for borrowing indirectly (by holding shares
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in a levered firm) when they can borrow
just as easily and cheaply on their own
account. It applies equally to trade-offs of
any choice of financial instruments. For example, the choice between long-term debt
and short-term debt would also not affect
the value of the firm. Generally, the choice
between issuing preferred stock, common
stock, or some combination of the two
should not have any effect on the overall
value of the firm. It also applies to the mix
of debt securities issued by the firm. The
choices of long- term versus short-term,
secured versus unsecured, senior versus
subordinated, and convertible and nonconvertible debt all should not have any
effect on the overall value of the firm.
37. Briefly explain how interest tax Generally, levered firms pay less tax than
shields contribute to the value equivalent unlevered firms. The savings
of stockholders' equity.
in taxes is called the interest tax shield.
U.S. firms can deduct interest payments
as pre-tax expenses, thereby reducing the
level of taxable income. Hence levered
firms have lower tax payments. This in turn
increases the value of the firm.
38. State Modigliani-Miller's Propo- The value of a levered firm is equal to
sition I corrected to include cor- the value of an equivalent unlevered firm
porate income taxes.
plus the present value of tax shields. In the
special case of permanent debt: VL = VU
+ (TC)(D), where TC = marginal corporate
tax rate.
39. Discuss the basic idea behind
Miller's arguments about debt
and taxes.
In equilibrium, taxes determine the aggregate amount of corporate debt but not the
amount issued by any particular firm. For a
given set of tax rates, both corporate and
personal, the market will adjust until there
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is no advantage to any firm issuing more
debt.
40. What is the relative tax advan- The relative tax advantage of debt can
tage of debt when corporate and be stated as: (1 - TP)/[(1 - TC)(1 - TPE)].
personal taxes are considered? Suppose all- equity income is in the form
of dividends, then TPE = TP. In that case
the relative tax advantage of debt is: 1/(1 TC). In the case where (1 - TP) = (1 - TC)(1
- TPE), the relative tax advantage is zero.
41. Discuss the 1995 results of
Rajan and Zingales from the
trade-off theory perspective.
Large firms tend to have higher debt ratios. Large firms are less exposed to the
costs of financial distress. Firms with high
amounts of tangible assets have higher debt ratios. Tangible assets are easier
to borrow against and thus induce fewer costs of financial distress. High market-to-book ratio firms are interpreted as
high-growth firms facing higher costs of
financial distress, and thus they borrow
more. The result on profitability—highly
profitable firms borrow less—goes against
the trade-off theory.
42. How is Modigliani-Miller's
Proposition I modified when
taxes and financial distress
costs are considered?
Financial distress occurs when bondholder contracts are broken or fulfilled with
great difficulty. Financial distress could
lead to bankruptcy. Financial distress is
costly. This is reflected in the market value
of the levered firm. Value of a levered firm
= value of an equivalent unlevered firm +
PV(tax shield) - PV(cost of financial distress).
43. Briefly discuss bankruptcy
costs.
There are direct and indirect costs to bankruptcy. Direct costs include legal and administrative costs of liquidation or reorganization. Indirect costs of potential bankruptcy (financial distress) include impaired
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ability to conduct business and increased
agency costs. Agency costs associated
with managerial actions under the threat
of bankruptcy include: risk shifting, underinvestment or refusal to invest more equity, cash in and run, bait, and switch, and
playing for time.
44. Discuss some examples of
conflicts of interest that may
arise between bondholders and
stockholders when a firm is in
financial distress.
When a firm is in distress, the shareholders have incentives to protect the value of their securities and hence take actions that—although increasing the value
of equity—might decrease the overall value of the firm and reduce the debtholders'
wealth. Some examples of such actions
are risk shifting, refusing to contribute equity capital, playing for time, and bait and
switch.
45. Briefly explain the trade-off the- A firm's debt-equity decision can be
ory of capital structure.
thought of as a trade-off between interest
tax shields and the present value of the
costs of financial distress. These two interact to provide an optimal capital structure
for a firm. This is called the trade-off theory.
46. Explain the pecking order theo- This theory is based on the observation
ry of capital structure.
that, in general, managers know more
about the firm's prospects, risks, and values than do outsiders. Their asymmetric
information affects managers' choices between internal and external financing and
between new issues of debt and equity.
The key problem is the difficulty of selling
securities to investors at a fair value. Investors infer—by the mere act of selling
stock—that the stock must be overvalued.
The implication is that firms prefer internal
financing to external financing. When firms
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are propelled to go for external financing,
they prefer debt to equity.
47. Explain the impact of govern- The capital markets naturally punish firms
ment loan guarantees on corpo- for excess use of debt via default and
rate financing.
bankruptcy. Firms in deep distress will naturally turn away from debt financing and
back towards equity financing. Intervention in the capital markets by the government to provide loan guarantees to firms
on the brink of failure works in the opposite
direction by encouraging further leveraging.
48. Briefly explain the term limited The shareholders of a corporation canliability
not be held personally responsible for the
debts of the corporation. This is called limited liability. Hence, a shareholder's loss is
limited to the amount he or she has invested in a corporation. This is an attractive
feature for investors.
49. Briefly explain the advantages • Corporations have infinite life.• Corpoof a corporation as a form of
rations have very many owners called
business organization
shareholders and therefore corporations
can raise funds more easily than other
forms of business.• There is a separation of ownership and management that
is helpful in running the corporation on a
day-to-day basis.• It is relatively easy to
transfer ownership in a corporation.• Corporations have limited liability.
50. Briefly explain the sequence of • Cash is raised by selling financial assets
cash flows between financial
to investors.• Cash is invested in the firm's
markets and the firm.
operation and used to purchase real assets. • Cash is generated by the firm's operations.• Cash is reinvested or returned
to investors.
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51. Briefly discuss the role of finan- Chief financial officer (CFO): Supervises
cial managers.
the treasurer and the controller in a large
corporation. CFO is involved in corporate
planning and financial policy.Treasurer: Is
responsible for obtaining funds and managing cash, banking relationships and investor relationships.
Controller: Is responsible for accounting
functions, payroll, and taxes.
52. Briefly explain some of the institutional arrangements that ensure that managers work toward
increasing the value of a firm.
• the board of directors, elected by shareholders, which scrutinizes managers' actions • competition among managers• the
threat of takeover that brings a new management team• incentive schemes that
are closely tied to the value of the firm like
stock options
53. Briefly explain the concept of
risk
If the future cash flows from an investment are not certain, then we call such an
investment risky. That means there is an
uncertainty about the future cash flows or
future cash flows could be different from
expected cash flows. The degree of uncertainty varies from investment to investment. Uncertain cash flows are discounted
using a higher discount rate than certain
cash flows. This is only one method of
dealing with risk. There are many ways to
consider risk while making financial decisions.
54. State the rate of return rule.
Invest as long as the rate of return on the
investment exceeds the rate of return on
equivalent- risk investments in the capital
market.
55. Discuss some of the advantages of using the payback
method
It tells you how quickly you can recover
your investment. The main advantage is
that it is easy to calculate and use.
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56. What are some of the disadvan- There are several disadvantages to the
tages of using the IRR method? IRR method. It is not useful in evaluating mutually exclusive projects and dependent projects. You can also get multiple
IRRS for projects having cash flows with
more than one change in sign. Also, IRR
cannot distinguish between borrowing and
lending projects. In most cases it may be
easier to use the NPV method.
57. Briefly discuss capital rationing.
There are two types of capital rationing;
soft rationing imposed by the company
and hard rationing imposed by the capital
markets. Capital rationing may result in the
firm forgoing some positive NPV projects,
thereby reducing a firm's value.
58. What are some of the important
points to remember while estimating the cash flows of a project?
• Estimate after-tax cash flows on an incremental basis. • Include all incidental
effects.• Include working capital requirements.• Include opportunity costs.
• Do not include sunk costs.• Take inflation
into consideration in a consistent manner.
59. Briefly explain how the decision The decision to replace an existing mato replace an existing machine chine is done for economic or technologis made?
ical reasons, or for both. An equivalent
annuity approach is used. As long as the
benefits exceed equivalent annual costs,
the decision will be a sound one.
60. Briefly explain how the cost of Many managers assume that the marginal
excess capacity is taken into
cost of excess capacity is zero and enconsideration.
courage employees to use up the excess
capacity. This may not be a very sound
way to utilize excess capacity. If we use the
equivalent annual cost (EAC) approach,
the cost of excess capacity can be estimated easily. Indiscriminate use of excess
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capacity may result in replacing the existing machine with a new machine sooner.
Earlier replacement is the cost of excess
capacity and must be taken into consideration.
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1. capital components
The elements in a firm's capital structure.
2. investment opportunity
schedule
A table or graph of a firm's potential investments ranked from the highest internal rate of
return to the lowest.
3. opportunity cost principle This concept argues that a firm's retained earnings are not free to the firm.
4. breakpoint
The point along the firm's marginal cost of capital (MCC) curve or schedule at which the MCC
increases.
5. target capital structure
A firm's shareholder wealth-maximizing combination of debt, and common and preferred
stock.
6. flotation costs
The costs associated with issuing new financial
securities.
7. Weighted Average Cost of The average cost of a firm's financial capital
Capital (WACC)
when averaged across all of its outstanding
debt and equity capital.
8. cost of capital
The minimum return that must be earned on
a firm's investments to ensure that the firm's
value does not decrease.
9. marginal cost of capital
The weighted average cost of the last dollar
raised by a firm, or the firm's incremental cost
of capital.
10. cost of debt
The cost associated with a firm's borrowed financial capital.
11. Estimation Methods Formula
Discounted Cash Flow Approach ?
formula for Discounted Cash Flow Approach :
rs = D1/P0 + g
formula for Capital Asset Pricing Model Approach :
rs = rRF +Bs x (rm-rRF)
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Capital Asset Pricing Model
Approach ?
12. The _________ is the inter- before-tax cost of debt
est rate that a firm pays on
any new debt financing.
13. Water and Power Company 11.11%-(1-45%) = .111-.55 = 6.11%
(WPC) can borrow funds at
an interest rate of 11.10%
for a period of five years. Its
marginal federal-plus-state
tax rate is 45%. WPC's
after-tax cost of debt is
_____________ (rounded to
two decimal places).
14. At the present time, Water and Power Company
(WPC) has 5-year noncallable bonds with a face
value of $1,000 that are
outstanding. These bonds
have a current market price
of $1,229.24 per bond, carry
a coupon rate of 10%, and
distribute annual coupon
payments. The company incurs a federal-plus-state
tax rate of 45%. If WPC
wants to issue new debt,
what would be a reasonable estimate for its after-tax cost of debt (rounded to two decimal places)?
3.00%
3.13%
2.09%
2.61%
coupon rate = 10%
NPER = years to maturity = 5
PMT = face value x coupon rate = 1000 x .10 =
$100
Face Value = $1,000
Price = PV = 1229.24
after-tax cost of debt = 2.61%
Remember, the before-tax cost (generic) of
Water and Power Company's 5-year 10% outstanding bonds can be estimated by computing the bonds' yield-to-maturity (YTM). Unfortunately, there isn't a simple equation that can
be used to easily solve for YTM, however, you
can use your financial calculator to quickly determine this value. To do this, you will first need
to compute the bonds' annual coupon payment
(using the annual coupon rate given in the problem). That is:
Annual Coupon = Bond's face value x Annual
coupon rate = $1,000×0.10 = $100 per year
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Then, the following inputs can be used in your
financial calculator to calculate the bonds' YTM
(I):
N PV PMT FV I
5 -1,229.24 100 1,000 4.74
Now that you have found that the bonds' before-tax cost of debt (generic) is 4.74%, then
multiply the before-tax cost of debt by 1 minus
the tax rate to determine the bonds' after-tax
cost of debt (generic):
After-tax cost of debt (generic)= generic x (1 T) = 4.74%×(10.45) = = 2.61%
15. Firms that carry preferred
stock in their capital structure want to not only distribute dividends to common stockholders but also
maintain credibility in the
capital markets so that they
can raise additional funds
in the future and avoid potential corporate raids from
preferred stockholders.
16. Blue Panda has preferred
stock that pays a dividend
of $5.00 per share and
sells for $100 per share. It
is considering issuing new
shares of preferred stock.
These new shares incur an
underwriting (or flotation)
cost of 1.50%.
preferred dividend = d = $5
price of preferred share = p = 100
floatation cost , f = 1.5% = 0.015
amount paid to underwriter, a = f*p = 0.015*100
= $1.50
How much will Blue Panda
pay to the underwriter on a
per-share basis?
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$1.27
$1.50
$1.65
$98.50
17. After it pays its underwriter, amount left after payment to underwriter, x = p
how much will Blue Panda - a = 100-1.5 = $98.50
receive from each share of
preferred stock that it issues?
$88.65
$1.50
$1.65
$98.50
$1.27
18. Based on this information, cost of preferred stock = d/x = 5/98.50 =
Blue Panda's cost of pre- 0.05076 or 5.076% = 5.08% (after rounding off)
ferred stock is ______
19. If a firm cannot ingreater than or equal to
vest retained earnings to
earn a rate of return
_________________ the required rate of return on retained earnings, it should
return those funds to its
stockholders.
20. The current risk-free rate Rf + BETA * RISK PREMIUM
of return is 4.20% and the = 4.20% + (0.87 * 6.6%)
current market risk premi- = 9.94%
um is 6.60%. Fuzzy Button Clothing Company has
a beta of 0.87. Using the
Capital Asset Pricing Model (CAPM) approach, Fuzzy
Button's cost of equity is
__________.
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21. Green Caterpillar Garden
Supplies Inc. is closely
held and, as a result,
cannot generate reliable
inputs for the CAPM
approach. Green
Caterpillar's bonds yield
11.50%, and the firm's
analysts estimate that the
firm's risk premium on its
stock relative to its bonds
is 4.50%. Using the
bond-yield-plus-risk-premium approach, the firm's
cost of equity is
___________.
COST OF EQUITY
= BOND YEILD + RISK PREMIUM
= 11.5% + 4.5%
= 16%
22. The stock of Blue HamThe DCF approach shows you that the price
ster Manufacturing Inc. is and the expected rate of return on a share of
currently selling for $45.56, common stock ultimately depend on the stock's
and the firm expects its div- expected cash flows. When dividends are exidend to be $2.35 in one
pected to grow at a constant rate, the DCF
year. Analysts project the formula can be expressed as:
firm's growth rate to be con- P0 = D1/(rs-g)
stant at 5.70%. Using the
discounted cash flow (DCF) However, in this problem, you are trying to find
approach, Blue Hamster's cost of equity (rs)—not the price of the stock
cost of equity is estimated (P0)—so you'll want to rearrange the equation
to be _______
to put it in terms of rs and then plug in the
values given in the problem to solve for the cost
of equity. That is:
rs = ($2.35/$45.56) + 0.0570
= 0.1086 = 10.86%
23. A firm will never have to
retained earnings
take flotation costs into account when calculating the
cost of raising capital from
________
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24. True or False: The following statement accurately
describes how firms make
decisions related to issuing
new common stock.
False: Flotation costs need to be taken into
account when calculating the cost of issuing
new common stock, but they do not need to
be taken into account when raising capital from
retained earnings.
The cost of issuing new
common stock is calculated the same way as the
cost of raising equity capital from retained earnings.
False: Flotation costs need
to be taken into account
when calculating the cost
of issuing new common
stock, but they do not need
to be taken into account
when raising capital from
retained earnings.
True: The cost of retained
earnings and the cost of
new common stock are calculated in the same manner, except that the cost of
retained earnings is based
on the firm's existing common equity, while the cost
of new common stock is
based on the value of the
firm's share price net of its
flotation cost.
25. Blue Hamster Manufacturing Inc. is considering a
one-year project that requires an initial investment
of $400,000; however, in
Cost of New investment is 400,000*1.05% =
420,000 with floatation cost
Cash flow after a year 520,000.
Hence return is (520,000-420,000)/420,000 =
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raising this capital, Blue
.2381
Hamster will incur an addi- = 23.81%
tional flotation cost of 5%.
At the end of the year,
the project is expected to
produce a cash inflow of
$520,000. The rate of return that Blue Hamster expects to earn on the project after its flotation costs
are taken into account is
___________
26. Blue Hamster has a current
stock price of $33.35 and
is expected to pay a dividend of $1.36 at the end
of next year. The company's growth rate is expected to remain constant at
4%. If the issue's flotation
costs are expected to equal
5% of the funds raised,
the flotation-cost-adjusted
cost of the firm's new common stock is ________
Cost of the firm = D1/P0 + g
where D1 is the dividend next year = $1.36
P0 = the price this year = $33.35
g=growth rate = 4% =0.04
Hence Cost of Capital / equity = $33.35×(1-5%)
= $1.36÷(r-4%) = $33.35×(1-.05) =
$1.36÷(r-.04)
= 31.6825r - 1.2673 = 1.36
= 31.6825r = 2.6273
r = 0.0429 = 4.29%
Taking into consideration flotation costs of 5%:
Cost of stock = 4.29% + 5% = 8.29%
27. Blue Hamster's addition to
earnings for this year is
expected to be $420,000.
Its target capital structure
consists of 50% debt, 5%
preferred stock, and 45%
common stock. Blue Hamster Manufacturing Inc.'s
retained earnings breakpoint is __________ (rounded to the nearest whole dollar).
Firms prefer to raise capital from retained earnings instead of issuing new stock whenever
possible, because no flotation costs are associated with raising capital from retained earnings.
However, if a firm has more good investment
opportunities than can be financed with retained earnings, it may need to issue new common stock. The retained earnings (RE) breakpoint is the total amount of capital that can be
raised before a firm must issue new common
stock. That is:
RE Breakpoint = Addition to Retained Earnings
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for the Year / Equity Fraction of Target Capital
Structure
= $420,000/0.45
= $933,333
28. The calculation of a weighted average cost of capital
(WACC) involves calculating the weighted average of
the required rates of return
on debt and equity, where
the weights equal the percentage of each type of financing in the firm's overall
capital structure.
29. ________ is the symbol that Re
represents the cost of raising capital by issuing new
stock in the weighted average cost of capital (WACC)
equation.
30. Nick Co. has $3.99 million total value = 3.99 + 1.36+1 = 6.35 million
of debt, $1.36 million of pre- weight of preferred stock = 1.36/6.35 = 21.42%
ferred stock, and $1 million of common equity. The
appropriate weight of the
firm's preferred stock in the
calculation of the company's weighted average cost
of capital is ________
31. The weighted average cost
of capital (WACC) is used
as the discount rate to evaluate various capital budgeting projects. However, it
is important to realize that
the WACC is an appropriate
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discount rate only for a project of average risk.
32. Consider the case of Turnbull Company.
Turnbull Company has a
target capital structure of
58% debt, 6% preferred
stock, and 36% common
equity. It has a before-tax
cost of debt of 8.20%, and
its cost of preferred stock is
9.30%. If Turnbull can raise
all of its equity capital from
retained earnings, its cost
of common equity will be
12.40%.
However, if it is necessary
to raise new common equity, it will carry a cost of
14.20%.
33. If its current tax rate is 40%, WACC = (36%12.40%) + (6%x9.30%) +
Turnbull's weighted aver- (58%x[8.20%x(1-40%)])
age cost of capital (WACC) = 4.45 + .56% + 2.85%
will be ________ higher if it =7.86%
has to raise additional common equity capital by issu- WACC = (36%x14.20%) + (6%x9.30%) +
ing new common stock in- (58%x[8.20%x(1-40%)])
stead of raising the funds = 5.11% + .56% + 2.85%
through retained earnings. =8.52%
Difference in WACC = 8.52% - 7.86%
= .66% or .64% with no rounding of previous
numbers
34. Turnbull Company is considering a project that
requires an initial in-
The first step to solving this problem is finding the weights of debt, preferred stock, and
common equity. You are given the total amount
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vestment of $570,000.00.
The firm will raise the
$570,000.00 in capital by issuing $230,000.00 of debt
at a before-tax cost of
11.10%, $20,000.00 of preferred stock at a cost of
12.20%, and $320,000.00 of
equity at a cost of 14.70%.
The firm faces a tax rate of
40%. The WACC for this project is ___________
of the initial investment, $570,000.00, and
you are told that you will raise $230,000.00
of debt, $20,000.00 of preferred stock, and
$320,000.00 of common equity. You will need to
perform the calculations that follow to compute
the weight (w) of each of these capital components:
Wd = $230,000.00/ $570,000.00
= 0.4035=40.35%
Wps = $20,000.00/$570,000.00
= 0.0351 = 3.51%
Ws = $320,000.00/$570,000.00
= 0.5614=56.14%
Now that you have found the weights of debt,
preferred stock, and common equity, plug this
information—along with the before-tax costs
of debt, preferred stock, and common equity
given in the problem—into the equation to solve
for the WACC:
WACC = (Wd×Rd(1T))+(Wps×Rps)+(Ws×Rs)
=
(0.4035×(11.10%×(10.40)))+(0.0351×12.20%)+(0.5
= 11.37%
35. Kuhn Corporation is considering a new project that
will require an initial investment of $4,000,000. It has a
target capital structure consisting of 45% debt, 4% preferred stock, and 51% common equity.
Kuhn has noncallable
bonds outstanding that mature in five years with a face
value of $1,000, an annual
coupon rate of 10%, and a
market price of $1,050.76.
You are given the weights of debt, preferred
stock, and common equity in this problem. You
must solve for the before-tax cost of debt, the
cost of preferred stock, and the cost of common
equity before you can solve for Kuhn's WACC.
You don't need to know that the project's initial
investment is $4,000,000 to solve the WACC,
because you already know the company's target capital structure.
The first step to solving this problem is finding
the company's before-tax cost of debt. Computing the yield-to-maturity (YTM) on the five-year
noncallable bonds issued by Kuhn tells you
the before-tax cost of debt will be on any new
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The yield on the company's
current bonds is a good approximation of the yield on
any new bonds that it issues.
The company can sell
shares of preferred stock
that pay an annual dividend
of $9.00 at a price of $92.25
per share.
Kuhn Corporation does not
have any retained earnings
available to finance this
project, so the firm will have
to issue new common stock
to help fund it. Its common stock is currently selling for $33.35 per share,
and it is expected to pay
a dividend of $1.36 at the
end of next year. Flotation
costs will represent 8.00%
of the funds raised by issuing new common stock.
The company is projected
to grow at a constant rate of
8.70%, and they face a tax
rate of 40%.
Kuhn Company's WACC
for this project will be
_________
bonds that the company wants to issue. There
isn't a simple equation that can be used to
easily solve for YTM, but you can use your
financial calculator to quickly determine this
value. However, you will first need to solve the
bonds' annual coupon payment, using the annual coupon rate given in the problem:
Annual couponAnnual coupon = = Bond's Face
value×Annual Coupon rateBond's Face value×Annual Coupon rate = = $1,000×0.10 =
$100
Remember, this annual coupon represents
the PMT in the computation of the bonds'
yield-to-maturity. Next, use your financial calculator to compute the bonds' YTM, as follows:
Input 5 -1050.76. 100 1,000
Keystroke. N PV PMT. FV I
Output 8.70
This tells you that the YTM on the outstanding
five-year noncallable bonds is 8.70%. This represents the before-tax cost of debt, Rd, that will
be used when you solve for Kuhn's WACC.
To solve for the company's cost of preferred
stock, use the equation that follows:
Rps = = Dps/NP0
= $9.00/$92.25
= 0.0976 = 9.76%
Finally, you need to solve for the cost of issuing
new common stock. Because the company is
issuing new common stock, make sure to include the flotation costs associated with issuing
new common stock in your calculations:
Re = D1/P0×(1F) + g = $1.36/$33.35×(10.08)
+ 0.09
= 0.1343 = 13.43%
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Now that you have found the cost of each
of the capital components, use this information to solve for the WACC: = (Wd ×
Rd(1T))+(Wps × Rps)+(ws×rs)wd×rd1T+wps×rps+ws×rs = = (0.45×(8.70% × (10.40)) +
(0.04 × 9.76%)+(0.51×13.43%)= 9.59%
Therefore, Kuhn will incur an expected cost of
9.59% for its financial capital of if it elects to
undertake this new project.
36. As a company raises more
and more funds, the cost
of those funds begins to
rise. As this occurs, the
weighted cost of each new
dollar rises. This is called
the marginal cost of capital. A graph that shows how
the weighted average cost
of capital changes as more
new capital is raised by the
firm is called the MCC (marginal cost of capital) schedule.
37. If this company raises
$160M, its weighted average cost of capital is
______
11.6%
38. The breakpoints in the MCC $50 and $122 Million because these are the
schedule occur at ________ two points in the graph shown in this question
of newly raised capital.
where the cost of capital line breaks and rises
perpedicularly).
39. Does the cost of capital
yes
schedule below match the
MCC schedule depicted on
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the graph?
Yes
No
40. Bryant Manufacturing is
considering the following
capital projects. The internal rate of return (IRR) has
been calculated for each
project.
Project Cost(millions of
dollars). IRR
A $40 11.6%
B $40 11.2%
C $80 10.8%
The optimal capital budget
(OCB) is the budget size
that maximizes the firm's
wealth given the opportunities for investment and
the cost of capital. Bryant's
managers have plotted the
marginal cost of capital
(MCC) schedule to reflect
how the cost of capital
increases as new capital
is raised. Assume that the
proposed projects are independent and equally risky
and that their risks are
equal to Bryant's average
existing assets.
41. The optimal capital budget
is $80.0 million, and the
weighted average cost of
capital (WACC) at the optimal capital budget is 11.0%.
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On the graph, this is where
the lines intersect. The MCC
schedule (organge line) is
the weighted average cost
of capital at different levels
of funding, and the investment opportunity schedule
(blue line) shows the projects ranked in descending
order by IRR.
The weighted average cost
of capital at the intersection is the discount rate that
will be used to calculate the
net present values (NPV)
for the projects. Any project to the left of the intersection will have a positive
NPV and should be accepted; any project to the right
of where the lines intersect
should be rejected because
the cost of capital is higher
than the project's IRR.
Note that the problem
states that the projects
are equally risky. Bryant
is seeking to maximize returns for the company as a
whole, so rather than looking at projects individually, it will accept the projects with the highest returns first, up to the point
where the cost of capital
is higher than the IRR. If
a project extends past the
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intersection, there are two
solutions: If possible, break
the project into parts and
accept the amount up to
the intersection; otherwise,
find the average cost to
finance the entire project
(some will be at the lower
rate and some at the higher
rate) and compare that to
the IRR of the project. Accept the project if the return
exceeds the average cost to
finance it.
42. The required rate of return
of an investor is the rate of
return that an investor demands to purchase a firm's
stocks or bonds and thus
provide funds for capital
investment. Therefore, required returns from the investors' point of view correspond to the required returns or the weighted average cost of capital (WACC)
from the firm's point of
view.
43. true or false:
true
The amount that an investor is willing to pay for
a firm's stock is inversely
related to the firm's cost
of common equity before
flotation costs.
44.
false
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The amount that an investor is willing to pay for
a firm's bonds is inversely
related to the firm's cost of
preferred stock.
45. A firm will lose wealth if
true
it invests in projects based
on a WACC that is lower
than the investors' required
rate of return.
46. A firm's cost of capital
true
is determined by the investors who purchase the
firm's stocks and bonds.
47. Flotation costs increase the true
cost of newly issued stock
compared to the cost of
the firm's existing, or already outstanding, common stock or retained earnings.
48. A firm will increase in val- false
ue if it invests in projects
based on a WACC that is
lower than the investors' required rate of return.
49. The firm's cost of debt is true
what an investor is willing
to pay for the firm's bonds
before considering the cost
of issuing the debt.
50. The difference between the true
cost of retained earnings
and the cost of new com16 / 20
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mon equity is the cost to issue the new common stock.
also known as the flotation
costs
51. The amount that an intrue
vestor is willing to pay for a
firm's preferred stock is inversely related to the firm's
cost of preferred stock before flotation costs.
52. The firm's cost of debt is
what an investor is willing to pay for the firm's
stock before considering
flotation costs.
false
53. The amount that an intrue
vestor is willing to pay for
a firm's bonds is inversely related to the firm's cost
of debt without considering the cost of issuing the
bonds.
54. The cost of retained earn- true
ings is the same as the cost
of internal (common) equity.
55. capital components
This term refers to the individual sources of
the firm's financing, including its debt, preferred
stock, retained earnings, and newly issued
common equity.
56. investment opportunity
schedule
A table or graph of a firm's potential investments listed in decreasing order of their internal
rates of return.
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57. opportunity cost principle This concept maintains that the firm's retained
earnings should generate a return for the firm's
shareholders.
58. breakpoint
The amount of capital expenditures made, or to
be made, at which the firm's marginal cost of
capital increases.
59. target capital structure
The combination of debt, preferred stock, and
common equity that will maximize the value of
the firm's common stock.
60. flotation costs
These costs are generally expressed as a percentage of the total amount of securities sold,
including the costs of printing the security certificates, applicable taxes, and issuance and
marketing fees.
61. marginal cost of capital
The average cost of the next dollar of financial
capital raised by a firm.
62. cost of capital
The return that providers of financial capital
require to induce them to provide capital to a
firm, and the associated cost to the firm for
securing these funds.
63. Weighted Average Cost of The average rate paid by a firm to secure the
Capital (WACC)
outstanding financial capital used to acquire
the firm's assets.
64. Cost of Debt
The return required by providers of capital
loaned to the firm.
65. Your boss has just asked
you to calculate your firm's
cost of capital. Below is potentially relevant information for your calculation.
What is your firm's Weighted Average Cost of Capital?
Market Value of Debt and Equity
Market Value of Debt = $90 Million
Market Value of Equity = $150 Million
Total Market Value = $210 Million
Weight of Capital Structure
Weight of Debt = 0.3750 [$90 Million / $210
Million]
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Common Equity: Book Value = $100 million, Market Value = $150 million,
Net Income from most recent fiscal year = $12 million, Required rate of return
(from CAPM) = 11%, Dividend Yield = 2%.
Debt: Book Value = $100
million, Market Value = $90
million, average coupon
rate = 4%, average yield
to maturity = 4.4%, average
maturity = 10 years.
Corporate Tax Rate = 21%.
Weight of Equity = 0.6250 [$150 Million / $210
Million]
After Tax Cost of Debt
After Tax Cost of Debt = Pre-tax Yield to maturity x (1 - Tax Rate)
= 4.40% x (1 - 0.21)
= 4.40% x 0.79
= 3.48%
Cost of Equity = 11.00%
Weighted Average Cost of Capital (WACC)
Therefore, the Weighted Average Cost of Capital (WACC) = [After Tax Cost of Debt x Weight
of Debt] + [Cost of equity x Weight of Equity]
= 3.48% x 0.3750] + [11.00% x 0.6250]
= 1.30% + 6.88%
= 8.18%
66. Description
What is your firm's Weighted Average Cost of Capital
(input as a raw number, i.e.
if your answer is 7.1%, enter
7.1)?
Corporate taxes are 21%.
The firm is financed with
the following securities:
Common Equity:
-> 5,000,000 shares
-> price per share = $50
-> ²=1.25,Mkt Risk Premium
= 5%, Risk-free rate = 4%.
Debt:
-> 200,000 bonds
-> face value per bond =
$1000
-> market price per bond=
$1075
-> coupon rate = 6%, 5
Market value of common equity = 5,000,000 *
50 = 250,000,000
Market value of bond = 200,000 * 1,075 =
215,000,000
Total market value = 250,000,000 +
215,000,000 = 465,000,000
Cost of equity = Risk free rate + beta (market
risk premium)
Cost of equity = 0.04 + 1.25 (0.05)
Cost of equity = 0.1025 or 10.25%
Coupon = (0.06 * 1000) / 2 = 30
Number of periods = 5 * 2 = 10
YTM = 4.3163%
Keys to use in a financial calculator: 2nd I/Y 2,
FV 1000, PV -1075, N 10, PMT 30, CPT I/Y
WACC = Weight of debt*after tax cost of debt +
weight of equity*cost of equity
WACC = (215,000,000 /
465,000,000)*0.043163*(1 - 0.21) +
(250,000,000 / 465,000,000)*0.1025
WACC = 0.015766 + 0.05511
WACC = 0.071 or 7.1
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years to maturity (assume
semi-annual payment.
67. Estimate your firm's
Weighted Average Cost of
Capital. Assume that the
current risk-free rate of interest is 3.5%, the market
risk premium is 5%, and the
corporate tax rate is 21%.
-> Debt:
• Total book value: $10 million
• Total market value: $12
million
• Coupon rate: 6%
• Yield to Maturity: 5%
-> Common Stock:
• Total book value: $15 million
• Total market value: $20
million
• Beta = 1.1
-> Preferred Stock:
• Total book value: $2 million
• Total market value: $2.5
million
• Price per share: $20
• Dividend per share: $1.50
What is your firm's Weighted Average Cost of Capital
(input as a raw number, i.e.
if your answer is 7.1%, input
7.1)?
Total Value = Total Market value of Debt + Total
Market value of Equity + Total market value of
Preferred stock = 12 + 20 +2.5 = 34.5
Cost of debt = 5%
Cost of Equity = 3.5% + 1.1*5% = 9%
Cost of Preferred Stock = 1.50/20 = 7.5%
WACC = Weight of Debt * Cost of Debt*(1-Tax
Rate) + Weight of Equity* Cost of equity +
weight of Preferred Stock * Cost of Preferred
Stock = 12/34.5 * 5%*(1-21%) + 20/34.5 * 9%
+ 2.5/34.5*7.5%
= 7.10% or 0.070986 or 0.071
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1. Cost of new external common
equity Re
A project financed with external equity must earn a higher
rate of return because it must cover the flotation costs.
Thus, the cost of new common equity is higher than that of
common equity raised internally by reinvesting earnings.
2. Weighted Aver- The weighted average of the after-tax component costs of
age Cost of Cap- capital—debt, preferred stock, and common equity. Each
ital (WACC)
weighting factor is the proportion of that type of capital in
the optimal, or target, capital structure.
3. After-tax cost of equal to the investors' required rate of return on debt less
debt (Rd(1-T)
the issuer's tax savings due to interest expense deductions:
After-tax cost of debt = Required return 2-Tax savings
= rstd(1 - T) or rd (1 - T)
4. After tax cost of After-tax cost = rstd(1 - T)
short term debt
Rstd (1-T)
Short-term debt should be included in the capital structure
only if it is a permanent source of financing in the sense
that the company plans to continually repay and refinance
the short-term debt.
5. Cost of preferred stock is calculated as the preferred dividend divided by the
stock Rps
net price the firm receives after deducting flotation costs:
Flotation costs on preferred stock are usually fairly high,
so we typically include the impact of flotation costs when
estimating rps.
6. Cost of common is the rate of return required by the firm's stockholders.
equity (or cost of
common stock)
7. Target Capital
Structure
which is defined as the mix of debt, preferred stock, and
common equity that minimizes its weighted average cost
of capital (WACC)
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8. Flotation cost (F) the commissions, legal expenses, and any other costs that
a company incurs when it issues new securities.
on preferred stock are usually fairly high, so we typically
include the impact of flotation costs when estimating rps
9. How can WACC
be both an average cost and a
marginal cost
because WACC is the cost an organization would occue to
raise each marginal dollar of capital and the marginal cost
of capital is thw weighted avergae cost of the last dollar of
capital raisesd
10. capital components
Sources of investor-supplied capital
11. Identify a firms Debt (Wd), preferred stock (Wp), and common equity (Wc)
major capital
structure components, and
give the symbols
for their respective costs and
weights
12. What is a component cost?
13. What is a tarCapital structure refers to the way a corporation finances
get capital struc- its assets through some combination of equity, debt, or
ture?
hybrid securities.
which is defined as the mix of debt, preferred stock, and
common equity that minimizes its weighted average cost
of capital (WACC):
14. percentage flota- the total dollar value of flotation costs divided by the istion cost for debt sue's total par value
(F)
15. net issue price
amount per bond that issuing company actually recieves
after it pays the flotation costs.
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16. constant yield
method
A method of amortizing bond discount or premium to
calculate the interest deduction allowed each period. The
amount of discount or premium amortized each period
is calculated to be the amount required so the interest
payment plus amortized discount, or the interest payment
minus the amortized premium, results in a return on the
bond's resulting basis each period equal to the bond's
yield to maturity at purchase.
17. de minimis
= 25% (Original years until matuirty)(Par value)
18. total net discount An original issue discount bond's issue price minus its
flotations costs. Also, can occur if an original issue bond's
issue price minus its flotation cost is less than par.
19. total net premium
An original issue premium bond's issue price minus its
flotations costs. If this total is less than par, then the bond
has a total net discount instead of a total net premium.
20. required rate of
return on stock
Rate that shareholders require to be fairly compensated
for the risk they bear. Also equal to the cost of common
stock because it is the cost a company incurs to provide
the required rate of return.
21. what is the after
tax cost of debt,
rather than its before tax required
rate of return,
used to calculate teh weighted
average cost of
capital?
Because tax gives incentive to debt, because interest is
bpaid before tax. So some amount of tax gets reduced as
interest comes under cost. So Due to tax correct measure
of cost to debt can be there leading to corrcect measurment of WACC
22. Is the relevant
cost of debt,
when calculating the WACC,
the interst rate
on already ous3 / 10
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tanding debt or
the rate on new
debt? WHY?
23. Does the component cost of preferred stock include or exclude
flotation costs?
24. Why is no tax ad- because preferred dividends, unlike interest on debt, are
justment made to not tax deductible, so no tax savings are associated with
the cost of pre- preferred stock
ferred stock?
25. Explain both the
historical and the
forward looking
approaches to
estimating the
market risk premium
26. what are the two 1.PAID UP CAPITAL
primary sources One of the two main sources of stockholders equity is
of equty capital? paid-in capital. Paid in capital is the money brought into the
business by selling stock in the company. These funds are
often the initial source of stockholders' equity. Over time,
firms might sell additional stock to raise money for various
reasons. For example , a company might need funds to
expand into new market. When more stock is sold, the
firm's stockholders' equity increases.
2.RETAINED EARNINGS
Retained earnings are the other main source of stockholders equity. These are made up of the accumulated yearly
profits earned by the firm,minus any dividend payments.
For example if a firm records a net profit of $100 million at
the end of 2018, then the stockholders' equity on the balance sheet increases by the same amount. These profits
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are a reflection of how successful a company has operated
over time.
27. explain why there
is a cost to using
reinvested earnings; that is, why
aren't reinvested
eanrings a free
source capital?
Net income can either be retained earnings or dividends.
The reason why retained earnings are retained is that this
amount of money can gain a better return than that it is
divided and invested by the shareholders. The investors of
the company request a rate of return on the investments.
That is the cost associated with the firm's retained earnings.
28. Which is generally the more
appropriate estimate of the
risk-free rate: the
yield on a short
term t-bill or the
yield on a 10-year
t-bond?
29. dividend growth ÏThe dividend growth approach, which is often called the
approach
dividend capitalization method (and which is sometimes
called the dividend-yield-plus-growth-rate approach or the
discounted cash flow (DCF) approach), adds the firm's
expected dividend growth rate to its expected dividend
yield to estimate the required return on stock:
30. dividend capatal- ÏThe dividend growth approach, which is often called the
ization method dividend capitalization method (and which is sometimes
called the dividend-yield-plus-growth-rate approach or the
discounted cash flow (DCF) approach), adds the firm's
expected dividend growth rate to its expected dividend
yield to estimate the required return on stock:
The growth rate for use in the dividend capitalization model can be based on historical growth rates of earnings and
dividends, the retention growth equation, which assumes
g 5 (1 2 Payout)(Return on equity), or on security analysts'
forecasts.
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31. payout ratio
the percent of net income that the firm pays out in dividends
= dividends/net income
= dividends per share/ earnings per share
32. retention ratio
the percent of net income that is reinvested and added to
retained earnings
= addition to retained earnings/ net inome
=net income - dividends / net income
= 1 - dividends per share / earnings per share
1 - payout ratio
33. retention growth shows how growth is related ot reinvestment
equation
= ROE (retiontion ratio)
= ROE (1 - payout ratio)
34. what inputs are The inputs you need are the current free cash flow figures,
required for the the projected growth rate of those cash flows, and your
dividend growth target rate of return to use as the discount rate.
approach?
35. What are three
- use historitcal growth rates
ways to estimate the ex- use retention growth model (payout ratio, retention ratio,
pected dividend retention rgowth equation)
growth rate?
- analysts forecasts
36. How is the
weighted average cost of capital calculated?
The weighted average of the after-tax component costs of
capital—debt, preferred stock, and common equity. Each
weighting factor is the proportion of that type of capital in
the optimal, or target, capital structure.
37. Why are flotation
costs higher for
stock then debt?
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38. Identify problems that occur
when estimating
the cost of capial for a provatelty
held firm? What
are some solutions?
Problems which occur when estimating the cost of capital
of a privately held firm:
- Valuation of assets in the form of the chattels of the
decease. Chattles are everyday possessions as opposed
to houses, investments.
- Increase in wealth and estate values generally has
brought an increasing number of estates into the Inheritance Tax (IHT) net.
Rise in living standards
Some people value particular thing at X value and another
one at Y.
Relative value of each thing is not easy to know
While distributing, some horse trading should be done
Solutions to problems:
Use empirical data from appraisals to reveal why existing
methodology is not reliable.
Prescriptive procedures for valuation of asset requiring the
use of scientific methods, as used in the Triad process,
need to be set forth to quantify the atypical uncertainties
in valuing this property type.
Use predefined standard methods for evaluation.
Always have legal documents for every step you take.
39. Explain the reasoning behind
bond yield plus
judgmental risk
premium approach
40. pure play method the company tries to find the betas of several publicly held
specialized companies in the same line of business as the
division being evaluated, and it then averages those betas
to determine the cost of capital for its own division.
Method of estimating a divisional beta as the average
of betas from other companies that compete only in the
division's line of business.
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41. acconting beta
method
Method of estimating a divisional beta by running a regression of the division's accounting return on assets against
the average return on assets for the market.
42. accounting betas Estimated by using accounting return on assets instead of
stock returns.
43. stand alone risk - reflects uncertainty about its cash flows.
-Three techniques are used in practice to assess
stand-alone risk: (1) sensitivity analysis, (2) scenario
analysis, and (3) Monte Carlo simulation.
-The risk an investor would take by holding only one asset.
In the context of project analysis, it is the risk a company
would have if the company had only one project and
it is caused by variability in a project's cash flows. The
standard deviation is used often to measure stand-alone
risk.
44. risk adjusuted
cost of capital
The rate used to discount a project's cash flows after
taking into consideration firm's overall cost of capital, the
divisional cost of capital and any additional subjective risk
assessments for the particular project, including its impact
on the firm's debt capacity. Also called the project cost
of capital, the riskadjusted cost of capital, and the hurdle
rate.
45. projected cost of The rate used to discount a project's cash flows after
capital
taking into consideration firm's overall cost of capital, the
divisional cost of capital and any additional subjective
risk assessments for the particular project, including its
impact on the firm's debt capacity. Also called the hurdle
rate and the risk-adjusted cost of capital. project financing
Financing method
46. hurdle rate
The rate used to discount a project's cash flows after
taking into consideration firm's overall cost of capital, the
divisional cost of capital and any additional subjective risk
assessments for the particular project, including its impact
on the firm's debt capacity. Also called the project cost of
capital and the risk-adjusted cost of capital.
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47. Based on the
CAPM, how
would one adjust
the corporations
overall cost of
capital to establish required return for most projects in a low risk
division and in
high risk division
48. Describe the
pure play and the
accounitng beta
methods for estimating divisional
betas
In the pure play method, the company tries to find the
betas of several publicly held specialized companies in
the same line of business as the division being evaluated,
and it then averages those betas to determine the cost of
capital for its own division.
the accounting beta method. Betas are normally found
by regressing the returns of a particular company's stock
against returns on a stock market index. However, we
could run a regression of the division's accounting return
on assets against the average return on assets for a
large sample of companies, such as those included in the
S&P 500. Betas determined in this way (that is, by using
accounting data rather than stock market data) are called
accounting betas.
49. what are the
three types of
risk to which
projects are exposed? Which
type of risk is
theoretically the
most relevant?
Why?
1. A project's stand-alone risk is due to the variability of its
cash flows. It is the risk that a company would have if the
company had only this one project. As we show in Chapter
11, it is often measured by the standard deviation of the
project's cash flows.
2. Corporate risk, which is also called within-firm risk, is
the variability the project contributes to the corporation's
returns, giving consideration to the fact that the project
represents only one asset of the firm's portfolio of assets
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and so some of its risk will be diversified away by other
projects within the firm.
3. Market risk, which is also called beta risk, is the risk
of the project as seen by a welldiversified stockholder
who owns many different stocks. A project's market risk is
measured by its effect on the firm's overall beta coefficient.
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1. A capital project's discount rate is also
called the ______ or
______________
cost of capital; required rate of return
rate required by investors on a financial asset of
comparable risk
It is the....
2. The cost of capital depends primarily on...
how funds are employed, rather than how funds
are raised
3. The WACC is the...
return required on the total assets of the firm
Each source of capital has a required return, R
The weighted average cost of capital, WACC,
reflects the average market return required on
all sources of long-term capital. In other words,
a firm's cost of capital will reflect both its cost of
debt capital and its cost of equity capital.
4. As the Balance Sheet
Debt: loans and bonds
makes evident, funding for
new assets is obtained
Equity: preferred stock and common stock
from:
5. WACC formula
6. Market value of equity
(common and preferred)
Market value of debt
We will use the symbol E (for equity) to stand
for the market value of the firm's equity. We
calculate this by taking the number of shares
outstanding and multiplying it by the price per
share.
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Similarly, we will use the symbol D (for debt) to
stand for the market value of the firm's debt. For
long-term debt, we calculate this by multiplying
the market price of a single bond by the number
of bonds outstanding.
If there are multiple bond issues (as there normally would be), we repeat this calculation of D
for each and then add up the results. If there
is debt that is not publicly traded (because it is
held by a life insurance company, for example),
we must observe the yield on similar publicly
traded debt and then estimate the market value
of the privately held debt using this yield as
the discount rate. For short-term debt, the book
(accounting) values and market values should
be somewhat similar, so we might use the book
values as estimates of the market values.
w
Finally, we will use the symbol V (for value) to
stand for the combined market value of the debt
and equity:
V=E+D
7. Estimating cost of preferred stock (Not on Form.
Sheet)
8. Estimating the cost of
debt:
the pre-tax Yield to Maturity, YTM (The coupon
rate is not the cost of debt!)
For firms with publicly held the pre-tax YTM on bonds of similar risk (issued
debt, Rd is...
by other firms)
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For firms without publicly
held debt, Rd is...
the after-tax YTM
But in the WACC formula
we find...
9. What is one important
thing to remember when
estimating the cost of
debt?
The coupon rate is not the cost of debt!
10. What is true of interest ex- Interest expense reduces income tax
pense?
This is why we take the pre-tax cost of debt (the
YTM) and multiply it by (1 - Tc). This gives us
the pre-tax cost appropriately reduced due to
the tax shield.
11. pre-tax vs after-tax for debt The interest expense a company pays on its
debt is tax-deductible
Interest expense (like all expenses) serves to
shield income from taxation, so paying interest
expense reduces income tax expense
12. The after-tax cost of debt is lower than
______ its pre-tax cost
13. pre-tax vs after-tax for eq- Dividend payments to preferred and common
uity
stockholders are not expenses
Dividend payments do not appear on the income statement (except, perhaps, as footnotes). Therefore, dividend payments are not
tax-deductible
14. The after-tax cost of equity the same as
is ______ the pre-tax cost
of equity
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15. Estimating cost of common stock option 1
16. What does the dividend
The model requires us to estimate g, the rate of
discount model require us growth if the company, by either..
to do that could be potentially harmful?
using historical data and calculating g, or
using online analysts' estimates
17. Disadvantages of the divi- Not useful if the firm does not pay dividends
dend discount model (4)
We are using past data to predict the future
RE is extremely sensitive to changes in g
The approach does not explicitly consider risk
18. Estimating cost of common stock option 2 (Not of
Form. Sheet)
19. What will we use as a
risk-free instrument?
US Treasury bills
20. How do we find Rm and
Once we know Rf, the market risk premium, (RM
Rf for the CAPM method of - Rf), can be estimated by finding the historical
estimating the required re- market (e.g. using S&P 500 data)
turn on equity?
We could employ analysts' estimates of beta
What about beta?
21. Disadvantages for the
CAPM method? (2)
RE is extremely sensitive to changes in beta
and the market risk premium, which are both
estimated
We are using past data to predict the future
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22. The returns demanded by the costs incurred by companies
investors are...
23. If companies do not pro- Investors flee
vide the demanded return
to investors: (3)
Stock price drops
The corporate fails to achieve its purpose
24. What does WACC represent?
The WACC represents an average cost to a
company
It is the overall return the firm must earn on its
existing assets to maintain the value of its stock.
It is also the required return on any investments
by the firm that have essentially the same risks
as existing operations. So, if we were evaluating
the cash flows from a proposed expansion of our
existing operations, this is the discount rate we
would use.
25. When should the WACC be it should be employed when valuing projects of
employed?
average risk
26. For projects of above-aver- adjusted upward
age risk, the discount rate
is often...
greater than average volatility of the project's
future cash flows
This implies....
higher
And results in a ______ required rate of return
27. The WACC is the firm's
________________
average cost of capital
an NPV analysis
It is the discount rate for
It is the required rate of re- IRR analysis
turn for an
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28. If a project earns more
than the WACC... (3)
Value (the NPV) is added to the firm
The stock price will rise
The goal of the firm is achieved
29. When will the WACC poten- When we are evaluating investments with risks
tially lead to problems?
that are substantially different from those of the
overall firm, use of the WACC will potentially
How can we fix this?
lead to poor decisions.
Try to determine what the cost of capital is for
such investments by trying to locate some similar investments in the marketplace, or adopt an
approach that involves making subjective adjustments to the overall WACC.
30. How can we evaluate the
value of a firm?
Just as we can evaluate the future cash flows
of a project to estimate the project's value, we
can evaluate the future cash flows from the total
assets of a firm to estimate the total firm's value
31. What is one issue with
calculating a firm's cash
flows in order to evaluate
the firm's value?
Interest paid is a financing cost, not an operating cost. However, the firm's actual cash flows
reflect the reduction of taxes because of debt
financing
We must adjust the cash flows to remove the
impact of the interest tax shield
32. Previous Cash Flow from
Assets equation, CFA
33. Cash Flow from Assets adjusted to remove the interest tax shield, CFA*,
34. Given the following income statement, what is
the adjusted OCF?
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35. Answer to above
36. What does removing the
impact of debt financing
do to cash flows?
Removing the impact of debt financing reduces
cash flows from assets
37. When asked to find the
adjusted CFA (adjusted to eliminate the impact
present value of a firm, use of the tax-shield from debt financing).
the...
38. Assume the company has
a WACC of 12% and is expected to grow at an annual rate of 5% per year forever
What is the present value
of the firm?
39. Part 1
Assume the company has
a WACC of 12%, and is expected to grow at an annual rate of 10% per year for
two years, followed by 5%
per year forever after
What is the present value
of the firm?
40. Part 2
Assume the company has
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a WACC of 12%, and is expected to grow at an annual rate of 10% per year for
two years, followed by 5%
per year forever after
What is the present value
of the firm?
41. Using the calculated
WACC from above, if the
market value of the firm's
debt is $150, and the firm
has 1,000 shares outstanding, what is the value per
share?
42. Valuing the firm finds
which variable from the
WACC equation?
V, the market value of the total capital structure.
43. flotation costs
If a company accepts a new project, it may
be required to issue, or float, new bonds and
stocks. This means that the firm will incur some
costs, which we call flotation costs.
Flotation costs are incurred by a publicly traded
company when it issues new securities, and
includes expenses such as underwriting fees,
legal fees and registration fees.
44. Suppose Spatt's target
capital structure is 60 percent equity, 40 percent
debt. The flotation costs
associated with equity are
still 10 percent, but the
flotation costs for debt are
less—say 5 percent.
Earlier, when we had different capital costs for
debt and equity, we calculated a weighted average cost of capital using the target capital
structure weights.
Here we will do much the same thing. We can
calculate a weighted average flotation cost, fA,
by multiplying the equity flotation cost, fE, by the
percentage of equity (E/V) and the debt flotation
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Calculate the weighted av- cost, fD, by the percentage of debt (D/V) and
erage flotation cost
then adding the two together
What does this cost mean? The weighted average flotation cost is 8 percent.
What this tells us is that for every dollar in outON FORM SHEET
side financing needed for new projects, the firm
must actually raise $1/(1 .08) = $1.087. In our
example, the project cost is $100 million when
we ignore flotation costs. If we include them,
then the true cost is $100 million/(1 fA) = $100
million/.92 = $108.7 million.
45. If the firm chooses to
finance a project with
weights other than it's target D/E ratio (for example,
it chooses to finance a project with all debt), should
it calculate flotation costs
using the target weights or
the weights actually used?
To take this into account, the firm should always
use the target weights in calculating the flotation
cost.
46. Tripleday Printing Company is currently at its target debt-equity ratio of 100
percent. It is considering
building a new $500,000
printing plant in Kansas.
This new plant is expected
to generate aftertax cash
flows of $73,150 per year
forever. The tax rate is 21
percent. There are two fi-
To begin, because printing is the company's
main line of business, we will use the company's
weighted average cost of capital to value the
new printing plant:
The firm should use the target weights, even
if it can finance the entire cost of the project
with either debt or equity. The fact that a firm
can finance a specific project with debt or equity
is not directly relevant. If a firm has a target
debt-equity ratio of 1, for example, but chooses
to finance a particular project with all debt, it
will have to raise additional equity later on to
maintain its target debt-equity ratio.
WACC= (E/V) × RE + (D/V) × RD × (1TC) = .50
× .20 + .50 × .10 × (1 .21) = .1395, or 13.95%
Because the cash flows are $73,150 per year
forever, the PV of the cash flows at 13.95 percent per year is:
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nancing options:
PV = $73,150/.1395 = $524,373
A $500,000 new issue
of common stock: The issuance costs of the new
common stock would be
about 10 percent of the
amount raised. The required return on the company's new equity is 20
percent.
A $500,000 issue of
30-year bonds: The issuance costs of the new
debt would be 2 percent of
the proceeds. The company can raise new debt at 10
percent.
What is the NPV of the new
printing plant?
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1. Dividend Percent- annual dividend divided by the closing price
age Yield
2. P/E Ratio
-closing price divided by the sum of the latest four quarters of earnings per share
-indicates how much investors are willing to pay for $1 of
current earnings
-the greater the risk of the firm, the lower this will be
3. common stock
residual
is a _________
of ownership in
that the claims
of the common
stockholders on
the firm's earnings and assets are considered only after the
claims of governments, debt holders, and preferred stockholders have been met
4. common stock
permanent
is considered a
_____ form of
long-term debt financing because,
unlike debt and
some preferred
stock, common
stock has no maturity date
5. calculation for
book value per
share
total common stockholders equity/number of shares outstanding
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6. Dividend Rights
Stockholders have the right to share equally on a
per-share basis in any distribution of corporate earnings
in the form of dividends.
7. Asset Rights
In the event of a liquidation, stockholders have the right to
assets that remain after the obligations to the government
(taxes), employees, and debt holders have been satisfied
8. Preemptive
Rights
stockholders may have the right to share proportionately
in any new stock sold
9. voting rights
stockholders have the right to vote on stockholder matters, such as the selection of the board of directors
10. Majority Voting
-must win more than 50% of the votes
-possible that a group of stockholders with a minority
viewpoint will have no representation on the board
11. Cumulative Voting -easier for stockholders with minority views to elect sympathetic board members
-rare among major corps and frequently opposed by management
-each share of stock represents as many votes as there
are directors to be elected
12. Cumulative Voting number of shares = (number of directors desired x numCalculation
bers of shares outstanding )/ (number of directors being
elected + 1) +1
13. Common Stock
Classes
-occasionally a firm my decide to create more than one
class of CS
-firm wishes to raise additional equity capital by selling
a portion of the existing owner's stock while maintaining
control of the firm
-makes certain classes of stock have unequal voting
rights
14. Stock Split
-if management feels that the firm's CS should sell at a
lower price to attract more purchasers
-frequently when companies do this, they chose to raise
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their dividend levels at the same time
-par value is reduced by half and the number of shares is
doubled
-no changes occur in the firm's account balances or capital structure
15. Reverse Stock
Splits
-the number of shares is decreased
-used to bring low-priced shares up to more desirable
trading levels
-many investors feel this indicates poor corporate health
-relatively uncommon
16. stock dividend
dividend to stockholders that consists of additional shares
of stock instead of cash
17. stock repurchas- -companies buying back their own stock (treasury stock)
es
reasons:
1) disposition of excess cash: may want to dispose of
excess cash that it has accumulated
2) financial restructuring: by issuing debt and using the
proceeds to repurchase its CS, a company can alter its
capital structure to gain the benefits of increased financial
leverage
3) future corporate needs- stock can be repurchased for
use in the future acquisitions of other companies, stock
option plans for executives, conversion of convertible securities and the exercise of warrants
4) reduction of takeover risk: increases the price of the
firms stock and reduces a firm's cash balance (increases
its debt proportion in the capital structure) and thereby
reduce returns to investors who might try to acquire the
firm
18. Underwriting
-normally when a corp wishes to issue new securities
and sell them to the public, it makes an arrangement with
an investment banker whereby the investment banker
agrees to purchase the entire issue at a set price
-investment banker then resells the issue to the public at
a higher price
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19. Negotiated Underwriting
an arrangement between the issuing firm and its investment bankers
20. Competitive Bid- the firm sells the securities to the underwriter that bids the
ding
highest price
-used by most regulated companies (utilities and railroads)
21. purchasing syndi- a group of investment bankers who agree to underwrite
cate
a new security issue in order to spread the risk of underwriting
22. if the security is
underpriced:
the issuing firm will not raise the amount of capital it could
have and the underwriter may lose a customer
23. if the security is
overpriced:
the underwriter may have difficulty selling the issue and
investors who discover that they paid too much may
choose not to purchase the next issue offered by either
the corp or the underwriter
24. "Best efforts"
underwriting with smaller company issues
investment banker has no further obligation to the issuing
company if some of the securities cannot be sold
-investment banker = broker
-does not assume the risk that the securities will not be
sold at a favorable price
25. Private Security -save on floatation (issuance) costs (costs of issuing new
Placement advan- securities) by eliminating underwriting costs
tages:
-avoid the time delays associated with the prep of registration statements and with the waiting period
-offer greater flexibility in the terms of the contract between the borrower and the lender
26. private security
placement MAJOR disadvantage
interest rates are about one-eight HIGHER than they are
for debt sold through underwriters, which adds up
27.
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Issuance of
Rights
-firms may sell their common stock directly to their existing stockholders through these, which entitle the stockholders to purchase new shares of the firm's stock at a
subscription price below the market price
28. Standby Underwriting
the type of underwriting in which the underwriter agrees
to purchase-- at the subscription price-- any shares that
are not sold to rights holders
-investment banker than resells the shares
-investment banker bears risk and is compensated by an
underwriting fee
29. Underwriting
Spread
-an investment banker who agrees to underwrite a security issue assumes a certain amount of risk and in return
requires compensation in the form of an underwriting
discount
30. Computation for Selling price to the public-proceeds to the company
the Underwriting
spread
31. Generally, direct -higher
issuance costs
-higher
are _____ for CS
than PS and direct
issuance costs
are ____ for PS
than debt issues
32. Other costs associated with new
security offerings:
1. cost of management time
2. cost of underpricing a new (initial) equity offering below
the correct market value
3. the cost of other incentives (over allotment or Green
Shoe option)
33. any company that required to register the issue with the SEC
plans to sell an
-involves prep of a registration statement and a prospecinterstate securi- tus
ty issue totaling
over 1.5$ million
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and having a maturity greater than
270 days is...
34. Prospectus
summarizes the info contained in the registration statement and is intended for the use of potential investors
35. preliminary
prospectus (red
herring)
contains a statement, marked in red, that says this is "not
ann offer to sell"
36. Shelf Registration -only available to larger firms
--high investment grade rating
-firm files a master registration statement
-then, free to sell small increments of offering over an
extended time period
37. When making fi- the expected future dividend stream and the discount rate
nancial decisions that investors apply to that dividend stream
that are consistent with the
goal of maximizing shareholder wealth, management should
be concerned
with how these
decisions affect
both...
38. the constant
earnings, dividends and stock price
growth valuation
model assumes
that a firm's
_____, _______,
and _______ are
expected to grow
at a constant rate,
g, for into the future
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Chapter 7
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39. Value Line Invest- -only represent one analyst's forecast for each company
ment Survey
-available online and at most public and university libraries
-reasonably accurate and closely related to investor expectations
40. Zacks Earnings
Estimates
provides summaries of long-term and short-term earnings growth expectations from more than 2100 analysts
-can be found online
41. Thomas Reuters
-similar to Zacks
-can also be found online
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Finance 300
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1. When a company is- flotation costs increase the cost of raising the capital.
sues new securities The company receives a smaller amount of the prohow flotation costs ceeds
affect the cost of raising that capital?
2. What does the weight to the portion of the total capital raised by the firm that
refer to in the weight- comes from a given source such as debt, preferred
ed average cost of
stock or equity
capital?
3. What is the decision rule for accepting or rejecting proposed projects when
using internal rate of
return?
Whenever the internal rate of return is grater than or
equal to the required rate of return the hurdle rate, the
project is accepted. When the internal rate of return
is less than this required rate of return the project is
rejected
4. What is capital rationing? Should a
firm practice capital
rationing?
The practice of setting dollar limits on what will be
invested in new capital budgeting projects. Yes except
for if it is a publicly traded company
5. Explain why we mea- this focuses on the change in the riskiness of the
sure a project's risk firm's existing portfolio
as the change in the
Cv
6. What is the marginal graphic depiction of the weighted average cost of
cost of capital sched- capital at different levels of financing. not always horule? is it always hori- izontal
zontal?
7. What are the criticisms for the pay
back method?
that cash flows after the payback period are ignored
and the time value money is not considered
8. How does the net pre- the net present value is the dollar amount of the
sent value relate to
change to the value of the firm if the project under
the value of the firm? consideration is accepted
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9. what are the advantages and disadvantages of the internal rate of return
method?
Advantage: the internal rate of return method is a discounted cash flow method and a number expressed
as a percentage.
Disadvantage: it is somewhat more difficult to calculate
10. What is a mutually ex- projects that compete against each other for our seclusive project?
lection
11. Why do we focus on cash flows changes the value of a firm. You can spend
cash flows instead of cash but you can not spend profit
profiles when evaluating proposed capital budgeting projects?
12. what is a sunk cost? sunk cost = cash-flow that has already occurred or
is it relevant when
will whether a project is accepted or rejected. it is
evaluating a proirrelevant when evaluating a proposed project
posed capital budgeting project?
13. How do we estimate
expected incremental
cash flows for a proposed capital budgeting project?
estimating the changes in sales and expenses that
are incremental to the project, adding back to the
incremental depreciation expense since depreciation
expense is a non-cash expense
14. How and why does
capital affect the incremental cash flow
estimation for a proposed large capital
budgeting project?
Many large projects require additional working capital. This investment in additional working capital becomes part of the initial investment. This investment is
recovered at the end of the project's life. There may be
some spontaneous increase in current liabilities associated with a project, but the change in net working
capital, if any, is likely to be a positive value requiring
an increase in the initial investment of that amount.
2/2
Fund of B Finance CH 9
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1. higher cost of retained earnings
Higher flotation costs will result in all
of the following except:
2. The flotation costs incurred when is- Which of the following differentiates
suing new securities.
the cost of retained earnings from the
cost of newly-issued common stock?
3. cause a firm to reject projects that Using the weighted average cost of
should have been accepted and
capital as the required rate of return
cause a firm to accept projects that for every project will:
were too risky.
4. less than 12%
Joe's Discount Club currently has a
weighted average cost of capital of
12%. Joe's has been growing rapidly
over the past several years, selling
common stock in each year to finance
its growth. However, due to difficult
economic times this year, Joe's decides to cut its dividend and increase
its retained earnings so that the common equity portion of its capital structure will include only retained earnings and no new common stock will
be sold. Joe's weighted average cost
of capital this year should be
5. After-tax cost of accounts payable
Which of the following should NOT be
considered when calculating a firm's
WACC?
6. Not all lines of business have equal
risk and it is likely that the firm will
accept projects whose returns are
unacceptably low in relation to the
risk involved.
Why should firms that own and operate multiple businesses that have
different risk characteristics use business-specific, or divisional costs of
capital?
7. Cost of carrying inventory
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Fund of B Finance CH 9
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Which of the following should not be
considered when calculating a firm's
WACC?
8. The incurrence of flotation costs
when new securities are issued
Which of the following causes a firm's
cost of capital (WACC) to differ from
an investor's required rate of return on
the company's common stock?
9. risk-free rate
All the following variables are used in
computing the cost of debt except
10. the marginal cost of capital.
The average cost associated with
each additional dollar of financing for
investment projects is:
11. cost of new common stock, cost of In general, which of the following
retained earnings, cost of preferred rankings, from highest to lowest cost,
stock, cost of debt
is most accurate?
12. favor projects in the research and
development division because the
higher risk projects look more favorable if a lower cost of capital is used
to evaluate them.
Acme Conglomerate Corporation operates three divisions. One division
involves significant research and development, and thus has a high-risk
cost of capital of 15%. The second division operates in business segments
related to Acme's core business, and
this division has a cost of capital of
10% based upon its risk. Acme's core
business is the least risky segment,
with a cost of capital of 8%. The firm's
overall weighted average cost of capital of 11% has been used to evaluate
capital budgeting projects for all three
divisions. This approach will
13. there are investors who stand ready Interest rate parity exists because
to engage in arbitrage
14. True
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Fund of B Finance CH 9
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A firm's weighted average cost of capital is a function of (1) the individual
costs of capital, (2) the capital structure mix, and (3) the level of financing
necessary to make the investment
15. cause the cost of capital to increase Due to changes in regulatory requirements, the transactions costs associated with selling corporate securities increased by $1 per share. This
change will
3/3
Ch. 15 | FIN3FA3
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1. When securities are issued under a firm commitment, b) True
the underwriter bears the risk of low sales.
a) True
b) False
2. Underpricing is a form of flotation costs incurred
when a firm issues new securities to the public.
a) True
b) False
b) True
3. An investor exercises her right to buy one additional C) $45.00
share at $20 for every five shares held. How much
should each share be worth after the rights issue if
they previously sold for $50 each?
A) $35.00
B) $41.67
C) $45.00
D) $46.00
4. A firm's first offering of stock to the general public is B) an IPO
known as:
A) first-stage financing
B) an IPO
C) a general cash offer
D) a seasoned offering
5. A secondary offering IPO occurs when:
A) new shares are sold to provide the company with
additional funds
B) the second public issue of equity becomes available
C) the company's founders or venture capitalists market a portion of their shares
D) not all of the shares in a primary IPO were sold
C) the company's founders or
venture capitalists
market a portion of
their shares
6. A major purpose of the prospectus is to:
A) inform investors of the security's rate of return
B) advise investors of the security's potential risk
B) advise investors of the security's potential
risk
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C) distribute stock warrants to prospective investors
D) list the security's dividend payment dates
7. Studies have shown that, on average, new security
issues are:
A) subject to flotation costs of approximately 32%
B) overpriced by the amount of the spread
C) underpriced
D) overpriced to reward venture capitalists
C) underpriced
8. The primary reason for an underwriters' syndication B) reduce the risk
is to:
of selling a large
A) monitor the actions of the different underwriters issue
B) reduce the risk of selling a large issue
C) increase the size of the spread
D) avoid the scrutiny of the Securities and Exchange
Commission
9. The consent of a corporation's stockholders must be C) increase in aureceived prior to any:
thorized capital
A) issue of new securities
B) selection of an underwriter
C) increase in authorized capital
D) private placement of securities
10. When securities are issued under a rights issue:
A) existing shareholders have the opportunity to expand their holdings
B) shares are offered to the public at a discount
C) the existing shares will increase in price
D) current shareholders have the right to resell their
stock to the issuer
A) existing shareholders have the
opportunity to expand their holdings
11. Which one of the following would not be included
B) No additional
among the benefits of shelf registration?
registration necesA) Reduction of lead-time for security issuance
sary for five years
B) No additional registration necessary for five years
C) Issuer can take advantage of favorable conditions
D) Issuer can search for best underwriting terms
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12. A firm has just issued $250 million of equity, which B) $30.0 million
caused its stock price to drop by 3%. Calculate the
loss in value of the firm's equity given that its market
value of equity was $1 billion before the new issue:
A) $7.5 million
B) $30.0 million
C) $33.3 million
D) $37.5 million
13. The difference between an IPO and a secondary offering is that:
A) the secondary offering does not incur direct costs
B) venture capitalists fund the secondary offering
C) additional, non-outstanding shares are issued in an
IPO
D) shares may be repurposed by the underwriter in a
secondary offering
C) additional, non-outstanding shares are issued in an IPO
14. What is the role of the underwriter in an issue of
securities?
both a and b
A) Underwriters manage the sale of the securities and
advise on the price at which the issue is sold. They
then buy the securities from the issuing company, and
resell them to the public.
B) The difference between the price at which the underwriter buys the securities and the price at which
they are resold is the underwriter's spread. Underwriting firms have expertise in such sales because they
are in the business all the time, whereas the company
raises capital only occasionally
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EZC1 Chapter 9 Test
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1. Flotation costs are costs that are incurred when True
a firm issues new securities.
2. When a firm's interest expense increases, the
firm's tax bill decreases.
True
3. The three ways to estimate the cost of common True
equity are with the CAPM, the Build-Up method,
and the Gordon Growth Model.
4. A more risky firm will have a higher cost of
equity.
True
5. A firm is issuing new debt to finance some capital investment project. The firm will issue 20,000
new $1,000 face-value bonds that will mature
in 20 years. The bonds have a coupon rate of
8% and are currently priced at par. The flotation
costs that are associated with this new bond
issue are expected to be $10 per bond. Further,
the company has a marginal tax rate of 34%.
Given this information, the before-tax cost of
debt is _______________.
Less than 7%
Equal to 8%
--> Greater than 8%
Less than 7.9%
Cannot be determined
6. A firm is issuing new debt to finance some capital investment project. The firm will issue 20,000
new $1,000 face-value bonds that will mature
in 20 years. The bonds have a coupon rate of
8% and are currently priced at par. The flotation
costs that are associated with this new bond
issue are expected to be $10 per bond. Further,
the company has a marginal tax rate of 34%.
Given this information, the before-tax cost of
debt is _______________.
8.45%
7.45%
8.00%
--> 8.10%
9.9%
1/6
The yield to maturity of
this bond is 8% because
the price equals the par
value. However, flotation
costs will increase the
borrowing costs so that
the yield is higher than
8%.
FV = -1000, PMT = -80,
PV = 1000-10 = 990,
N = 20, Compute I/Y =
8.103%.
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7. A firm is issuing new debt to finance some capi- 6.85%
tal investment project. The firm will issue 15,550 3.98%
new $1,000 face-value bonds that will mature in 8.15%
10 years. The bonds will pay a $35 semiannual --> 7.96%
coupon and similar bonds are currently priced 9.54%
at 95% of par. The flotation costs that are associated with this new bond issue are expected FV = -1000 PMT = -35
to be $15 per bond. Further, the company has a PV = 950-15 = 935, N =
marginal tax rate of 34%. Given this information, 10*2 = 20; compute I/Y =
the before-tax cost of debt is _______________. 3.977*2 = 7.955%
8. A new start-up company just obtained financing 10.8%
from a small business loan. The terms of the
--> 5.48%
loan were the following:
8.3%
11.1 %
Length: 8 years
7.57%
Annual Interest Rate: 8.3%
WACC = C/V*Kcs +
P/V*Kps + D/V*Kd(1-t) =
Monthly Payments: $10,350.
D = 1, V = 1 Kd = 8.3%,
t = 34% = 1*8.3*(1-.34) =
This loan is the only capital being used by the 5.48%
firm. If the marginal tax rate is 34%, what is the
weighted average cost of capital?
9. A company has a beta of 1.5. The expected re- Less than the average
turn on the market is 15% and the risk free rate is firm in the market.
3.5%. Given this information, the company has a
cost of equity that is ______________.
Twice the cost of equity
of the average firm in the
market.
Equal to the average firm
in the market.
--> Greater than the average firm in the market.
Cannot be determined.
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EZC1 Chapter 9 Test
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Answer Explanation:
Firms with a beta of 1
have similar systematic
risk as the market. The
CAPM suggests that the
cost of equity is only a
firm-specific function of
beta. Therefore, a firm
with a beta greater than 1
will have a greater cost of
equity than the average
firm in the market. A firm
with a beta of 2 will have
a cost of equity that is
twice that of the average
firm in the market.
10. A company has a beta of 1.5. The expected re- 24.66%
turn on the market is 15% and the risk free rate is 19.50%
3.5%. Given this information, the company has a --> 20.75%
cost of equity that is ______________.
17.25%
21.55%
Kcs = 3.5 + 1.5(15-3.5)
=20.75%
11. A company just issued new stock that will pay a
dividend of $4 per share each year and expected
to grow at a constant rate of 3% per year indefinitely. The price at which the shares were issued
was $38. The underwriters have charged $6 per
share in flotation costs. Given this information,
what is the cost of equity for this company?
13.5%
--> 15.5%
12.9%
17.1%
18.5%
Kcs= [4/(38-6)] + .03 =
.155 or 15.5%
12. A new start-up is attempting to estimate the cost 18.54%
of equity for new shares that the company will 13.65%
soon issue. The long-term bond yield is expect- --> 17.33%
3/6
EZC1 Chapter 9 Test
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ed to be 4%, the equity risk premium is expected
to be 5.5%, the micro-cap risk premium and the
start-up risk premium are expected to be 3.5%
each. Flotation costs are also expected to sum
to 5%. Given this information, what is the cost
of equity for this new start-up?
21.50%
15.41%
Kcs= 4+5.5+3.5+3.5 =
16.5%*1.05 = 17.33%
13. Another Co. has a current share price of $35
--> 10.24%
and a total of 15 million shares outstanding. The 10.01%
company currently has debt with a total face
8.79%
value of $880 million. These outstanding bonds 9.55%
are currently priced to yield 7.9% while quoting 12.55%
at 96.023% of total face value. The company also
has preferred shares outstanding. The current C = $35*15M = $525 M;
market value of preferred shares is $155 million. D = $880 M*.96023 =
The price of the preferred shares is $46 and the $845 M; P = $155; V =
dividend (which is paid in perpetuity) is $5.10 C+D+P = $1,525 M.
per share. The company recently paid a dividend
to common stock holders of $3.99 and antici- Kcs = [(3.99*1.06)/35] +
pates growing the dividend at a constant rate of .06 = .1808 or 18.08%
6% per year indefinitely. If the corporate tax rate Kp = 5.10/46 = .1109 or
is 34%, what is the WACC of this company?
11.09%
Kd = 7.9%
WACC =
(525/1525)*18.08 +
(155/1525)*11.09 +
(845/1525)*7.9*(1-.34) =
10.24%
14. Another Co. has both debt and common equity
as part of its capital structure. In particular, the
company has 1 million shares of equity outstanding and 30,000, 20-year bonds (that were
just issued). The current share price is $32. Furthermore, the beta of the firm is 1.5 while the
market risk premium is 10.5% and the expected
return on the market is 14.5%. The face value of
4/6
12.05%
14.55%
--> 13.00%
11.48%
15.74%
$32 M, D = $30M*.972
= $29.16M; V = C +D =
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the bonds is $1,000 and the annual coupon rate 32+29.16=61.16M
is 9%. Their current long-term bonds are selling
for $972. If the corporate tax rate is 40% what is Kd = (FV = -1000, PMT
the WACC of the ABC Co?
= -90, PV = 972, N = 20)
I/Y = 9.314%
Kcs = 4+1.5(10.5) =
19.75%
WACC =
(29.16/61.16)*9.314%*(1-.40
15. A company is looking to issue new bonds and
equity to finance a marketing campaign. In particular, the company will issue new short-term
bonds that have a $1,000 face value, a coupon
rate of 8%, and a maturity of 7 years. Similar
bonds are priced at 95% of par (or face value).
The company will also issue longer term bonds
that have a face value of $1,000, a coupon rate of
10%, and a maturity of 20 years. Similar longer
term bonds are priced at $1,000. Both of these
bonds will pay semi-annual coupons. The company also anticipates financing the marketing
campaign with some internal and external equity. The company has a beta of 1.3. Expected
returns on the market are 15% and the yield on
current t-bills is 3%. The company has a marginal tax rate of 34%. After these new security
issues, the total market value of the short term
debt will be $175million. The total market value
of the long term debt will be $325 million. The
total market value of common equity will be
$300 million. Of the $300 million in equity market
value, the company will use $50 million of internal equity to finance the marketing campaign.
Therefore, $250 million of new external equity
will be issued. Given this information, what is
5/6
--> 11.44%
17.41%
10.81%
14.65%
12.54%
D - D(short-term) =
175, D(long-term) = 325,
C(internal) = 50, C(external) = 250, V =
175+325+50+250=800
Kd(short term) = (FV =
-1000, PMT = -40, PV =
950, N = 14) I/Y = 4.49*2
= 8.98%
Kd(long-term) = (FV =
-1000, PMT = -50, PV =
1000, N = 40)I/Y = 5*2 =
10%
Kcs = 3+1.3(15-3) =
18.6%
After accounting for flotation costs:
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the WACC for this company? (Note: Flotation
costs will sum to 5%)
Kd(short term) =
8.98*1.05 = 9.43%
Kd(long term) = 10*1.05
= 10.5%
Kcs(external) =
18.6*1.05 = 19.53%
WACC = (50/800)*18.6
+ (250/800)*19.53 +
(175/800)*9.43*(1-.34) +
(325/800)*10.5*(1-.34) =
11.44%
16. WACC= C/V kcs + P/V kps + D/V kd (1-t)
where:
a. C = the market value of
common stock
b. P = the market value of
preferred stock
c. D = the market value of
debt
d. V = C + P + D
e. kcs = cost of common
stock
f. kps = cost of preferred
stock
g. kd = cost of debt
h. t = tax rate
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The Cost of Capital
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1. The cost of capital is the rate of return The cost of capital is denoted in perrequired by those who have provided centage returns.
the firm capital.
2. Flotation costs are costs associated Flotation costs are costs that are inwith new security issuance and will curred when a firm issues new secuincrease the cost of capital.
rities. Flotation costs are costs associated with new security issuance.
3. The cost of debt is the total interest The higher the tax rate, the larger
rate paid on bonds or the bond's yield the tax shield and the lower the afto maturity.
ter-tax cost of debt.
4. When a firm's interest expense inA bond that is priced at par (or face)
creases, the firm's tax bill decreas- value has a yield to maturity equal
es.Interest expense is taken out of the to the coupon rate.
income statement before taxes are
calculated.
5. The more risky the firm, the more that As the firm becomes more risky, the
investors will require (in terms of re- cost of capital will increase.
turn). Therefore, more risk leads to
higher costs of equity.
6. The CAPM, the Build-Up method and Capital Asset Pricing Model CAPM
the Gordon Model are the three ways Ri = Rrf + ²i(Rm - Rrf)
to estimate the cost of equity.
where Ri is the return on the ith
security, Rrf is the risk free rate, Rm
is the return on the market, ²i is the
security's beta, and [Rm - Rrf] is the
market risk premium.
7. Build-Up Method, used commonly in Bond yield
small businesses
+ Equity risk premium
+ Micro-cap risk premium
+ Start-up risk premium
Required rate of return
8.
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The Cost of Capital
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Build-Up Method - large cap stock we The sum of the bond yield and the
would simply add the bond yield to equity risk premium is also known
the equity risk premium
as the base equity rate.
9. Build-Up Method -small but well-es- The sum of the base equity rate
tablished company, we would simply and the micro-cap risk premium is
add the micro-cap risk premium to the known as the micro-cap equity rate.
base equity rate.
10. Build-Up Method -start-up company's micro-cap equity rate plus start-up
required rate of return, we would add risk premium
the start-up risk premium to the micro-cap equity rate
11. Some firms do not pay dividends and SGR =ROE [1-b] b= dividend payout
will have a high growth rate g, which ratio [dividend / Net Income]
is approximated by ROE*b. Therefore,
if ROE has historically been high, it's
possible that a firm that does not pay
dividends will have a higher cost of
equity than a firm to does pay dividends.
12. As E[Rm] increase in the CAPM, the
return required by shareholders (or
expected return) increases.
Rm is the return on the market.
2/2
Required Rate of Return = Risk
Free Rate + Risk Premium
UCI Management 109 Final exam
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1. When a firm improves (lowers) its days of
inventory it generally:
releases cash locked up in
inventory.
2. Assume the following data: EBIT = 400; Net ROE = NI/average equity =
income = 100; Average equity = 1000. Calcu- 100/1000 = 10%.
late the ROE
(return on equity).
3. Efficiency ratios indicate:
I only
I) whether the firm is using its assets productively;
II) whether the firm is liquid;
III) whether the firm is profitable;
IV) how highly the firm is valued by investors
4. To calculate the total value of the firm (V), one market values of debt and
should rely on the:
equity.
5. Given are the following data for Vinyard Cor- Use market values: D/V =
poration:
1,000/4,000 = 0.25 (25%);
E/V = 3,000/4,000 = 0.75
Balance Sheet (book value)
(75%).
Asset Value 2, 500 Debt 1, 000
Equity 1, 500
Balance Sheet (market value)
Asset Value 4,000 Debt 1,000
Equity 3,000
Calculate the proportions of debt (D/V) and
equity (E/V) that you would use for estimating
Vinyard's weighted average cost of capital
(WACC):
1/4
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6. Given are the following data for year 1:
Profits after taxes = $20 million; Depreciation
= $6 million; Interest expense = $4 million;
Investment in fixed assets = $12 million; Investment in working capital = $4 million. Calculate the free cash flow (FCF) for year 1:
FCF = 20 + 6 - 12 - 4 = $10
million.
formula = EBIT - Taxes +
Depreciation & Amortization
- Capex - Change in Working Capital,
7. Consider the following data:
FCF1 = $7 million; FCF2 = $45 million; FCF3
= $55 million. Assume that free cash flow
grows at a rate of 4% for year 4 and beyond. If
the weighted average cost of capital is 10%,
calculate the value of the firm.
Horizon value in year 3 =
(55)(1.04)/(0.10 - 0.04) =
$953.33 million;
PV = (7/1.10) + (45/1.10^2)
+ [(55 + 953.33)/(1.10^3)] =
$801.12 million.
8. The Granite Paving Company is all-equity financed and has the following free cash flows
in years 1-4: $3 million ($3M); $3.7M; $4M;
$4.2M. After year 4, the firm is expected to
grow at a sustainable rate of 3% per annum.
With a WACC of 12%, what is the horizon
value in year 4 of Granite Paving Co?
Use year 5 FCF to calculate horizon value in year 4:
(4.2 × 1.03)/(0.12 - .03) =
$48.07M.
9. A Wall Street Journal quotation for a company has the following values: Div: $1.12, PE:
18.3, Close: $37.22.
Calculate the approximate dividend payout
ratio for the company.
PE ratio = price per
share/earnings per share;
Earnings per share =
(37.22)/18.3 = 2.03; Dividend payout =
1.12/2.03 = 0.55 = 55%.
10. Suppose you invest equal amounts in a port- Expected return = 0.5(16) +
folio with an expected return of 16% and a 0.5(4) = 10%
standard deviation of returns of 18% and a
risk-free asset with an interest rate of 4%. Calculate the expected return on the resulting
portfolio.
11. Suppose the beta of Microsoft is 1.13, the
E(R) = 3 + 1.13(8) =
risk-free rate is 3%, and the market risk pre- 12.04%.
mium is 8%. Calculate the expected return for
Microsoft.
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12. Super Computer Company's stock is sellr = (114 + 6 - 100)/100 =
ing for $100 per share today. It is expected 20%.
that—at the end of one year—it will pay a
dividend of $6 per share and then be sold for
$114 per share. Calculate the expected rate
of return for the shareholders.
13. Casino Inc. expects to pay a dividend of $3 P0 = Div1/(r - g) = (3/(0.18 per share at the end of year 1 (D1) and these 0.06)) = 25.
dividends are expected to grow at a constant
rate of 6% per year forever. If the required
rate of return on the stock is 18%, what is the
current value of the stock today?
14. One can estimate the dividend growth rate for plow-back rate × the return
a stable firm as:
on equity (ROE).
15. Ocean Co. just paid a dividend of $2 per share Sustainable growth = ROE ×
out of earnings of $4 per share. If the book plowback ratio;
value per share is $25, what is the expected Payout ratio = 50%; Plowgrowth rate in dividends (g)?
back ratio = 50%; g = (1 0.5)(4/25) = 0.08, or 8%.
16. Assume the following data for a stock: Beta =
0.5; Risk-free rate = 4%; Market rate of return
= 12%; and Expected rate of return on the
stock = 10%. Then the stock is:
r = 4 + (0.5) × (12 - 4) = 8%;
the expected rate of return
is more than the required
rate of return. The stock is
underpriced, and the price
must increase to make the
required 8% return realistic.
If the stock is underpriced, it
would plot above the SML.
17. The company cost of capital is the appropri- average-risk projects.
ate discount rate for a firm's:
18. If a firm uses the same company cost of cap- I, II, and III
ital for evaluating all projects, which situation(s) will likely
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occur?
I) The firm will reject good low-risk projects;
II) The firm will accept poor high-risk projects;
III) The firm will correctly accept projects with
average risk
19. The market value of Cable Company's equity Company cost of capis $60 million and the market value of its debt ital = (40/100)(5%) +
is $40 million. If the required rate of return (60/100)(15%) = 11%.
on the equity is 15% and that on its debt is
5%, calculate the company's cost of capital.
(Assume no taxes.)
20. On a graph with common stock returns on beta
the Y-axis and market returns on the X-axis,
the slope of the regression line represents:
21. Generally, an industry beta, calculated from a True
portfolio of companies in the same industry,
is more accurate than a beta estimate for a
single company.
22. Modigliani and Miller's Proposition I states
that:
the market value of any firm
is independent of its capital
structure
23. The law of conservation of value implies that the value of any asset is preserved regardless of the nature of the claims against it
24. Minimizing the weighted average cost of cap- market value of the firm.
ital (WACC) is similar to maximizing the:
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1.
The WACC accounts for interest tax shields after-tax cost of debt
by using the:
2.
When should managers use caution when ap- - When a project is less
plying the WACC formula?
risky than average
- When a project would
increase the firm's target
debt ratio
- When a project is riskier
than average
- When a project would
decrease the firm's target
debt ratio
3.
Suppose that a firm has a capital structure of
40% debt and 60% equity. The cost of debt is
7.5% and the cost of equity is 18%. The firm is
taxed at the 35% marginal tax rate. Calculate
the after-tax WACC.
4.
Suppose that a large auto manufacturer is
WACC =
considering the addition of a new plant to
5%(1-.35)(0.4)+11%(.6)=7.9%;
manufacture parts. They have already determined that the project's NPV is 0. They have
estimated after-tax yearly cash flow at $1.975
million in perpetuity. The cost of debt is 5%
and the cost of equity is 11%. They are taxed
at a marginal tax rate of 35%. The company's
debt ratio is 40% and its equity ratio is 60%.
What must be the market value of the asset?
5.
In order for a company to correctly use the
WACC to value a project, the following requirements must be met:
1 / 24
Cost of debt after-tax=8*(1-tax rate)
=8*(1-0.35)=5.2%
WACC=Respective
cost*Respective weight
=(0.4*5.2)+(0.6*18)
which is equal to
=12.75%
- The risk level of the project must match the risk
level of the firm's other assets
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- The project must not alter
the firm's existing debt ratio
6.
How does the WACC formula account for the By using the after-tax cost
value of interest tax shields?
of debt
7.
Using an industry WACC for a company with- - the company and industry
in that industry assumes that:
have about the same risk
level
- the company and the
industry have about the
same financing terms
8.
The WACC formula should be used for projects that offer:
9.
Identify some of the common considerations - How financing costs are
that managers make when using the WACC to determined
value a company.
- How other current liabilities affect net working capital calculations
- That there may be multiple sources of financing
- The WACC of comparable
companies
average risk to the firm's
existing assets
10. The after-tax weighted average cost of capital adding the weighted averis determined by:
age after-tax cost of debt to
the weighted average cost
of equity
11. A project's cost of equity will equal its expect- it has a NPV of zero
ed return when:
12. What is the relationship between the WACC,
the cost of equity, and the opportunity cost
of capital if a company or project is financed
solely by equity?
13.
2 / 24
The WACC, the cost of equity, and the opportunity
cost of capital will all be
equal
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Allison and Sara Kim are twin sisters who run
a company that operates three successful
Korean BBQ restaurants in LA's Koreatown.
They are considering moving to Boise, Idaho
to be closer to their family and would like to
open a Korean BBQ there. The new venture
holds a higher level of risk than their existing company profile because the restaurant
would be the first of its kind in Boise. In addition, the twins would finance the new restaurant mostly with debt, whereas the current
company has little debt on its books. What are
some of the problems with using the WACC in
this situation?
- The debt incurred for the
new restaurant is unrelated
to the project's hurdle rate
- The expected return required by investors and the
borrowing rate would both
rise
- The risk profiles of the
current company and the
new venture differ
14. Which of the following statements characIt assumes the project is a
terizes the weighted average cost of capital carbon copy of the firm
formula?
15. As the ratio of debt to equity increases, what The cost of equity increashappens to the cost of equity and the WACC? es and the WACC decreases
16. Tell Computers, a large maker of PCs, is
considering the purchase of Leap Systems,
a small technology company whose capital
structure differs from Tell's. Tell's debt beta is
.2 and its equity beta is 1.1. The risk free interest rate is 4% and the market risk premium is
8%. Tell's debt-equity ratio is 50/50, whereas
Leap's debt-equity ratio is 40/60. What is the
recalculated cost of equity? (Hint: Recalculate the equity beta first).
Step 1: Calculate the asset
beta. (.2 x .5) + (1.1 x .5) =
.65. Step 2: Recalculate the
equity beta. .65 + (.65 - .2)
x .6667 = .95. Recall that
D/E = .4/.6 = .6667. Step 3:
Recalculate the cost of equity. .04 + .08 (.95) = .116
or 11.6%.
17. As the debt ratio increases, the cost of equity interest tax shields
increases, but the WACC declines. This is because of:
18. Suppose that H20 Resources has an equity =.02 + (.06).9 = .074 or
beta of .9. The current risk free rate of interest 7.4%
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is 2% and the market risk premium is 6%.
What is the company's cost of equity?
19. Suppose that a corporation has a cost of debt .08 x (1-.35) x .4 + .11 x .6
of 8% when it has 40% of its value tied up in = 8.68%
debt. Its cost of equity is 11% when 60% of its
value is in equity. If the corporate tax rate is
35%, what is the corporation's WACC?
20. As the debt ratio increases, why does the
The existence of tax
weighted average cost of capital decrease? shields on debt interest
payments
21. Thought Pod Computers, a large maker of
Calculate the asset beta.
laptop PCs, is considering the purchase of (.2 x .5) + (1.2 x .5) = .70.
Jumper Systems, a small technology com- Step 2: Recalculate the eqpany whose capital structure differs from
uity beta. .70 + (.70 - .20)
Thought Pod's. Thought Pod's debt beta is .2 x .6667 = 1.03. Recall that
and its equity beta is 1.2. The risk free interest D/E = .4/.6 = .6667. Step
rate is 4% and the market risk premium is
3: Recalculate the cost of
8%. Thought Pod's debt-equity ratio is 50/50, equity. .04 + .08 (1.03) =
whereas Jumper's debt-equity ratio is 40/60. .1227 or 12.27%.
What is the recalculated cost of equity? (Hint:
Recalculate the equity beta first).
22. Suppose that Radd Pharma has an equity
Reason:
beta of 1.2. The current risk free rate of inter- 2% + (6% &#x002A; 1.2) =
est is 2% and the market risk premium is 6%. 9.2%
What is the company's cost of equity?
23. Which of the following is an important asCompanies rebalance their
sumption required if using the WACC formu- capital structure to mainla?
tain a constant debt ratio.
24. True or false: The Modigliani-Miller model derives a discount rate for a company with a
perpetual stream of cash flows financed with
debt that changes over time.
4 / 24
False:
MM's discount rate applies
to companies with a level,
perpetual stream of cash
flows financed by fixed,
perpetual debt.
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25. Happy Sanitation has a long-standing con- Setting its debt to value ratract with the city of Portland to provide
tio to zero
garbage pickup services; the company's contract generates a level stream of cash flows
financed by debt. Happy Sanitation uses the
Modigliani-Miller formula to determine its after-tax discount rate. How would the company unlever its discount rate?
26. Financial managers often use the WACC be- value
cause the debt capacity of a firm or project
depends on its future _______, which will
fluctuate over time.
27. Financial managers generally use
___________ when data are available for
firms with similar assets, operations, business risks, and growth opportunities.
the industry WACC
28. If a project's financing differs from that of the - investment projects are
overall company or industry, it's usually still not usually separately fiacceptable to use the WACC because:
nanced
- managers focus on the
project's impact on the
firm's overall debt capacity
- the company borrows
against its existing assets
29. The Modigliani-Miller Formula shows an af- - a level stream of cash
ter-tax discount rate for a company or project flows in perpetuity
with:
- debt financed at a constant rate in perpetuity
30. Rouge Pharmaceuticals has a long-standing Setting its debt to value racontract with the city of Cleavland to protio to zero
vide medical services; the company's contract generates a level stream of cash flows
financed by debt. Rouge Pharmaceuticals
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mine its after-tax discount rate. How would
the company unlever its discount rate?
31. Which formula do most financial managers
use to determine a discount rate and why?
Weighted Average Cost
of Capital, because it
assumes constant market-value debt ratios and
rebalancing
32. Which is the most commonly used cost of
capital formula?
Weighted average cost of
capital (WACC)
33. True or false: The capital asset pricing model True:
can be used to find the WACC.
The CAPM can be used to
calculate the expected return to equity, which in turn
is used in the WACC formula
34. True or false: If a project's debt capacity is True
materially different from the company's existing assets, or if the company's overall debt
policy changes, the WACC should be adjusted.
35. True or false: The capital asset pricing model True
(CAPM) can be used to calculate the expected
return to equity, which in turn is used in the
WACC formula.
36. Suppose that Alpha Technologies has an as- 1.3 + (1.3 - .98) x .6 = 1.49
set beta of 1.3, a debt beta of .98, and a
debt-to-equity ratio of .6. Calculate Alpha's
equity beta.
37. Suppose that a company takes on an unusually risky project. How is the company likely
to estimate the opportunity cost of capital for
the project?
6 / 24
Use estimates of risk and
expected return for companies with similar risk characteristics to the project
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38. Suppose that Zuma Technologies has an as- 1.5 + (1.5 - .9) x .7 = 1.92
set beta of 1.5, a debt beta of .9, and a
debt-to-equity ratio of .7. Calculate Zuma's
equity beta.
39. Project M requires an initial investment of $25 Zero
million. The project is expected to generate
$2.25 million in after-tax cash flow each year
forever. If the weighted average cost of capital
(WACC) is 9 percent, calculate the NPV of the
project.
40. Given are the following data for Golf Corpora- 40 percent debt and 60
tion:
percent equity
Market price/share = $12; Book value/share
= $10; Number of shares outstanding = 100
million; Market price/bond = $800; Face value/bond = $1,000; Number of bonds outstanding = 1 million. Calculate the proportions of
debt (D/V) and equity (E/V) for Golf Corporation that you should use for estimating its
weighted average cost of capital (WACC).
41. Lowering the debt-equity ratio of the firm can I, II, III, IV
change the firm's
I) financial leverage;
II) cost of equity;
III) cost of debt;
IV) effective tax rate
42. Given are the following data for Vinyard Cor- 25 percent debt and 75
poration:
percent equity
Vinyard Corporation (Book values, $Millions)
Asset Value$2,500 $1,000 Debt
$1,500Equity
$2,500 $2,500
Vinyard Corporation (Market values, $Mil7 / 24
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lions)
Asset Value $4,000 $1,000 Debt
$3,000 Equity
$4,000 $4,000
Vinyard Corporation (Liquidating values,
$Millions)
Asset Value $1,500 $750 Debt
$750 Equity
$1,500 $1,500
Calculate the proportions of debt (D/V) and
equity (E/V) that you would use for estimating
Vinyard's weighted average cost of capital
(WACC).
43. Johnston Company has a 7 percent cost of 11 percent
debt, a 50 percent debt ratio, and a 15 percent
cost of equity. The marginal tax rate is 25
percent. What is Johnston's WACC if it were
100 percent equity financed?
44. To calculate the total value of the firm (V), one market values of debt and
should rely on the
equity.
45. Mirion Tech, Inc., has rE of 12%, an rD of 6%, 9.58%
at a debt-equity ratio of 0.50. Mirion plans to
raise enough preferred stock to retire half of
their outstanding common stock, which currently has a market value of $7 million. If the
preferred stock has an expected rate of return
of 10%, what is the new WACC? (Assume a
21% marginal corporate tax rate and that rD
remains at 6%.)
46. While calculating the weighted average cost Market values
of capital, which values should one use for D,
E, and V?
47.
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One calculates the after-tax weighted average WACC = rD (1 TC)(D/V) +
cost of capital (WACC) as
rE (E/V); (where V = D + E).
48. When using the weighted average cost of
I and II only
capital (WACC) to discount cash flows from
a project, we assume the following:
I) The project's risks are the same as those of
the firm's other assets and remain so for the
life of the project.
II) The project supports the same fraction of
debt to value as the firm's overall capital
structure, and that fraction remains constant
for the life of the project.
III) The cash flows from the project occur in
perpetuity.
49. A local bakery chain is considering the pur- -$700,000 + ($80,000/.11)
chase of a very popular French bakery for
= $27,272.73
$700,000. The chain estimates that the French
bakery will generate cash flows of $80,000
per year in perpetuity after taxes. The chain's
WACC is 11%. What is the project's NPV?
50. The ___________ is the present value, at the terminal value
horizon year of a firm, of all subsequent future cash flows.
Multiple choice question.
51. Many real-world companies base their capital industry averages
structure decisions on:
52. Which of the following regarding free cash
flow are true?
9 / 24
- It is calculated assuming the firm is all-equity financed
- To value a company,
you can discount the free
cash flows at the after-tax
WACC
- It is the cash available
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to investors after all investments are made
53. True or false: Depreciation is deducted from True
net income and is then added back to free
Net income is calculated
cash flow calculations.
after various noncash expenses, including depreciation. Therefore depreciation must be added back
when calculating free cash
flows.
54. A large computer chain is considering the
-$1,700,000 +
purchase of a very popular software compa- ($180,000/.10) = $100,000
ny for $1,700,000. The chain estimates that
the software company will generate cash
flows of $180,000 per year in perpetuity after
taxes. The chain's WACC is 10%. What is the
project's NPV?
55. Sandy is the CFO of Pacific Northern Bank,
a large regional bank that is considering
the purchase of Mountain Bluebird Bank, a
statewide bank that has a large portion of that
Idaho's commercial lending market. She can
estimate Mountain Bluebird's cash flows for
the next 10 years relatively easily, but after
that she is having trouble. What should Sandy
do?
Forecast the first 10 years
and then add a terminal
value to the cash flows in
the 10th year
56. North Pole Importers, a holiday decor compa- A WACC of 13%
ny, is considering the purchase of Elf's Ears,
a maker of holiday hats and hairpieces. Elf's
Ears is privately held, but a study of its assets
reveals that it can support the same proportion of debt-to-equity as North Pole. North
Pole has a WACC of 13%. What should North
Pole use for the WACC of Elf's Ears?
57. Free cash flow equals:
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profit after tax + depreciation investment in fixed assets investment in working
capital
58. ____________ is the amount of cash the firm Free cash flow
has available to payout to investors, after
making all investments necessary for growth.
59. Net income is calculated
_________ interest, whereas free cash flow
is calculated __________ interest. Capital expenditures and working capital investments
do not reduce ___________ , but they do reduce ________.
1. after
2. before
3. net income
4. free cash flow
60. ABC Corporation is considering the purchase of DEF Corporation. ABC has calculated the present value of DEF's cash flows
for the first eight years as being $30 million.
The free cash flow is $4.1 million, the WACC
is 7%, and the long-run growth is expected to
be 4%. What is the value of DEF? (Hint: First,
calculate the horizon value.)
$4.1 million / (.07 - .04)
= $136.67 million. The PV
at Year 0 = 1/(1.07)^8 x
$136.67 million = $79.54
million. Therefore the PV of
the company = $30 million
+ $79.54 million = $109.54
million.
61. Sara Jones, the chief financial officer at
Fastek, a computer software firm, has spent
a few hours estimating the terminal value for
QuikStart, an acquisition target that makes
face recognition software. She has determined that Fastek should proceed with the
purchase. What is one analysis technique
Sara Jones should do before presenting
these findings to the board of directors?
Compare QuikStart's P/E
and market to book value
ratios with those of competitors
62. Sequoia Holdings Corporation is considering the purchase of The Evergreen Company, a firm with a similar risk and debt profile. Sequoia is using the WACC to help value Evergreen. In the first year, Evergreen is
$4.6 million + $100,000 $5.2 million = -$500,000
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expected to have an after-tax profit of $4.6
million. Depreciation on its equipment is estimated at $100,000. Evergreen is expected to
need considerable investments in fixed assets and working capital, estimated at $5.2
million. What is the free cash flow for Evergreen's first year if Sequoia proceeds with the
acquisition?
63. Suppose that a maker of athletic gear is considering the purchase of an athletic shoe
manufacturer to expand its offerings. The
shoe manufacturer has been valued at $59.3
million, of which 43% is debt and 57% is
equity. The shoe manufacturer has 2 million
shares outstanding. What price per share will
the athletic gear company be willing to pay
for the shoe maker?
$59.3 million x .57 = $33.8
million in equity. $33.8 million / 2 million shares =
$16.90 per share
64. Two Cute, a children's clothing maker, is considering the purchase of Wee Ones, another
children's clothing company with a similar
risk profile and debt-equity ratio. Wee Ones is
projected to have free cash flows of $800,000
in Year 1, with a growth rate of 8% in Years
2 through 8. Free cash flows, including depreciation and excluding investments in fixed
assets and working capital, are expected to
be $1.6 million in Year 9. After that, growth
is expected to slow to 4% for the long run.
The weighted average cost of capital is 10%.
Using these free cash flow figures, calculate
the present value of Wee Ones. (Hint: You will
need to calculate the horizon value.)
First, calculate the FCFs,
growing at 8% each
year, for Years 1 8. Then, discount these
FCFs at a 10% WACC:
$5,461,095.87. Next, calculate the horizon value: $1.6 million / (.1
- .04) = $26,666,666.67.
The PV at Year 0 =
1/(1.1)^8 x $26,666,666.67
= $12,440,196.81. Therefore the PV of the
company = $5,461,095.87
+ $12,440,196.81 =
$17,901,292.67 or about
$17.9 million.
65. Dr. Pete, the chief financial officer at Securely, - Look for potential liquia computer security firm, has spent a few
dation assets that would
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hours estimating a horizon value for Speak
Up, an acquisition target that makes voice
recognition software. He has determined that
his company should proceed with the purchase. What should Dr. Pete do before presenting his findings to his board of directors?
66. Heavenly Teas is valued at $8.7 million, of
which 30% is debt. The firm has 500,000
shares outstanding. What is Heavenly Teas'
value per share?
change the value of Speak
Up
- Compare Speak Up's P/E
and market to book value
ratios with those of competitors
- Perform a detailed analysis of Speak Up's projected future costs and growth
rates
If 30% of Heavenly Teas'
value is debt, then 70%
is equity. The total value of its equity is therefore $8.7 million x .7 =
$6.09 million. Divide the
value of the equity by the
shares outstanding to find
the share price: $6.09 million / 500,000 shares =
$12.18.
67. Suppose that Shingles Limited, a maker of $16.7 + $44.8 - $30 = $31.5
wooden roof shingles, is considering the pur- million
chase of SaferHomes Shingles, a maker of
fireproof asphalt and fiberglass roof shingles.
The firms have similar risk and debt-equity
profiles. SaferHomes has a PV of cash flows
for years 1-7 projected at $16.7 million and the
PV of the horizon value is projected at $44.8
million. SaferHomes has debt with a book and
market value of $30 million. What is the total
value of SaferHomes' equity?
68. Suppose that Allen's Books, a bookseller
$1.1 million + $2.3 million specializing in economics books, is consid- $130,000 = $3.27 million
ering the purchase of Sandy's Books, a bookseller specializing in finance books. The firms
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have similar risk and debt-equity profiles.
Sandy's PV of cash flows for years 1-6 is projected at $1.1 million and the PV of the horizon value is projected at $2.3 million. Sandy's
Books has debt with a book and market value
of $130,000. What is the total value of Sandy's
equity?
69. FCF1 = $20 million; FCF2 = $20 million; FCF3 $261.57 million
= $20 million. Assume that free cash flow
grows at a rate of 5 percent for year 4 and beyond. If the weighted average cost of capital
is 12 percent, calculate the value of the firm.
70. Consider the following data for Kriya Compa- $78.1 million
ny:
Year: 1 2 3 4
Free Cash Flow (FCF) (in millions): 4 5 6 6.24
A constant growth rate of 4 percent is sustained forever after year 3. The weighted average cost of capital is 10 percent.Calculate the
present value of the horizon value. (Assume
that the horizon value includes the 6.24M FCF
in year 4.)
71. Given are the following data for Outsource $70 million
Company: PV (of FCFs for years 1-3) = $35
million; PV (horizon value) = $65 million. Suppose that the market value of the debt = $30
million. Calculate the total market value of
equity of the firm.
72. Given are the following data for year 1:Profits $9.5 million
after taxes = $14 million; Depreciation = $6
million; Interest expense = $6 million; Investment in fixed assets = $12 million; Investment
in working capital = $3 million. The corporate
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tax rate is 25 percent. Calculate the free cash
flow (FCF) for year 1.
73. Consider the following data:
FCF1 = $7 million;
FCF2 = $45 million;
FCF3 = $55 million.
$801.12 million
Assume that free cash flow grows at a rate
of 4 percent for year 4 and beyond. If the
weighted average cost of capital is 10 percent, calculate the value of the firm.
74. Given are the following data for Outsource $14
Company: PV (of FCFs for years 1-3) = $35
million; PV (horizon value) = $65 million. Suppose that the market value of the debt = $30
million and the number of shares outstanding
= 5 million. Calculate the share price.
75. When one uses the after-tax weighted aver- automatically considered
age cost of capital (WACC) to value a levered because the after-tax cost
firm, the interest tax shield is
of debt is included within
the WACC formula.
76. Given are the following data for Outsource $100 million
Company: PV (of FCFs for years 1-3) = $35
million; PV (horizon value) = $65 million. Calculate the value of the firm.
77. Given are the following data for year 1:Profits $13 million
after taxes = $20 million; Depreciation = $6
million; Interest expense = $4 million; Investment in fixed assets = $12 million; Investment
in working capital = $4 million. The corporate
tax rate is 25 percent. Calculate the free cash
flow (FCF) for year 1.
78. Given are the following data for year 1:Profit $2 million
after taxes = $5 million; Depreciation = $2 mil15 / 24
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lion; Investment in fixed assets = $4 million;
Investment net working capital = $1 million.
Calculate the free cash flow (FCF) for year 1.
79. Cosmic Beer Crafter is considering develop- The call option on Space
ing a new beer called the Space Beer 1. There Beer 2
is a similar product already available in the
market, so sales are expected to be low. However, with the manufacture of the Space Beer
1, Cosmic Beer Crafter would have the ability
to develop the Space Beer 2, an out of this
world beer unlike any beer ever made. What
is the strategic value of the Space Beer 1
investment?
80. Soda Pop Enterprises is considering the pur- Discounted cash flow
chase of another company, Yum Yum Chips.
They believe the purchase will give them the
option to use Yum Yum Chips to enter the organic food market by starting to make organic kettle cooked chips. Sales of the organic
chips are expected to be $100,000 the first
year, $500,000 the second year, $1 million in
the third year, and then grow by 10% in perpetuity. What method can Soda Pop Enterprises
use to value the underlying asset (the organic
chip sales) of the call option?
81. A piece of land adjacent to Soleil Properties'
condo complex is expected to go up for sale
in two years. Soleil is considering buying the
land because it gives them the option to develop another condo complex. They estimate
that the condo complex would cost $20 million to develop and that future cash flows on
the sale of the condos have a present value of
$28 million. What is the exercise price of the
call option?
82.
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The exercise price on a
real option is equal to the
initial outlay involved in the
investment; in this case it is
equal to $20 million.
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What two real options are available to virtual- - The option to expand
ly every business?
- The option to abandon
83. Why should discounted cash flow analysis DCF averages the downnot be used to value a real asset call option? side versus the upside, and
the value of a call option
depends only on the upside
84. Cosmic Toys International is considering de- The call option on Space
veloping a new toy called the Space Orbit 1. Orbit 2
There is a similar product already available in
the market, so sales are expected to be low.
However, with the manufacture of the Space
Orbit 1, Cosmic Toys would have the ability
to develop the Space Orbit 2, an out of this
world toy unlike any toy ever made. What is
the strategic value of the Space Orbit 1 investment?
85. Call options on real assets require calculat- non-traded real asset
ing the value of a ___________.
86. A piece of land adjacent to Soleil Properties' It is a 2 year call on an ascondo complex is expected to go up for sale set worth $28 million
in two years. Soleil is considering buying the
land because it gives them the option to develop another condo complex. They estimate
that the condo complex would cost $20 million to develop and that cash flows on the
sale of the condos have a net present value
of $28 million. What can be said of the option
to invest in the condo complex?
87. The two real options available to virtually
expand
every business are the option to abandon and
the option to _____.
88. The net present value of Investment A is -$12 APV= -$12m + $19m =
million. The option to expand to Investment $7m
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B is worth $19 million. What is the adjusted
present value?
89. Which of the following are examples of real
asset call options?
Newmont Mining (NEM)
buys land in Colorado to
secure mining rights, it may
be a new gold mining operation in a few years if gold
prices increase.
90. How does a firm benefit from an option to
delay?
- It delays decision making until more information
is available.
- It allows the firm to invest
in a project in stages.
- It prevents losses from
hasty business decisions.
91. What is the decision rule for real asset call
options?
Adjusted present value
(APV)
92. Which of the following are examples of real
asset call options? (2)
- A condo developer buys
land adjacent to a current
complex to use as a parking lot, but may turn it into
another condo complex in
a few years
- A technology company
begins development on a
new technology that could
be leveraged to develop
another new technology
93. DBT Properties recently bought a small rental When forecasted cash
home on a large piece of land in Arizona. They flows are sufficiently large
are considering tearing the house down and
putting up a large condo complex in 3 years,
once they all have retired and can live in one
of the new condos. They have learned that
a new upscale shopping mall and hotel are
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being built right next door to their property.
When should DBT exercise the option to build
the condo complex?
94. When might a business owner invest in a
When cash flows are suffinew project early instead of holding onto the ciently large
option?
95. Exxon Mobil is planning to acquire land in
- Exxon Mobil should buy
Alberta, Canada. Exxon Mobil is currently be- the land now and if oil
ing offered a very attractive price for the land. prices show no possibility
However, oil prices are currently at historic of rising, it can sell the land
lows. What should the company do with this in the future.
investment proposal?
- Exxon Mobil should buy
the land now but delay the
decision to drill.
96. What are some valuable options available to - The option to expand in
an entrepreneur planning to invest in a new the future
business venture?
- The option to abandon in
the future
97. Which of the following is an example of an
option to delay?
A firm purchases land today but decides to construct the plant in two years
based on future demand
for its product
98. Suppose you own a house that can be converted into a residential rental property or
into a small hair salon, but not both. Both projects have positive NPVs. Identify an important reason why it may be wise to "wait and
see" before deciding upon an investment.
You can learn about the
general level of cash flows
by looking at other similar residential rental properties and small hair salons
99. When a project's forecasted cash flows are
____________, managers capture the cash
flows by __________.
sufficiently large, investing
right away
100.
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Suppose you own a piece of land downtown
and are considering renovating it to house
either a coffee shop or a sushi joint. Both
have positive NPVs, so you decide to wait and
see for awhile to analyze cash flows for both
potential businesses. Eventually you decide
to open a sushi joint, but are surprised at
how high your cash flow estimates had to be
in order to make the decision. Identify three
reasons why your cash flows had to be so
high to invest in the sushi restaurant.
- Initial cash flows would be
small, the costs of continuing to wait and see are
small
- Building the sushi restaurant means forgoing the
option to open the coffee
house
- Competitive pressures of
potential new market entrants must also be considered
101. Based on future demand for its product, a
option to delay
firm purchases land today but decides to construct the plant in two years. This is an example of an ____________.
102. Suppose you own a trailer that can be converted into a rental property or into a food
truck, but not both. Both projects have positive NPVs. Identify two important reasons
why it may be wise to "wait and see" before
deciding upon an investment.
- You can learn about the
relative size of future cash
flows of the rental property
versus the food truck
- You can learn about the
general level of cash flows
by looking at other similar
rental properties and food
trucks
103. The option to abandon a project, investment, put
or new business venture is equivalent to a
____ option.
104. True or false: NPVs for capital investment pro- True
jects usually assume fixed economic lives.
105. Suppose you own a small commercial build- - Initial cash flows would be
ing in downtown Denver, and are considering small, the costs of continrenovating it as a gourmet pizza parlor or a uing to wait and see are
small craft brewery. Both have positive NPVs, small
so you decide to wait and see for awhile to an- - Competitive pressures of
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alyze cash flows for both potential businesses. Eventually you decide to open a small
craft brewery, but are surprised at how high
your cash flow estimates had to be in order to
make the decision. Identify three reasons why
your cash flows had to be so high to invest in
the small craft brewery.
potential new market entrants must also be considered
- Building the small craft
brewery means forgoing
the option to open the
gourmet pizza parlor
106. Which of the following illustrates flexible pro- A Spanish clothing empire
duction?
adjusts manufacturing according to the popularity of
its items
107. The option to invest in a new business ven- call, put
ture or project is a ______ option. The option to abandon a project, investment, or new
business venture is equivalent to a ______
option.
108. Caleb's Cookies sells its goods at the local a call option
farmer's market. Caleb has a base production
of 200 cookies per week. He has the ability
to make 100 more cookies per week, and in
peak times such as the holiday season and
the first market of the season, he makes the
extra cookies. The ability to produce the extra
cookies is:
109. Why does conventional NPV analysis under- It assumes a fixed economestimate the true value of a business propos- ic life for a project.
al?
110. Flexible production means the ability to vary production inputs or out___________________.
puts in response to fluctuating demand or prices.
111. Patsy's Candies sells its goods at the local a call option
farmer's market. Patsy has a base production
of 450 boxes of chocolates per week. She
has the ability to make 170 more boxes of
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chocolates per week, and in peak times such
as the holiday season and the first market
of the season, he makes the extra boxes of
chocolates. The ability to produce the extra
boxes of chocolates is:
112. Which of the following scenarios fails to de- The articles of incorporascribe a possible real option embedded in a tion amended to allow for
project analysis?
stock splits and reverse
stock splits
113. The discounted cash-flow (DCF) approach
should be
augmented by added
analysis if a decision has
significant imbedded options.
114. An abandonment option, in effect,
limits the downside risk of
an investment project.
115. The following are examples of expansion op- I, II, III, and IV
tions:
I) A mining company acquires mineral rights
to land that is not worth developing today but
could be profitable if ore prices increase.
II) A film studio acquires the rights to produce
a film based on the novel.
III) A real estate developer acquires a parcel
of land that could be turned into a shopping
mall.
IV) A pharmaceutical company purchases a
patent to market a new drug.
116. Permanently rejecting an investment today IV only
might not be a good choice because
I) the size of the firm will decline;
II) there are always errors in the estimation of
NPVs;
III) the project's real option value is negative;
IV) the company is forgoing the option to
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make the investment in the future if economic
and industry conditions change for the better
117. A rational manager may be reluctant to com- the value of the option to
mit to a positive net present value project
wait is high.
when
118. Which of the following conditions might lead Uncertainty about future
a financial manager to delay a positive-NPV project value increases.
project? (Assume that project NPV—if undertaken immediately—is held constant.)
119. Which of the following are examples of real I, II, III, and IV
options?
I) the option to expand if an investment project succeeds;
II) the option to wait (and learn) before investing;
III) the option to shrink or abandon a project;
IV) the option to vary the mix of output or the
firm's production methods
120. An example of a real option is
all of the options are correct.
121. Assume the following data for Project X: NPV +$2 million
of the project without abandonment: $2 million; abandonment option value: $4 million.
Calculate the adjusted present value (APV) of
the project.
122. Dividend Reinvestment Plans have the option Automatically reinvesting
of:
some or all of their cash
dividends in shares of
stock.
123. A stock split is characterized by all of the
following, except:
124.
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Paid in cash to outstanding
shareholders.
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Which of the following dividends are never in
the form of cash?
I) regular dividend;
II) special dividend;
III) stock dividend;
IV) liquidating dividend
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1. Mirion Tech, Inc., has rE of 12%, an rD of 6%, at a
9.58%
debt-equity ratio of 0.50. Mirion plans to raise enough
preferred stock to retire half of their outstanding common stock, which currently has a market value of $7
million. If the preferred stock has an expected rate
of return of 10%, what is the new WACC? (Assume a
21% marginal corporate tax rate and that rD remains
at 6%.)
2. Lowering the debt-equity ratio of the firm can change I, II, III, and IV
the firm's
I) financial leverage;
II) cost of equity;
III) cost of debt;
IV) effective tax rate
3. A firm has debt beta of 0.2 and an asset beta of 1.9. If 3.18
the debt-equity ratio is 75 percent, what is the levered
equity beta?
4. While calculating the weighted average cost of capital, Market Values
which values should one use for D, E, and V?
5. Given are the following data for Golf Corporation:Mar- 40 percent debt
ket price/share = $12; Book value/share = $10; Num- and 60 percent eqber of shares outstanding = 100 million; Market
uity
price/bond = $800; Face value/bond = $1,000; Number of bonds outstanding = 1 million. Calculate the
proportions of debt (D/V) and equity (E/V) for Golf
Corporation that you should use for estimating its
weighted average cost of capital (WACC).
6. Given are the following data: Cost of debt = rD =
8.42 percent
6.0%; Cost of equity = rE = 12.1%; Marginal tax rate =
21%; and the firm has 50 percent debt and 50 percent
equity. Calculate the after-tax weighted average cost
of capital (WACC).
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7. To calculate the total value of the firm (V), one should Market values of
rely on the
debt and equity
8. Johnston Company has a 7 percent cost of debt, a
11 percent
50 percent debt ratio, and a 15 percent cost of equity.
The marginal tax rate is 25 percent. What is Johnston's
WACC if it were 100 percent equity-financed?
9. Given are the following data for Outsource Company: $14
PV (of FCFs for years 1-3) = $35 million; PV (horizon
value) = $65 million. Suppose that the market value
of the debt = $30 million and the number of shares
outstanding = 5 million. Calculate the share price.
10. Consider the following data:FCF1 = $20 million; FCF2 $261.57 million
= $20 million; FCF3 = $20 million. Assume that free
cash flow grows at a rate of 5 percent for year 4 and
beyond. If the weighted average cost of capital is 12
percent, calculate the value of the firm.
11. When one uses the after-tax weighted average cost of automatically concapital (WACC) to value a levered firm, the interest tax sidered because
shield is
the after-tax cost
of debt is included
within the WACC
formula.
12. Given are the following data for Outsource Company: $70 million
PV (of FCFs for years 1-3) = $35 million; PV (horizon
value) = $65 million. Suppose that the market value of
the debt = $30 million. Calculate the total market value
of equity of the firm.
13. Free cash flow (FCF) and net income (NI) differ in the I, II, and III only
following ways:
I) Net income accrues to shareholders, calculated after interest expense; free cash flow is calculated assuming all flows go to equity holders.
II) Net income is calculated after various noncash
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expenses, including depreciation; FCF adds back depreciation.
III) Capital expenditures and investments in working
capital do not appear in net income calculations; they
do reduce free cash flows.
IV) Net income is never negative; free cash flows can
be negative for rapidly growing firms, even if the firm
is profitable, because investments can exceed cash
flows from operations.
14. Consider the following data:FCF1 = $7 million; FCF2 = $801.12 million
$45 million; FCF3 = $55 million. Assume that free cash
flow grows at a rate of 4 percent for year 4 and beyond.
If the weighted average cost of capital is 10 percent,
calculate the value of the firm.
15. Given are the following data for year 1:Profit after tax- $2 million
es = $5 million; Depreciation = $2 million; Investment
in fixed assets = $4 million; Investment net working
capital = $1 million. Calculate the free cash flow (FCF)
for year 1
16. Given are the following data for year 1:
$13 million
Profits after taxes = $20 million; Depreciation = $6
million; Interest expense = $4 million; Investment in
fixed assets = $12 million; Investment in working capital = $4 million. The corporate tax rate is 25 percent.
Calculate the free cash flow (FCF) for year 1.
17. Dividend Reinvestment Plans have the option of:
Automatically reinvesting some or all
of their cash dividends in shares of
stock.
18. A stock split is characterized by all of the following,
except:
Paid in cash to
outstanding shareholders.
19.
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Benson Company has 150,000 outstanding shares @ 300,000 shares @
$20/share. The company has declared a two-for-one $10/share
stock split. How many shares will be outstanding and
at what value after the split?
20. On January 2, Michigan Mining declared a
$2-per-share quarterly
February 6
dividend payable on March 9th to stockholders of
record on Friday, February 9. What is the latest date
by which you could purchase the stock and still get
the recently declared dividend?
21. The following statements are true of dividend reinvestment plans (DRIPs):
I, II, and III
I) They are offered by the companies to their shareholders.
II) Generally, new shares are issued at a discount.
III) The dividends are taxable as ordinary income
22. According to behavioral finance, investors prefer div- investors preidends because
fer the discipline
that comes from
spending only the
dividends.
23. According to financial executives' views on dividend We try to avoid
policy, which of the following statements is most fre- reducing the diviquently cited?
dend.
24. Which of the following lists events in chronological
order from earliest to latest?
Declaration date,
ex-dividend date,
record date
25. Generally, investors interpret the announcement of a bad news, and the
decrease in dividends as
stock price drops.
26. Which of the following are true?
I, II, and III
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I) Firms have long-run target dividend payout ratios.
II) Dividend changes follow shifts in long-term, sustainable earnings.
III) Managers are reluctant to make dividend changes
that might have to be reversed.
27. Consider the procedure whereby the firm states a
Dutch auction
series of prices at which it is prepared to repurchase
stock. Shareholders then submit offers indicating how
many shares they wish to sell and at which price. The
firm then calculates the lowest price at which it is able
to buy the desired number of shares. This procedure
is known as a(n)
28. Dividend policy changes are decided and announced III only
by
I) the managers of a firm;
II) the government;
III) the board of directors
29. The act of buying or selling the underlying asset via Exercising
the option contract is called _______________ the option.
30. An investor, in practice, can buy
II only
I) an option on a single share of stock
II) blocks of 100 options
31. The value of a put option at expiration equals the
higher of the exercise price minus
market price of the
share and zero.
32. Suppose an investor sells (writes) a put option. What The owner will not
will happen if the stock price on the exercise date
exercise the opexceeds the exercise price?
tion.
33.
I only
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The value of a put option is negatively related to the:
I) stock price;
II) volatility of the underlying stock price;
III) exercise price
34. Suppose the underlying stock pays a dividend before II and III only
the expiration of options on that stock. This will:
I) increase the value of a call option;
II) increase the value of a put option;
III) decrease the value of a call option;
IV) decrease the value of a put option
35. The value of any option (both call and put options) is I and II only
positively related to the
I) volatility of the underlying stock price;
II) time to expiration;
III) risk-free rate;
36. The writer (seller) of a regular exchange-listed put-op- has the obligation
tion on a stock
to buy 100 shares
of the underlying
stock at the exercise price.
37. All else equal, as the underlying stock price increases: the put price decreases.
38. If the risk-free interest rate increases, then
call option prices
increase.
39. Suppose Ralph's stock price is currently $50. In the
next six months it will either fall to $30 or rise to
$80. What is the option delta of a call option with an
exercise price of $50?
0.600
40. The delta of a put option always equals
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the delta of an
equivalent call option minus one.
41. Why does a discounted cash-flow approach to options valuation not work?
Finding the opportunity cost of
capital is impossible as the risk of
options changes
every time the
stock price moves.
42. What does an equity option's delta reflect?
The number of
shares needed to
replicate one call
option
43. Suppose ACC's stock price is currently $25. In the
$8.57
next six months it will either fall to $15 or rise to $40.
What is the current value of a six-month call option
with an exercise price of $20? The six-month risk-free
interest rate is 5 percent per six-month period. (Use
the replicating portfolio method.)
44. Suppose ABCD's stock price is currently $50. In the $8.09
next six months it will either fall to $40 or rise to $80.
What is the current value of a six-month call option
with an exercise price of $50? The six-month risk-free
interest rate is 2 percent (periodic rate).
45. A call option has an exercise price of $100. At the
exercise date, the stock price could be either $50 or
$150. Which investment strategy provides the same
payoff as the stock?
Lend PV of $50
and buy two calls.
46. Suppose VS's stock price is currently $20. In the next $2.14
six months it will either fall to $10 or rise to $30. What
is the current value of a put option with an exercise
price of $15? The six-month risk-free interest rate is 5
percent per six-month period.
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47. An example of a real option is
the option to make
follow-on investments, the option
to abandon a project, the option to
wait before investing
48. The following are examples of expansion options:
I, II, III, and IV
I) A mining company acquires mineral rights to land
that is not worth developing today but could be profitable if ore prices increase.
II) A film studio acquires the rights to produce a film
based on the novel.
III) A real estate developer acquires a parcel of land
that could be turned into a shopping mall.
IV) A pharmaceutical company purchases a patent to
market a new drug.
49. The opportunity to defer investing to a later date may IV only
have value because
I) the cost of capital may increase in the near future;
II) uncertainty may be increased in the future;
III) the project has positive, short-term cash flows;
IV) market conditions may change and increase the
NPV of the project
50. The discounted cash-flow (DCF) approach should be augmented by
added analysis if
a decision has significant imbedded
options.
51. Assume the following data for Project X: NPV of the +$2 million
project without abandonment: $2 million; abandonment option value: $4 million. Calculate the adjusted
present value (APV) of the project.
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52. Which of the following are examples of real options? I, II, III, and IV
I) the option to expand if an investment project succeeds;
II) the option to wait (and learn) before investing;
III) the option to shrink or abandon a project;
IV) the option to vary the mix of output or the firm's
production methods
53. A rational manager may be reluctant to commit to a
positive net present value project when
the value of the option to wait is high.
54. An abandonment option, in effect,
limits the downside risk of an investment project.
55. Which of the following conditions might lead a fiUncertainty about
nancial manager to delay a positive-NPV project?
future project val(Assume that project NPV—if undertaken immediate- ue increases.
ly—is held constant.)
56. Which of the following are examples of applications of I, II, III, and IV
real options analysis?
I) a strategic investment in the computer business;
II) the valuation of an aircraft purchase option;
III) the option to develop commercial real estate;
IV) the decision to mothball an oil tanker
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1. The effect of financial leverage depends on the com- earnings before inpany's _____________.
terest and taxes
2. The equation for M & M Proposition I, without taxes, is VL=VU
best shown as:
3. Samuel Corp. provides the following information:
EBIT = $286.50
Tax (TC ) = 35%
Debt = $810
RU = 15%
What is the value of the firm?
VU = EBIT *(1-Tc)
/ Ru
$286.50*(1-.35) /
.15
$1,241.53
4. Samuel Corp. provides the following information:
EBIT = $386.50
Tax (TC ) = 35%
Debt = $810
RU = 15%
What is the value of Samuel's equity?
VU = EBIT *(1-Tc)
/ Ru
$386.50 * (1-.35) /
.15
=$1,674.83
Equity is worth
the difference between total firm
with and debt
worth
Vu-D
1,674.83 - 810
=$864.83
5. The effect of financial leverage on the performance of firm's level of operthe firm depends on the
ating income
6. For a levered firm where bA = beta of assets and bD = bE = bA + (D/E) *
beta of debt, the equity beta (bE) equals
[bA-bD]
7. The beta of an all-equity firm is 1.2. Suppose the firm bE = 1.2 +
changes its capital structure to 50 percent debt and 50 (0.5/0.5) *(1.2-0.2)
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percent equity using 8 percent debt financing. What is
the equity beta of the levered firm? The beta of debt is 2.2
0.2. (Assume no taxes.)
8. A firm has a debt-to-equity ratio of 1.0. If it had no debt, rE = 12 + 1.0 *
its cost of equity would be 12 percent. Its cost of debt (12-9)
is 9 percent. What is its cost of equity if there are no
taxes?
15%
9. Modigliani and Miller's Proposition I states that
the market value
of any firm is independent of its capital structure
10. Learn and Earn Company is financed entirely by com- rE = 0.2 + (0.5/0.5)
mon stock that is priced to offer a 20 percent expected * (0.2-0.08)
return. If the company repurchases 50 percent of the
stock and substitutes an equal value of debt yielding 32%
8 percent, what is the expected return on its common
stock after refinancing?
11. MM Proposition II states that
I, II and III
I) the expected return on equity is positively related to
leverage;
II) the required return on equity is a linear function of
the firm's debt to equity ratio;
III) the risk to equity increases with leverage
12. When a firm has no debt, then such a firm is known as I and III only
I) an unlevered firm;
II) a levered firm;
III) an all-equity firm
13. A firm's equity beta is 1.2 and its debt is risk free.
Solve for BA
Given a 0.7 debt to equity ratio, what is the firm's asset
beta? (Assume no taxes.)
1.2 = bA + 0.7 *
(bA-0)
1.2 = 1.7bA
bA = 1.2/1.7
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.706
14. A firm is unlevered and has a cost of equity capital of 9 rE = 9 + 2*(9-7)
percent. What is the cost of equity if the firm becomes
levered at a debt-equity ratio of 2? The expected cost 13%
of debt is 7 percent. (Assume no taxes.)
15. The capital structure of the firm can be defined as
II only
I) the firm's mix of different debt securities;
II) the firm's mix of different securities used to finance
assets;
III) the market imperfection that the firm's managers
can exploit
16. Wealth and Health Company is financed entirely by
common stock that is priced to offer a 15 percent expected return. The common stock price is $40/share.
The earnings per share (EPS) is expected to be $6. If
the company repurchases 25 percent of the common
stock and substitutes an equal value of debt yielding
6 percent, what is the expected value of earnings per
share after refinancing? (Ignore taxes.)
Firm borrows
$10/share
Interest per share
= $10 * .06 = $0.60
New EPS =
(6-0.60)/0.75 =
$7.20/share
17. If MM's Proposition I holds, minimizing the weighted market value of
average cost of capital (WACC) is the same as maxi- the firm
mizing the
18. For an all-equity firm,
as EBIT increases,
the EPS increases
by the same percentage
19. The asset beta of a levered firm is 1.1. The beta of debt bE = 1.1 + 0.5
is 0.3. If the debt equity ratio is 0.5, what is the equity (1.1-0.3)
beta? (Assume no taxes.)
1.5
20. Health and Wealth Company is financed entirely by rE = rA +
common stock that is priced to offer a 15 percent ex- (D/E)*(rA-rD)
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pected return. If the company repurchases 25 percent
of the common stock and substitutes an equal value 15 = (0.25/0.75) *
of debt yielding 6 percent, what is the expected return (15-6)
on the common stock after refinancing? (Ignore taxes.)
18%
21. A firm has zero debt in its capital structure. Its overall rE = 10 + (60/40)
cost of capital is 10 percent. The firm is considering *(10-8)
a new capital structure with 60 percent debt. The interest rate on the debt would be 8 percent. Assuming 13
there are no taxes, its cost of equity capital with the
new capital structure would be
22. Learn and Earn Company is financed entirely by common stock that is priced to offer a 20 percent expected rate of return. The stock price is $60 and the
earnings per share are $12. The company wishes to
repurchase 50 percent of the stock and substitutes an
equal value of debt yielding 8 percent. Suppose that
before refinancing, an investor owned 100 shares of
Learn and Earn common stock. What should he do if
he wishes to ensure that risk and expected return on
his investment are unaffected by this refinancing?
Sell 50 shares and
purchase $3,000
of 8% debt
(bonds):
Refinancing results in a D/E ratio
of 1
The new expected return on the
stock increases
from 20% to 32%
With 50 shares
(worth $3,000)
and $3,000 of 8%
debt, the expected
return remains at
0.5 * 32% + 0.5 *
8%
20%
23. Capital structure is irrelevant if
I) capital markets are efficient;
I, II and III
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II) each investor can borrow/lend on the same terms
as the firm;
III) there are no tax benefits to debt
24. A firm has a debt-to-equity ratio of 0.50. Its cost of debt 14 = (1/3) *10 +
is 10 percent. Its overall cost of capital is 14 percent. (2/3)*X
What is its cost of equity if there are no taxes?
Solve for X
42 = 10 + 2X
X=16%
25. For a levered firm,
as EBIT increases,
EPS increases by
a larger percentage
26. _________ tax rate is the amount of tax payable on the Marginal
next dollar earned.
27. The equation for M & M Proposition I, with taxes, is
best shown as:
VL = VU + Tc * D
28. Lollipop Corp. provides the following information:
EBIT = $286.50
Tax (TC )= 35%
Debt= $810
Cost of debt capital = 10%
RU = 15%
What is the value of the firm?
VU = $1,241.53
VL = VU + Tc * D
VL = $1,241.53 +
0.35 *$810
$1,525.03
29. MM Proposition I with corporate taxes states that:
I and II
I) capital structure can affect firm value by an amount
that is equal to the present value of the interest tax
shield;
II) by raising the debt-to-equity ratio, the firm can
lower its taxes and thereby increase its total value;
III) firm value is maximized by using an all-equity capital structure
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30. What are some of the possible consequences of finan- III only
cial distress?
I) Bondholders, who face the prospect of getting only
part of their money back, will likely want the company
to take additional risks.
II) Equity investors would like the company to cut its
dividend payments to conserve cash.
III) Equity investors would like the firm to shift toward
riskier lines of business.
31. In order to calculate the tax shields provided by debt, marginal corpothe tax rate used is the
rate tax rate
32. When faced with financial distress, managers of firms I, II and III
acting on behalf of their shareholders' interests will
tend to:
I) issue large quantities of low-quality debt versus low
quantities of high-quality debt;
II) favor paying high dividends to shareholders;
III) delay the onset of bankruptcy as long as they can
33. If a firm permanently borrows $50 million at an interest Pv of interest tax
rate of 10 percent, what is the present value of the
shield = (0.21)(50)
interest tax shield? Assume a 21 percent marginal
= $10.5 million
corporate tax rate.
34. What signal is sent to the market when a firm decides stock price is too
to issue new stock to raise capital?
high
35. Which of the following entities likely has the highest a pharmaceutical
cost of financial distress?
development company
36. If a corporation cannot use its interest payments as a I and II
tax shield for a particular year because it has suffered
a loss, it is still possible to use the tax shield because:
I) the carry-back provision allows corporations to carry back the loss and receive a tax refund up to the
amount of taxes paid in the previous two years;
II) the carry-forward provision allows corporations to
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carry forward the loss and use it to shield income in
subsequent years
37. If a firm permanently borrows $100 million at an interest rate of 8 percent, what is the present value of
the interest tax shield? (Assume that the marginal
corporate tax rate is 21 percent
PV (int tax shield)
= (0.21)(100) =
$21 million
38. The main advantage of debt financing for a firm is:
I) no SEC registration is required for bond issues;
II) interest expenses are tax deductible;
III) unlevered firms have higher value than levered
firms
II only
39. Assume the marginal corporate tax rate is 21 percent. VU = 100
The firm has no debt in its capital structure. It is valued Tc = 0.21 * 50 =
at $100 million. What would be the value of the firm if it 10.5
issued $50 million in perpetual debt and repurchased VL = VU + TcB
the same amount of equity?
=100 + 10.5 =
$110.5
40. The pecking order theory of capital structure implies II and III only
that:
I) high-risk firms will end up borrowing more;
II) firms prefer internal finance;
III) firms prefer debt to equity when external financing
is required
41. The costs of financial distress depend on the:
I) probability of financial distress;
II) corporate and personal tax rates;
III) magnitude of costs encountered if financial distress occurs
I and III only
42. According to the trade-off theory of capital structure, optimal capital
structure occurs
when the PV of
tax savings on account of additional
borrowing just off7 / 18
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sets the increase
in the PV of cost
distress
43. Although the use of debt provides tax benefits to the I only
firm, debt also puts pressure on the firm to:
I) meet interest and principal payments, which if not
met can put the company into financial distress;
II) make dividend payments, which if not met can put
the company into financial distress;
III) meet both interest and dividend payments, which
when met increase the firm cash flow;
IV) meet increased tax payments, thereby increasing
firm value
44. The MM theory with taxes implies that firms should II and III only
issue maximum debt. In practice, this is not true because:
I) debt is more risky than equity;
II) bankruptcy and its attendant costs are a disadvantage to debt;
III) the payment of personal taxes may offset the tax
benefit of debt
45. Assuming that bonds are sold at a fair price, the ben- stockholders of the
efits from the interest tax shield go to the
firm
46. Bombay Company's book and market value balance PV of tax shield
sheets are as follows:
: -$200 (0.21) =
(NWC = net working capital; LTA = long term assets; D -$42
= debt; E = equity; V = firm value):
Book Values Market Values NWC 200 500 DNWC 200
500 DLTA 2,300 2,00 ELTA 2,800 2,500 E 2,500 2,500 V
3,000 3,000 V
According to MM's Proposition I corrected for taxes,
what will be the change in company value if Bombay
issues $200 of equity and uses it to make a perma8 / 18
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nent reduction in the company's debt? Assume a 21
percent marginal corporate tax rate.
47. When financial distress is a possibility, the value of a I + II - III
levered firm is a function of:
I) value of the firm if all-equity-financed;
II) present value of tax shield;
III) present value of costs of financial distress;
IV) present value of omitted dividend payments
48. When faced with financial distress, managers of firms I, II and III
acting on behalf of their shareholders' interests will
tend to:
I) favor high-risk, high-return projects even if they
have negative NPV;
II) refuse to invest in low-risk, low-return projects with
positive NPVs;
III) delay the onset of bankruptcy as long as they can
49. Which of the following is not a potential result from
financial distress?
due to interest tax
shields, the firm's
effective tax rate is
very low
50. If a firm has preferred stock, the after-tax weighted
average cost of capital (WACC) equals
rD (1-Tc)(D/V) +
rP (P/V) + rE
(E/V) (where V =
D+E+P)
51. A firm has debt beta of 0.2 and an asset beta of 1.9. If bE = bA + (D/E)
the debt-equity ratio is 75 percent, what is the levered *(bA-bD)
equity beta?
1.9 + 0.75 * (1.9 0.2)
=3.175
52. Project M requires an initial investment of $25 million. NPV= -25 +
The project is expected to generate $2.25 million in (2.25/0.09)
after-tax cash flow each year forever. If the weighted
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average cost of capital (WACC) is 9 percent, calculate
the NPV of the project.
0
53. While calculating the weighted average cost of capital, market values
which values should one use for D, E, and V?
54. Given are the following data for Golf Corporation:
Use market values
Market price/share = $12;
Book value/share = $10;
Number of shares outstanding = 100 million;
Market price/bond = $800;
Face value/bond = $1,000;
Number of bonds outstanding = 1 million.
E = (12)*100 =
$1,200
D= (800)*1 = $800
V=D+E = $2,000
D/V = 800/2,000 =
0.4
Calculate the proportions of debt (D/V) and equity
E/V = 1,200/2,000
(E/V) for Golf Corporation that you should use for es- = 0.6
timating its weighted average cost of capital (WACC).
55. To calculate the total value of the firm (V), one should market values of
rely on the
debt and equity
56. When using the weighted average cost of capital
I and II only
(WACC) to discount cash flows from a project, we
assume the following:
I) The project's risks are the same as those of the
firm's other assets and remain so for the life of the
project.
II) The project supports the same fraction of debt to
value as the firm's overall capital structure, and that
fraction remains constant for the life of the project.
III) The cash flows from the project occur in perpetuity.
57. Given are the following data: Cost of debt = rD =
6.0%; Cost of equity = rE = 12.1%; Marginal tax rate =
21%; and the firm has 50 percent debt and 50 percent
equity. Calculate the after-tax weighted average cost
of capital (WACC).
58.
10 / 18
WACC =
(0.5)(1-.21)(6.0) +
(0.5)(12.1) =
8.42%
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One calculates the after-tax weighted average cost of WACC =
capital (WACC) as
rD(1-Tc)(D/V) +
rE(E/V)
59. Lowering the debt-equity ratio of the firm can change I, II, III, and IV
the firm's
I) financial leverage;
II) cost of equity;
III) cost of debt;
IV) effective tax rate
60. Consider the following data for Kriya Company:
1. 6.24/0.10-0.04 =
104
Year: 1 2 3 4 Free Cash Flow (FCF) (in millions):4 5 6
6.24
4/1.10 + 5/1.10^2
A constant growth rate of 4 percent is sustained for- + (6+104)/1.10^3
ever after year 3. The weighted average cost of capital
is 10 percent.Calculate the value of the firm.
$90.4
61. Given are the following data for year 1:Profits after
FCF = 20 +6 +
taxes = $20 million; Depreciation = $6 million; Interest (1-0.25)*4-12-4
expense = $4 million; Investment in fixed assets = $12
million; Investment in working capital = $4 million. The $13m
corporate tax rate is 25 percent. Calculate the free
cash flow (FCF) for year 1.
62. Consider the following data for Kriya Company:
PV(horizon value)
= 6.24/(.10-.04) /
Year: 1 2 3 4 Free Cash Flow (FCF) (in millions):4 5 6 1.10^3
6.24
A constant growth rate of 4 percent is sustained forev- 78.14
er after year 3. The weighted average cost of capital is
10 percent.Calculate the present value of the horizon
value. (Assume that the horizon value includes the
6.24M FCF in year 4.)
63. Consider the following data:FCF1 = $20 million; FCF2 1. 20 * 1.05 / .12 = $20 million; FCF3 = $20 million. Assume that free 0.05 = 300
cash flow grows at a rate of 5 percent for year 4 and
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beyond. If the weighted average cost of capital is 12 2. 20/1.12 +
percent, calculate the value of the firm.
20/1.12^2 + 20 +
300 /1.12^3
$261.57m
64. Free cash flow (FCF) and net income (NI) differ in the I, II, and III only
following ways:
I) Net income accrues to shareholders, calculated after interest expense; free cash flow is calculated assuming all flows go to equity holders.
II) Net income is calculated after various noncash
expenses, including depreciation; FCF adds back depreciation.
III) Capital expenditures and investments in working
capital do not appear in net income calculations; they
do reduce free cash flows.
IV) Net income is never negative; free cash flows can
be negative for rapidly growing firms, even if the firm
is profitable, because investments can exceed cash
flows from operations.
65. Given are the following data for Outsource Company: PV (firm) = PV
PV (of FCFs for years 1-3) = $35 million; PV (horizon (FCF for yr 1-3) +
value) = $65 million. Suppose that the market value of PV (horizon value)
the debt = $30 million. Calculate the total market value --> 35 +65 = 100
of equity of the firm.
Total value of equity = 100-30 = 70
66. When one uses the after-tax weighted average cost of automatically concapital (WACC) to value a levered firm, the interest tax sidered because
shield is
the after-tax cost
of debt is included
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within the WACC
formula
67. Given are the following data for Outsource Company: Tota value of eqPV (of FCFs for years 1-3) = $35 million; PV (horizon uity = 100-30 =
value) = $65 million. Suppose that the market value 70 (from previous
of the debt = $30 million and the number of shares
problem)
outstanding = 5 million. Calculate the share price.
Value per share =
70/5m outstanding
= $14
68. Given are the following data for year 1:Profit after tax- FCF =5+2-4-1 =
es = $5 million; Depreciation = $2 million; Investment
in fixed assets = $4 million; Investment net working 2
capital = $1 million. Calculate the free cash flow (FCF)
for year 1.
69. Given are the following data for Outsource Company: PV(firm) = 35 + 65
PV (of FCFs for years 1-3) = $35 million; PV (horizon = 100
value) = $65 million. Calculate the value of the firm.
70. Given are the following data for year 1:Profits after
FCF = 14 + 6 +
taxes = $14 million; Depreciation = $6 million; Interest (1-.25) *6 -12 -3 =
expense = $6 million; Investment in fixed assets = $12 $9.5m
million; Investment in working capital = $3 million. The
corporate tax rate is 25 percent. Calculate the free
cash flow (FCF) for year 1.
71. Consider the following data:FCF1 = $7 million; FCF2 = horizon value in
$45 million; FCF3 = $55 million. Assume that free cash yr 3 = 55(1.04)
flow grows at a rate of 4 percent for year 4 and beyond. / (.10-.04) =
If the weighted average cost of capital is 10 percent, $953.33m
calculate the value of the firm.
PV=(7/1.10) +
45/(1.10^2) + 55
+953.33 / 1.10^3
$801.12m
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72. Dividend Reinvestment Plans have the option of:
Automatically reinvesting some or all
of their cash dividends in shares of
stock.
73. A stock split is characterized by all of the following,
except:
Paid in cash to
outstanding shareholders.
74. Benson Company has 150,000 outstanding shares @
$20/share. The company has declared a two-for-one
stock split. How many shares will be outstanding and
at what value after the split?
300,000 shares at
$10/share. Notice
that the total market value is unchanged after the
split. The market
value is 3,000,000
75. Firms can pay out cash to their shareholders in the
following way(s):
I) dividends;
II) share repurchases;
III) interest payments
I and II only
76. Which of the following lists events in chronological
order from earliest to latest?
Declaration date,
ex-dividend date,
record date
77. On January 2, Michigan Mining declared a
February 6
$2-per-share quarterly dividend payable on March 9th
to stockholders of record on Friday, February 9. What
is the latest date by which you could purchase the
stock and still get the recently declared dividend?
78. According to behavioral finance, investors prefer div- investors preidends because
fer the discipline
that comes from
spending only the
dividends
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79. Generally, investors interpret the announcement of an good news, and
increase in dividends as
the stock price increases
80. Suppose that there are no taxes, transactions costs, Eliminate negative
or other market imperfections. Which of the following NPV projects
actions is most likely to make shareholders better off?
81. One possible reason that shareholders often insist on they do not
higher dividends is
trust managers
to spend retained
earnings wisely
82. If dividends are taxed more heavily than capital gains, should be willing
then investors
to pay more for
stocks with low
dividend yields
83. Consider the procedure whereby the firm states a
Dutch auction
series of prices at which it is prepared to repurchase
stock. Shareholders then submit offers indicating how
many shares they wish to sell and at which price. The
firm then calculates the lowest price at which it is able
to buy the desired number of shares. This procedure
is known as a(n)
84. Which of the following dividends are never in the form III only
of cash?
I) regular dividend;
II) special dividend;
III) stock dividend;
IV) liquidating dividend
85. Dividend policy may affect firm value because
I and III only
I) there is an unsatisfied clientele that prefer dividends
to capital gains;
II) there are sufficient loopholes in the tax system that
wealthy shareholders can avoid taxes on dividends;
III) well-managed companies prefer to signal their
worth by paying high dividends
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86. Dividend policy changes are decided and announced III only
by
I) the managers of a firm;
II) the government;
III) the board of directors
87. Generally, investors view the announcement of an
open-market repurchase program as
good news, and
the stock price increases
88. The following statements are true of dividend reinvestment plans (DRIPs):
I) They are offered by the companies to their shareholders.
II) Generally, new shares are issued at a discount.
III) The dividends are taxable as ordinary income.
I, II and III
89. Generally, investors interpret the announcement of a bad news, and the
decrease in dividends as
stock price drops
90. The following are indicators that the firm has a cash I, II and III
surplus:.
I) Free cash flow is reliably positive.
II) The firm has a low debt ratio compared to similar
firms.
III) The firm has sufficient debt capacity to cover unexpected opportunities or setbacks.
91. Which of the following are true?
I, II and III
I) Firms have long-run target dividend payout ratios.
II) Dividend changes follow shifts in long-term, sustainable earnings.
III) Managers are reluctant to make dividend changes
that might have to be reversed.
92. Which of these dates, when arranged in chronological dividend payment
order, occurs last?
date
93.
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According to financial executives' views on dividend we try to avoid
policy, which of the following statements is most fre- reducing the diviquently cited?
dend
94. Firms can repurchase shares in the following ways:
I) open market repurchase;
II) tender offer;
III) Dutch auction;
IV) direct negotiation with a major shareholder
I, II, III and IV
95. Two corporations A and B have exactly the same risk, The after tax reand both have a current stock price of $100. Corpora- turns must be the
tion A pays no dividend and will have a price of $120 same
one year from now. Corporation B pays dividends and
will have a price of $113 one year from now after
Return stock A =
paying the dividend. The corporations pay no taxes 20% (or $20)
and investors pay no taxes on capital gains, but pay a Return stock B =
30 percent income tax on dividends. What is the value 20% (or $20)
of the dividend that investors expect corporation B to
pay one year from today?
Stock B delivers
$13 cap gains and
therefore must deliver an after-tax
dividend of $7
Pre-tax dividend is
(120-113) / 0.7 =
$10
96. Company X has 100 shares outstanding. It earns
$1,000 per year and announces that it will use all
$1,000 to repurchase its shares in the open market
instead of paying dividends. Calculate the number of
shares outstanding at the end of year 1, after the first
share repurchase, if the required rate of return is 10
percent.
17 / 18
Share price beginning of year =
[$1000/0.1]/100 =
$100 per share
share price at
end of year (before repurchase) =
$100*1.10 = $110
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NUmber of shares
purchased =
$1000/$110 = 9.09
100-909 = 90.91
shares remain
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1. A firm has issued $5 par value preferred stock that
$9.50
pays a $0.80 annual dividend. The stock currently sells
for $9.50. In calculating WACC, what should one use
for the value of the firm's preferred stock?
$4.2
$5.00
$0.80
$9.50
2. The APV method is most useful in analyzing
small projects.
large international projects.
domestic projects.
projects having the same risk as the firm.
Large international projects
3. Which of the following statements regarding guarantees and government restrictions on international
projects is (are) true?
The value of the guarantees is subtracted from the
APV and the value of the government restrictions is
subtracted from the APV.
The value of the guarantees is added to the APV and
the value of the government restrictions is added to
the APV.
The value of the guarantees is added to the APV and
the value of the government restrictions is subtracted
from the APV.
The value of the guarantees is subtracted from the
APV and the value of the government restrictions is
added to the APV.
The value of
the guarantees is
added to the APV
and the value
of the government
restrictions is subtracted from the
APV.
4. Project M requires an initial investment of $25 million. 0
The project is expected to generate $2.25 million in
after-tax cash flow each year forever. If the weighted
average cost of capital (WACC) is 9 percent, calculate
the NPV of the project.
5. Firms can repurchase shares in several ways. Which Through direct neones? Select all that apply.
gotiation with a
1 / 13
Take-home 9 Chapter 19 Financing and Valuation
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Through an ESOP
Through direct negotiation with a major shareholder
Through a Dutch auction process
Through an auction by the candle
Through a tender offer
Through open market repurchase
major shareholder
Through a Dutch
auction process
Through a tender
offer
Through open
market repurchase
6. 4. The 1-year bonds of Casino, Inc., have a 12 percent Not 9.1%, 14%
coupon rate and trade in the market at a yield of 14
percent. There is a 5 percent chance that Casino will
default and pay nothing. What cost of debt should be
used in Casino's WACC?
9.1 percent
8.3 percent
14 percent
12 percent
7. Given are the following data for Outsource Company: 70 m
PV (of FCFs for years 1-3) = $35 million; PV (horizon
value) = $65 million. Suppose that the market value of
the debt = $30 million. Calculate the total market value
of equity of the firm.
8. AAA has 100 million shares outstanding, a current
90 m
share price of $25, and no debt. AAA's management
believes that the shares are under-priced, and that the
true value is $30 per share. AAA plans to pay $250
million in cash to its shareholders by repurchasing
shares. Management expects that very soon new information will come out that will cause investors to
revise their opinion of the firm and agree with AAA's
assessment of the firm's true value.If AAA is able
to repurchase shares prior to the market becoming
aware of the new information regarding AAA's true
value, then the number of shares outstanding following the repurchase is closest to:
10 million
2 / 13
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90 million
75 million
92 million
9. Project AAA requires an initial investment of
-7,692,308
25,000,000. The project is expected to generate
2,250,000 in after-tax cash flows each year forever. If
WACC = 0.13, calculate the NPV of the project.6.
10. 10. Assume you are using a two-stage DCF to value 225.869
firm AAA. The first stage of your analysis includes the
next three years, after that you assume a constant
growth perpetuity. You have the following free cash
flows for AAA:
FCF Year 1: 4
FCF Year 2: 5
FCF Year 3: 6
A constant growth rate of g=0.04 is sustained forever
after year 3. The weighted average cost of capital is
r=0.063. Calculate the present value of the "horizon
value", precise to 3 digits after the comma:
11. Assume a capital market that satisfies the MM assumptions. In this market a firm engages in a leveraged recapitalization, i.e. buying back some of its
equity using newly issued debt. How is this going to
affect the returns that investors expect from the firm?
This will not affect the return to shareholders because
the tax benefit of debt will be exactly offset by the
increase in bankruptcy costs.
This will decrease the cost of capital of the firm because of the tax benefits of debt financing, i.e. the fact
that interest expenses lower taxable income and thus
increase cash flows available to investors.
This will not affect the cost of capital overall, but
increase the return to shareholders.
This will reduce the cost of equity because equity
is mechanically becoming less risky, decreasing the
WACC of the firm.
3 / 13
This will not affect
the cost of capital overall, but increase the return
to shareholders.
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12. Given are the following data for Outsource Company: 100 million
PV (of FCFs for years 1-3) = $35 million; PV (horizon
value) = $65 million. Calculate the value of the firm.
13. Which assumptions and arguments are central to the
pecking order theory of capital structure?
Managers generally have leverage targets, and if a
firm through external shocks deviates from that target
temporarily, managers will take actions to move leverage back to its optimum, over time.
Firms generally prefer internal to external financing
Firms' managers and investors face an asymmetric
information problem - managers know more about
their firms and their firms' projects than investors.
Firms with risky, intangible assets should primarily
rely on equity financing.
Managers will value the availability of financial slack,
i.e. readily available financing inside the firm, since
this financial slack can be spent on investment projects without needing to raise external financing (and
encountering the costs of asymmetric information associated with it)
A firm announcing that it will issue equity will generally be regarded as bad news by investors, since
managers would only issue equity as a last resort,
and investors therefore assume the company must
be closer to financial distress than they may have
previously believed.
4 / 13
Managers generally have leverage
targets, and if a
firm through external shocks deviates from that
target temporarily,
managers will take
actions to move
leverage back to
its optimum, over
time.
Firms generally
prefer internal to
external financing
Firms' managers
and investors face
an asymmetric information problem - managers
know more about
their firms and
their firms' projects than investors
Firms with risky,
intangible assets
should primarily
rely on equity financing.
A firm announcing
that it will issue
equity will generally be regarded as bad news
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by investors, since
managers would
only issue equity as a last resort, and investors
therefore assume
the company must
be closer to financial distress than
they may have previously believed.
14. A firm finances itself with 30 percent debt, 60 percent 11.05
common equity, and 10 percent preferred stock. The
before-tax cost of debt is 5 percent, the firm's cost
of common equity is 15 percent, and that of preferred
stock is 10 percent. The marginal tax rate is 30 percent.
What is the firm's weighted average cost of capital?
11.05 percent
10.75 percent
10.05 percent
12.50 percent
15. If a firm permanently borrows $16 million at an interest 4,800,000
rate of i=6%, what is the present value of the interest
tax shield? Assume that the tax rate is 30%. Insert the
actual number, not in millions. Calculate your answer
precise with all significant digits.
16. Mirion Tech, Inc., has rE of 12 percent, an rD of 6
9.3 percent
percent, at a debt-equity ratio of 0.50. Mirion plans
to raise enough preferred stock to retire half of their
outstanding common stock, which currently has a
market value of $7 million. If the preferred stock has
an expected rate of return of 10 percent, what is the
new WACC? (Assume a 35 percent marginal corporate
tax rate and that rD remains at 6 percent.)
6.60 percent
9.30 percent
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14.23 percent
11.02 percent
17. The Granite Paving Company is all-equity financed 48.1
and has the following free cash flows in years 14: $3
million ($3M); $3.7M; $4M; $4.2M. After year 4, the firm
is expected to grow at a sustainable rate of 3 percent
per annum. With a WACC of 12 percent, what is the
horizon value in year 4 of Granite Paving Co?
18. AAA has 100 million shares outstanding, a current
Not 28.75
share price of $25, and no debt. AAA's management
believes that the shares are under-priced, and that the
true value is $30 per share. AAA plans to pay $250
million in cash to its shareholders by repurchasing
shares. Management expects that very soon new information will come out that will cause investors to
revise their opinion of the firm and agree with AAA's
assessment of the firm's true value.Assume that AAA
is able to repurchase shares prior to the market becoming aware of the new information regarding AAA's
true value. After the repurchase, and following the release of the new information regarding the true value
of AAA, the firm's share price is closest to:
$30.00
$30.60
$28.75
$31.50
19. Assume a capital market that satisfies the MM assumptions. In this market a firm engages in a leveraged recapitalization, i.e. buying back some of its
equity using newly issued debt. How is this going to
affect the value of the firm?
6 / 13
This will not affect the value
of the firm because the cash
flows available to
all investors do
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not change, what
changes is simply
how these cash
flows are shared
between different
types of investors.
20. Given the following data for year 1:
Profits after taxes = $21 millions;Depreciation = $6
millions;Investment in fixed assets = $12 millions;Investment in working capital = $4 millions;Calculate
the free cash flow (FCF) for year 1 (as always ,be
careful to enter the amount in dollars, not in millions
of dollars)
11 million
profits after tax
+ dep - changes
in fixed assets changes in W.C.
21. Project M requires an initial investment of $25 million. 9 percent
The project is expected to generate $2.25 million in
after-tax cash flow each year forever. Calculate the IRR
for the project.
8 percent
9 percent
10 percent
7 percent
22. 8. Profits after taxes = $20 million; Depreciation = $6 13 million?
million; Interest expense = $4 million; Investment in
fixed assets = $12 million; Investment in working capital = $4 million. The corporate tax rate is 25 percent.
Calculate the free cash flow (FCF) for year 1.
$4 million
$13 million
$8 million
$6 million
23. Given are the following data for Outsource Company: $14
PV (of FCFs for years 1-3) = $35 million; PV (horizon
value) = $65 million. Suppose that the market value
of the debt = $30 million and the number of shares
outstanding = 5 million. Calculate the share price.
$6
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$13
$20
$14
24. The MFC Corporation needs to raise $200 million for $20
its mega project. The NPV of the project using all-equity financing is $40 million. If the cost of raising funds
for the project is $20 million, what is the APV of the
project?
$20 million
$160 million
$240 million
$40 million
25. A firm has a total market value of $10 million while
11.6 percent
its debt has a market value of $4 million. What is
the after-tax weighted average cost of capital if the
before-tax cost of debt is 10 percent, the cost of equity
is 15 percent, and the tax rate is 35 percent?
11.6 percent
13 percent
8.8 percent
10.4 percent
26. The following situations typically require that the
firm's financial manager or a third party value an entire business in order to make important decisions
(select all statements that are correct):
When a firm considers introducing a major new product, it has to decide what the business line is worth in
order to set a price for the product.
If firm A is about make a takeover offer for firm B, then
A's financial managers have to decide how much the
combined business A + B is worth under A's management.
The financial manager is in charge of the firm's accounting and cash management, but does not ever
value the firm itself.
When a firm issues a bond, investors must assess
8 / 13
When a firm
goes public, the
investment bank
must evaluate how
much the firm (and
it's equity) is worth
in order to set the
price.
If firm is considering the sale of
one of its divisions or a business line, it has to
decide what the division or the busi-
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how much the firm is worth in order to set the price.
When a firm goes public, the investment bank must
evaluate how much the firm (and it's equity) is worth
in order to set the price.
If firm is considering the sale of one of its divisions or
a business line, it has to decide what the division or
the business line is worth in order to negotiate with
potential buyers.
ness line is worth
in order to negotiate with potential
buyers.
If firm A is about
make a takeover
offer for firm B,
then A's financial
managers have
to decide how
much the combined business A
+ B is worth under
A's management.
27. Which of the following is NOT a step in the adjusted Calculating the afpresent value method?
ter-tax WACC
Calculating the unlevered value of the project
Calculating the value of the interest tax shield
Calculating the after-tax WACC
Y. Assessing the risk of the project
Deducting costs arising from market imperfections or
other side-effects of financing
28. In the APV framework, how would you treat side effects of financing? Select all correct statements.
Advantageous financing conditions offered by suppliers, such as zero-interest credit for limited time,
increase APV
Interest tax shields increase APV
The present value of financial distress costs, even if
hard to estimate, decreases APV
Loans made available by the government at
above-market interest rates increase NPV
Issue costs for equity required for a project decrease
APV
9 / 13
Advantageous financing conditions
offered by suppliers, such as
zero-interest credit
for limited time, increase APV
Interest tax shields
increase APV
The present value of financial distress costs, even
if hard to estimate,
decreases APV
Issue costs for eq-
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uity required for
a project decrease
APV
29. Given the following data for AAA Company: PV (of
25.42
FCFs for years 1-3) = $35 millions; PV (horizon value)
= $65 million; Value of the firm's debt = $30 million;
Number of shares outstanding = 2,754,100.Calculate
the price per share for the firm, precise to 2 digits after
the comma:
30. Given the following data: Cost of debt = rD = 0.01;
0.0368
Cost of equity = rE = 0.067; Marginal tax rate = 35%;
and the firm has 50% debt and 50% equity. Calculate
the after-tax weighted average coat of capital (WACC),
precise to four digits after the comma:
31. Given the following data: FCF year 1 = $7 million; FCF 801129477
yrear 2 = $45 million; FCF year 3 = $55 million; free
cash flow grows at a rate of 4% for year 4 and beyond.
If the weighted average cost of capital is 10%, calculate the value of the firm. Please provide your number
rounded to full dollars, no digits after the comma (in
dollars, not in millions of dollars!).
32. A firm is using $30 million in debt, $10 million in
0.1156
preferred stock and $60 million in common equity to
finance its assets. If the before tax cost of debt is 8%,
cost of preferred stock is 10% , and the cost of common equity is 15%; calculate the weighted average
cost of capital for the firm assuming a tax rate of 35%.
33. In the case of large international investments, the pro- C. I, II, III, and IV
ject might include:
I) custom-tailored project financing
II) special contracts with suppliers
III) special contracts with customers
IV) special arrangements with governments
A. I and II only
B. I, II, and III only
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C. I, II, III, and IV
D. IV only
34. True or false: discounting at the WACC assumes that True
debt is rebalanced every period to maintain a constant
ratio of debt to market value of the firm
35. True or False: the value of the firm is the PV of FCF - False
PV of horizon value
36. True or False: The WACC formula does not change
when preferred stock is included
False
37. True or false: the market value of debt is very close to True
book value of debt for healthy firms
38. True or False: Adjusted PV is equal to base-case NPV True
plus the sum of the PV of any financing side effects
39. True or False: Generally, subsidized loan decreases
the APV of a project
False
40. True or False: APV = NPV(base-case assuming all
equity financing) - NPV(financing side effects)
True
where financing
side effects =
all costs/benefits
directly resulting
from the project's
financing
41. Examples of financing side-effects that affect NPV
* interest tax
shields
* issue costs of external financing
* special financing packages offered by suppliers
or governments
* government subsidies
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* government restrictions
42. Firm AAA is financed with (market values) 200 debt 25
and 300 equity. Cost of debt is 6%, cost of equity is
12%. The corporate tax rate is 35%. Firm AAA is considering a new project that will produce the following
free cash flows:
Year 0 - 100
Year 1 40
Year 2 50
Year 3 60
Assume that this new project is of average risk for
AAA and that the firm wants to hold constant its debt
to equity ratio. The unlevered value of AAA's new project is closest to:
38
25
21
18
35
32
43. 3. Firm AAA is financed with (market values) 200 debt NOT 8.75%
and 300 equity. Cost of debt is 6%, cost of equity is
12%. The corporate tax rate is 35%. Firm AAA is considering a new project that will produce the following
free cash flows:
Year 0 - 100
Year 1 40
Year 2 50
Year 3 60
Assume that this new project is of average risk for
AAA and that the firm wants to hold constant its debt
to equity ratio. AAA's unlevered cost of capital is closest to:
9.60%
8.75%
7.10%
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7.50%
10.25%
6.40%
44. Consider the following data for Kriya Company: A
$78.1 million
constant growth rate of 4 percent is sustained forever
after year 3. The weighted average cost of capital is
10 percent. Calculate the present value of the horizon
value. (Assume that the horizon value includes the
6.24M FCF in year 4.)
$78.1 million
$90.4 million
$104 million
$75.1 million
45. If we take an MM-assumptions firm, and add taxes.
Then, lowering the debt-equity ratio of a firm can
change:
13 / 13
The cost of equity
The relative proportions of financing used by the
firm
The cost of debt
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1. Capital budgeting projects that incorporate both in- D.) I and II only
vestment and financing decision side effects can be
properly analyzed by:
I) adjusting the project's present value (APV);
II) adjusting the project's discount rate (WACC);
III) relying only on MM Propositions I and II
2. To calculate the total value of the firm (V), one should A.) market values
rely on the
of debt and equity
A) market values of debt and equity.
B) market value of debt and the book value of equity.
C) book values of debt and the market value of equity.
D) book values of debt and equity
3. One should determine the after-tax weighted average
cost of capital by
A) multiplying the weighted average after-tax cost of
debt by the weighted average cost of equity.
B) adding the weighted average before-tax cost of
debt to the weighted average cost of equity.
C) adding the weighted average after-tax cost of debt
to the weighted average cost of equity.
D) dividing the weighted average before-tax cost of
debt to the weighted average cost of equity.
C.) adding the
weighted average
after-tax cost of
debt to the weighted average cost of
equity.
4. One calculates the after-tax weighted average cost of
capital (WACC) as
A) WACC = rD (D/V) + rE (E/V); (where V = D + E).
B) WACC = rD (1 TC)(D/V) + rE (E/V); (where V = D + E).
C) WACC = rD (D/V) + rE (1 TC)(E/V); (where V = D + E).
D) WACC = (1 TC) × ( rD (D/V) + rE (E/V)); (where V = D
+ E).
B.)WACC = rD (1
TC)(D/V) + rE
(E/V); (where V =
D + E).
5. While calculating the weighted average cost of capital, C.) Market Values
which values should one use for D, E, and V?
A) Book values
B) Liquidating values
C) Market values
D) Market value of debt and book value of equity
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6. Given are the following data for Golf Corporation:
Market price/share = $12; Book value/share = $10;
Number of shares outstanding = 100 million; Market
price/bond = $800; Face value/bond = $1,000; Number of bonds outstanding = 1 million. Calculate the
proportions of debt (D/V) and equity (E/V) for Golf
Corporation that you should use for estimating its
weighted average cost of capital (WACC).
A) 40% debt and 60% equity
B) 50% debt and 50% equity
C) 45.5% debt and 54.5% equity
D) 66.7% debt and 33.3% equity
A.) Use market values (in
millions): E =
(12)(100) = $1,200
D = (800)(1) =
$800 V = D + E =
$2,000
D/V = 800/2,000
= 0.4 (40%)E/V =
1,200/2,000 = 0.6
7. Given are the following data: Cost of debt = rD = 6.0%; A.) WACC =
Cost of equity = rE = 12.1%; Marginal tax rate = 21%; (0.5)(1 0.21) (6.0)
and the firm has 50% debt and 50% equity. Calculate + (0.5)(12.1) =
the after-tax weighted average cost of capital (WACC). 8.42%.
A) 8.42%
B) 7.1%
C) 9.0%
D) 5.9%
8. A firm has a total market value of $10 million while
its debt has a market value of $4 million. What is
the after-tax weighted average cost of capital if the
before-tax cost of debt is 10% , the cost of equity is
15% , and the tax rate is 21% ?
A) 13.0%
B) 12.2%
C) 8.8%
D) 10.4%
B.) WACC =
0.4(0.10)(1 0.21)
+ 0.6(0.15) =
12.16%.
9. Project M requires an initial investment of $25 million. C.) NPV = 25 +
The project is expected to generate $2.25 million in 2.25/0.09 = 0
after-tax cash flow each year forever. If the weighted
average cost of capital (WACC) is 9% , calculate the
NPV of the project.
A) 2.5 million
B) +2.5 million
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C) Zero
D) +2.1 million
10. When one uses the after-tax weighted average cost of
capital (WACC) to value a levered firm, the interest tax
shield is
A) not accounted for by the use of the WACC.
B) considered by deducting the interest payment from
the cash flows.
C) automatically considered because the after-tax
cost of debt is included within the WACC formula.
D) capitalized by the levered cost of equity
C.) automatically considered because the after-tax
cost of debt is included within the
WACC formula.
11. Given are the following data for year 1:
D.) FCF = 20 + 6 +
Profits after taxes = $20 million; Depreciation = $6 mil- (1 0.25) x 4 12 4
lion; Interest expense = $4 million; Investment in fixed = $13 million
assets = $12 million; Investment in working capital =
$4 million. The corporate tax rate is 25% . Calculate the
free cash flow (FCF) for year 1.
A) $4 million
B) $6 million
C) $8 million
D) $13 million
12. Given the following data for year 1: Profits after tax- B.) FCF = 14 + 6 +
es = $14m; Depreciation = $6m; Interest expense =
(1 0.25) x 6 12 3
$6m; Investment in fixed assets = $12m; Investment = $9.5 million
in working capital = $3m. The corporate tax rate = 25%
. Calculate the free cash flow (FCF) for year 1.
A) $4 million
B) $9.5 million
C) $6 million
D) $7 million
13. Given are the following data for year 1: Profit after
D.) FCF = 5 + 2 4
taxes = $5m; Depreciation = $2m; Investment in fixed 1 = 2
assets = $4m; Investment net working capital = $1m.
Calculate the free cash flow (FCF) for year 1.
A) $7 million
B) $3 million
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C) $11 million
D) $2 million
14. Given are the following data for Outsource Co: PV (of
FCFs for years 1-3) = $35 million; PV (horizon value) =
$65 million. Calculate the value of the firm.
A) $100 million
B) $65 million
C) $30 million
D) $170 million
A.) PV(firm) = PV
(of FCFs for years
13) + PV (horizon
value) = 35 + 65 =
100.
15. Given are the following data for Outsource Company: B.) PV(firm) = PV
PV (of FCFs for years 1-3) = $35 million; PV (horizon (of FCFs for years
value) = $65 million. Suppose that the market value of 13) + PV (horizon
the debt = $30 million. Calculate the total market value value) = 35 + 65 =
of equity of the firm.
100.
A) $100 million
Total value of equiB) $70 million
ty = 100 30 = 70
C) $30 million
D) $35 million
16. Given are the following data for Outsource Company: B.) PV(firm) = PV
PV (of FCFs for years 1-3) = $35 million; PV (horizon (of FCFs for years
value) = $65 million. Suppose that the market value 13) + PV (horizon
of the debt = $30 million and the number of shares
value) = 35 + 65 =
outstanding = 5 million. Calculate the share price.
100.
A) $20
Total value of equiB) $14
ty = 100 30 = 70;
C) $13
Value per share =
D) $6
70/5 = $14
17. ) Johnston Company has a 7% cost of debt, a 50% debt A.) MM proposiratio, and a 15% cost of equity. The marginal tax rate is tion I allows: (0.5 ×
25% . What is Johnston's WACC if it were 100% equity 7) + (0.5 × 15) =
financed?
11% = rA.
A) 11%
B) 10.13%
C) 7.50%
D) 15%
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1. When the financial decisions are consistent with the False
best interests of the stockholders, then there is a
violation of the agent-principal relationship and an
agency problem exists.
2. A corporation is responsible for all the obligations
False
of the business, even if those obligations exceed the
amount the proprietor has invested in the business
3. Although unlimited liability is a major disadvantage of True
a proprietorship, liability insurance is often available
to reduce the risk of losing business and non-business assets.
4. An agency problem occurs if managers who are afraid False
of losing their jobs reject a promising but somewhat
risky project even though the project is not likely to
benefit the firm's owners.
5. An insurance company known as AIG collected fees True
and sold way more credit default swaps than it could
pay off and went bankrupt during the 2008 financial
crisis.
6. Before the 2008 financial crisis, high risk mortgage-backed securities which included sub-prime
mortgages had been given very high ratings by the
rating firms such as Moody's, Standard and Poor's,
and Fitch.
True
7. Cash inflows expected sooner result in a lower stock True
price.
8. Cash outflows expected sooner result in a lower stock True
price.
9. Company value does not depend on future cash flows, False
their timing, and their riskiness.
10.
True
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Corporations are legal entities separate from their
owners unlike proprietorships and partnerships.
11. Corporations exist separately from their owners, and True
therefore they can "live" beyond the death of their
original owners.
12. Each general partner in a partnership is only liable as False
much as funds put into the business in the first place.
13. If a managing director uses a private jet even though False
the common stockholders do not receive enough value because private jet is too costly to the corporation,
then there is no agency problem.
14. In a corporation, the board of directors look out for the True
interests of the stockholders.
15. It is less likely that a financial crisis similar to the 2008 False
may happen if the housing prices go up much more
quickly than personal income.
16. Other stakeholders whose interests are often consid- True
ered in financial decisions include employees, customers, and members of the communities in which the
firm's plants are located.
17. Publicly traded corporations can raise capital by issu- True
ing new shares of common stock to the public.
18. Stock price maximization and stockholder wealth
maximization are not the same thing.
False
19. Stockholders have limited liability for the corporation's activities.
True
20. The agency problem does not exist when the interests True
of a firm's managers (the agents) are in harmony with
those of the firm's owners (the principals).
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21. The basic financial goal of such firms is to maximize False
the prices of the firm's bonds.
22. The financial manager, and the other managers of a True
business firm, are agents for the owners of the firm.
23. The sales are the same as cash inflows because busi- False
nesses sell goods and services and always collect
cash at the time of the sale.
24. The sooner cash flows are expected to be received,
the greater the firm value, and the later those cash
flows are expected, the less the firm value.
True
25. When the degree of risk associated with future cash True
flows goes down, the stock price goes up.
26. Before and at the beginning of the 2008 Financial
True
Crisis, housing prices had been going up much more
quickly than personal income, and many people purchased houses with the sub-prime mortgages which
were packaged as the mortgage-backed securities rated highly by the rating agencies such as Moody's,
Standard and Poor's, and Fitch.
27. Cash outflows expected later result in a lower stock False
price.
28. We saw in 2008 that some very large firms such as
True
Lehman Brothers, Merrill Lynch, Bear Sterns, along
with giant government-sponsored mortgage enterprises (GSEs) Fannie Mae and Freddie Mac to name
only a few, either failed or needed huge government
bailouts.
29. While financial managers pursue the goal of wealth False
maximization for the firm's owners, they can ignore
several legal and ethical challenges influence such
as legal considerations about environmental statutes
mandating pollution control equipment, workplace
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safety standards, civil rights laws, and intellectual
property laws that regulate the use of others' ideas.
30. An agency problem occurs if managers who are afraid True
of losing their jobs reject a promising but somewhat
risky project even though the project is likely to benefit the firm's owners.
31. An insurance company known as AIG collected fees False
and sold limited numbers of credit default swaps, was
able to pay off its obligations and made profits during
the 2008 financial crisis.
32. Any event or financial decision that increases the
risk associated with receipt of expected cash flows
reduces stock price.
True
33. Cash inflows expected sooner result in a lower stock False
price.
34. Closely held corporations are private and the shares True
of these firms are not traded on organized exchanges
nor on an organized over the counter market such as
Nasdaq.
35. Corporations cannot be taxed as separate legal enti- False
ties and cannot pay their own income tax just as if they
were individuals.
36. For businesses that sell stock publicly, the financial False
manager's role is to maximize the firm's profits.
37. Larger future inflows raise the stock price
True
38. Stock price maximization and the stockholder wealth False
maximization are not the same thing.
39. Stockholders usually do not take an active role in the True
management of the business and they are represented by the board of directors.
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40. When risk increases, the stock price goes down; and True
conversely, when risk decreases, the stock price goes
up.
41. We saw in 2008 that some very large firms such as
False
Lehman Brothers, Merrill Lynch, Bear Sterns, along
with giant government-sponsored mortgage enterprises (GSEs) Fannie Mae and Freddie Mac to name
only a few, were very profitable and successful.
42. Which of the following statement is correct?
-All the answers are incorrect.
Risk increases the firm value when owners and investors are less certain about a firm's expected cash
inflows.
-Correct! When risk increases, the stock price goes
down; and conversely, when risk decreases, the stock
price goes up.
-Profit as defined in accounting is simply the difference between taxable income and expenses.
-Stockholders have unlimited liability and can lose
more than the amount they paid to buy the stock
43. Which of the following statement is correct?
-Correct! Cash inflows increase a firm's value, whereas cash outflows decrease it.
-Cash outflows expected sooner result in a higher
stock price.
-All the answers are incorrect.
When firms spend time and money to monitor and
reduce agency problems, we call these outlays of time
and money as principal benefits.
-An agency problem occurs if the managing director
buys the jet, because he calculates that the benefits
of the jet to the stockholders is greater than its cost.
44. Which of the following statement is correct?
The basic financial goal of such firms is to maximize
the prices of the firm's bonds.
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Correct! The sooner a company expects to receive
cash and the later it expects to pay out cash, the more
valuable the firm and the higher its stock price will be.
Stockholders have unlimited liability and can lose
more than the amount they paid to buy the stock.
Corporations do not have legal entities separate from
their owners like proprietorships and partnerships.
All the answers are incorrect.
45. Which of the following statement is correct?
Correct! Financial managers decide when and where
to find money sources and how much money to raise,
and decide how much money to return to the firm's
investors.
All the answers are incorrect.
In a corporation, the board of directors look out for the
interests of the bondholders.
Risk increases the firm value when owners and investors are less certain about a firm's expected cash
inflows.
The sales are the same as cash inflows because businesses sell goods and services and always collect
cash at the time of the sale.
46. Which of the following statement is incorrect?
Most of the answers are correct.
When the financial decisions are not consistent with
the best interests of the stockholders, then there is
a violation of the agent-principal relationship and an
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agency problem exists.
The sooner a company expects to receive cash and
the later it expects to pay out cash, the more valuable
the firm and the higher its stock price will be.
Correct! With financial monitoring costs such as accounting audits, the firm resources are expended to
increase agency conflicts.
The sole proprietor is responsible for any tax liability
generated by the business, and the tax rates are those
that apply to an individual.
47. Which of the following statement is incorrect?
The sooner a company expects to receive cash and
the later it expects to pay out cash, the more valuable
the firm and the higher its stock price will be.
The more certain owners and investors are about a
firm's expected cash inflows, the higher they will value
the company.
Stock price maximization and stockholder wealth
maximization are different ways of saying the same
thing.
Most of the answers are correct.
Correct Answer Risk increases the firm value when
owners and investors are less certain about a firm's
expected cash inflows.
48. Which of the following statement is incorrect?
Closely held or close corporations are owned by a
small number of stockholders and do not extend ownership opportunities to the general public.
The basic goal of the business firm is to maximize the
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wealth of the firm's owners by adding value; it is not
to maximize profits.
Most of the answers are correct.
Correct! Cash inflows expected later result in a higher
stock price.
When risk increases, the stock price goes down; and
conversely, when risk decreases, the stock price goes
up.
49. Which of the following statement is incorrect?
Any event or financial decision that increases the
risk associated with receipt of expected cash flows
reduces stock price.
The sub-prime mortgage were riskier than traditional
mortgages and the sub-prime mortgage paid a higher
interest rate.
Correct! The sales are the same as cash inflows because businesses sell goods and services and always
collect cash at the time of the sale.
If we multiply the number of shares of stock outstanding times the current market price we get the market
value of the firm's equity.
Most of the answers are correct.
50. Which of the following statement is incorrect?
Correct! A corporation is responsible for all the obligations of the business, even if those obligations exceed the amount the proprietor has invested in the
business.
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Most of the answers are correct.
The sole proprietor is responsible for all the obligations of the business, even if those obligations exceed
the amount the proprietor has invested in the business.
Financial managers act as agents for the stockholders
who are principals.
Concentrating on company value, not profits, is a better measure of financial success.
51. A corporation:
Correct! is a legal entity separate from its owners.
has its identity defined by its bylaws.
is prohibited from entering into contractual agreements.
has its existence regulated by the rules set forth in its
charter.
is ultimately controlled by its board of directors.
52. All of the following are true about corporations with
the exception of:
Correct Answer shareholders have unlimited liability
corporations are separate legal entities
shareholders pay taxes on dividend income received
from the corporation
corporations can raise capital and become large because of limited liability
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corporations have different legal
constraints depending upon the state of residence
53. An example of a principal of a firm is:
Correct! the owner
the chairman of the board
the agent
the CEO
the treasurer
54. Examples of agency problems for a corporation include all of the following except:
none of the answers is correct
a corporate country club membership for lower management
Correct! overtime hours posted by salaried management
the purchase of a corporate jet for middle managers
first-class travel by lower management
55. In a general partnership, each partner is personally
liable for:
the partnership debts that he or she created.
all personal and partnership debts incurred by any
partner, even if he or she was unaware of those debts.
his or her proportionate share of all partnership debts
regardless of which partner incurred that debt.
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the debts of the partnership up to the amount he or
she invested in the firm.
Correct Answer the total debts of the partnership,
even if he or she was unaware of those debts.
56. Larger corporate profit and cash inflows than what
had been expected usually:
have no effect on the stock price
will reduce the fluctuations of the stock price
mean a lower stock price
none of the answers is correct
Correct! mean a higher stock price
57. Profit maximization:
is the same as shareholder wealth maximization
is the best goal for any firm
Correct! may not consider future cash flows or risk
always maximizes the wealth of the owners
is the ultimate goal of a firm
58. Shareholder wealth maximization:
is usually discounted by bondholders
the same as profit maximization
is a long-run perspective used by financial managers
for internal use only
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is an accounting number
Correct! takes a long-run perspective that focuses on
the owners
59. The goal of financial management is to increase the:
future value of the firm's total equity.
dividends paid per share.
book value of equity.
number of shares outstanding.
Correct! current market value per share.
60. Todd and Cathy created a firm that is a separate legal
entity and will share ownership of that firm on a 50/50
basis. Which type of entity did they create if they have
no personal liability for the firm's debts?
General partnership
Limited partnership
Public company
Correct! Corporation
Sole proprietorship
61. Which of the following affects the value of a firm's
stock?
risk associated with cash flows
amount of cash flows
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timing on cash flows
all of the answers is correct
Correct! new product lines
62. Which of the following are effective means of aligning management goals with shareholder interests? (I.
Employee stock options, II. Threat of a takeover, III.
Management bonuses tied to performance goals, IV.
Threat of a proxy fight)
Correct! I, II, III, and IV
I, II, and III only
I, III, and IV only
I and III only
II and IV only
63. Which of the following statements is false?
Agency problems are not as pronounced in sole proprietorships.
none of the answers is correct
Each form of business has its distinct advantages and
disadvantages.
Maximization of owner (shareholder) value and societal benefits are not always consistent.
Correct! Corporate earnings are tax deductible
64. Which one of the following best matches the primary
goal of financial management?
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Increasing traffic flow within the firm's stores
Increasing the firm's liquidity
Correct! Increasing the market value of firm
Transforming fixed costs into variable costs
Increasing the dollar amount of each sale
65. Which one of the following functions should be assigned to the treasurer rather than the controller?
Data processing
Cost accounting
Tax management
Correct! Cash management
None of the answers is correct
66. Which one of the following is most apt to align management's priorities with shareholders' interests?
Increasing employee retirement benefits
Allowing a manager to decorate his or her own office
once he or she has been in that office for a period of
3 years or more
Allowing employees to retire early with full retirement
benefits
Increasing the number of paid holidays that long-term
employees are entitled to receive
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Correct! Compensating managers with shares of
stock that must be held for 3 years before the shares
can be sold
67. Which one of the following situations is most apt to
create an agency conflict?
Hiring an independent consultant to study the operating efficiency of the firm
Compensating a manager based on his or her division's net income
Selling an underproducing segment of the firm
Giving all employees a bonus if a certain level of
efficiency is maintained
Correct! Rejecting a profitable project to protect employee jobs
68. Which one of the following statements correctly applies to a sole proprietorship?
Correct! Obtaining additional equity is dependent on
the owner's personal finances.
The business entity has an unlimited life.
Debt financing is easy to arrange in the firm's name.
The owner enjoys limited liability for the firm's debts.
The ownership can easily be transferred to another
individual.
69. Which statement is correct about limited partners?
they can lose only one half of their initial investment
none of the answers is correct
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they have no tax liability
Correct! they have limited liability
they always have management control
equal to the percent of their investment
70. Will and Bill both enjoy sunshine, water, and surfboards. Thus, the two friends decided to create a business together renting surfboards, paddle boats, and
inflatable devices in California. Will and Bill will equally share in the decision making and in the profits or
losses. Which type of business did they create if they
both have full personal liability for the firm's debts?
Sole proprietorship
Correct! General partnership
Joint stock company
Limited partnership
Corporation
71. Which of the following statement is correct?
All the answers are incorrect.
Any event that increases and/or speeds up the receipt
of expected cash flows decreases stock price.
Correct! Financial managers decide when and where
to find money sources and how much money to raise,
and decide how much money to return to the firm's
investors.
Businesses cannot buy goods and services without
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cash outflows and always have to pay cash at the time
of purchase.
Marketing managers decide when and where to find
money sources and how much money to raise, and decide how much money to return to the firm's investors.
72. Which of the following statement is correct?
Increases in stock price translate to decreases in
stockholder wealth.
All the answers are incorrect.
The lower the expected cash inflows and the higher the expected cash outflows, the higher the firm's
stock price will be.
Correct Answer An agency problem occurs if the managing director buys the jet, even though he knows the
benefits to the stockholders do not justify the cost.
Company value does not depend on future cash flows,
their timing, and their riskiness.
73. Which of the following statement is correct?
Stockholders have unlimited liability for the corporation's activities.
Smaller future cash outflows lower the stock price.
Company value does not depend on future cash flows,
their timing, and their riskiness.
All the answers are incorrect.
Correct! A written contract called the articles of part-
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nership spells out the rights and responsibilities of
each partner.
74. Which of the following statement is incorrect?
Most of the answers are correct.
The non-manager workers, creditors, suppliers, customers, and members of the community where the
business is located are called stakeholders who are
people who have a "stake" in the business.
It is more likely that a financial crisis similar to the
2008 may happen if the housing prices go up much
more quickly than personal income.
Corporations are legal entities separate from their
owners unlike proprietorships and partnerships.
Correct Answer Cash outflows expected sooner result
in a higher stock price.
75. Which of the following statement is incorrect?
A controller is responsible for cost accounting, financial accounting, and information system activities.
In a corporation, the board of directors look out for the
interests of the stockholders.
Most of the answers are correct.
Correct! The government-sponsored enterprises
known as federal reserve bank and FDIC bought many
of the sub-prime mortgages and bundled them into
mortgage-backed securities.
Other stakeholders whose interests are often considered in financial decisions include employees, cus18 / 25
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tomers, and members of the communities in which the
firm's plants are located.
76. Which of the following statement is incorrect?
Corporations are legal entities separate from their
owners unlike proprietorships and partnerships.
When the financial decisions are not consistent with
the best interests of the stockholders, then there is
a violation of the agent-principal relationship and an
agency problem exists.
Cash inflows expected sooner result in a higher stock
price.
Correct Answer If a managing director uses a private
jet even though the common stockholders do not receive enough value because private jet is too costly
to the corporation, then there is no agency problem.
Most of the answers are correct.
77. Hillary Rotteneggs wishes to form a company that will
specialize in toxic waste removal and storage. Which
type of business form would be most advantageous?
A partnership due to limited liability for all its partners
A sole proprietorship due to its low cost and ease of
formation.
A partnership due to its low cost and diversification of
ownership.
Any of the above would be equally acceptable.
Correct! A corporation due to its limited liability.
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78. In a general partnership, each partner is personally
liable for:
the partnership debts that he or she created.
all personal and partnership debts incurred by any
partner, even if he or she was unaware of those debts.
his or her proportionate share of all p
partnership debts regardless of which partner incurred that debt.
Correct! the total debts of the partnership, even if he
or she was unaware of those debts.
the debts of the partnership up to the amount he or
she invested in the firm.
79. In a very large corporation, the financial planning is a
responsibility of:
Correct! treasurer
vice president of marketing
controller
financial accountant
none of the answers is correct
80. Larger corporate profit and cash inflows than what
had been expected usually:
have no effect on the stock price
will reduce the fluctuations of the stock price
mean a lower stock price
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Correct! mean a higher stock price
none of the answers is correct
81. Margie opened a used book store and is both the 100
percent owner and the store's manager. Which type of
business entity does Margie own if she is personally
liable for all the store's debts?
General partnership
Correct! Sole proprietorship
Joint stock company
Limited partnership
Corporation
82. Maria is the sole proprietor of an antique store which
she has operated at the same location for the past 16
years. The store rents the space in which it is located
but does own all of the inventory and fixtures. The
store has an outstanding loan with the local bank
but no other debt obligations. There are no specific
loan covenants or assets pledged as security for the
loan. Due to a sudden and unexpected downturn in
the economy, the store is unable to generate sufficient
funds to pay the loan payments due to the bank. Which
of the following options does the bank have to collect
the money it is owed? (I. Sell the inventory and use
the cash raised to apply to the debt, II. Sell the store
fixtures and use the cash raised to apply to the debt,
III. Take funds from Maria's personal account at the
bank to pay the store's debt, IV. Sell any assets Maria
personally owns and apply the proceeds to the store's
debt)
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I and II only
Correct! I, II, III, and IV
I, II, and III only
I only
III only
83. Marti had an unexpected surprise when she ate her
Lotsa Good cereal this morning. She found a piece of
metal mixed in her cereal. The potential claim which
Marti has against this firm is that of a(n):
general creditor.
debtholder.
Correct! stakeholder.
agent.
shareholder.
84. One of the most important disadvantages of the corporate form of business is:
Correct! double taxation
unlimited owner liability
limited owner liability
ease of transferring ownership
tax deductibility of interest expenses on debt
85.
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Profit maximization:
Correct! may not consider future cash flows or risk
always maximizes the wealth of the owners
is the ultimate goal of a firm
is the same as shareholder wealth maximization
is the best goal for any firm
86. Read this statement: The primary goal of the business
firm is to maximize the wealth of the firm's owners. For
a corporation, this statement means that managers
should focus on maximizing the wealth of its shareholders or its:
Correct! stock price
sales revenue
profits
minimize the risk
net income
87. Shareholder wealth maximization:
the same as profit maximization
Correct! takes a long-run perspective that focuses on
the owners
is usually discounted by bondholders
is a long-run perspective used by financial managers
for internal use only
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is an accounting number
88. Stakeholders include which of the following?
suppliers
creditors
employees
Correct! all of the above
owners
89. Which of the following are effective means of aligning management goals with shareholder interests? (I.
Employee stock options, II. Threat of a takeover, III.
Management bonuses tied to performance goals, IV.
Threat of a proxy fight)
I and III only
II and IV only
Correct! I, II, III, and IV
I, II, and III only
I, III, and IV only
90. Which one of those factors affect the decision making
process of financial managers?
environmental laws
Correct! all of these factors affect the decisions
workplace safety laws
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intellectual property laws
civil rights
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1. 1. The Financial Management Decision Process Capital budgeting (decid[LO1] What are the three types of nancial man- ing whether to expand
agement decisions? For each type of decision, a manufacturing plant),
give an example of a business transaction that capital structure (decidwould be relevant.
ing whether to issue
new equity and use the
proceeds to retire outstanding debt), and working capital management
(modifying the firm's credit collection policy with its
customers).
2. Sole Proprietorships and Partnerships [LO3]
What are the four primary disadvantages of the
sole proprietorship and partnership forms of
business organization? What benets are there
to these types of business organization as opposed to the corporate form?
Disadvantages: unlimited
liability, limited life, difficulty in transferring ownership, hard to raise capital funds. Some advantages: simpler, less regulation, the owners are
also the managers, sometimes personal tax rates
are better than corporate
tax rates.
3. Corporations [LO3] What is the primary disadvantage of the corporate form of organization?
Name at least two advantages of corporate organization.
The primary disadvantage of the corporate
form is the double taxation to shareholders of
distributed earnings and
dividends. Some advantages include: limited liability, ease of transferability, ability to raise capital,
and unlimited life.
4. Sarbanes-Oxley [LO4] In response to the Sar- In response to Sarbanes-Oxley Act, many small rms in the Unit- banes-Oxley, small firms
ed States have opted to "go dark" and delist have elected to go dark
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their stock. Why might a company choose this because of the costs of
route? What are the costs of "going dark"?
compliance. The costs to
comply with Sarbox can
be several million dollars,
which can be a large percentage of a small firms
profits. A major cost of
going dark is less access to capital. Since the
firm is no longer publicly
traded, it can no longer
raise money in the public market. Although the
company will still have access to bank loans and
the private equity market, the costs associated
with raising funds in these
markets are usually higher than the costs of raising
funds in the public market.
5. Corporate Finance Organization [LO4] In a
large corporation, what are the two distinct
groups that report to the chief nancial ofcer?
Which group is the focus of corporate nance?
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The treasurer's office
and the controller's office are the two primary organizational groups
that report directly to
the chief financial officer. The controller's office handles cost and financial accounting, tax
management, and management information systems, while the treasurer's office is responsible
for cash and credit management, capital budgeting, and financial plan-
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ning. Therefore, the study
of corporate finance is
concentrated within the
treasury group's functions.
6. Goal of Financial Management [LO2] What goal To maximize the curshould always motivate the actions of a rm's rent market value (share
nancial manager?
price) of the equity of
the firm (whether it's publicly-traded or not).
7. Agency Problems [LO4] Who owns a corpora- In the corporate form of
tion? Describe the process whereby the owners ownership, the shareholdcontrol the rm's management. What is the main ers are In the owners
reason that an agency relationship exists in the of the firm. The sharecorporate form of organization? In this context, holders elect the direcwhat kinds of problems can arise?
tors of the corporation,
who in turn appoint the
firm's management. This
separation of ownership
from control in the corporate form of organization
is what causes agency
problems to exist. Management may act in its
own or someone else's
best interests, rather than
those of the shareholders.
If such events occur, they
may contradict the goal
of maximizing the share
price of the equity of the
firm.
8. Primary versus Secondary Markets [LO3]
A primary market transacYou've probably noticed coverage in the nan- tion.
cial press of an initial public offering (IPO) of a
company's securities. Is an IPO a primary mar3 / 12
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ket transaction or a secondary market transaction?
9. Auction versus Dealer Markets [LO3] What
does it mean when we say the New York Stock
Exchange is an auction market? How are auction markets different from dealer markets?
What kind of market is NASDAQ?
In auction markets like
the NYSE, brokers and
agents meet at a physical
location (the exchange) to
match buyers and sellers of assets. Dealer markets like NASDAQ consist of dealers operating at dispersed locales
who buy and sell assets
themselves, communicating with other dealers either electronically or literally over-the-counter.
10. Not-for-Prot Firm Goals [LO2] Suppose you
were the nancial manager of a not-for-prot business (a not-for-prot hospital, perhaps). What
kinds of goals do you think would be appropriate?
Such organizations frequently pursue social
or political missions, so
many different goals are
conceivable. One goal
that is often cited is revenue minimization; i.e.,
provide whatever goods
and services are offered
at the lowest possible
cost to society. A better approach might be
to observe that even
a not-for-profit business
has equity. Thus, one answer is that the appropriate goal is to maximize
the value of the equity
11. Goal of the Firm [LO2] Evaluate the following Presumably, the current
statement: Managers should not focus on the stock value reflects the
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current stock value because doing so will lead risk, timing, and magnito an overemphasis on short-term prots at the tude of all future cash
expense of long-term prots.
flows, both short-term
and long-term. If this is
correct, then the statement is false
12. Ethics and Firm Goals [LO2] Can our goal of
maximizing the value of the stock conict with
other goals, such as avoiding unethical or illegal behavior? In particular, do you think subjects like customer and employee safety, the environment, and the general good of society t in
this framework, or are they essentially ignored?
Think of some specic scenarios to illustrate
your answer.
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An argument can be
made either way. At the
one extreme, we could argue that in a market economy, all of these things
are priced. There is thus
an optimal level of, for example, ethical and/or illegal behavior, and the
framework of stock valuation explicitly includes
these. At the other extreme, we could argue
that these are non-economic phenomena and
are best handled through
the political process. A
classic (and highly relevant) thought question
that illustrates this debate
goes something like this:
"A firm has estimated that
the cost of improving the
safety of one of its products is $30 million. However, the firm believes that
improving the safety of
the product will only save
$20 million in product liability claims. What should
the firm do?"
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13. International Firm Goal [LO2] Would our goal of
maximizing the value of the stock be different if
we were thinking about nancial management in
a foreign country? Why or why not?
The goal will be the same,
but the best course of
action toward that goal
may be different because
of differing social, political, and economic institutions.
14. Agency Problems [LO4] Suppose you own
stock in a company. The current price per share
is $25. Another company has just announced
that it wants to buy your company and will
pay $35 per share to acquire all the outstanding stock. Your company's management immediately begins ghting off this hostile bid. Is
management acting in the shareholders' best
interests? Why or why not?
The goal of management
should be to maximize the
share price for the current
shareholders. If management believes that it can
improve the profitability of
the firm so that the share
price will exceed $35,
then they should fight
the offer from the outside company. If management believes that this
bidder or other unidentified bidders will actually
pay more than $35 per
share to acquire the company, then they should
still fight the offer. However, if the current management cannot increase
the value of the firm beyond the bid price, and no
other higher bids come in,
then management is not
acting in the interests of
the shareholders by fighting the offer. Since current
managers often lose their
jobs when the corporation
is acquired, poorly monitored managers have an
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incentive to fight corporate takeovers in situations such as this.
15. Agency Problems and Corporate Ownership We would expect agency
[LO4] Corporate ownership varies around the problems to be less seworld. Historically individuals have owned the vere in countries with a
majority of shares in public corporations in the relatively small percentUnited States. In Germany and Japan, however, age of individual ownbanks, other large nancial institutions, and oth- ership. Fewer individual
er companies own most of the stock in public owners should reduce
corporations. Do you think agency problems the number of diverse
are likely to be more or less severe in Germany opinions concerning corand Japan than in the United States? Why?
porate goals. The high
In recent years, large nancial institutions such percentage of institutionas mutual funds and pension funds have been al ownership might lead
becoming the dominant owners of stock in the to a higher degree of
United States, and these institutions are beagreement between owncoming more active in corporate affairs. What ers and managers on deare the implications of this trend for agency
cisions concerning risky
problems and corporate control?
projects. In addition, institutions may be better able
to implement effective
monitoring mechanisms
on managers than can
individual owners, based
on the institutions' deeper resources and experiences with their own management. The increase in
institutional ownership of
stock in the United States
and the growing activism
of these large shareholder groups may lead to a
reduction in agency problems for U.S. corporations
and a more efficient market for corporate control.
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16. Executive Compensation [LO3] Critics have
charged that compensation to top managers
in the United States is simply too high and
should be cut back. For example, focusing on
large corporations, Ray Irani of Occidental Petroleum has been one of the best-compensated CEOs in the United States, earning about
$54.4 million in 2007 alone and $550 million
over the 2003-2007 period. Are such amounts
excessive? In answering, it might be helpful to
recognize that superstar athletes such as Tiger
Woods, top entertainers such as Tom Hanks
and Oprah Winfrey, and many others at the top
of their respective elds earn at least as much, if
not a great deal more.
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How much is too much?
Who is worth more, Ray
Irani or Tiger Woods? The
simplest answer is that
there is a market for executives just as there is
for all types of labor. Executive compensation is
the price that clears the
market. The same is true
for athletes and performers. Having said that, one
aspect of executive compensation deserves comment. A primary reason
executive compensation
has grown so dramatically is that companies
have increasingly moved
to stock-based compensation. Such movement
is obviously consistent
with the attempt to better align stockholder and
management interests. In
recent years, stock prices
have soared, so management has cleaned up.
It is sometimes argued
that much of this reward
is simply due to rising
stock prices in general, not managerial performance. Perhaps in the future, executive compensation will be designed
to reward only differential
performance, i.e., stock
price increases in ex-
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cess of general market increases
17. What does liquidity measure? Explain the
Liquidity measures how
trade-off a rm faces between high liquidity and quickly and easily an aslow liquidity levels.
set can be converted to
cash without significant
loss in value. It's desirable
for firms to have high liquidity so that they have
a large factor of safety in meeting short-term
creditor demands. However, since liquidity also
has an opportunity cost
associated with it—namely that higher returns can
generally be found by investing the cash into productive assets—low liquidity levels are also desirable to the firm. It's
up to the firm's financial management staff to
find a reasonable compromise between these
opposing needs.
18. Why might the revenue and cost gures shown
on a standard income statement not be representative of the actual cash inows and outows
that occurred during a period?
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The recognition and
matching principles in financial accounting call for
revenues, and the costs
associated with producing those revenues, to be
"booked" when the revenue process is essentially complete, not necessarily when the cash
is collected or bills are
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paid. Note that this way
is not necessarily correct;
it's the way accountants
have chosen to do it.
19. In preparing a balance sheet, why do you think Historical costs can be
standard accounting practice focuses on his- objectively and precisely
torical cost rather than market value?
measured whereas market values can be difficult
to estimate, and different analysts would come
up with different numbers.
Thus, there is a tradeoff
between relevance (market values) and objectivity
(book values).
20. In comparing accounting net income and oper- Depreciation is a
ating cash ow, name two items you typically nd non-cash deduction that
in net income that are not in operating cash ow. reflects adjustments
Explain what each is and why it is excluded in made in asset book valoperating cash ow.
ues in accordance with
the matching principle in
financial accounting. Interest expense is a cash
outlay, but it's a financing cost, not an operating
cost.
21. Under standard accounting rules, it is possible
for a company's liabilities to exceed its assets.
When this occurs, the owners' equity is negative. Can this happen with market values? Why
or why not?
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Market values can never be negative. Imagine
a share of stock selling
for -$20. This would mean
that if you placed an order for 100 shares, you
would get the stock along
with a check for $2,000.
How many shares do you
want to buy? More gener-
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ally, because of corporate
and individual bankruptcy
laws, net worth for a person or a corporation cannot be negative, implying
that liabilities cannot exceed assets in market value.
22. Suppose a company's cash ow from assets is For a successful companegative for a particular period. Is this neces- ny that is rapidly expandsarily a good sign or a bad sign?
ing, for example, capital
outlays will be large, possibly leading to negative
cash flow from assets.
In general, what matters
is whether the money is
spent wisely, not whether
cash flow from assets is
positive or negative.
23. Suppose a company's operating cash ow has It's probably not a good
been negative for several years running. Is this sign for an established
necessarily a good sign or a bad sign?
company, but it would
be fairly ordinary for a
start-up, so it depends.
24. Could a company's change in NWC be negative in a given year? ( Hint: Yes.) Explain how
this might come about. What about net capital
spending?
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For example, if a company were to become more
efficient in inventory management, the amount of
inventory needed would
decline. The same might
be true if it becomes better at collecting its receivables. In general, anything that leads to a decline in ending NWC relative to beginning would
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have this effect. Negative net capital spending would mean more
long-lived assets were liquidated than purchased.
25. Could a company's cash ow to stockholders be
negative in a given year? ( Hint: Yes.) Explain
how this might come about. What about cash
ow to creditors?
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If a company raises more
money from selling stock
than it pays in dividends
in a particular period, its
cash flow to stockholders
will be negative. If a company borrows more than it
pays in interest, its cash
flow to creditors will be
negative.
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1. At its most basic CORPORATIONS GENERALLY IS ABOUT HUMAN RElevel, what is cor- LATIONSHIPS IN THE BUSINESS CONTEXT
porations about?
2. What is a corpo- A corporation is a legal entity that can own property, enter
ration?
into contracts, sue and be sued. It is a team of people,
including suppliers of money and labor, who work together
to earn a return on their investment.
3. 2 Types of Corpo- A) Closed Corporation ’ Held by a small group of people
rations
and not publicly traded. Stockholders consist of founders
and key investors; not publicly traded; individuals act as s/h
and assume the position of directors and officers typically.
(usually, a closed corporation operates like a partnership).
B) Publicly Traded Corporation ’ Shares are publicly traded.
Any given company or person can have any number of
shares.
4. Characteristics A) Separate Entity
of a Corporation B) Perpetual Existence
(short)
C) Limited Liability
D) Centralized Management
E) Transferability of Ownership Interests
5. Corporation
Statutes
i) Model Business Corporation Act (MBCA) ’ Not a real
statute that has been enacted by a legislature. Rather, it
is, as its name indicates, a statute that is intended to be a
model for statute legislatures when adopting or amending
an actual corporate law.
ii) Delaware General Corporation Law (DGCL) ’
6. Organic Documents
A) Articles of Incorporation ’ Every statute requires that
each corporation have its own articles of incorporation
(sometimes called the charter or the certificate of incorporation), which must be filed with state officials and which
represents the "constitution" of that corporation
B) Bylaws ’ Every corporation also has bylaws, which
usually set forth the details of the corporation's internal
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governance arrangements, such as procedures for calling
and holding meetings.
7. Corporate Actors A) Stockholders (or shareholders
B) Board of Directors acts for the corporation
C) Other corporate actors are "stakeholders," including
creditors, employees, customers, and the community,
8. Corporate Secu- A) Corporations raise money by issuing securities to their
rities
investors. There are two types of securities: debt and equity
B) A corporations articles of incorporation specify how
many shares of common stock and preferred stock the
corporation is authorized to issue
9. Equity securities Equity securities consist of common stock and preferred
stock
10. Common stock
1) Common stock assumes the greatest risk of the success or failure of the corporate and has the greatest expected return
a) Holders of common stock have a residual claim to the
corporation's income and assets
b) Common stockholders can receive payment through
dividends, cash payments which the corporation may
make at the discretion of the board of directors
c) In a public corporation, common stockholders typically
are entitled to vote and can play a greater role in the
corporation than the holders of other types of securities,
but that role is not as great a role as that played by the
managers
d) If the corporation becomes insolvent, common stockholders are paid last, and in many cases, will receive
nothing
11. Preferred stock
2) Preferred stock sits between common stock and debt
a) It is less risk than common stock but more risk than debt
b) Typically, preferred stockholders will receive a fixed
dividend payment although the declaration of a preferred
stock dividend is also at the discretion of the board of
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directors
c) The most common forms of preference are the right
of the preferred stockholders to receive a dividend before
any dividends are paid to the holders of common stock
and the right to receive distributions in liquidation before
any distributions are made to the common stock.
12. Debt Securities
ii) Debt Securities generally are the least risky and have
the lowest expected return.
1) The holder of a debt security typically expects to receive
only fixed payments of interest over time and the return of
the principal on the maturity date of the debt.
2) Even if the corporation does well, the holder of the debt
security only receives a fixed payment
3) If the corporation becomes insolvent, and its assets
must be liquidated, debt securities will have priority over
equity securities
4) Debt securities can be secured or unsecured and are
called bonds, debentures, or notes
13. Issuance of
shares ...
B) A corporations articles of incorporation specify how
many shares of common stock and preferred stock the
corporation is authorized to issue
i) The portion of the authorized stock that has been sold
and remains in the hands of stockholders is outstanding
stock
ii) A corporation's board of directors generally may sell authorized but unissued stock on whatever terms it decides
reasonable
14. Corporate
Choice of Law
A) No requirement that a corporation incorporate in the
state of its principal place of business, it can incorporate
under the laws of whatever state best suits its needs
B) Internal Affairs Doctrine ’ Means that the relationship
between shareholders and managers (directors and officers), will be governed by the corporate statutes and case
law of the state where the corporation is incorporated
C) External affairs of a corporation are generally governed
by the law of the place where the activities occur and by
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federal and state regulatory statutes rather than by the
place of incorporation
’’ 1) Labor laws that govern employees; environmental law;
etc.
15. Internal Affairs
Doctrine
Means that the relationship between shareholders and
managers (directors and officers), will be governed by the
corporate statutes and case law of the state where the
corporation is incorporated
i) The relationship among what are described as directors,
(the officers whom have the day-to-day operations), the
shareholders and employees—what their rights are with
one another
’’ 1) What are the voting rights that s/s are able to exercise?
’’ 2) To get information from management
’’ 3) Ability to have influence as to who is put on the ballet
as a nominee
ii) The idea of the internal affairs doctrine is that we need
at least some core that is predictable so we can know if
managers need to be elected by a majority or a plurality McDermott Inc. v. Lewis
16. External Affairs
i) External affairs of a corporation are generally governed
by the law of the place where the activities occur and by
federal and state regulatory statutes rather than by the
place of incorporation
’’ 1) Labor laws that govern employees; environmental law;
etc.
17. Fiduciary Duties A) The duty to provide the faith and confidence and the
duty of care, loyalty and obedience
B) Business Judgment Rule
C) Enforcing a claim
’’ i) Shareholders are not authorized to act directly for the
corporation, and thus cannot enforce a corporate claim
against the managers
18. The duty to pro- i) Directors, officers and controlling shareholders owe a
vide the faith and fiduciary duty to the corporation; and through the corporaconfidence and tion to the shareholders
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the duty of care, ii) Duty of care requires a director to act in the corporations
loyalty and obe- best interest and to exercise reasonable care in overdience ...
seeing the corporations affairs and in making business
decisions
iii) Corporate managers who breach their fiduciary duties
can be held personally liable for any losses they cause the
corporation
19. Business Judgment Rule
i) In order to encourage directors to take risks on behalf
of the corporation w/out fear of personal liability for any
losses which may ensue, courts have developed this rule
ii) Under this rule, courts will defer to the judgment of the
board of directors, absent highly unusual circumstances,
such as conflict of interest or gross inattention
’ a) Gross negligence is the standard for board of directors
iii) BJR creates a presumption that, "in making a business
decision, the directors of a corporation acted on an informed basis, in good faith, and in the honest belief that
the action was taken in the best interest of the company
’ a) Unless the P can rebut the presumption, a court will
evaluate the substantive merits of the action
’ b) To rebut the presumption, P must show ...
’’’ 1) Was not informed;
’’’ 2) Was not made in good faith;
’’’ 3) Did not have a rational business purpose (i.e., constituted a waste of corporate assets);
’’’’’’ A) Waste only is "what the corporation has received is
so inadequate in value that no person of ordinary, sound
business judgment would deem it worth that which the
corporation has paid"
’’’ 4) Was made by a director or directors w/ a personal
interest in the decision; or
’’’ 5) Was made by a director or directors who otherwise
were not independent
’ c) Informed and rational basis = duty of care
’ d) Disinterested and independent (has two methods of
analysis = duty of loyalty
’’’ 1) Are there members who are interested?
’’’ 2) If yes ’ Are all other directors independent of that
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interested party?
iv) Structurally, the BJR implements the basic corporate
attribute of centralized management by insulating the
board's decision-making prerogatives from shareholder
and judicial second-guessing
20. Enforcing a claim i) Shareholders are not authorized to act directly for the
for breach of
corporation, and thus cannot enforce a corporate claim
fiduciary duty ... against the managers
ii) The derivative suit was developed to alleviate this problem
’’ a) It is an action in equity brought by a shareholder on
behalf of the corporation
’’ b) Action is brought against the corporation for failure to
bring an action in law against some third party, most often
an alleged careless or unfaithful manager, who is also a
defendant in the suit
’’’’ 1) The corporation (the real party at interest) is a nominal defendant and the plaintiff-shareholder (in reality, her
attorney), controls prosecution of the suit
’’ c) Any recovery, either through judgment or settlement,
belongs to the corporation for whose benefits the suit has
been brought
21. Rights of the Corporation under
the First Amendment
A) Corporations may not use treasury funds as expenditures to support political candidates
B) Instead, they need to set up Political Action Committees
(PAC) & raise revenues separately and can support that
way
C) Rationale is that if a corporation used its own treasury
funds then s/h who produce revenue for the corporation
could be supporting a politician they don't support. By
setting up a PAC only those who support the politician can
give money
D) Also, corporations are not natural personas
22. Humanitarian Ef- A) A business corporation is organized and carried on
forts by Corpora- primarily for the profits of the shareholders
tion
i) Corporation can act humanitarianly if that humanitarian
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effect is a secondary effect or purpose that comes after the
primary purpose of creating a profit or long-term benefits
of the company
B) Corporations should do a human rights due diligence
analysis to examine risks of violations of human rights
23. Who is your
client?
i) If you are representing the corporation, then the corporation is your client, not any of the individual directors,
officers or shareholders
ii) When looking to who can speak on behalf of the corporation you look to the chain of command
24. California
i) California holds the view that if the most important
Approach—Pseu- interest in the company are operated in California—if 50
do Foreign
percent of the company is run in the state—then California
Affairs (to
state law will apply
internal affairs)
25. Characteristics
of a General
Partnership
i) Association of two or more people
ii) Formed by partnership agreement
iii) At-will or definite period
’’ a) At-will dissolved by any partner withdrawal
iv) Each partner has an equal voice
v) Personal liability
vi) Majority decision making
26. Characteristics
of a Limited
Partnership
i) Partnership w/ general & limited partners
’’ a) General partners have comparable liability to the liability they have in a general partnership, but a limited partners
liability is limited to the capital she has contributed to the
partnership
’’ b) Limited partners have no voice in the active management of the partnership
ii) Formed by partnership agreement and filing certificate
with the state
iii) General partners manage and have personal liability
iv) Limited partners are passive investors and have no
personal liability
v) Dissolved by withdrawal of a general partner
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27. Characteristics i) Legal entity separate from shareholders
of a Corporation ’’ a) The corporation pays taxes, not individuals
ii) Formed by filing articles of incorporation with the state
iii) Perpetual life
iv) Board of directors manage
v) Common shareholders elect board and vote on major
matters
vi) No shareholder liability
vii) Majority vote by directors and shareholders
28. Characteristics
of a Limited
Liability
Company
i) Legal entity distinct from members
ii) Formed by operating agreement and filing articles of
organization
iii) Perpetual life
iv) Default: Member-managed
v) Manager-managed: managers act for LLC; members
vote on major matters
vi) No member liability
vii) Can elect tax treatment as partnership
a) Partnership is not a taxpaying entity. Partnership income and expenses are said to "flow/pass through" to the
partners in proportion to their ownership interests
29. Accounting & Fi- ASSETS = LIABILITIES + EQUITY
nancial Reporting - Fundamental equation of financial accounting ...
30. Accounting & Financial Reporting - Assets generally
Assets include entries representing the property, both tangible and intangible, owned by the firm. Can have current
assets, fixed assets, and intangible assets
’’ a) Assets are values at what is called their "historical
cost," which is what the company paid for them, not what
they are currently worth
31. Accounting & Fi- Include cash and other assets which in the normal course
nancial Report- of business will be converted into cash in the reasonably
near future
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ing - Current as- 1) Cash = money in the till and money in demand deposits
sets ’
in the bank
2) Marketable Securities = securities that can be readily
sold and converted into cash and are not held for current
operations
3) Accounts Receivable = amounts not yet collected from
customers to whom goods have been shipped or services
delivered
4) Notes or Loans Receivable = somewhat analogous
to accounts receivable. Usually represents a very large
portion of the assets of firms engaged in financing businesses
5) Inventory = goods held for use in production or for
sale to customers (average cost method; first in, first out
method; last in, last out method)
6) Prepaid Expenses = payments a firm has made in
advance for services it has not yet received
7) Deferred Charges = type of asset similar to prepaid expenses, in that they reflect payments made in the current
period for goods or services that will generate income in
subsequent periods
32. Accounting & Financial Reporting - Assets - Inventory methods
Inventory = goods held for use in production or for sale to
customers
A) Average Cost Method ’ visualizes inventory as sold at
random from a bin
B) First in, first out Method ’ visualizes inventory as flowing
through a pipeline
C) Last in, last out Method ’ visualizes inventory as being
added to and sold from the top of the stack
33. Accounting & Financial Reporting - Fixed Assets ’
Sometimes referred to as long-term assets or as property
plant and equipment, are assets a firm uses to conduct its
operations
’ 1) Land, equipment, machinery, office equipment
’ 2) Balance sheet value (or book value) = Cost less allowance for depreciation
34.
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Accounting & Financial Reporting - Intangible
Assets ’
Such as patents or trademarks—have no physical existence, but often have substantial value
’ 1) GAAP requires firms to carry intangible assets they
have purchased at cost less an allowance for amortization
(the equivalent of depreciation, applied to intangibles)
35. Accounting & Fi- Liabilities account for the accounts that firms owe to othnancial Report- ers, whether pursuant to written evidence of indebtness or
ing - Liabilities
otherwise
’ a) Current liabilities ’ Debt the firm owes that must be paid
within one year of the balance sheet date
’ b) Long-term liabilities ’ Debts due more than one year
from the balance sheet date
36. Accounting & Fi- Equity (sometimes referred to as net worth) represents the
nancial Report- accounting value of the interests of the firm's owners
ing - Equity
a) Appears on the right side of the balance sheet b/c it
may be considered as the amount that is "owed" to the
stockholders
37. Accounting & Financial Reporting - Financial statements
are produced
through a 3-stage
process
i) First ’ "Recording and controls" stage
’’ a) Company records in its books information concerning
every transaction in which it's involved
ii) Second ’ "Accounting stage"
’’ a) Company classifies and analyzes the information and
presents it in a set of financial statements
iii) Third ’ "Audit stage"
’’ a) Company, usually with the assistance of independent
public accountants, verifies the information it has recorded
and the manner in which it has presented the financial
accounting
38. Accounting & Financial Reporting - Bookkeeping
i) Every transaction which a company is involved is included in the company's leger
ii) Bookkeeping works within following three categories ...
’’ a) Internal Auditor
’’ b) Outside Auditors
’’ c) Audit Board Committee
39.
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Accounting & Financial Reporting - Bookkeeping works within following three
categories ...
a) Internal Auditor ’ first line of defense against financial
fraud
’’ 1) GAAP (Generally Accepted Accounting Principals):
’’’’ A) Gives companies the general guidelines and requirements of how to do your financial statement, i.e., things
that you have to do when making these reports
b) Outside Auditors ’ look at how things are recorded and
for irregularities
’’ 1) If they find no irregularities they offer a "clean" opinion
that it represents fairly in all material aspects
’’ 2) Note that these outside auditors are hired by management are in a position that their performance will decide
whether they are hired next year and so on, creating its
own issues
c) Audit Board Committee ’ Job is to make sure that the
companies financial statement is accurate and not misleading
’’ 1) CEO and CFO must personally certify that the financial
statements are in fact accurate
40. Accounting & Financial Reporting - Retained
Earnings
A) The cumulative amount the company has retained from
its products
B) Represents the difference/surplus between revenues
and cost
’’ i) Revenue - Cost = Income
’’ ii) Income - Dividends = Retained earnings
’’ iii) Paid in equity + retained earnings = Total Equity
41. Accounting & Financial Reporting - Retained
Earnings - Ratio's
i) Investors look at financial statements in different ways,
such as ...
’’ a) *Current ratio = Current Assets / Current Liabilities*
’’’’ 1) Analysts typically like a 2:1 ratio, this suggests you have
enough cushion to pay your bills as they become due
’’ b) *Debt/Equity Ratio = Long-term Debt / Total Equity*
’’’’ 1) Here, analysts typically like a 1:1 ratio, suggesting you
have as much equity as you owe debt
42. Accounting & Fi- A) Within a fiscal year the money that a company earns
nancial Report- and the expenses it incurs and the result is the net income
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ing - Income
Statement
or net profit, and at the end of the fiscal year the net income
is carried over to the total equity line on the balance sheet
B) Revenues and expenses are recorded on an accrued
basis rather than a cash basis
i) Accrual method says that what we want to do is determine when you are entitled to receive revenue and when
we want to record that during that period
ii) Underlying rationale is that you want to match up the
cost and revenue so you can match up how profitable or
well the company is doing
43. Accounting & Financial Reporting - Statement of
Cash Flow
A) Something to reconcile the fact that on the one hand
you're using the accrual method to reconcile costs and on
the other hand you need to know where you are in terms
of cash flow
B) Cash flow just makes certain type of adjustments as to
which components of the statement reflect where cash is
going in and going out
C) Most important is cash flow from operating activities
i) If you have a good cash flow from operating activities
you have a health business
ii) If you have a good cash flow from investing and you're
not an investing company that can be odd & sometimes it
could be from debt
44. Equity Securities i) Represents permanent commitments of capital to a
corporation by which the contributor is given shares in the
corporation in the type of share that the corporation is
authorized to issue
’’ a) Articles of incorporation will create authorized shares
’’ b) Until shares are first sold to stockholders they are
authorized, but unissued
’’ c) When sold, they are authorized and issued or authorized and outstanding
’’ d) If they are repurchased by the corporation they become
authorized and issued, but not outstanding
45. Process of issu- Before a corporation that has issued all the shares authoing more shares rized by the articles of incorporation can issue more stock,
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it must amend the articles of incorporation to authorize
additional shares
’’ a) Board of directors must recommend the amendment,
which must then be approved by the holders of at least a
majority of its outstanding stock
’’ b) Shareholders, particularly in closely held corporations,
may be reluctant to approve a board resolution to issue
more shares out of the fear that those additional shares
will dilute their voting power
’’’’ 1) Dilution ’ Reduction in the economic return of your
shares and the voting power and control you can exert by
owning those shares
46. Common stock ’ The most basic of all corporate securities ...
1) Dividends
2) Capital Gains
3) Elect Directors
4) Vote on major transactions
5) Vote to amend to Articles
6) Amend the Bylaws
47. Warrant
Warrant gives the creditor the option to buy the stock by
a particular time, for a particular price, and when this is
exercise the corporation has to issue additional stock to
cover the obligation
48. DEBT SECURITIES
i) A bond is a loan to the company for a fixed period of time
’’ a) There is a maturity date where you have to pay back to
the principal and there is always annual interest
ii) Bond is a K that is governed by the terms and the K and
the terms are set forth in what is called an Indenture
’’ a) Indenture sets out the companies full obligations to the
creditors, the company has no fiduciary duty to creditors,
their entire obligation and relationship is set forth in the K
49. In order to
pierce the corporate veil, a P must
prove ...
(1) The owner has exercised such control that the corporation has become a mere instrumentality of the owner,
which is the real actor; (domination)
’’ i) Factors ...
’’’’ (1) Disregard of corporate formalities;
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’’’’ (2) Inadequate capitalization (big one);
’’’’ (3) Intermingling of funds;
’’’’ (4) Overlap in ownership, officers, directors, and personnel;
’’’’ (5) Common office space, address, and telephone numbers of corporate entities;
’’’’ (6) The degree of discretion shown by the allegedly dominant corporation;
’’’’ (7) Whether the dealing between the entities are at arms
length;
’’’’ (8) Whether the corporations are treated as independent
profit centers (big one);
’’’’ (9) Payment of guarantee of the corporation's debt by the
dominating entity; and
’’’’ (10) Intermingling of property between entities
’’ ii) No one factor is decisive
(2) Such control has been used to commit a fraud or other
wrong; and
(3) The fraud or wrong results in an unjust loss or injury to
the P
50. Piercing the Corporate Veil general overview -- advantages, etc.
1) A principal advantage of the corporate form is that a
shareholders potential loss is limited to the amount that
she invested in the enterprise.
A) This limited liability means that a corporation's creditors
can look only to the corporation's assets for payment for
their claims
B) The typical test of unfairness is that the entity has been
undercapitalized, where a corporation will be using the
corporate form only to avoid liability
C) The purpose of the doctrine of piercing the corporate
veil is to prevent an independent corporation from being
used to defeat the ends of justice ... to perpetuate fraud,
to accomplish a crime, or otherwise to evade the law
51. Piercing the Cor- A) Courts make the distinction between contract creditors
porate Veil -and tort creditors
Tort Creditors vs. B) With contract creditors, plaintiffs will have had every
opportunity to get personal guarantees in the contracts,
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Contract Creditors
or to protect themselves in the event that funds were not
available; whereas, with a tort, it kind of just happens and
you can't prepare for it
’’ i) Court's won't usually impose this strict approach on contract creditors, but they may do it for financial institutions
or lenders
52. Piercing the Corporate Veil -- Equitable Ownership of the Corporation
A) An individual who exercised sufficient control over the
corporation may be deemed to be an "equitable owner,"
notwithstanding the fact that the individual is not a shareholder of the corporation
’’ i) A non-shareholder defendant may be, "in reality" the
equitable owner of a corporation where the non-shareholder defendant "exercises considerable authority over
the corporation to the point of completely disregarding the
corporate form and acting as though its assets are his
alone to manage and control"
53. Piercing the
Corporate Veil
-- Parent-Subsidiary Corporation
A) *Alter Ego Doctrine* ’ Allows the imposition of liability on
a corporation for the acts of another corporation when the
subject corporation is organized or operated as a mere
tool or business conduit
’’ i) Alter ego is demonstrated "by evidence showing a
blending of identities, or a blurring of lined distinctions,
both formal and substantive, between two corporations."
’’ ii) "An important consideration is whether the corporation
is underfunded or undercapitalized, which is an indication
that the company is a mere conduit or business tool"
B) *Single Business Enterprise Doctrine* ’ States that
when corporations are not operated as separate entities,
but integrate their resources to achieve a common business purpose, each constituent corporation may be held
liable for the debts incurred in pursuit of that business
purpose
’’ i) Like the alter ego doctrine, the single business enterprise doctrine is an equitable remedy, which applies when
the corporate form is "used as part of an unfair device to
achieve an inequitable result"
’’ ii) Where the corporate form is used as a shield behind
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which injustice is sought to be done by those who have
control of it that equity penetrates the corporate veil
54. Corporate AuA) §141 says that the business and affairs of every corthority -- DGCL § poration shall be managed by the board unless otherwise
141
provided in the code, or in the certificate of incorporation
B) In order for the board to act, it must ...
’’ i) Must be a quorum present
’’’’ a) Usually 1/3, but articles of incorporation or bylaws will
specify
’’ ii) Unlike shareholders, board members may not vote by
proxy
55. Corporate AuA) Regular Meeting ’ Scheduled, can be held without nothority -- Types of tice, and typically at least quarterly meetings
Meetings
B) Special Meetings ’ Can be called pursuant to articles
that are set forth in the bylaws, needs to give notice &
some general information about what the meeting will be
about
’’ i) If there is an emergency, the notice requirement can be
waived
56. Corporate Authority -- Board
Composition
A) Directors
’’ i) Directors can be inside or outside
B) Committees ’ Boards delegate responsibilities to committees, who then have a certain amount of discretion with
regard to their specific responsibilities, but they can't take
action that would require s/h approval, can't fill vacancies
on the board or on the committee, can't adopt/amend/repeal bylaws w/out full board approval
57. Corporate Authority -- Directors, you are not
independent if ...
You are not independent if ...
a) You have been an employee of the company, or a family
member has been an executive of the company
b) You or a family member received more than $120,000 in
direct compensation in any twelve month period over the
past three years
c) If you or a family member are affiliation in any way with
some outside auditor of the company
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58. Corporate Aui) *Audit Committee*
thority -- Commit- ’’ a) Presentation of the corporations financial statements
tees
fairly and accurately reflects the financial position of the
company
’’ b) Be composed solely of independent directors
’’ c) At least three of them have to be financially literate
’’ ’’ 1) Generally, this means a member must be able to read
and understand fundamental financial statements
ii) *Compensation Committee*
’’ a) Oversees the way senior executives are paid
’’ b) Responsible for establishing the terms of any stock
options executives may get as compensation
’’ c) Must be comprised entirely of independent directors
iii) *Nominating Committee*
’’ a) Must be comprised entirely of independent directors
’’ b) Responsible for nominating candidates for the board
of directors and deciding whether current directors should
be nominated for reelection
iv) *Governance Committee*
’’ a) Some companies have established this committee in
recent years
’’ b) Survey the extent to which there are processes set up
for the board to act effectively and for the directors to be
held accountable
’’ c) Keeping detailed minutes of the meeting
59. Agency—Action
Binding the
Corporation ’
Parties to the
legal agency
relationship
i) Corporation = Principal
ii) Board = Agent/Principal
iii) Officers = Agent/Principal
iv) Managers = Agent
60. Agency—Action
Binding the
Corporation ’
Types of
Authority
i) Actual Authority ’ Principal specifies expressly what the
agent is authorized to do, through words or conduct
ii) Apparent Authority ’ Perceptions of the third party, not
the principal.
iii) Inherent Authority ’ Infers from the position holds that
the agent has authority
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iv) Ratification of Authority ’ Focuses on the principal, if the
agent has acted w/out authority but the principal takes no
steps to repudiate the authority and accepts the benefits of
the authority, than we can say that the principal has ratified
the authority
61. Agency—Action
Binding the
Corporation ’
Types of
Authority ’
Apparent
Authority ’
Perceptions of the third party, not the principal.
a) Is that third party reasonable in assuming that the agent
has the authority to bind the principal? If she does not
believe that the agent has the authority, the principal is
under a duty to investigate
b) Anytime you're dealing w/ a wholly owned subsidiary,
it's a good idea for the other company to do its due diligence and inquire whether the subsidiary is authorized to
act in the way that it is acting w/out approval of its parent
company
62. Agency—Action
Binding the
Corporation ’
Types of
Authority ’
Inherent
Authority ’
Inherent Authority ’ Infers from the position holds that the
agent has authority
a) Somewhat analogous to apparent authority, can be said
that inherent authority is a type of apparent authority
b) If one of two innocent parties must suffer due to betrayal
of trust—either the principal or the third party—the loss
should fall on the party who is most at fault. B/C the
principal puts the agent in a position of trust, the principal
should bear the loss
63. Agency—Action
Binding the
Corporation ’
Types of
Authority ’
Ratification of
Authority ’
Focuses on the principal, if the agent has acted w/out
authority but the principal takes no steps to repudiate the
authority and accepts the benefits of the authority, than we
can say that the principal has ratified the authority
a) The ratification only applies to that specific transaction,
does not create future authority
64. Ten Best Practices in Board
Governance
1) The majority of directors should be independent of the
company and its management
2) Board members should be recruited for their relevant
business, industry or financial expertise
3) Any independent internal audit function (even if
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part-time) should be in place and report directly to the
audit committee
4) A code of ethics that applies to all officers, board members, and employees should be adopted and monitored for
adherence by the board
5) A well-publicized whistle-blower process should be
established so employees, vendors, and customers can
anonymously report concerns
6) The board should adopt appropriate policies and procedures to manage processes, establish guidelines, and
determine appropriate risk thresholds for all significant
products and services
7) The board should establish a suitable committee structure—consistent with the institution's size and complexity—that encourages open participation by independent
directors
8) The board, through its audit committee, should verify
the institution's financial management strength and effectiveness through an annual external audit
9) Management and the board of directors should have
formal succession plans in place that are reviewed annually
10) The board and board committees should conduct a
rigorous self-assessment at least every two years
65. Key Responsibil- A) Providing the institution with effective, competent manities of Effective agement
Board Members B) Working with management to promote ethical, positive
corporate culture
C) Actively helping plan the long-term direction and goals
for the institution
D) Setting clear policies and monitoring the institution's
operations for compliance
E) Knowing where the institution stands and staying
abreast of its financial health
F) Ensuring the institution complies with all ... regulations
G) Attending meetings and actively participating in board
discussions
H) Conducting periodic evaluations of individual member
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and overall board performance
I) Ensuring and maintaining the board's independence
66. Red Flags of Deficiency in Governance to Watch
For
A) A strong or dominant CEO "runs the show," soliciting
little or no input from others and not tolerating the opposing
view
B) Board members don't hold the CEO or management
team accountable for actions or inactions
C) Board members are accustomed to receiving information packets at the beginning of a meeting, rather than in
advance
D) Meeting materials are sent in advance, but board members do little or no preparation
E) Packets provided to members don't contain pertinent
information or are in a format that makes determining risk
exposures and judging the effectiveness of risk management difficult
F) Meetings are characterized by little or no discussion,
or board members go out of their way to avoid conflict,
resulting in rubber stamping
G) Board members believe the institution exists for personal benefit and engage in self-serving transactions at
the institutions expense
H) Board minutes are poorly kept and contain little information on matters discussed during the meetings or
actions taken by the board
I) No assessment of the board, its committees, or individual directors is ever performed to determine the effectiveness or contributions made to the institution's decision-making process or success
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1. introduction
U.S. monetary policy affects all kinds of economic and
financial decisions people make in this country—whether
to get a loan to buy a new house or car or to start up a
company, whether to expand a business by investing in a
new plant or equipment, and whether to put savings in a
bank, in bonds, or in the stock market, for example. Furthermore, because the U.S. is the largest economy in the
world, its monetary policy also has significant economic
and financial effects on other countries.
The object of monetary policy is to influence the performance of the economy as reflected in such factors as
inflation, economic output, and employment. It works by
affecting demand across the economy—that is, people's
and firms' willingness to spend on goods and services.
While most people are familiar with the fiscal policy
tools that affect demand—such as taxes and government
spending—many are less familiar with monetary policy
and its tools. Monetary policy is conducted by the Federal
Reserve System, the nation's central bank, and it influences demand mainly by raising and lowering short-term
interest rates.
2. how is the feder- The Federal Reserve System (called the Fed, for short) is
al reserve struc- the nation's central bank. It was established by an Act of
tured?
Congress in 1913 and consists of the Board of Governors
in Washington, D.C., and twelve Federal Reserve District
Banks (for a discussion of the Fed's overall responsibilities, see The Federal Reserve System: Purposes and
Functions).
The Congress structured the Fed to be independent within
the government--that is, although the Fed is accountable
to the Congress and its goals are set by law, its conduct
of monetary policy is insulated from day-to-day political
pressures. This reflects the conviction that the people who
control the country's money supply should be independent
of the people who frame the government's spending decisions.
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3. what makes the
fed independent?
Three structural features give the Fed independence in its
conduct of monetary policy: the appointment procedure for
Governors, the appointment procedure for Reserve Bank
Presidents, and funding.
Appointment procedure for Governors. The seven Governors on the Federal Reserve Board are appointed by
the President of the United States and confirmed by the
Senate. Independence derives from a couple of factors:
first, the appointments are staggered to reduce the chance
that a single U.S. President could "load" the Board with appointees; second, their terms of office are 14 years--much
longer than elected officials' terms.
Appointment procedure for Reserve Bank Presidents.
Each Reserve Bank President is appointed to a five-year
term by that Bank's Board of Directors, subject to final
approval by the Board of Governors. This procedure adds
to independence because the Directors of each Reserve
Bank are not chosen by politicians but are selected to
provide a cross-section of interests within the region, including those of depository institutions, nonfinancial businesses, labor, and the public.
Funding. The Fed is structured to be self-sufficient in the
sense that it meets its operating expenses primarily from
the interest earnings on its portfolio of securities. Therefore, it is independent of Congressional decisions about
appropriations.
4. how is the fed in- Even though the Fed is independent of Congressional
dependent within appropriations and administrative control, it is ultimately
the government? accountable to Congress and comes under government
audit and review. Fed officials report regularly to the Congress on monetary policy, regulatory policy, and a variety
of other issues, and they meet with senior Administration
officials to discuss the Federal Reserve's and the federal
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government's economic programs. The Fed also reports
to Congress on its finances.
5. who makes mon- The Fed's FOMC (Federal Open Market Committee) has
etary policy?
primary responsibility for conducting monetary policy. The
FOMC meets in Washington eight times a year and has
twelve members: the seven members of the Board of
Governors, the President of the Federal Reserve Bank
of New York, and four of the other Reserve Bank Presidents, who serve in rotation. The remaining Reserve Bank
Presidents contribute to the Committee's discussions and
deliberations.
In addition, the Directors of each Reserve Bank contribute
to monetary policy by making recommendations about
the appropriate discount rate, which are subject to final
approval by the Governors.
6. what are the
Monetary policy has two basic goals: to promote "maxigoals of US mon- mum" sustainable output and employment and to promote
etary policy?
"stable" prices. These goals are prescribed in a 1977
amendment to the Federal Reserve Act.
What do maximum sustainable output and employment
mean?
In the long run, the amount of goods and services the
economy produces (output) and the number of jobs it
generates (employment) both depend on factors other
than monetary policy. These factors include technology
and people's preferences for saving, risk, and work effort.
So, maximum sustainable output and employment mean
the levels consistent with these factors in the long run.
But the economy goes through business cycles in which
output and employment are above or below their long-run
levels. Even though monetary policy can't affect either
output or employment in the long run, it can affect them
in the short run. For example, when demand weakens and there's a recession, the Fed can stimulate the
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economy—temporarily—and help push it back toward its
long-run level of output by lowering interest rates. That's
why stabilizing the economy—that is, smoothing out the
peaks and valleys in output and employment around their
long-run growth paths—is a key short-run objective for the
Fed and many other central banks.
7. If the Fed
can stimulate the
economy out of
a recession, why
doesn't it stimulate the economy
all the time?
Persistent attempts to expand the economy beyond its
long-run growth path will press capacity constraints and
lead to higher and higher inflation, without producing lower
unemployment or higher output in the long run. In other
words, not only are there no long-term gains from persistently pursuing expansionary policies, but there's also a
price—higher inflation.
8. what's so bad
High inflation is bad because it can hinder economic
about higher in- growth, and for a lot of reasons. For one thing, it makes
flation?
it harder to tell what a change in the price of a particular
product means. For example, a firm that is offered higher
prices for its products can have trouble telling how much of
the price change is due to stronger demand for its products
and how much reflects the economy-wide rise in prices.
Moreover, when inflation is high, it also tends to vary a
lot, and that makes people uncertain about what inflation
will be in the future. That uncertainty can hinder economic growth in a couple of ways—it adds an inflation risk
premium to long-term interest rates, and it complicates
further the planning and contracting by businesses and
households that are so essential to capital formation.
That's not all. Because many aspects of the tax system
are not indexed to inflation, high inflation distorts economic
decisions by arbitrarily increasing or decreasing after-tax
rates of return to different kinds of economic activities.
In addition, it leads people to spend time and resources
hedging against inflation instead of pursuing more productive activities.
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Another problem is that a surprise inflation tends to redistribute wealth. For example, when loans have fixed rates,
a surprise inflation redistributes wealth from lenders to
borrowers, because inflation lowers the real burden of
making a stream of payments whose nominal value is
fixed.
9. So should the
Fed try to get the
inflation rate to
zero?
Actually, there's a lot of debate about that. While some
economists have suggested zero inflation as a target,
others argue that an inflation rate that's too low can be
a problem. For example, if inflation is very low or close
to zero, then short-term interest rates also are likely to
be very close to zero. In that case, the Fed might not
have enough room to lower short-term interest rates if it
needed to stimulate the economy. Of course, the Fed could
conduct policy using more unconventional methods (such
as trying to reduce long-term interest rates), but it's not
clear that those methods would be as easy to use or as
effective. Another problem is that, when inflation is very
close to zero, there's a bigger risk of deflation.
10. What's so bad
First, let's talk about the difference between disinflation
about deflation? and deflation. Disinflation just means that the rate of inflation is slowing—say, from 3% a year to 2% a year. Deflation, in contrast, means that there's a fall in prices; and it's
not just a fall in prices in some sectors—like the familiar
falling prices of a lot of computer equipment. Rather, in a
deflation, prices are falling throughout the economy, so the
inflation rate is negative. That may sound good, if you're a
consumer.
But, in fact, deflation can be as bad as too much inflation.
And the reasons are pretty similar. For example, to go
back to the case of the fixed-rate loan, a surprise deflation
also redistributes wealth, but in the opposite direction from
inflation, that is, from borrowers to lenders. The reason is
that deflation raises the real burden of making a stream of
payments whose nominal value is fixed.
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A substantial, prolonged deflation, like the one during the
Great Depression, can be associated with severe problems in the financial system. It can lead to significant
declines in the value of collateral owned by households
and firms, making it more difficult to borrow. And falling
collateral values may force lenders to call in outstanding
loans, which would force firms to cut back their scale of
operations and force households to cut back consumption.
Finally, in a deflationary episode, interest rates are likely
to be lower than they are during periods of low inflation,
which means that the Fed's ability to stimulate the economy will be even more limited.
11. So that's why the Yes. Price "stability" is basically a low-inflation environother goal is "sta- ment where people and firms can make financial decisions
ble prices"?
without worrying about where prices are headed. Moreover, this is all the Fed can achieve in the long run.
12. If low inflation is
the only thing the
Fed can achieve
in the long run,
why isn't it the
sole focus of
monetary policy?
Because the Fed can determine the economy's average
rate of inflation, some commentators—and some members of Congress as well—have emphasized the need
to define the goals of monetary policy in terms of price
stability, which is achievable.
But the Fed, of course, also can affect output and employment in the short run. And big swings in output and
employment are costly to people, too. So, in practice, the
Fed, like most central banks, cares about both inflation
and measures of the short-run performance of the economy.
13. Are the two goals Yes, sometimes they are. One kind of conflict involves
ever in conflict? deciding which goal should take precedence at any point
in time. For example, suppose there's a recession and
the Fed works to prevent employment losses from being too severe; this short-run success could turn into a
long-run problem if monetary policy remains expansionary
too long, because that could trigger inflationary pressures.
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So it's important for the Fed to find the balance between
its short-run goal of stabilization and its longer-run goal of
maintaining low inflation.
Another kind of conflict involves the potential for pressure
from the political arena. For example, in the day-to-day
course of governing the country and making economic
policy, politicians may be tempted to put the emphasis on
short-run results rather than on the longer-run health of
the economy. The Fed is somewhat insulated from such
pressure, however, by its independence, which allows it to
strive for a more appropriate balance between short-run
and long-run objectives.
14. Why don't the
goals include
helping a region
of the country
that's in recession?
Often, some state or region is going through a recession
of its own while the national economy is humming along.
But the Fed can't concentrate its efforts on expanding the
weak region for two reasons. First, monetary policy works
through credit markets, and since credit markets are linked
nationally, the Fed simply has no way to direct stimulus
only to a particular part of the country that needs help.
Second, if the Fed stimulated whenever any state had
economic hard times, it would be stimulating much of the
time, and this would result in excessive stimulation for the
overall country and higher inflation.
But this focus on the well-being of the national economy
doesn't mean that the Fed ignores regional economic
conditions. It relies on extensive regional data and anecdotal information, along with statistics that directly measure developments in regional economies, to fit together
a picture of the national economy's performance. This is
one advantage to having regional Federal Reserve Bank
Presidents sit on the FOMC: They're in close contact with
economic developments in their regions of the country.
15. Why don't the
In theory, stock prices should reflect the value of firms'
goals include try- "fundamentals," such as their expected future earnings.
ing to preSo it's hard to come up with logical explanations for why
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vent stock market "bubbles"
like the one at the
end of the 1990s?
they would get out of line, that is, why a bubble would
form. After all, U.S. stock markets are among the most
efficient in the world—there's a lot of information available
and the trading mechanisms function very smoothly. And
stock market analysts and others devote huge amounts of
resources to figuring out what the appropriate price of a
stock is at any point in time.
Even so, it's hard to deny the evidence of mispricing from
episodes like the rise and fall of the Nasdaq over the last
decade or so: it went from a monthly average of a little
more than 750 in January 1995 to a peak of just over
4,800 in March 2000, before falling back to roughly 1,350
in March 2003. Unfortunately, evidence of a bubble is easy
to find after it has burst, but it's much harder to find as the
bubble is forming. The reason is that policymakers—and
other observers—can find it hard to tell whether stock
prices are moving up because fundamentals are changing
or because prices are out of line with fundamentals.
Even if the Fed suspected that a bubble had developed,
it's not clear how monetary policy should respond. Raising
the funds rate by a quarter, a half, or even a full percentage point probably wouldn't make people slow down
their investments in the stock market when individual stock
prices are doubling or tripling and even broad stock market
indexes are going up by 20% or 30% a year. It's likely that
raising the funds rate enough to burst the bubble would
do significant harm to the economy. For instance, some
have argued that the Fed may have worsened the Great
Depression by trying to deflate the stock market bubble of
the late 1920s.
16. Should the Fed Not at all. Stock markets provide information about the
ignore the stock future course of the economy that the Fed may find useful
market then?
in conducting policy. For instance, a sustained increase in
the stock market is likely to make households feel wealthier, which tends to make them increase their consumption.
And if the economy were already at full capacity, this would
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cause inflationary pressures. So a sustained increase in
the stock market could lead the Fed to modify its inflation and output forecasts and adjust its policy response
accordingly.
Beyond concerns about the economy, the Fed also pays
attention to the stock market because of its concerns
about financial market stability. A good example of this is
what happened after the stock market crash of 1987. At
that time, the Fed cut interest rates and stated that it was
ready to supply the liquidity needs of the market because it
wanted to ensure that markets would continue to function.
17. What are the
The Fed can't control inflation or influence output and emtools of U.S. mon- ployment directly; instead, it affects them indirectly, mainly
etary policy?
by raising or lowering a short-term interest rate called the
"federal funds" rate. Most often, it does this through open
market operations in the market for bank reserves, known
as the federal funds market.
18. What are bank re- Banks and other depository institutions (for convenience,
serves?
we'll refer to all of these as "banks") keep a certain amount
of funds in reserve to meet unexpected outflows. Banks
can keep these reserves as cash in their vaults or as
deposits with the Fed. In fact, banks are required to hold a
certain amount in reserves. But, typically, they hold even
more than they're required to in order to clear overnight
checks, restock ATMs, and make other payments.
19. What is the feder- From day to day, the amount of reserves a bank wants to
al funds market? hold may change as its deposits and transactions change.
When a bank needs additional reserves on a short-term
basis, it can borrow them from other banks that happen
to have more reserves than they need. These loans take
place in a private financial market called the federal funds
market.
The interest rate on the overnight borrowing of reserves is
called the federal funds rate or simply the "funds rate." It
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adjusts to balance the supply of and demand for reserves.
For example, if the supply of reserves in the fed funds
market is greater than the demand, then the funds rate
falls, and if the supply of reserves is less than the demand,
the funds rate rises.
20. What are open
market operations?
The major tool the Fed uses to affect the supply of
reserves in the banking system is open market operations—that is, the Fed buys and sells government securities on the open market. These operations are conducted
by the Federal Reserve Bank of New York.
Suppose the Fed wants the funds rate to fall. To do this,
it buys government securities from a bank. The Fed then
pays for the securities by increasing that bank's reserves.
As a result, the bank now has more reserves than it wants.
So the bank can lend these unwanted reserves to another
bank in the federal funds market. Thus, the Fed's open
market purchase increases the supply of reserves to the
banking system, and the federal funds rate falls.
When the Fed wants the funds rate to rise, it does the
reverse, that is, it sells government securities. The Fed
receives payment in reserves from banks, which lowers
the supply of reserves in the banking system, and the
funds rate rises.
21. What is the discount rate?
Banks also can borrow reserves directly from the Federal
Reserve Banks at their "discount windows," and the discount rate is the rate that financially sound banks must
pay for this "primary credit." The Boards of Directors of the
Reserve Banks set these rates, subject to the review and
determination of the Federal Reserve Board. ("Secondary
credit" is offered at higher interest rates and on more restrictive terms to institutions that do not qualify for primary
credit.) Since January 2003, the discount rate has been
set 100 basis points above the funds rate target, though
the difference between the two rates could vary in principle. Setting the discount rate higher than the funds rate is
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designed to keep banks from turning to this source before
they have exhausted other less expensive alternatives. At
the same time, the (relatively) easy availability of reserves
at this rate effectively places a ceiling on the funds rate.
22. What about for- Purchases and sales of foreign currency by the Fed are
eign currency op- directed by the FOMC, acting in cooperation with the Treaerations?
sury, which has overall responsibility for these operations.
The Fed does not have targets, or desired levels, for the
exchange rate. Instead, the Fed gets involved to counter
disorderly movements in foreign exchange markets, such
as speculative movements that may disrupt the efficient
functioning of these markets or of financial markets in
general. For example, during some periods of disorderly
declines in the dollar, the Fed has purchased dollars (sold
foreign currency) to absorb some of the selling pressure.
Intervention operations involving dollars, whether initiated
by the Fed, the Treasury, or by a foreign authority, are not
allowed to alter the supply of bank reserves or the funds
rate. The process of keeping intervention from affecting
reserves and the funds rate is called the "sterilization" of
exchange market operations. As such, these operations
are not used as a tool of monetary policy.
23. How does monetary policy affect
the U.S. economy?
The point of implementing policy through raising or lowering interest rates is to affect people's and firms' demand
for goods and services. This section discusses how policy
actions affect real interest rates, which in turn affect demand and ultimately output, employment, and inflation.
24. What are real interest rates and
why do they matter?
For the most part, the demand for goods and services
is not related to the market interest rates quoted in the
financial pages of newspapers, known as nominal rates.
Instead, it is related to real interest rates—that is, nominal
interest rates minus the expected rate of inflation.
For example, a borrower is likely to feel a lot happier about
a car loan at 8% when the inflation rate is close to 10%
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(as it was in the late 1970s) than when the inflation rate is
close to 2% (as it was in the late 1990s). In the first case,
the real (or inflation-adjusted) value of the money that the
borrower would pay back would actually be lower than the
real value of the money when it was borrowed. Borrowers,
of course, would love this situation, while lenders would
be disinclined to make any loans.
25. So why doesn't
the Fed just set
the real interest
rate on loans?
Remember, the Fed operates only in the market for bank
reserves. Because it is the sole supplier of reserves, it can
set the nominal funds rate. The Fed can't set real interest
rates directly because it can't set inflation expectations
directly, even though expected inflation is closely tied to
what the Fed is expected to do in the future. Also, in
general, the Fed has stayed out of the business of setting
nominal rates for longer-term instruments and instead
allows financial markets to determine longer-term interest
rates.
26. How can the
Fed influence
long-term rates
then?
Long-term interest rates reflect, in part, what people in
financial markets expect the Fed to do in the future. For
instance, if they think the Fed isn't focused on containing
inflation, they'll be concerned that inflation might move up
over the next few years. So they'll add a risk premium
to long-term rates, which will make them higher. In other
words, the markets' expectations about monetary policy
tomorrow have a substantial impact on long-term interest
rates today. Researchers have pointed out that the Fed
could inform markets about future values of the funds rate
in a number of ways. For example, the Fed could follow a
policy of moving gradually once it starts changing interest
rates. Or, the Fed could issue statements about what kinds
of developments the FOMC is likely to focus on in the
foreseeable future; the Fed even could make more explicit
statements about the future stance of policy.
27. How do
these policy-induced changes
Changes in real interest rates affect the public's demand
for goods and services mainly by altering borrowing costs,
the availability of bank loans, the wealth of households,
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in real interest
rates affect the
economy?
and foreign exchange rates.
For example, a decrease in real interest rates lowers
the cost of borrowing; that leads businesses to increase
investment spending, and it leads households to buy
durable goods, such as autos and new homes.
In addition, lower real rates and a healthy economy may
increase banks' willingness to lend to businesses and
households. This may increase spending, especially by
smaller borrowers who have few sources of credit other
than banks.
Lower real rates also make common stocks and other
such investments more attractive than bonds and other
debt instruments; as a result, common stock prices tend
to rise. Households with stocks in their portfolios find that
the value of their holdings is higher, and this increase in
wealth makes them willing to spend more. Higher stock
prices also make it more attractive for businesses to invest
in plant and equipment by issuing stock.
In the short run, lower real interest rates in the U.S. also
tend to reduce the foreign exchange value of the dollar,
which lowers the prices of the U.S.-produced goods we
sell abroad and raises the prices we pay for foreign-produced goods. This leads to higher aggregate spending on
goods and services produced in the U.S.
The increase in aggregate demand for the economy's
output through these different channels leads firms to
raise production and employment, which in turn increases
business spending on capital goods even further by making greater demands on existing factory capacity. It also
boosts consumption further because of the income gains
that result from the higher level of economic output.
28.
Wages and prices will begin to rise at faster rates if monetary policy stimulates aggregate demand enough to push
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How does mone- labor and capital markets beyond their long-run capacitary policy affect ties. In fact, a monetary policy that persistently attempts
inflation?
to keep short-term real rates low will lead eventually to
higher inflation and higher nominal interest rates, with no
permanent increases in the growth of output or decreases
in unemployment. As noted earlier, in the long run, output
and employment cannot be set by monetary policy. In
other words, while there is a trade-off between higher
inflation and lower unemployment in the short run, the
trade-off disappears in the long run.
Policy also affects inflation directly through people's expectations about future inflation. For example, suppose
the Fed eases monetary policy. If consumers and businesspeople figure that will mean higher inflation in the
future, they'll ask for bigger increases in wages and prices.
That in itself will raise inflation without big changes in
employment and output.
29. Doesn't U.S. inflation depend on
worldwide capacity, not just U.S.
capacity?
In this era of intense global competition, it might seem
parochial to focus on U.S. capacity as a determinant of
U.S. inflation, rather than on world capacity. For example,
some argue that even if unemployment in the U.S. drops
to very low levels, U.S. workers wouldn't be able to push
for higher wages because they're competing for jobs with
workers abroad, who are willing to accept much lower
wages. The implication is that inflation is unlikely to rise
even if the Fed adopts an easier monetary policy.
This reasoning doesn't hold up too well, however, for a
couple of reasons. First, a large proportion of what we
consume in the U.S. isn't affected very much by foreign
trade. One example is health care, which isn't traded internationally and which amounts to nearly 15% of U.S. GDP.
More important, perhaps, is the fact that such arguments
ignore the role of flexible exchange rates. If the Fed were
to adopt an easier policy, it would tend to increase the
supply of U.S. dollars in the market. Ultimately, this would
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tend to drive down the value of the dollar relative to other
countries, as U.S. consumers and firms used some of
this increased money supply to buy foreign goods and
foreigners got rid of the additional U.S. currency they did
not want. Thus, the price of foreign goods in terms of U.S.
dollars would go up—even though they would not in terms
of the foreign currency. The higher prices of imported
goods would, in turn, tend to raise the prices of U.S. goods.
30. How long does it
take a policy action to affect the
economy and inflation?
It can take a fairly long time for a monetary policy action to
affect the economy and inflation. And the lags can vary a
lot, too. For example, the major effects on output can take
anywhere from three months to two years. And the effects
on inflation tend to involve even longer lags, perhaps one
to three years, or more.
31. Why are the lags So far, we've described a complex chain of events that
so hard to prelinks a change in the funds rate with subsequent changes
dict?
in output and inflation. Developments anywhere along this
chain can alter how much a policy action will affect the
economy and when.
For example, one link in the chain is long-term interest
rates, and they can respond differently to a policy action,
depending on the market's expectations about future Fed
policy. If markets expect a change in the funds rate to
be the beginning of a series of moves in the same direction, they'll factor in those future changes right away,
and long-term rates will react by more than if markets had
expected the Fed to take no further action. In contrast, if
markets had anticipated the policy action, long-term rates
may not move much at all because they would have factored it into the rates already. As a result, the same policy
move can appear to have different effects on financial
markets and, through them, on output and inflation.
Similarly, the effect of a policy action on the economy also
depends on what people and firms outside the financial
sector think the Fed action means for inflation in the future.
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If people believe that a tightening of policy means the
Fed is determined to keep inflation under control, they'll
immediately expect low inflation in the future, so they're
likely to ask for smaller wage and price increases, and
this will help achieve low inflation. But if people aren't
convinced that the Fed is going to contain inflation, they're
likely to ask for bigger wage and price increases, and that
means that inflation is likely to rise. In this case, the only
way to bring inflation down is to tighten so much and for so
long that there are significant losses in employment and
output.
32. What problems
do lags cause?
The Fed's job would be much easier if monetary policy had
swift and sure effects. Policymakers could set policy, see
its effects, and then adjust the settings until they eliminated any discrepancy between economic developments and
the goals.
But with the long lags associated with monetary policy
actions, the Fed must try to anticipate the effects of its
policy actions into the distant future. To see why, suppose
the Fed waits to shift its policy stance until it actually sees
an increase in inflation. That would mean that inflationary
momentum already had developed, so the task of reducing inflation would be that much harder and more costly
in terms of job losses. Not surprisingly, anticipating policy
effects in the future is a difficult task.
33. How does the
Fed decide the
appropriate setting for the policy
instrument?
The Fed's job of stabilizing output in the short run and
promoting price stability in the long run involves several
steps. First, the Fed tries to estimate how the economy is
doing now and how it's likely to do in the near term—say,
over the next couple of years or so. Then it compares
these estimates to its goals for the economy and inflation.
If there's a gap between the estimates and the goals, the
Fed then has to decide how forcefully and how swiftly
to act to close that gap. Of course, the lags in policy
complicate this process. But so do a host of other things.
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34. What things
complicate the
process of determining how the
economy is doing?
Even the most up-to-date data on key variables like employment, growth, productivity, and so on, reflect conditions in the past, not conditions today; that's why the
process of monetary policymaking has been compared
to driving while looking only in the rearview mirror. So, to
get a reasonable estimate of current and near-term economic conditions, the Fed first tries to figure out what the
most relevant economic developments are; these might be
things like the government's taxing and spending policies,
economic developments abroad, financial conditions at
home and abroad, and the use of new technologies that
boost productivity. These developments can then be incorporated into an economic model to see how the economy
is likely to evolve over time.
35. Sounds
easy—plug the
numbers into the
model and get an
answer. So
what's the
problem?
There are lots of problems. One problem is that models
are only approximations—they can't capture the full complexity of the economy. Another problem is that, so far, no
single model adequately explains the entire economy—at
least, you can't get economists to agree on a single model;
and no single model outperforms others in predicting future developments in every situation. Another problem is
that the forecast can be off base because of unexpected,
even unprecedented, developments—the September 11
attacks are a case in point. So in practice, the Fed tries
to deal with this uncertainty by using a variety of models
and indicators, as well as informal methods, to construct
a picture of the economy. These informal methods can
include anecdotes and other information collected from
all kinds of sources, such as the Directors of the Federal
Reserve Banks, the Fed's various advisory bodies, and
the press.
36. So now are we
in a position
to compare the
Fed's estimates
with its goals?
Not so fast. Coming up with operational measures of
the goals is harder than you might think, especially the
goal for the rate of maximum sustainable output growth.
Unfortunately, this is not something you can go out and
measure. So, once again, the Fed has to turn to some
sort of model or indicator to estimate it. And it's hard to be
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certain about any estimate, in part because it's hard to be
certain that the model or indicator the estimate is based on
is the right one. There's one more important complication
in estimating the rate of maximum sustainable growth—it
can shift over time!
37. What problems
does a shift in
the rate of maximum sustainable
growth cause?
The experience of the late 1990s provides a good example
of the policy problems caused by such a shift. During
this period, output and productivity surged at the same
time that rapid innovation was transforming the information technology industry. In the early stages, there was no
way for the Fed—or anybody else—to tell why output was
growing so fast. In other words, the Fed had to determine
how much of the surge in output was due to unusually
rapid technical progress and whether this implied an increase in the economy's trend growth rate.
This was a crucial issue because policy would respond
differently depending on exactly why the economy was
growing faster. If it was largely due to the spread of new
technologies that enhanced worker and capital productivity, implying that the trend growth rate was higher, then the
economy could expand faster without creating inflationary
pressures. In that case, monetary policy could stand pat.
But if it was just the economy experiencing a more normal
business cycle expansion, then inflation could heat up. In
that case, monetary policy would need to tighten up.
The Fed's job was complicated by the fact that statistical models did not find sufficient evidence to suggest a
change in the trend growth rate. But the Fed looked at a
variety of indicators, such as the profit data from firms,
as well as at informal evidence, such as anecdotes, to
conclude that the majority of the evidence was consistent
with an increase in the trend growth rate. On that basis, the
Fed refrained from tightening policy as much as it would
have otherwise.
38.
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Does the trend
Yes, it does. A good example, with a pretty bad outcome,
growth rate ever was what happened in the early 1970s, a period marked
fall?
by a significant slowdown in the trend growth rate. A number of economists have argued that the difficulty in determining that such a slowdown had actually taken place
caused the Fed to adopt an easier monetary policy than
it might otherwise have, which in turn contributed to the
substantial acceleration in inflation observed later in the
decade.
39. What happens
when the estimates for growth
and inflation are
different from the
Fed's goals?
Let's take the case where the forecast is that growth will
be below the goal. That would suggest a need to ease
policy. But that's not all. The Fed also must decide two
other things: (1) how strongly to respond to this deviation
from the goal and (2) how quickly to try to eliminate the
gap. Once again, it can use its models to try to determine
the effects of various policy actions. And, once again, the
Fed must deal with the problems associated with uncertainty as well as with the measurement problems we have
already discussed.
40. Uncertainty
seems to be a
problem at every
stage. How does
the Fed deal with
it?
Uncertainty does, indeed, pervade every part of the monetary policymaking process. There is as yet no set of
policies and procedures that policymakers can use to deal
with all the situations that may arise. Instead, policymakers
must decide how to proceed by going case by case.
For instance, when policymakers are more uncertain
about their reading of the current state of the economy,
they may react more gradually to economic developments
than they would otherwise. And because it's hard to come
up with unambiguous benchmarks for the economy's performance, the Fed may look at more than one kind of
benchmark. For instance, because it's hard to get a precise estimate of the trend growth rate of output, the Fed
may look at the labor market to try to figure out where the
unemployment rate is relative to some kind of benchmark
or "natural rate," that is, the rate that would be consistent
with price stability. Alternatively, it might try to determine
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whether the stance of policy is appropriate by comparing
the real funds rate to an estimate of the "equilibrium interest rate," which can be defined as the real rate that would
be consistent with maximum sustainable output in the long
run.
These issues are far from settled. Indeed the Fed spends
a great deal of time and effort in researching various ways
to deal with different kinds of uncertainty and in trying
to figure out what kind of model or indicator is likely to
perform best in a given situation. Since these issues aren't
likely to be resolved anytime soon, the Fed is likely to
continue to look at everything.
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Ch. 16: Program Management
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1. 1. Which of the following best de- ANS: A Assess, plan, implement, evalscribes the steps in program man- uate
agement?
The program management process is
A. Assess, plan, implement, evalu- similar to the nursing process. Proate
gram management consists of assessB. Identify, initiate, implement
ing, planning, implementing, and evalC. Organize, operationalize, mobi- uating a program.
lize, subsidize
DIF: Cognitive Level: Remember
D. Substantiate, negotiate, evalu- (Knowledge) REF: pp. 276-277
ate
2. 2. Which of the following best de- ANS: C Ensure that health care serscribes the ultimate goal of provices are acceptable, equal, effective,
gram planning?
and efficient
A. Avoid unanticipated conflicts in
the program development phase
B. Provide adequate funding to
meet the program's resource requirements
C. Ensure that health care services are acceptable, equal, effective, and efficient
D. Prevent unnecessary duplication of services
Although the other options are aspects
of program planning, they address only
limited concerns. The comprehensive
goal of program planning is to ensure
that health care services are acceptable, equal, efficient, and effective.
DIF: Cognitive Level: Understand
(Comprehension) REF: p. 277
3. 3. Which of the following best de- ANS: B To match client needs, provider
scribes the purpose of strategic strengths, and agency resources
planning?
Strategic planning involves matching
A. To anticipate client needs now client needs, provider strengths and
and in the future
competencies, and agency resources.
B. To match client needs, provider Everyone involved can anticipate what
strengths, and agency resources will be needed to implement the proC. To maximize effective use of
gram, what will occur during implemenagency resources
tation, and what the outcomes will be.
D. To utilize provider strengths and DIF: Cognitive Level: Understand
competencies
(Comprehension) REF: p. 277
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4. 4. Which would be an appropriate
descriptor that meets all criteria for
defining a client to be served by a
program?
A. All women ages 40 to 50 who
have not had a menstrual period
for 3 consecutive months
B. Immigrants residing in Central County for less than 5 years
who have difficulty understanding
care instructions because of limited English proficiency
C. Pregnant women who have received nutritional counseling but
whose nutritional status did not
improve
D. Children ages 18 months to 5
years old who have been treated
for nutritional deficiencies at the
Central County Clinic
5. 5. After completing a needs assessment, the nurse is confident
that he has identified the highest
priority health programming need
within the community. He presents
his ideas at a community interest
meeting, and the attendees show
essentially no interest in being involved. Knowing that the health
problem must be addressed he
proceeds with implementation as
planned. Which of the following is
the most likely outcome of the program?
ANS: B Immigrants residing in Central County for less than 5 years who
have difficulty understanding care instructions because of limited English
proficiency
The client should be defined by biological and psychosocial characteristics,
by geographical location, and by the
problems to be addressed. For example, in a community with a large number
of preschool children who require immunizations to enter school, the client
population may be described as all children between 4 and 6 years of age
residing in Central County who have
not had up-to-date immunizations. This
example tells the reader who the client
is, what the need is, how large the population is, and where they are located.
DIF: Cognitive Level: Analyze (Analysis) REF: pp. 277-278
ANS: D The program will fail because
of the community's lack of interest.
The needs to be met for the client population must be identified by both the
client and the health provider. If the
client population does not recognize
the need, the program will usually fail.
DIF: Cognitive Level: Apply (Application) REF: pp. 278-279
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A. Community members will become increasingly positive about
the new program.
B. Others will recognize the importance of the program and become
involved.
C. The public health agency will
both publicize and expand the program.
D. The program will fail because of
the community's lack of interest.
6. 6. A nurse is assessing a community to determine the feasibility of
implementing a new program on
bike safety for youth in the community. Which of the following aspects should the nurse investigate
to make this determination?
ANS: D Whether all involved support
the need for such a program
What people think about the need for
a program, or program feasibility, might
differ among health providers, agency
administrators, policymakers, and potential clients. Feasibility means the
A. Whether the community, espe- program's viability, practicality, achievcially agency clients, desire a pro- ability, or likelihood of success. Everygram
one involved must be supportive for a
B. Whether local politicians sup- program to succeed.
port the agency's idea for a proDIF: Cognitive Level: Apply (Applicagram
tion) REF: pp. 278-279
C. Whether agency professionals
think a program is needed
D. Whether all involved support the
need for such a program
7. 7. A community is examining which ANS: B Choose to do nothing
programs are needed within the
community, the populations they The need and demand for a program
will target, and how they will be
are determined by working with the
funded. Which of the following
client. This stage of planning creates
would be the least risky decision options for solving the problem and
for the community to make?
considers several solutions. Each option for program solution is examined
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A. Choose whichever option is
the least expensive of agency resources
B. Choose to do nothing
C. Choose whatever the agency administration prefers
D. Choose whatever the majority of
clients prefer
8. 8. A nurse checks health department records to compare the number of new teen clients presenting
for birth control counseling and
management in the 2 months before and after an education intervention program to decrease teen
pregnancy. Which of the following
steps of the evaluation process is
being completed by the nurse?
A. Engage stakeholders
B. Justify conclusions
C. Gather credible evidence
D. Focus on the evaluation design
9. 9. A nurse is planning a program
to teach cardiac health at the senior citizens center. Which of the
following is an effectively written
objective for the program?
for its uncertainties (risks) and consequences. A "do nothing" decision is always the decision with the least risk to
the provider.
DIF: Cognitive Level: Apply (Application) REF: p. 279
ANS: C Gather credible evidence
When the nurse gathers credible evidence, the following information is collected: indicators that will be used,
sources of data, quality of the data,
quantity of information to be gathered,
and the logistics of the data gathering
phase. Data gathered should provide
credible evidence and should convey a
well-rounded view of the program.
DIF: Cognitive Level: Apply (Application) REF: p. 283
ANS: A By the end of the program each
participant will report walking at least
30 minutes a day at least 5 days each
week.
Useful program objectives must include
A. By the end of the program each a statement of the specific behaviors
participant will report walking at desired, using an action verb that can
least 30 minutes a day at least 5
be seen and measured. Voicing a comdays each week.
mitment is not an outcome action; it
B. By the end of the program each is only a verbal agreement. The verb
participant will voice a commitunderstand is not an action verb that
ment to walk at least 30 minutes a can be seen and measured. Only "will
day.
report walking 30 minutes a day at least
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C. By the end of the program
each participant will understand
the need for physical exercise.
D. Each participant will voice a
commitment to engage in physical
exercise each day.
10. 10. The nurse contacts participants who completed an educational program on breast self-exams to see whether they have
any questions and to determine
whether they are doing breast
self-exams. Which of the following
types of evaluation is being implemented by the nurse?
5 days each week" has a specific outcome action that can be seen and measured.
DIF: Cognitive Level: Apply (Application) REF: p. 283
ANS: D Summative evaluation
Formative evaluation occurs on an ongoing basis while the program exists.
In comparison, summative evaluation
assesses program outcomes after the
program is completed.
DIF: Cognitive Level: Apply (Application) REF: pp. 277, 284-285
A. Final evaluation
B. Formative evaluation
C. Goal evaluation
D. Summative evaluation
11. 11. A nurse is completing a summative evaluation of a program
designed to decrease obesity in
school-age children. Which of the
following is the most important
question for the nurse to ask?
ANS: C Has obesity in school-age children decreased?
Summative evaluation looks at the end
result of the program. The major benefit
of program evaluation is that it shows
whether the program is meeting its purA. Are school-age children satis- pose. It should answer the following
fied with the program?
questions: Are the needs for which the
B. Can parents and guardians sup- program was designed being met? Are
port the program requirements? the problems it was designed to solve
C. Has obesity in school-age chil- being solved? If the program does not
dren decreased?
achieve the purpose for which it is deD. What is the program cost com- signed, important concerns of satisfacpared with the program benefit? tion and cost are irrelevant. So if the
program purpose is to decrease obesity, the outcome of importance is a
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decrease in obesity.
DIF: Cognitive Level: Apply (Application) REF: p. 277
12. 12. Evaluation is underway for
a statewide program to decrease
teen injury and death associated
with teens who drive while under
the influence of alcohol. Which of
the following questions would best
be used for the summative evaluation of the program?
ANS: B How do statistics for injuries
and deaths associated with drunk driving compare for teens in the year following the program?
13. 13. A committee concludes that a
program's objectives were met and
that activities received positive ratings from the community; yet the
program will be discontinued because cost was triple the amount
anticipated. Which of the following
program evaluation measures created a problem?
ANS: D Sustainability
Summative evaluation is evaluation to
assess program outcomes or as a follow-up of the results of the program
activities. Two of the options are exA. Are program participants con- amples of questions used for formative
tinuing to attend the programs, and evaluation. The goal is addressed in the
do their satisfaction scores indi- question about statistics; however, the
cate that they are pleased with the goal was not to decrease drinking of
program?
alcohol but to decrease driving when
B. How do statistics for injuries
drinking alcohol.
and deaths associated with drunk DIF: Cognitive Level: Analyze (Analydriving compare for teens in the sis) REF: p. 277
year following the program?
C. How does the amount of alcohol intake by teens compare before
and after participants enter into the
program?
D. What problems are identified as
the program is implemented?
The aspects of program evaluation include the following: evaluation of relevance—need for the program; adequacy—program addresses the extent of the need; progress—tracking
of program activities to meet program
objectives; efficiency—relationship between program outcomes and the
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A. Adequacy
B. Effectiveness
C. Impact
D. Sustainability
resources spent; effectiveness—ability to meet program objectives and
the results of program efforts; impact—long-term changes in the client
population; and sustainability—enough
resources (usually money) to continue
the program.
DIF: Cognitive Level: Apply (Application) REF: pp. 284-285
14. 14. Based on projected increases
in the number of older U.S. citizens, a planning committee wants
to establish a day care program for
the community's older adult population. During which stage is the
need for this program being assessed?
ANS: C Preactive stage
The preactive stage is one in which
assessment is based on the projection
of a future need.
DIF: Cognitive Level: Apply (Application) REF: p. 278
A. Inactive stage
B. Interactive stage
C. Preactive stage
D. Reactive stage
15. 15. Which of the following methods ANS: D Use past and current data to
would be the most interactive ap- project future needs.
proach to assessing a community's need?
Stages used in assessing client need
include the following: preactive—proA. Define needs based on the cur- jecting a future need; reactive—definrent health status of the communi- ing the problem based on past needs
ty.
identified by the client or the agency; inB. Examine past needs as identi- active—defining the problem based on
fied by the agency as well as the the existing health status of the populacommunity.
tion to be served; and interactive—deC. Project future needs based on scribing the problem using past and
current trends.
present data to project future populaD. Use past and current data to pro- tion needs.
ject future needs.
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DIF: Cognitive Level: Understand
(Comprehension) REF: p. 278
16. 16. A committee of health care professionals would like to establish
a countywide program to improve
Hispanic immigrant access to culturally competent health care services. Which of the following persons would be most helpful as a
key informant?
A. Hospital administrator
B. Hispanic community leader
C. National expert on cultural competency
D. Politician or county official
17. 17. A nurse is conducting a needs
assessment but has a limited budget. Which of the following data
sources would the nurse most likely eliminate?
ANS: B Hispanic community leader
Key informants are leaders in the community who are knowledgeable about
community needs. In this scenario, the
Hispanic leader most likely knows more
about the needs of the Hispanic community than the others listed.
DIF: Cognitive Level: Apply (Application) REF: p. 280
ANS: D Surveys
Surveys tend to be expensive when
compared with other methods; therefore the nurse would want to consider
other options if on a limited budget.
A. Community forums
DIF: Cognitive Level: Apply (ApplicaB. Examination of community indi- tion) REF: p. 280
cators
C. Focus groups
D. Surveys
18. 18. A nurse is conducting program ANS: A Choose the type of evaluation
evaluation. Which of the following to be done
would be the first action the nurse
would take?
To do a program evaluation, first
choose the type of evaluation you wish
A. Choose the type of evaluation to to do. Second, identify the goal and
be done
objectives for evaluation. Third, decide
B. Determine who will be involved who will be involved in the evaluation.
in the evaluation
Fourth, answer the questions related to
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C. Identify the goal and objectives the type of evaluation.
for the evaluation
DIF: Cognitive Level: Apply (ApplicaD. Obtain answers to specific ques- tion) REF: p. 285
tions related to the program being
evaluated
19. 19. Which of the following proANS: B Providing a diabetes managegrams demonstrates the use of ter- ment program for persons with diatiary prevention?
betes mellitus
A. Developing an in-school clinic
that provides birth control counseling and contraception
B. Providing a diabetes management program for persons with diabetes mellitus
C. Providing cardiovascular fitness
evaluations at annual health fairs
D. Setting up free blood pressure
screenings at popular department
stores and supermarkets
The aim of tertiary prevention programs
is to reduce complications from disease. Developing an in-school clinic is
a primary prevention (pregnancy has
not occurred). Fitness evaluations at
health fairs and blood pressure screenings are secondary prevention programs (screening identifies conditions
early and determines incidence/prevalence).
DIF: Cognitive Level: Analyze (Analysis) REF: p. 284
20. 20. Which of the following are elements of the MAPP (Mobilizing for
Action Through Planning and Partnership) Program Planning Model?
(Select all that apply.)
ANS: A, C
A. Generate shared visions and common values
C. Develop a framework for long-range
planning
A. Generate shared visions and
common values
B. Assess priorities in health problems
C. Develop a framework for
long-range planning
D. Choose health priorities
The elements of MAPP include: mobilizing community members and organizations, generating shared visions and
common values, developing a framework for long-range planning, conducting needs assessments in four areas: community strengths, local public health system, community health
status, and focus of change, and implementing the plan. Assessing prior-
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ities in health problems and choosing
health priorities are part of other program planning models.
DIF: Cognitive Level: Remember
(Knowledge) REF: p. 281
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1.
Sole proprietorship, partnership, and True
corporation are the three legal forms of
business ownership.
2.
"What are you willing to do to set up
True
and operate your business?" is one of
the questions you should ask yourself
when choosing a form of ownership.
3.
How much control do you want?" is not False
a major consideration when starting a
new business
4.
Choosing the right form of business
ownership will give the owner everything he or she desires.
5.
There are pros and cons for sole propri- False
etorships and partnerships, but not for
corporations.
6.
No single form of ownership will give
you everything you want and you will
have to accept some tradeoffs.
7.
It is not necessary to decide if the busi- False
ness should survive the owner(s) in the
startup stage.
8.
Financing needs are not directly related False
to selecting a form of business ownership.
9.
Liability is a major issue in the forma- True
tion and type of ownership of a new
business enterprise.
False
True
10. It is imperative to decide which form of True
business ownership offers the features
that are most important to you.
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11. The most common type of business
ownership in the United States is the
sole proprietorship, which has one
owner
True
12. A sole proprietorship is a legal form of True
business ownership
13. Some of the advantages of a sole pro- True
prietorship business are that it is easy
and inexpensive to form, there are few
government regulations, and the owner
has complete control over his/her buisness
14. If a sole proprietorship incurs a debt
or suffers a catastrophe, the owner is
personally liable for it.
True
15. When the owner of a sole proprietorship dies, the business by law is allowed to continue to preprtuity
False
16. The sole proprietor supplies all the dif- True
ferent talents needed to make the business a success
17. Sole proprietorship account for bout
72% of all U.S. buisnesses
True
18. Sole propietor find it easier to obtain
outside financing than do owners of
other types of. business enterprises
False
19. Profits earned are taxed as personal in- True
come and there are no special taxes to
pay in the sole proprietorship form of
business ownership
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20. With a sole proprietorship, you the own- True
er are in effect the buisness
21. As a sole proprietor, you can reduce
True
your risks with insurance;howver, you
still carry a substantial liability
22. As a sole proprietor, your person assets False
are not at risk for the sake of the business
23. Jerry Foster is a sole proprietorship
who owns a canoe renting business.
Jerry's employee, Terry Gibbs, greets
customers at the company's office,
loads the customers and their rented
canoes onto a van, provides them with
safety instructions and drives them upstream. Once unloaded the canoers are
on their own to float back to the company's office to check in. Although there
have been minor accidents, no one has
drowned in the nine years the business
has been in operation. Jerry plans to
add kayaks and rubber rafts next year.
The scenery is beautiful and each day
people see wild animals come down to
the water.
If someone does drown this year,
who will be held liable?
a. Terry Gibbs
b. Jerry Foster
c. Terry and Jerry
d. the customer and/or his canoe
partner
(B)
24. If Jerry wanted to bring Terry into the B
business, and he was concerned about
the cost of changing his form of organization, what legal form of organization
would he most likely switch to?
a. corporation
b. partnership
c. joint venture
d. sole proprietorship
25.
D
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What benefit will Jerry enjoy over the
years as the sole owner of his canoe
renting company?
a. He'll be able to make all of the management decisions.
b. He'll keep all of the business profits.
c. He'll avoid paying special taxes.
d. all of the above
26. Under the ____ form of ownership, any C
money borrowed by the business is
loaned to the owner personally.
a. partnership
b. corporation
c. sole proprietor
d. stewardship
27. What is a sole proprietorship?
A sole proprietorship is a business owned by only one person.
It is the most common form of
ownership, accounting for about
72 percent of all U.S. businesses.
It's the easiest and cheapest type
of business to form.
28. Discuss the disadvantages of owning a The owner must supply all the
sole proprietorship.
different talents needed to make
the business a success. When
the owner dies the business dissolves. He or she will have to rely
on his or her own resources for
financing. If the company incurs a
debt or suffers a catastrophe, the
owner is held personally liable for
it; that is, the owner has unlimited
liability.
29. If you have the talent to run a busifalse
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nance the business with all your own
resources, you should consider operating as a partnership.
30. A partnership is a business that is joint- true
ly owned by two or more people
31. The partnership agreement of the ac- true
counting firm of Baines & Sweeney
should include conditions for dissolving the partnership.
32. A partnership agreement specifies
each owner's rights and responsibilities in the business.
true
33. Jane, Karla, and Brenda have set up
an accounting firm. An essential part
of their partnership agreement is the
division of the business income.
true
34. A major problem with partnerships is false
limited liability. Each partner is personally liable for his or her own actions, but
not for the actions of all the partners.
35. In a partnership one partner can be
true
sued for unpaid debts incurred by another partner.
36. Some people with substantial assets false
may hesitate to enter a partnership.
They don't want to lose some or all of
these assets because of the mistakes
of other partners. To offset this possible
loss they can form an unlimited partnership.
37. Ben Cohen and Jerry Greenfield started false
Ben & Jerry's as a corporation.
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38. In a limited partnership the limited part- true
ners' losses are limited to their investment in the business and not their personal assets.
39. In a limited partnership, although one true
partner runs the business, any number
of the others may have partial involvement in the business.
40. A limited partnership is restricted to
joint ownership by two people.
false
41. Major advantages of a partnership over fasle
a sole proprietorship include having diverse management talent and the ability
to sell shares of stock to the public to
raise operating funds.
42. A major disadvantage of a partnership true
is that partners may disagree on how
to operate the business and divide the
profits.
43. Studies show that partnerships are
false
more successful than sole proprietorships.
44. How does a limited partnership over- To overcome the defect of partcome the unlimited liability defect of a nerships, the law permits a limgeneral partnership?
ited partnership arrangement. A
single general partner runs the
business and is responsible for
its liabilities. Any number of limited partners are allowed to participate with limited involvement,
and their losses are limited to the
amount of their investments.
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45. Explain and give an example of the con- A major problem with partnercept of unlimited liability in a partner- ships is unlimited liability. Each
ship.
partner is personally liable not
only for his or her own actions but
also for the action of all of the
partners. For example, you are
a partner in a dry cleaning business and one day you return from
lunch to find the building on fire.
You find out that the fire started
because your partner fell asleep
while smoking. You also find out
that your fire insurance was canceled because your partner forgot to pay the bill. In the end, you
estimate the loss to the building
and everything inside at $1.2 million. Since the business doesn't
have the cash or other assets to
cover losses, you, as a partner in
the business, will be held personally liable for the damages.
46. A corporation is a legal entity that is
True
entirely separate from the parties that
own it.
47. Corporations are limited to large,
well-known companies.
false
48. Corporations are owned by sharehold- true
ers who invest money in the business
by buying shares of stock.
49. In a corporation, all of the owners help false
run the business.
50. The most important benefit of incorpo- false
ration is the continuity to which shareholders are exposed.
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51. The shareholders elect a board of direc- false
tors, primarily from within the corporation, who manage the company.
52. One drawback to incorporation—one true
that often discourages small businesses from incorporating—is the fact that
corporations are costly to set up.
53. The board of directors of a corporation True
sets the company's policies, goals and
decisions, and approves the distribution of dividends.
54. The most important benefit of incorpo- true
ration is the limited liability to which the
owners are exposed.
55. Any corporation can raise more money fasle
than a partnership because it has better
credit.
56. Continuity is an advantage of a corpo- false
ration; however, ease in transferability
is a disadvantage.
57. A disadvantage of a corporation is that true
managers and shareholders may have
goals that conflict.
58. A major reason many people choose
not to incorporate is because of the
costs involved and double taxes that
must be paid.
true
59. In corporations, the individuals who
own and manage a business are the
same people.
false
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60. The S-corporation follows the same tax true
rules as a sole proprietorship or partnership
61. A disadvantage of the S-corporation is false
unlimited liability.
62. Pinnacle Games will be able to form an false
S-corporation because it has 128 employees—fewer than the 200 maximum
allowed by law.
63. A limited liability company (LLC) com- True
bines the advantages of a corporation
and the advantages of a partnership
without many of the rules and restrictions imposed on regular corporations
64. The earnings of a limited liability com- false
pany (LLC) are only taxed once—when
they are paid out to employees in the
form of wages and salaries.
65. Limited liability company (LLC) owners false
must be U.S. citizens.
66. A business that is owned and contrue
trolled by those who use its services is
called a
cooperative.
67. Cooperatives can increase profits for True
its producer-members and lower costs
for its consumer-members.
68. A not-for-profit corporation is formed to true
serve some public purpose and not for
financial gain.
69.
true
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The vast majority of not-for-profit corporations are neither rich nor famous,
but nevertheless make significant contributions to society.
70. Pat Smith and George Johnson own
true
five flower shops in Manhattan. They
want to open a wholesale flower business to supply their shops as well as
others in their geographical area. They
currently operate as a partnership but
are considering changing their legal
form of organization. One reason for
doing this is to increase the likelihood
that they will be able to raise the funds
needed to expand.
The partners should consider converting to a corporation.
71. The corporate form of organization
false
would give them more access to funds
but they would still be personally liable
for any loans.
72. An S-corporation would give them a
true
more favorable tax treatment than a regular corporation.
73. They would most likely form a public
corporation.
false
74. If they form a corporation and Pat Smith false
gets into an accident with the company's van and the van is not insured,
George Johnson could be held personally liable for any damages resulting
from the accident.
75.
false
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If George Johnson died, the company
would cease to exist.
76. An alternative approach to traditional
business growth is to merge with or
acquire another company.
true
77. The rationale behind growth through true
merger or acquisition is that one plus
one equals three: the combined company is more valuable than the sum of the
two separate companies.
78. An acquisition occurs when two com- false
panies combine to form a new company. A merger is the purchase of one
company by another with no new company being formed.
79. The rationale behind mergers and acquisitions is to grab a bigger share of
the market and improve profitability.
true
80. Companies are motivated to merge or true
acquire other companies for a number
of reasons, including gaining complementary products.
81. As a general rule it is not feasible to
false
gain new markets or open new distribution channels through mergers and
acquisitions.
82. Realizing more efficient economies of fasle
scale is not practical through mergers
or acquisitions.
83. A hostile takeover is a takeover that
true
is resisted by the targeted company's
management and its board of directors.
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84. Scuffy the Tugboat is a family-run busi- true
ness that makes tugboats. It is owned
by three brothers, Jack, Frank, and Bob.
Their first tugboat is still towing ships
in Boston Harbor, and over the years,
success has allowed them to grow the
company by plowing money back into
it. Now, however, they want to expand
but they are not sure how they should
do this. They are also unsure about
which legal form of organization is best
for them.
Scuffy the Tugboat could not operate as
a sole proprietorship.
85. If Scuffy the Tugboat operates as a part- false
nership each of its owners would have
limited liability
86. To maximize the likelihood of obtaining false
financing from the bank to expand, the
three brothers should form a partnership.
87. If the three brothers form a limited part- false
nership, all three could be limited partners and therefore limit their liability.
88. Perhaps the best legal form of organiza- false
tion for Scuffy the Tugboat is a limited
liability company (LLC). This would give
the three brothers limited liability and
would mean they would not pay personal taxes on their company's earnings.
89. The brothers are considering joining a true
cooperative of tugboat operators. This
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would allow them to join with other tugboat operators to market their services
and purchase supplies such as gasoline. If the cooperative is successful,
they would share in the cooperative's
financial success.
90. They could expand their operations
false
by acquiring another tugboat company.
This type of deal is called a merger.
91. Compare and contrast mergers and ac- Both mergers and acquisitions
quisitions.
are ways companies can grow.
Although the two are often
thought of as synonymous, the
terms merger and acquisition
mean slightly different things. A
merger occurs when two companies combine to form a new company. An acquisition is the purchase of one company by another with no new company being
formed.
92. Discuss the motivations behind merg- Companies merge or acquire
ers, acquisitions, and takeovers.
other companies for a number
of reasons: to gain complementary products; attain new markets
or distribution channels; and realize more efficient economies of
scale.
93. As someone who has identified a busi- true
ness opportunity and assumed the risk
of creating and running a business to
take advantage of it, Rick Jurmain is an
entrepreneur
94. Entrepreneurs usually start with few re- false
sources but build their businesses with
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the collective help of family members
and investors.
95. Entrepreneurs typically stay their chart- false
ed courses rather than cater to changing situations.
96. At the end of the day, entrepreneurs'
true
successes will depend on their ability
to manage and grow the organizations
that they created to implement their visions.
97. Explain why some individuals become The main reasons include the deentrepreneurs.
sire to be one's own boss, to
achieve financial independence,
to enjoy creative freedom, and to
use one's skills and knowledge.
Entrepreneurs are usually passionate about what they're doing.
98. It is unlikely that you'd decide to set up true
a new company to make cars.
99. The purpose of starting a business is to true
satisfy customers.
100. There are more than 40 million small
businesses in the United States.
false
101. Innovators at large businesses are the false
primary driving force behind the discovery of new ways of doing old things.
102. The success of small businesses in fos- true
tering creativity has caused many large
companies to respond by downsizing in
order to act more like small companies.
103.
false
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Over the last two decades, women have
become the majority of small business
owners.
104. The success of small businesses in fos- false
tering creativity has gone unnoticed by
big businesses.
105. More than three-fourths of all U.S.
false
adults are either self-employed or work
for small businesses.
106. Small businesses in the U.S. generate true
about 50% of our gross domestic product (GDP).
107. Mary Gonzalez recently expanded her true
chain of flower shops. As the only small
flower shop located in major airports
in the Midwest, she has a unique operation. She has 72 employees in 30
shops, and although her company isn't
dominant in its industry, her shops are
busy year round. To accommodate her
unique clientele, Mary developed the
idea of packaging flowers in small waterproof pots that won't leak either in
the airport or aboard planes.
Gonzalez's company should be considered a small business.
108. Small businesses like Gonzalez's account for about 50 percent of the U.S.
gross domestic product each year
true
109. Gonzalez's business is not a small
business because it's unique in the
flower-shop industry.
false
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110. Because Gonzalez's company is inde- false
pendently operated, the Small Business Administration would consider it
a large business.
111. Gonzalez's shop managers regularly
false
think of new ways to market their products, improve their quality, keep them
fresher, and meet consumer needs. In
this respect, Gonzalez's business is unusual among small businesses.
112. What do small businesses do?
Small businesses create jobs,
spark innovation, and provide opportunities for many people, including women and minorities,
to achieve financial success and
independence. In addition, they
may complement the economic
activity of large organizations by
providing them with components
and services and handling the
distribution of their products.
113. Because Green Thumb Landscapers
true
buys goods from other firms and sells
them to consumers, the company is a
retailer.
114. Among small businesses, the sertrue
vice-producing sector is larger than the
goods-producing sector.
115. The service-producing sector includes false
manufacturing, construction, and agriculture.
116. Unfortunately for small business, the
service-producing sector has been
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steadily decreasing in revenues over
the past 10 years.
117. The largest areas of the goods-produc- true
ing sector are construction and manufacturing.
118. In what industries are small businesses Small businesses are concentratconcentrated?
ed in two sectors. The goods-producing sector includes companies that involve manufacturing, construction, and agriculture. The service-producing sector involves wholesale trade,
transportation, communications,
finance, insurance, real estate,
and such professional services
as health care, advertising, accounting, and personal services.
119. A rewarding aspect of being a business false
owner is that you can't get fired—an
advantage that comes under the heading of "Creative Freedom and Personal
Satisfaction."
120. A survey conducted by the Wall Street true
Journal indicates that, by and large,
small business owners have had more
satisfying business experiences than
they would have had as top-level executives.
121. One advantage of working for someone false
else is the likelihood of making more
money than if you were running your
own business.
122. Because an owner can delegate both false
authority and responsibility, entrepre17 / 66
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neurs often have more free time than
people who work for someone else.
123. Summarize the advantages and disad- Advantages include indevantages of business ownership.
pendence, financial rewards,
lifestyle, learning opportunities,
creative freedom, and personal satisfaction. Disadvantages include financial risk, stress, time
commitment, and undesirable
duties.
124. he first step before actually starting a
business is to get financing.
false
125. Franchises are considered an easy,
cost-efficient way to start your own
business.
false
126. Buying a franchise is the most comfalse
mon, though riskiest, option for starting
a new business.
127. If he bought a local combination minia- true
ture golf course and driving range,
Bernard Blanco would find that buying
an existing business is an easier option
than starting from scratch.
128. When buying a franchise, the business false
owner must pay a monthly royalty fee
but typically reserves the right to buy
core products from other suppliers.
129. Franchises generally don't include
such complex products as hotels.
false
130. Starbucks' Howard Schultz is an exam- false
ple of a person who came up with a
business idea as a result of a hobby.
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131. Brothers Ronnie and Jacob are both in a
college; Ronnie is a senior and Jacob
a sophomore. They're both majoring in
business administration and want to
open a small business a few years after graduation. They understand that it's
important to gain more management
experience and build good credit ratings. Ronnie wants more security in his
work and would be satisfied working
with an older partner until he "learns
the ropes." More than Jacob, he'd prefer
a business that's been established for
a few years. Although he likes a certain degree of independence, he's willing to follow directions and take advice.
Jacob, on the other hand, wants more
freedom to make his own choices and
to succeed or fail on his own merits.
He's quite creative and likes to set his
own rules.
By following your advice, Ronnie would
probably enjoy all of the advantages
of small business ownership except
_____.
a. time commitment
b. financial rewards
c. lifestyle freedom
d. creative freedom and personal satisfaction
132. Among the disadvantages of business d
ownership, Jacob would probably balk
at the prospect of_____.
a. financial risk
b. time commitment
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c. stress
d. unlimited liability
133. As Jacob's business advisor, what
a
would you probably advise him to do?
a. Start a business from scratch.
b. Buy an existing business.
c. Buy a franchise.
d. Go into business with his brother.
134. Among the disadvantages of business c
ownership, both brothers would probably balk at the prospect of _____.
a. time commitment
b. stress
c. undesirable duties
d. financial risk
135. If you were a business advisor, what
would you probably recommend for
Ronnie?
a. Start a business from scratch.
b. Buy an existing business.
c. Buy a franchise.
d. Go into business with his brother.
c
136. Explain the benefits of obtaining a fran- Benefits include the right to use
chise.
a company's brand name and
sell its products, the availability of advertising and help in
picking a location, and the ability to start and operate a business. In effect, you've bought a
prepackaged, ready-to-go business that's proven successful
elsewhere. You also get ongoing
support from the franchiser, who
has a vested interest in your success.
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137. Evaluate the differences between start- Although starting a business from
ing a new business from scratch and scratch is the riskier option, this
buying an existing business.
approach lets owners start with
clean slates and allows them to
build their businesses the way
they want. Entrepreneurs select
the goods or services that they
want to offer, the locations of
their businesses, and all of their
employees, but it's up to them
to develop customer bases and
build reputations. If you decide to
buy an existing business, you'll
already have a proven product,
customers, suppliers, a known location, and trained employees. It
will also be much easier to predict
the future success of your business.
138. How does franchising work and in what You may obtain a small business
industries do we find franchises?
by buying a franchise. As the
buyer, you're the franchisee and
have purchased the right to use
the seller's (franchisor's) brand
name and to sell its goods or
services. Because the franchisor
will help you in finding a location
and start and operate your business, as well as furnish advertising, you're getting a prepackaged business that's proven successful elsewhere. Franchises
are used to market products in
a variety of industries, including food, retail, hotels, travel,
real estate, cleaning and other
services, and even weight-loss
centers and wedding services.
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There are thousands of franchises, many of which are quite familiar—SUBWAY®, McDonald's,
7-Eleven, Holiday Inn, Budget
Rent-A-Car, Radio Shack, and
Jiffy Lube.
139. The "Management Plan" section of
true
the business plan provides information
about the qualifications of each member of the management team.
140. The "Target Market" section of the busi- true
ness plan profiles future customers.
141. The "Financial Plan" section of the
true
business plan reports the amount of
cash needed by the company for startup and initial operations.
142. The most important step in the process true
of starting a business is creating a business plan—a document that identifies
a company's goals and explains how
they'll be achieved.
143. A business plan explains the goods
true
and services that you intend to sell
and specifies the qualifications of your
management team.
144. The "Executive Summary" provides an true
overview of your business plan by paraphrasing key sentences from each section of the plan.
145. The "Mission Statement" section of the false
business plan contains the fundamental beliefs about what is and what isn't
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appropriate and important in conducting company activities.
146. The most common use of a business false
plan is to persuade potential customers
to buy your goods or services
147. The "Executive Summary" section of false
a business plan answers the question
"What is the outlook for the industry?"
148. The "Development and Production"
section of the business plan explains
why your proposed offerings will be
better than those of competitors.
false
149. In order to meet the financial needs for d
future business growth as well as current demands, TruWood Cabinet Makers must secure a business loan of
$125,000 from a local bank. The loan
committee has asked owner and general manager Jarret Jones to write a comprehensive business plan that meets all
of First Security Bank's requirements
for such a large loan. After a lot of research and careful writing, the plan is
constructed and ready for presentation
to the loan committee.
The section of his business plan in
which Jones sets forth the purpose of
his cabinet-making business—its reason for existing—is called the _____.
a. "Executive Summary"
b. "Vision Statement"
c. "Statement of Goals"
d. "Mission Statement"
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150. Jones knows that busy loan officers
b
don't have the time to read his entire
plan and prefer instead a synopsis or a
condensed version that summarizes it.
To address this fact, Jones:
a. limited his plan to 8-10 pages.
b. included a well-written executive
summary.
c. turned the project over to a professional writer.
d. thoroughly documented all research
findings and projections.
151. The dollars and cents of the business a
plan are especially important to loan
committees. Jones is well aware that
an entrepreneur must show how, when,
and why the business will make a profit.
He thus ensures that his _____ section
details his startup costs and sources
of funding, his projections of sales revenue, cost of goods sold, operating
and financing expenses, profits, and his
forecasts of cash flow.
a. financial plan
b. marketing
c. production and operations
d. management
152. Jones includes a(n) _____ section in his d
business plan to cover items of interest
that aren't otherwise covered in it—his
résumé, copies of sales contracts, a
copy of his lease, and so on.
a. marketing
b. production and operations
c. personal
d. appendix
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153. As a practical businessman, Jones
a
knows that his business plan must
demonstrate his knowledge of his customers (including the demographics of
various customer segments), product
promotion, pricing, and the essentials
of distribution. Thus his inclusion of a
strong _____ plan.
a. marketing
b. promotion and advertising
c. industry analysis
d. financial and management
154. What is the most common use of a busi- The most common use of a business plan?
ness plan is persuading investors
and/or lenders to provide financing. Investors are particularly interested in the quality of the business concept and the ability of
management to make the venture successful.
155. What does a mission statement do?
The mission statement describes
the purpose or mission of your
organization—its reason for existence. It tells the reader what
your organization is committed to
doing. It can be concise or it may
be fairly detailed.
156. What elements does a business plan
encompass?
A business plan tells the story of your business concept.
It specifies the qualifications of
your management team and describes your legal form of business ownership. It also explains
the goods or services that you
intend to sell. It identifies your
customers and competitors, de-
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scribes your approach to product
development, production methods, and marketing activities, and
details your projected profits and
borrowing needs.
157. The critical financial concept of cash true
flow tracks money coming in as well as
money going out of a business.
158. Under the Small Business Administra- true
tion's SCORE program, retired executives help business people who need
advice.
159. In order to limit your financial risk, it's false
usually advisable to pour limited financial resources into a new business.
160. Unfortunately, most small business
false
owners ultimately fail and regard the
decision to start a small business as an
unwise choice.
161. As a business owner, if you need indi- true
vidualized advice from experienced executives on how to manage your business, you can get it through the Service
Corps of Retired Executives (SCORE).
162. List three reasons why some business- The failure rate for small busies fail.
nesses is high, and the reasons
include bad business ideas, managerial inexperience or incompetence, lack of customer focus,
and inability to handle growth.
163. Explain at least three of the nine keys to Being successful as a business
succeeding in managing a business. owner requires more than coming up with a brilliant idea and
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working hard. You need to learn
how to manage and grow your
business. As an owner, you'll
also need to know your business,
know the basics of business management, have the proper attitude, get adequate funding, manage your money effectively, manage your time effectively, know
how to manage people, satisfy
your customers, and know how to
compete.
164. The management function of planning false
entails allocating resources (people,
equipment and money) to carry out the
company's plans.
165. To control operations, managers mea- true
sure the results and compare them with
the results that were laid out in the original plan.
166. A business plan ensures that a compa- false
ny's work will be done.
167. When a manager motivates employees true
to achieve organizational goals he or
she is engaging in the management
function of directing.
168. Describe the four functions that managers perform.
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(1) Planning: You must set goals
and determine the best way to
achieve them. As a result of
the planning process, everyone
in the organization knows what
should be done, who should do
it, and how it should be done.
(2) Organizing: You have to organize things if you want your
Business Exam 2 (4,5,6,7,8)
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plan to become a reality. You
have to put people and other
resources in place in order to
make things happen. (3) Directing: You need to be a leader
who can motivate your people to
do well. (4) Controlling: You have
to control your operations—that
is, measure performance results
and compare them with the results that you laid out in your original plans.
169. Generating an idea and establishing an true
overall course of action for the long
term is known as strategic planning.
170. The mission statement describes the true
purpose of your organization—the reason for its existence.
171. Core values are the fundamental beliefs true
about what's important and what is and
isn't appropriate in conducting company activities.
172. In developing tactical plans, managers false
identify those aspects of the business
that are most likely to be adversely affected by change.
173. Wendy's publicrelations team respond- true
ed quickly to counteract the effects of
bad publicity when a diner claimed that
she'd found a fingertip in a bowl of chili.
174. A SWOT analysis defines what an orga- false
nization stands for.
175.
true
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When late McDonald's CEO Jim Cantalupo explained his goal to revitalize
the company by increasing sales in existing restaurants, his objective was to
assess the company's place in its business environment.
176. In setting strategic goals and perforfalse
mance objectives, Joan Rivers of DayMark Solutions would begin by drawing
up a detailed list of what she wanted to
achieve.
177. Operational plans are broken down into false
various tactical plans that provide detailed action steps to be taken.
178. Core values describe the purpose of
false
your organization and the reason for its
existence.
179. Objectives are major accomplishments false
that the company wants to achieve over
a long period of time
180. The best time for management to prac- false
tice crisis management is when a crisis
occurs in their company.
181. Department heads at St. Claire Machine b
Works, a $5million metal fabricating
company with operations in four states,
are meeting to determine both the
management responsibilities that they
share in common and those that differ
according to different functions. They
all set goals, allocate resources, motivate employees, and compare results
with original goals. Marketing oversees
sales and advertising, while production
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handles purchasing, engineering, and
fabrication. Finance oversees accounting, raising capital, and paying/collecting bills.
Each department _____ its work.
a. outsources
b. organizes
c. audits
d. advertises
182. 45. When they compare results with
original goals, St. Claire department
heads are engaged in the function of
_____.
a. planning
b. organizing
c. controlling
d. leading
c
183. All department heads are involved in
_____.
a. planning
b. purchasing
c. research and development
d. strategic planning
a
184. There's no evidence that St. Claire de- d
partment heads are involved in _____.
a. leading
b. controlling
c. planning
d. strategic planning
185. In developing a flexible style of management for keeping employees motivated on a regular basis, St. Claire
department heads are engaged in the
function of _____.
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c
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a. planning
b. organizing
c. directing
d. controlling
186. Which of the following is a step in the c
contingency planning process?
a. Set up teams trained to deal with
emergencies.
b. Set performance targets to direct all
company activities.
c. Develop alternative courses of action
in case an anticipated change does occur.
d. Assess the company's strengths and
weaknesses.
187. What is a mission statement?
A mission statement describes
the purpose of the organization—the reason for its existence—and tells people what the
organization is committed to doing.
188. Explain contingency planning.
Contingency planning entails
identifying those aspects of a
business that are most likely to be adversely affected by
change. Managers develop alternative courses of action in case
an anticipated change occurs.
189. Explain the concept of SWOT analysis. SWOT analysis assesses the external factors that could influence a company in either a
positive or negative way. Such
factors could include economic
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tations. SWOT analysis stands
for an organization's Strengths,
Weaknesses, Opportunities, and
Threats.
190. Identify the steps in the strategic plan- Identify the purpose of the organing process.
nization
Prepare a mission statement
Select core values
Conduct SWOT analysis
Set goals and objectives
Develop tactical plans
Create operational plans
191. Middle managers, who direct all of the false
major activities that must be performed
if the company is to fulfill its mission,
are responsible for an organization's
general health and performance.
192. As a first-line manager Joe Smith might true
also hold the title of foreman or supervisor.
193. Some companies prefer a customer di- false
vision structure because it allows them
to perform operations and customer
service more efficiently.
194. A company usually has a product division structure when it must
move goods through several production steps.
false
195. An organization chart is a diagram or true
visual representation delineating the interrelationships of positions within an
organization.
196.
false
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To educate new employees, orientation
trainers at Valparaiso Communications
use an organization chart in which horizontal connecting lines show the firm's
chain of demand.
197. Under its matrix structure, Nike creates true
product teams made up of designers,
marketers, and other specialists to design new products.
198. When a manager delegates work to sub- false
ordinates, he denies them the opportunity to learn new skills.
199. Managers engage in the organizing
true
function when they allocate resources
to carry out a company's plans.
200. First-line managers report to top man- false
agement and oversee the activities of
middle managers.
201. In designing an organizational struc- true
ture, management uses departmentalization to group specialized jobs into
meaningful units.
202. A departmentalized organization
false
groups together people who have
comparable skills and perform similar
tasks.
203. An organizational structure is consid- false
ered wide if communications must filter
upward through two or more management layers.
204.
false
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Strategic planning is often delegated
to combined teams of top, middle, and
first-line managers.
205. The process of organizing activities
true
into clusters of related tasks that can be
handled by certain individuals is called
specialization.
206. There are more people at the middle lev- false
el of the organization than at the bottom
level.
207. COO stands for Chief Organization Of- false
ficer.
208. General Motors Corp., as everyone
true
knows, makes many brands of cars,
SUVs, vans, trucks, and hybrid vehicles. Production and assembly plants
are located in numerous states and
countries. Each make of vehicle—such
as Chevy, Pontiac, and Saturn—is produced by a separate division.
GM is probably best characterized as a
product division company.
209. Research has shown that, because car false
buyers' tastes vary from state to state,
GM should organize its U.S. operations
geographically.
210. Given its size, GM is not likely to reor- true
ganize as a functional organization.
211. To reduce duplication of operations and false
increase efficiency in ordering parts
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and controlling costs, GM should reorganize into functional departments.
212. Because the company serves the needs false
of individual consumers, businesses,
police departments, and the military,
GM's stock would be worth more if it
reorganized into customer divisions.
213. What are the consequences of failure to Managers who are reluctant to
delegate authority?
delegate (as many are) not
only overburden themselves with
tasks that could be handled by
others, but deny subordinates the
opportunity to learn and develop
new skills.
214. Identify the three levels of management
in a typical organization and briefly describe the responsibility of manager at
each of these levels.
Typically, there are three levels
of management: top managers,
who are responsible for overall
performance; middle managers,
who report to top managers and
oversee lower-level managers;
and first-line managers, who supervise employees to make sure
that work is performed correctly
and on time.
215. What are the responsibilities of middle Middle managers report to top
managers?
management and oversee the
activities of first-line managers.
They're responsible for developing and implementing activities and allocating the resources
needed to achieve the objectives
set by top management.
216. What's the difference between central- Whereas centralization concenized and decentralized decision mak- trates decision making at the
ing?
top level of management, de35 / 66
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centralization spreads it throughout the organization. Some decisions—such as strategic planning—shouldn't be delegated to
lower-level employees, but many
lowerlevel responsibilities—say,
managing copycenter operations—can easily be delegated.
217. What's the purpose of specialization in The first step in designing an oran organization?
ganizational structure is twofold:
(1) identifying the activities that
need to be performed in order to
achieve organizational goals and
(2) breaking down these activities
into tasks that can be performed
by individuals or groups of employees. This twofold process of
organizing activities into clusters
of related tasks is called specialization, and its purpose is to improve efficiency.
218. Managers at ACE Consulting, who gen- true
erally seek input from subordinates before making decisions, favor a democratic leadership style.
219. At first glance, you probably wouldn't
want to work for an autocratic leader.
true
220. If members of your team are unmotivat- true
ed and don't seem interested in providing input, it makes sense to move away
from a democratic style of leadership.
221. Managers who've developed a laisfalse
sez-faire leadership style tend to make
decisions without soliciting input from
subordinates.
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222. As a manager who mentors and devel- false
ops subordinates, providing them with
challenging opportunities, Tom Jones
is a transactional leader.
223. If you are leading a team which is new- false
ly formed, unfamiliar with what needs
to be done, under a tight deadline and
looking to you for direction, it is best
to follow a laissez-faire leadership style
(at least on a temporary basis).
224. Employees generally dislike working false
for democratic leaders and like working
for autocratic leaders.
225. In today's organizations, in which team false
building and information sharing are
important, most experts believe that the
transactional leadership style is most
effective.
226. Transactional leaders exercise authori- true
ty based on their rank in an organization and focus their attention on identifying mistakes.
227. Describe the laissez-faire leadership
style.
Managers adopt a "hands-off"
approach and provide relatively little direction to subordinates.
They may advise employees but
usually give them considerable
freedom to solve problems and
make decisions on their own.
228. Compare and contrast the transaction- Managers adopting a transacal leadership style with the transforma- tional style exercise authoritional leadership style.
ty according to their rank in
the organization, let subordinates
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know what's expected of them,
and step in when mistakes are
made. Practicing a transformational style, manages mentor and
develop subordinates and motivate them to achieve organizational rather than merely personal goals. Transformational leadership is effective in organizations
that value team building and information sharing.
229. Setting standards by which performance will be measured is part of the
transformational process.
false
230. he process of comparing actual to
planned performance and taking corrective action is called controlling.
true
231. What are the five-steps in the control
process?
The control function can be
viewed as a five-step process: (1)
establish standards, (2) measure
performance; (3) compare actual
performance with standards and
identify any deviations; (4) determine the reason for deviations,
and (5) take corrective action if
needed.
232. Identify two reasons why actual performance might differ from standards and
explain why the control process is helpful in both situations.
There are two possible reasons
for a deviation between actual
performance and standards. The
most likely is that performance
was lower than expected (or higher than expected). But it is also
possible that standards were not
set correctly. In both situations,
the control process has been
helpful. In the first instance, man-
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agement was alerted to a problem that can be corrected. In the
second case, management has
discovered a defect in planning,
which can also be corrected.
233. You'll probably be hired for your first job true
based on your technical skills.
234. The ability to reason abstractly and an- true
alyze complex situations depends on
conceptual skills.
235. When solving a problem, generating
false
possible solutions is the toughest part
of the process.
236. The toughest part of the problemsolv- true
ing process is selecting the best option.
237. Thinking outside the box" involves the false
use of your technical skills.
238. In the sixstep model of problem solv- false
ing, selecting the best option is the final
task.
239. As a newly hired first-line manager, So- false
phie Volka will call extensively on her
interpersonal skills.
240. You'll probably be hired for your first job false
based on your conceptual skills.
241. Describe the skills needed at various
levels of management.
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The skills needed by managers
vary according to level. Top managers need strong conceptual skills, while those at mid
levels need good interpersonal
skills and those at lower levels
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need solid technical skills. All
managers need strong communication, decision-making, and
time-management skills.
242. Why are communication skills critical
to success in an organization?
At all levels of an organization,
you will be judged on your ability to communicate, both orally and in writing. Whether talking informally or making a formal presentation, you must express yourself clearly and concisely. Talking too loudly, rambling, and using poor grammar
reduces your ability to influence
others, as does poor written communication. Confusing and error-riddled documents (including
e-mails) will reflect poorly on you.
243. Explain the six-step approach to prob- (1) Identify the problem that you
lem solving.
want to work on. Step one is getting to know your problem. (2)
Gather relevant data. Gather information that will shed light on
the problem. (3) Clarify the problem. Once you've reviewed all the
facts, you'll recognize options to
solving it. (4) Generate possible
solutions. (5) Select the best option (clearly the toughest part of
the whole process). (6) Implement your decision and monitor
your choice. The real test of the
solution will be the results you
get.
244. The process whereby Starbucks works true
to provide satisfying jobs, a positive
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work environment, and fair compensation and benefits is called human resource management (HRM).
245. Strategic human resource planning is true
the process of developing ways to satisfy an organization's human resource
needs.
246. Because internal hiring signals them true
that they can move up in a company,
it's a good policy for motivating current
employees.
247. If a business is looking to hire internally, true
bulletin boards are good spots for posting ads.
248. Temps are often cheaper than perma- true
nent workers, particularly because they
rarely receive costly benefits.
249. The job analysis process entails gath- false
ering information on candidates, evaluating their qualifications, and choosing
the right one.
250. Like many organizations, the FBI will
use your application as an initial
screening tool.
true
251. A job study not only identifies the tasks, false
responsibilities, and skills that a job entails, but also specifies the knowledge
and abilities needed to perform it.
252. Complementary workers are part-time false
employees hired to supplement a company's permanent workforce.
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253. Starbucks uses strategic HR planning false
to assess whether its employees are
satisfied with their jobs.
254. Working at temporary jobs lets you
false
move around to different companies
and gain a variety of skills while getting
paid the same as permanent workers
and receiving benefits.
255. What constitutes discrimination in re- Discrimination occurs when a
cruiting and hiring employees?
person is treated unfairly on the
basis of a characteristic that's unrelated to ability. Under federal
law, it's illegal to discriminate in
recruiting and hiring on the basis
of race, color, religion, sex, national origin, age, or disability.
256. What's a contingent worker?
A contingent worker is hired to
supplement a company's permanent workforce. Most are independent contractors, consultants, or free- lancers who are
paid by the firms that hire them.
257. What are some of the reasons for filling Hiring internally sends a posipositions internally?
tive signal to employees that they
can move up in the company. It's
also a strong motivation tool and
a reward for good performance.
In addition, because an internal
candidate is a known quantity, it's
easier to predict his or her success in a new position. Finally, it's
cheaper to recruit internally.
258. Orientation refers to the means by
which employers introduce new employees to their jobs.
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259. When you start a new job, a good em- true
ployer will take things slowly and refrain from swamping you with facts
about the company.
260. Pfizer, the world's largest pharmaceuti- true
cal company, regards employee growth
and development as its top priority.
261. In the 1950's more than 60 percent of false
the workforce was composed of white
males; today white males make up only
20 percent of the workforce.
262. Willowbend Tours operates a chain of b
25 touring guides throughout the Appalachian Mountains in the eastern
United States. Each office employs two
guides, one receptionist/office assistant, and one equipment handler. One
guide specializes in canoe and rafting outings while the other is a hiking specialist. Of the three job categories, guides are by far the most difficult to recruit. Next comes the receptionist/office assistants, followed by the
equipment handlers, who are basically unskilled workers. Turnover among
guides is 20 percent, 30 percent among
office staff, and 60 percent among
equipment handlers. Owners find that
recruiting, motivating, and keeping a
quality workforce is an ongoing challenge.
Willowbend equipment handlers appear to be _____ workers.
a. temporary
b. entry-level
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c. highly paid
d. senior
263. Where is management most likely to
c
find new tour guides?
a. Through classified ads in local newspapers
b. Through county or citygovernment
employment offices
c. Through specialized publications or
employment agencies
d. Through college job fairs
264. When Willowbend Tours was founded, d
the owners prepared a job _____ to
identify the duties and activities involved in each position.
a. analysis
b. specification
c. evaluation
d. description
265. Willowbend management is not likely to a
use _____ as a method of motivate and
train employees.
a. job rotation
b. orientation
c. on-the-job training
d. coaching
266. The job specification for _____ is no
a
doubt the most detailed.
a. tour guides
b. office personnel
c. equipment handlers
d. both tour guides and office personnel
267. Maria has worked at Starbuck's for a
d
week. Her supervisor is helping her become a "barista." The process she is
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going though is called _____.
a. orientation
b. off-the-job training
c. formal training
d. on-the-job training
268. In twofactor theory, hygiene factors in- true
clude working conditions.
269. In his expectancy theory, Victor Vroom true
proposes that employees will work hard
to earn rewards which they value and
which they consider obtainable.
270. In two factor theory, hygiene factors are false
those that contribute strongly to job
satisfaction.
271. According to Abraham Maslow, safety false
needs, which are placed at the very bottom of his hierarchy of needs, are the
easiest to satisfy.
272. According to twofactor theory, motiva- false
tion factors may alleviate job dissatisfaction but won't improve job satisfaction.
273. Expectancy theory focuses on our per- false
ceptions of how fairly we feel we're being treated relative to others.
274. According to Herzberg, giving somebody a raise or improving a person's
working conditions will lead to increased job satisfaction.
false
275. ack finds a job as a night janitor in the Maslow would say that Jack's solibrary, and although he feels secure, he cial need—the need to belong
starts to feel cut off from his friends.
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Which of the needs in Maslow's hierarchy is not being satisfied? How did
Maslow characterize this need?
and have friends—is not being
satisfied.
276. Psychologist Frederick Herzberg concluded that in order to understand employee satisfaction, he had to divide
work factors into two categories. Describe these two categories.
These two factors are motivation
factors and hygiene factors. Motivation factors are strong contributors to job satisfaction. Hygiene
factors, though not strong contributors to job satisfaction, must
be present to satisfy workers' expectations and prevent job dissatisfaction.
277. Explain Abraham Maslow's hierarchy-of-needs theory.
Maslow's model is shaped like a
pyramid. At the large base level
are physiological needs (involving such life-sustaining needs as
food and shelter). The next level
up consists of safety needs (such
as financial stability and freedom
from physical harm). Next are
social needs (the need to belong and have friends). The fourth
level entails esteem needs (the
need for self-respect and status).
The top level embraces self-actualization needs (the need to
reach one's full potential or to
achieve some creative success).
278. Employers who provide for flextime set true
guidelines and allow employees to designate starting and quitting times.
279. Many companies practice job redesign true
to make jobs more interesting and challenging.
280.
true
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In several studies of stress in the accounting profession, unmarried workers reported higher levels of stress than
any other group.
281. Job enrichment is the policy of enhanc- false
ing a job by adding tasks at similar skill
levels.
282. If employees work for ten hours a day false
for four days a week to earn three-day
weekends, they're taking advantage an
employer's flextime policy.
283. As part of its family-friendly program, true
the accounting firm KPMG allows employees to aggregate all paid daysoff
and use them in any way they want.
284. Explain a compressed work week.
Rather than work 8 hours a day
for five days a week, you might
elect to earn a three-day weekend by working 10 hours a day for
four days a week.
285. Describe and give an example of flextime.
Employers who provide for flextime set guidelines that allow employees to designate starting and
quitting times. Guidelines, for example, might specify that all employees must work 8 hours a day
(with an hour for lunch) and that
four of those hours must be between 10 a.m. and 3 p.m. Thus,
you could come in at 7 a.m. and
leave at 4 p.m. while coworkers arrive at 10 a.m. and leave
at 7 p.m. If appropriate provisions were made, you could even
choose to work from 8 a.m. to
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noon, take two hours for lunch,
and then work from 2 p.m. to 6
p.m.
286. Feedback from all points of view is
called 360-degree feedback.
true
287. When a company downsizes, it lays off true
workers because revenues are down.
288. Incentive programs are designed to re- true
ward employees for good performance.
289. Benefits are forms of compensation
other than salaries.
true
290. Most companies today strive for diverse workforces.
true
291. Abercrombie & Fitch got in trouble with true
the EEOC for hiring a disproportionate
number of white sales people.
292. Employees generally don't want man- false
agers to tell them how to improve performance.
293. Meetings to discuss performance tend true
to make managers appear judgmental
rather than supportive.
294. Employees at software maker SAS In- true
stitute, which encourages employees to
stay home with sick children, fall into
the category of "happy workers."
295. Medical insurance is a legally required false
benefit that companies must offer.
296.
false
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The amount that an employee is paid
is almost always the primary factor in
determining whether he or she stays
with or leaves a company.
297. Under the employment-at-will doctrine, true
employers can fire employees at will
298. How does job sharing work?
Under job sharing, two people
share one full-time position, splitting salary and benefits according to the share of the job performed. Often they arrange their
schedules to include at least
an hour of shared time during which they can communicate
about their responsibilities.
299. The magnitude of bonuses favors em- true
ployees at the top of a firm's hierarchy.
300. What is a profit-sharing plan?
A profit-sharing plan is an incentive program that uses a predetermined formula to distribute a
share of company profits to eligible employees.
301. Describe four different types of benefits Such benefits include (1) paid
as a major component of a compensa- time off (vacations, holidays, and
tion package.
sick leave); (2) insurance (health
benefits, life and disability insurance); (3) retirement benefits;
(4) legally required benefits (social security and Medicare, unemployment insurance, workers'
compensation).
302. When conflict erupts between employ- false
ees and employers, a collective union is
often formed.
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303. The process of settling differences and true
establishing mutually agreeable conditions under which employees will work
is called collective bargaining.
304. Picketing is an approach to resolvfalse
ing labor-contact disputes by following
the recommendations of impartial third
parties.
305. Labor-union density has steadily declined since the mid-1950s
true
306. At least in part, the decline in latrue
bor-union density can be attributed to
the fact that more women, who are more
likely to work part-time, have entered
the workforce
307. Grievances are worker's complaints on true
contract-related matters.
308. Boycotting means that workers walk
false
away from their jobs and refuse to return until a labor-management dispute
has been resolved.
309. When there's a discrepancy between false
what workers want and what management is willing to give, top executives
step in as negotiators to bring the two
sides together.
310. Strikebreakers are union workers who false
are willing to cross picket lines to replace strikers
311. Jeff Craddock is a plant supervisor
for Made Right Wood Products Inc.,
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Business Exam 2 (4,5,6,7,8)
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which makes both standardized and
customized signs out of solid wood and
wood veneers. Over the past few years,
the firm has grown steadily and now
employs more than 200 people working two shifts. Keeping employees motivated, however, is a constant challenge
for both Craddock and production manager Marie Horowitz. Both try hard to
apply motivational techniques that they
learned in college, encountered in local workshops, and discovered during
the course of on-the-job training. Made
Right, it seems, has a higher percentage of single parents and older workers than the industry average, and that
fact seems to be one of the problems:
More workers ask for time off to do
things with their children, and older employees visit a lot of doctors. As elsewhere, tardiness and absenteeism also
cut into production efficiency. Craddock and Horowitz are once again rethinking possible approaches to employee motivation.
Of all Made Right's employees, _____
are likely to experience the greatest
stress on the job.
a. older workers
b. males
c. married workers
d. single parents
312. Both Craddock and Horowitz are con- c
vinced that if employees felt better
about themselves on the job, performance would improve. To enhance job
satisfaction, they have thus decided to
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help workers satisfy what Maslow's hierarchy of needs calls _____ needs.
a. self-actualization
b. security
c. esteem
d. accomplishment
313. Four recent and well-qualified job hires a
have asked to cut back from 40 to 20
hours per week. Although Made Right
typically hires part-time workers only
during seasonal rush periods, Horowitz
wants to accommodate these employees. What's her best option?
a. Job sharing
b. Compressed work weeks
c. Temp workers
d. Telecommuting
314. _____ would probably be the best so- c
lution to the problems faced by single
parents at Made Right.
a. Compressed work weeks
b. Job rotation
c. Flextime
d. Bonuses
315. When discussing performance with em- b
ployees, Craddock and Horowitz could
avoid a common mistake by providing
_____.
a. constructive criticism
b. open and honest feedback
c. customized rewards
d. monetary incentives
316. Some governmental and not-for-prof- true
it organizations are experiencing higher than average turnover rates. To reduce the high cost of replacing em52 / 66
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ployees, they're adopting techniques
used in the private sector. Because
many of these organizations maintain centralized authority structures
with strict policies and procedures, retaining workers—and maintaining efficiency in both costs and performance—means that changes must be
made these areas
Government agencies run the risk of
losing many employees when they put
wage caps on future pay raises.
317. One effective strategy for improving
true
employee retention is involving employees more deeply in decision making.
318. An element of trust is quite important true
in the minds of an employee when he
or she weighs the prospect of leaving a
job.
319. Publicsector organizations are more
true
likely to be unionized than privatesector organizations.
320. During the past few decades, courts
have undercut employers' rights
grounded in the employment-at-will
doctrine.
true
321. Explain mediation and arbitration.
Mediation is an approach to labor-dispute resolution in which
an impartial third party assesses
the situation and makes recommendations for reaching an
agreement. A mediator's advice
can be accepted or rejected. If
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the two sides are willing to accept the decision of a third party,
they may opt instead for arbitration, under which the third party
studies the situation and arrives
at a binding agreement.
322. An organization is a group of people
false
with complementary skills who work together to achieve a specific goal
323. In the case of the team that created
true
the RAZR cell phone, the common goal
was to create and bring to market an
ultrathin cell phone that would help Motorola regain its lofty position in the cell
phone market.
324. Teams are essential to business organi- true
zations because they have been found
to increase workplace performance.
325. Members of a team work independently, false
but come together primarily to share
information.
326. Team members function interdependently.
true
327. Members of a working group go about true
their jobs independently.
328. Team-based projects rarely fail
false
329. Recently, major organizations have be- false
gun to rely less on teams and more on
individuals to improve operations.
330. Most teams are unaccountable to those false
higher up in the organization.
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331. Self-managing work teams are often
true
allowed to schedule assignments, but
they are rarely allowed to fire coworkers.
332. Miscommunications can easily occur
with virtual teams and it's difficult to
establish trust.
true
333. The leader of a selfmanaging team may true
determine overall goals, but employees
control the activities needed to meet
them.
334. A virtual team should be limited to five false
to ten members.
335. Briefly compare and contrast the four
main categories of teams.
In the manager-led team, the
leader defines the team's goals
and activities and is responsible for its achieving its assigned
goals.
The leader of a self-managing team may determine overall
goals, but employees control the
activities needed to meet them.
A cross-functional team is designed to take advantage of the
special expertise of members
drawn from different functional areas of the company.
On a virtual team, geographically
dispersed members interact electronically in the process of pursing a common goal.
336. Teams are more effective when team
members depend on one another.
true
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337. Generally, the more that team members false
derive satisfaction from being on the
team, the more fun they have and the
less committed they become to achieving goals.
338. Teams function more effectively when true
leadership responsibility is shared over
time.
339. The idea of group cohesiveness refers false
to the interest level of a team to the
project they are working on.
340. According to the idea of group cotrue
hesiveness, groups are most effective
when their members like being part of
the group.
341. The bigger the team, the more satisfied false
members tend to be.
342. When it comes to teams, there is no
such thing as too much group cohesiveness.
false
343. A cohesive team with goals that are
true
aligned with the goals of the organization is most likely to succeed.
344. When there is too much conformity
within a group it can become ineffective.
true
345. For a team to succeed, team members true
must communicate with each other.
346. The tendency to conform to group
true
pressure in making decisions is called
groupthink.
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347. In a team-based organization, teams are true
interdependent.
348. Difficulty in maintaining a high level of true
motivation is the chief cause of frustration among members of teams.
349. Employers today look for an individtrue
ual's ability to develop and sustain motivation when they are hiring new managers.
350. What is group cohesiveness? Why is Team cohesiveness refers to the
it important? Identify four factors that attractiveness of a team to its
contribute to team cohesiveness.
members. If a group is high in cohesiveness, membership is quite
satisfying to its members and
they will likely want to remain on
the team. When members want to
remain with the team, the team
will likely be more effective than
when its members are unhappy
and want to leave the team.
The following five factors are important to group cohesiveness:
(1) size - smaller teams are more
cohesive; (2) Similarity - when
people on the team share similar attitudes and experience, the
members are happier and more
cohesive; (3) success - when the
team is successful, members are
satisfied and more cohesive; (4)
exclusiveness - when it is hard
to get into a group, current team
members are happier and more
cohesive; (5) competition - teams
that are motivated to achieve
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perform other teams are more cohesive.
351. Teams don't always work. Identify four Members are unwilling to cooperfactors that make it less likely that
ate; they don't or won't commit to
teams will succeed in an organization? a common goal or set of activities.
Management fails to provide
needed resources.
Managers fail to delegate authority to the team.
Teams are unwilling to cooperate
with other teams in the organization.
352. More than two thirds of all students re- true
port having participated in some sort of
group project.
353. A survey of Fortune 1000 companies false
reveals that only about 20 percent rely
on selfmanaging teams.
354. Typically a team performs well because true
its members possess some level of talent.
355. Successful teams require that every
member have some mixture of communication, financial and managerial
skills.
false
356. Effective teamwork develops over time true
as team members learn how to handle
various team-based tasks.
357. The business world is dominated by
teams.
true
358.
false
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Students who have worked in groups in
college advise other students to avoid
conflict by being more lenient with
deadlines.
359. As a college student and as a memtrue
ber of the workforce, most of us will
be members of a team more often than
leaders.
360. Relationship-building roles address
false
challenge number one—accomplishing
the team goals.
361. Task facilitators are especially valuable true
when assignments aren't clear or when
progress is too slow.
362. When you challenge unmotivated behavior among team members you're
performing a task-facilitating role.
false
363. Teams are most effective when there's a true
good balance between task facilitation
and relationship building among members.
364. It is difficult for any one given member true
of a group to perform both the task-facilitating and the relationship-building
roles because some people are better
at focusing on tasks and others on relationships.
365. individuals who play blocking roles are false
generally good at building consensus
among the group.
366. When teams attempt to confront dysfunctional members, they usually end
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up destroying morale, creating conflict,
and hindering progress instead.
367. Team members who use the blocking
tactic of overanalyzing tend to blow
things out of proportion
false
368. Summarize the advice on how to survive group work in college.
Draw up a team charter that
spells out rules of conduct for the
team. Share your ideas with your
team. Pick a regular meeting time
and never miss a meeting. Be
considerate of each other. Create
a process for resolving conflict.
Utilize the strengths of each team
member. Don't do all the work
yourself. Set intermediate deadlines for each team member to
get his or her work done.
369. In contributing to the new-product de- true
sign and development process, industrial designers such as Chris Arnholt must effectively communicate both
ideas and practical specifications.
370. The design and development process false
usually succeeds even without input
from other areas of the organization.
371. Nonverbal communication is the extrue
change of information through behavior such as facial expressions and tone
of voice.
372. Chris Arnholt's responsibility as chief false
designer of the RAZR required him
to communicate his ideas about the
product's visual and physical features
but not about the production process60 / 66
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es and manufacturing requirements for
building it.
373. Chris Arnholt made recommendations true
for the design of the RAZR through
drawings, models, and verbal communications.
374. Newproduct design is an integrative
process, meaning that contributions
from other functional areas within an
organization are not necessary.
false
375. Chris Arnholt's drawings, specs, and true
recommendations for the RAZR reflected his collaboration with people from
all functional areas at Motorola.
376. Chris Arnholt had a vision for the RAZR true
phone that he called "rich minimalism."
377. Good communication skills can make true
decisions more convincing and certain
and problem solving faster.
378. Discuss the ways in which organizaBusinesses benefit in several
tions benefit from effective communica- ways when they're able to foster
tion.
effective communication among
their employees:
Decisions are more convincing
and problem solving is faster.
Warning signs of potential problems appear earlier.
Workflow moves more smoothly
and productivity increases.
Business relationships are
stronger.
Marketing messages are more
persuasive.
The company's professional im61 / 66
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age is enhanced.
Employee satisfaction goes up
and turnover goes down.
The firm and its investors enjoy
better financial results.
379. if you write a memo to a coworker
true
you are using a lateral communication
channel.
380. Communication may flow laterally in or- true
ganizational settings, but more often it
flows up or down.
381. Downward communication flows from true
higher organizational levels to lower organizational levels.
382. Lateral communication flows from low- false
er to higher organizational levels.
383. Upward communication usually provides managers with information that
they need for making decisions.
true
384. As information seeps downward, it
true
tends to lose some of its original clarity
and often becomes distorted or downright wrong.
385. Internal communication is shared by
people at all levels within a company
and parties outside the company.
false
386. An organization's formal communica- true
tion network consists of all communications that flow along its official lines
of authority.
387.
true
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Every company also has an informal
communication network known as the
grapevine
388. Information on the grapevine is usually false
very accurate.
389. Managers should make every attempt false
to eliminate the grapevine in an organization.
390. Discuss the difference between internal Organizational communication
and external communication.
flows through two different channels. Internal communication is
shared by people at all levels
within a company. External communication occurs between parties inside a company and parties outside the company, such
as suppliers, customers, and investors.
391. What are barriers to communication?
List two different types.
Barriers to communication include anything that prevents people from communicating as effectively as possible. Among groups,
two types of barriers are common. Cultural barriers, sometimes called cultural filters, are
the barriers that result from differences among people of different
cultures. Functional barriers arise
when communication must flow
among individuals or groups who
work in different functional areas
of an organization.
392. What should a manager do about the
grapevine?
Managers should learn to live
with the grapevine because it is
here to stay. They should try to
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tune in to it and make the most of
it. They should learn what is going
on and try to correct inaccurate
information. Managers should not
participate in rumors and should
check the accuracy of what they
hear on the grapevine.
393. The communication skill ranked high- false
est in importance in business is the
ability to create technical reports.
394. Good communicators are able to com- true
pose and send e-mails and have the
ability to adapt messages to different
receivers.
395. When writing to a coworker with whom true
you are friends, you can be less formal
than when you are writing to your manager or a client.
396. It is common and appropriate to forfalse
ward an email without permission from
the sender.
397. Dale Carnegie created a four-step
process for preparing and delivering
presentations.
true
398. When using slides in a presentation it is false
important to detail all of the information
you intend to cover on each slide.
399. It is perfectly acceptable to read the
false
slides to your audience during a presentation so that nothing important is
missed.
400.
true
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Memos are effective at conveying fairly
detailed information.
401. There are multiple forms of standard
false
memo format that vary from company
to company and sometime even within
the same company.
402. The RE in a memo stands for "reminder."
false
403. Memos should be concise yet complete true
and summarize information effectively.
404. Tone of voice is considered nonverbal true
communication.
405. If a person yawns in a meeting he or she true
is demonstrating nonverbal communication.
406. Nonverbal cues often tell you what's on true
a person's mind more than words can
do.
407. The best way to get over your fear
of making a presentation is through
preparation.
false
408. If your message is simple your best ap- false
proach would likely be to talk by phone.
409. It would be inappropriate to send a for- false
mal e-mail to your manager.
410. Recipients of e-mails often use the sub- true
ject line to decide whether to open or
delete a message.
411.
false
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You should include multiple messages
in your email, especially if you want responses to several items.
412. Provide some tips for writing effective Distinguish between formal and
email messages.
informal situations. When writing
to a coworker with whom you
are friends, you can be less formal than when you are writing to
your manager or a client. Write
a meaningful subject line and
keep the message focused and
readable. Avoid including multiple messages or requests in
one email. When writing emails
when you are upset, always think
before you hit the "send" button. Proofread your work and
use spell check before sending
any email. Don't assume privacy.
You shouldn't send anything you
wouldn't want posted on the office bulletin board. Try to respond
promptly to the person who sent
you an e-mail. Always show respect and restraint in your emails.
413. You are an HR manager. Write a memo
to your employees notifying them about
the mandatory overtime that will be in
effect during the holiday season. Use
standard memo format.
66 / 66
Responses will vary but should
include the TO, FROM, DATE, RE
and follow the memo format presented in the book. Paragraphs
should be short and to the point.
Macroeconomics, Chapter 14, "Monetary Policy"
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1. A nation's *monetary policy ob- the *central bank* and the *government*
jectives* and the framework for
*setting and achieving those objectives* stem from a relationship between...
2. Where is U.S.'s *monetary poli- In the mandate of the *Board of Governors
cy objectives* set out by?
of the Federal Reserve* system, defined
by the *Federal Reserve Act of 1913*
3. Goals of monetary policy
maximum employment, stable prices, and
moderate long-term interest rates
4. Are the goals of monetary poli- Only in the long-run; conflict in the
cy in harmony?
short-run
5. What is the key goal of monetary policy?
Price stability; the source of maximum employment and moderate long-term interest
rates.
6. What encourages the maximum Price stability
sustainable growth rate of potential GDP?
7. Between what does the Fed face Between *inflation/interest rates*, and
a tradeoff?
*inflation/real GDP*, *employment/unemployment*
8. What are the means of achiev- The fed must "maintain a long-run
ing the monetary policy goals? growth of the monetary and credit aggregates commensurate with the economy's
long-run potential to increase population."
9. What are the two measures of *Consumer Price Index* and *personal
inflation that the Fed pays atten- consumption expenditure deflator*
tion to?
10. What is the core inflation rate? it is the PCE deflator, minus the price of
food and fuel
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11. Why does the Fed use the core More stable and less volatile than total CPI
inflation rate?
inflation rate
12. What did Alan Greenspan say Unhelpful and false precision
about having a specific numerical inflation target?
13. What did Ben Bernanke say
It should be 1 and 2 percent a year
about having a specific numerical inflation target?
14. What is the primary goal of mon- stable prices (price stability); means to
etary policy?
achieve the other two goals
15. What indicators does the Fed
look to, to gauge state of output
and employment relative to full
employment?
labor force participation rate, the unemployment rate, measures of capacity utilization, activity in the housing market, the
stock market, and regional information
16. Beige book
Contains the summarized data of the current state of the economy
17. What number stands as the
Output gap
overall state of aggregate demand relative to potential GDP?
18. Output gap
The percentage deviation of real GDP
from potential GDP
19. Who is responsible for the con- Board of Governors of the Federal Reduct of monetary policy?
serve system and the Federal Open Market Committee
20. What is the role of Congress in No role; Board of Governors report to Conmaking monetary policy?
gress
21. What is the role of the President Appoints the members and the chairman
in monetary policy?
of the Board of Governors
22.
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What is monetary policy instru- Variable that the Fed can directly control
ment? Which ones does the Fed or at least very closely target; *monetary
use?
base* and the *federal funds rate*
23. Federal funds rate
Interest rate in the federal funds market
24. When federal funds rate is
high...
Fed aimed at lowering inflation
25. By what percentage does the quarter of a percentage point
Fed usually change the federal
funds rate?
26. How does the Fed move the FFR Uses open-market operations to adjust the
to target level?
quantity of monetary base
27. The higher the FFR...
the greater is the quantity of overnight
loans supplied and the smaller is the quantity of overnight loans demanded
28. Where does the Fed's decision Beige book
making begin?
29. What does the Fed try to forecast?
Inflation rate, unemployment rate, and output gap
30. If inflation is above comfort
zone...
the Fed considers raising FFR
31. If inflation is below comfort
zone...
the Fed considers lowering FFR
32. If unemployment rate is below
natural unemployment rate...
might increase inflation, and calls for higher interest rate
33. If unemployment rate is above might decrease inflation, and calls for a
natural state...
lower interest rate
34. Inflationary gap (positive output higher interest rate
gap) leads to...
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35. Recessionary gap (negative
output gap) leads to...
lower interest rate
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Financial Goals
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1. Education goals Enable individuals to prepare for future success in the
workplace
2. Financial goals
Specific objectives to be accomplished through financial
planning
3. Financial planning
A tool used to achieve financial success based upon the
development and implementation of
financial goals
4. Goal
The end result of something a person intends to acquire,
achieve, do, reach, or accomplish
sometime in the near or distant future
5. Longterm goals
Goals specified as more than one year
6. Shortterm goals Goals specified as less than one year
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1. An Overview of
Managerial Finance (pg.1)
In this chapter, we introduce finance by providing you with
(1) a description of the discipline
(2) an indication of the goals companies should attain,
as well as the conduct that is acceptable when pursuing
these goals.
As you will discover, a corporation acts in the best interests
of its owners (stockholders) when decisions are made that
increase the firm's value, which in turn increase the value
of its stock.
2. 1-1 WHAT IS FINANCE? (pg.1)
Finance is concerned with decisions about money.
~Financial decisions deal with how money is raised and
used by businesses, governments, and individuals.
3 General Concepts of Finance---To Make Sound Financial Decisions [Everything Else Equal]:
(1) more value is preferred to less
(2) the sooner cash is received, the more valuable it is
(3) less risky assets are more valuable than (preferred to)
riskier assets.
3. 1-1a General Ar- The study of finance consists of four interrelated areas:
eas of Finance
(pg.2)
1.) Financial Markets and Institutions:
2.) Investments:
3.) Financial Services:
4.) Managerial (Business) Finance:
4. 1.) Financial Mar- Include:
kets and Institu- -Banks
tions (pg.2)
-Insurance Companies
-Savings and Loans
-Credit Unions
Are an integral (fundamental) part of the general financial
services marketplace.
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The success of these organizations requires an understanding of factors:
-that cause interest rates and other returns in the financial
markets to rise and fall
-regulations that affect such institutions
-various types of financial instruments such as,
~mortgages
~automobile loans
~certificates of deposit, that institutions offer.
5. 2.) Investments
(pg.2)
This area of finance focuses on the decisions made by
businesses and individuals at they choose securities for
their investment portfolios.
The Major Functions in the Investments Area Are:
a.) determining the values, risks, and returns associated
with such financial assets as stocks and bonds
b.) determining the optimal mix of securities that should be
held in a port olio of investments
6. 3.) Financial Ser- Refer to functions provided by organizations that deal with
vices (pg.2)
the management of money.
~Persons who work in these organizations, which include
banks, insurance companies, brokerage firms, and similar companies, provide services that help individuals and
companies determine how to invest money to achieve
such goals as home purchase, retirement, financial stability and sustainability, budgeting, and so forth.
7. 4.) Managerial
(Business) Finance (pg.2)
Deals with decisions that all firms make concerning their
cash flows, including both inflows and outflows.
~As a consequence, managerial finance is important in
all types of businesses, whether they are public or private,
and whether they deal with financial services or the manufacture of products.
-Financial managers also have the responsibility for deciding the credit terms under which customers can buy,
how much inventory the firm should carry, how much cash
to keep on hand, whether to acquire other firms (merger
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analysis), and how much of each year's earnings should
be paid out as dividends versus how much should be
reinvested in the firm.
8. 1-1b The Importance of Finance
in Non-Finance
Areas (pg.24)
Let's consider how finance relates to some of a business's
non-finance areas that students often study in college.
1.) Management
2.) Marketing
3.) Accounting
4.) Information Systems
5.) Economics
There are financial implications in virtually all business decisions, and non-financial executives must know enough
finance to incorporate these implications into their own
specialized analyses.
9. -*Treasurer*
(pg.4)
Has direct responsibility for managing the firm's cash and
marketable securities, planning how the firm is financed
and when funds are raised., managing risk, and overseeing the corporate pension fund.
10. -*Controller*
(pg.4)
Is responsible for the activities of the accounting and tax
departments.
11. 1-2 ALTERNATIVE FORMS
OF BUSINESS ORGANIZATION (pg.4)
There are 3 Major Forms if Business Organization in the
United States:
(1) Proprietorship
(2) Partnership
(3) Corporation
12. 1-2a Proprietorship (pg.4-5)
An unincorporated (not formed into a legal corporation)
business owned by one individual.
3 Advantages:
1.) It is easily and inexpensively formed.
~Only licenses required by the state and municipality (a
city or town that has corporate stays and local government) in which the business operates are needed.
2.) It is subject to few government regulations.
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3.) It is taxed like an individual, not like a corporation; thus,
earnings are taxed only once.
4 Limitations:
1.) The proprietor has unlimited personal liability for business debts, be causes any debts if the business are considered obligations of the sole owner.
2.) A proprietorship's life is limited to the time the individual
who created it owns the business.
~When a new owner takes over the business, legally the
firm becomes a new proprietorship (even if the name of
the business does not change).
3.) Transferring ownership is somewhat difficult.
~Disposing of the business is similar to selling a house
in that the proprietor must eek out and negotiate with a
potential buyer, which generally takes weeks or months to
complete.
4.) It is difficult for a proprietorship to obtain large sums of
capital because the firm's financial strength generally is
based only on the financial strength of the sole owner.
Unlike corporations, proprietorships cannot raise funds by
issuing stocks and bonds to investors.
13. 1-2b Partnership An unincorporated business owned by two or more per(pg.5)
sons (owners).
-The advantages of the partnership are the same as those
of a proprietorship, except that most partnerships have
more sources available for raising funds because there are
more owners, with more relatives, more friends, and more
opportunities to raise funds through credit.
- The business-related activities of any of the firm's partners can bring ruin to the other partners, even though
those partners are not direct parties to such activities.
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14. 1-2c Corporation A legal entity created by state, separate and distinct from
(pg.5-6)
its owners and managers, having unlimited life, easy transferability of ownership, and limited liability.
~A legal entity created by a state, which means that a
corporation has the legal authority to act like a person
when conducting business.
It is separate and distinct from its owners and managers.
This separateness gives the corporation four major advantages:
1.) A corporation offers its owners *limited liability.*
2.) Ownership interests can be divided into shares of
stock, which can be *transferred far more early* than can
proprietorship or partnership interests.
~Shares of stock can be bought and sold in minutes
3.) A corporation can continue after its original owners and
mangers no longer have a relationship with the business;
thus it is said to have *unlimited life.*
~The life of a corporation is based on the longevity of its
stock, not the longevity of those who own the stock (the
owners).
4.) The first three factors---limited liability, easy transferability of ownership interest, and unlimited life---make it
much easier for corporations than for proprietorships or
partnerships to raise money un the financial markets.
~In addition, corporations can issue stocks and bonds
to raise funds, whereas proprietorships and partnerships
cannot.
2 Disadvantages:
Setting up a corporation, as well as periodic filings of
required state and federal reports, is more complex and
time-consuming than for a proprietorship or partnership.
1.)
a.) When the corporation is created, a corporate chatter
must be filed with the secretary of the state in which the
firm incorporates.
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b.) bylaws must be drawn up by the founder
2.)
Because the earnings of the corporation are taxed at
the corporate level and then any earnings paid out as
dividends are again taxed as income to stockholders,
corporate earnings are subject to *double taxation.*
15. -Corporate Char- A document filed with the secretary of state in which a
ter (pg.6)
business is incorporated that provides information about
the company, including its name, address, directors, and
amount of capital stock.
16. -Bylaws (pg.6)
A set of rules drawn up by the founders of the corporation that indicates how the company is to be governed;
includes procedures for electing directors, rights of stockholders, and how to change the bylaws when necessary.
17. 1-2d Hybrid
Forms of Business: LLP, LLC,
and S Corporation (pg.6)
Alternative business forms that include some of the advantages, and avoid some of the disadvantages, of the three
major forms of business have evolved over time.
In this section, we provide a brief description of 3 popular
*hybrid forms* that exist today.
-LimitedLiabilityPartnership (LLP)
-Limited Liability Company (LLC)
-S Corporation
For the following reasons, the values of any business, other than a very small concern, probably will be maximized
if it is organized as a corporation (pg.7):
1.) Limited liability reduces the risks borne by investors. All
else equal, *the lower the firm's risk, the higher its market
value.*
2.) *A firm's current value is related to its future growth
opportunities,* and corporations can more easily attract
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funds to take advantage of growth opportunities than
can incorporated businesses (only corporations can issue
stocks and bond to raise funds).
3.) Corporate ownerships can be transferred more easily
than ownership of either a proprietorship or a partnership.
~Therefore, all else equal, investors would be willing to
pay more for a corporation than for a proprietorship or
partnership, which means that the corporate form of an
organization can *enhance the value* of a business.
18. -LimitedLiability- A partnership wherein at least one partner is designated
Partnership
as a *general partner* with unlimited person financial lia(LLP) (pg.6)
bility, and the other partners are *limited partners* whose
liability is limited to amounts they invest in the firm.
~Only the general partners can participate in the management of the business.
-In other states, all partners in an LLP are fully liable for the
general debts of the business, but an individual partner is
not liable for the negligence, irresponsibly, or similar acts
committed by any other partner (thus the limited liability).
19. -Limited Liability Offers the limited personal liability associated with a corCompany (LLC) poration; however, the company's income is taxed like that
(pg.6)
of a partnership.
20. -S Corporation
(pg.7)
A corporation with no more than 100 stockholders (and
only one type of stock) that elects to be taxed in the same
way as proprietorships and partnerships, so that business
income is only taxed once.
~That is, income passes through the company to the
owners so that it is taxed only once.
The major differences between an S corporation and an
LLC are that an LLC can have more than 100 stockholders
(members) and more then one type of stock (membership
interest).
21.
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1-3 WHAT
GOAL(s)
SHOULD
BUSINESSES
PURSUE?
(pg.7-11)
*Stock price maximization is the most important goal of
most corporations.*
*The same actions that maximize stock prices also benefit
society.*
1.) Note that stock price maximization requires efficient,
low-cost plants that produce high-quality goods and services that are sold at the lowest possible prices.
2.) Stock price maximization requires the development
of products that consumers want and need, so the profit
motivate leads to new technology, to new products, and to
new jobs.
3.) Finally , stock price maximization necessitates efficient
and courteous service, adequate stocks of merchandise,
and well located business establishments.
^These factors are necessary to maintain a customer base
that generates sustainable profits.
22. -Stockholder
Wealth
Maximization
(pg.7)
The appropriate goal for management decisions' considers the risk and timing associated with expected cash
flows to maximize the price of the firm's common stock.
~Translates into maximizing the value of the firm as
measured by the price of its common stock.
23. 1-3a Managerial
Actions to Maximize Shareholder Wealth (pg.8)
An indication of how management can affect price of a
company's stock:
1.) First, the value of any investment, such as stock, is
based on the cash flows the asset is expected to generate
during its life.
2.) Second, the investors prefers to receive a particular
cash flow sooner rather than later.
3.) And, third, investors generally are risk averse, which
means they are willing to pay more for investments with
more certain future cash flows than for investments with
less certain, or riskier, cash flows, everything else equal.
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For these reasons, we know that managers can increase
the value of a firm by making decisions that increase the
value of a firm by making decisions that increase the
firm's expected future cash flows, generate the expected
cash flows sooner, increase certainty of the expected cash
flows, or produce any combination of these actions.
-Although managerial actions affect the value of a firm's
stock, external factors also influence stock prices.
~based on both internal and external constraints, management makes a long-run strategic policy decisions that
chart a future course for the firm.
24. -Value (pg.8)
The present, or current, value of cash flows that an asset
is expected to generate in the future.
~The worth of the expected future cash flows restated in
current dollars---that is, the *present (current) value* of the
future cash flows.
25. 1-3b Should
Earnings per
Share (EPS)
Be Maximized?
(pg.9-10)
EPS=Earnings per Share
26. 1-3c Managers'
Roles as Agents
of Stockholders
(pg.10-11)
Because they generally are not involved in day-to-day
operations, stockholders of large corporations "permit"
(empower) the executives to make decisions about how
the firms are run.
~Of course, the stockholders want the managers to make
decisions that are consistent with the goal of wealth maximization.
EPS= NI/Shares
NI=Net Income 1
Mechanisms used by large corporations to motivate managers to act in the shareholders' best interests include:
1.) Managerial Compensation (Incentives):
A common method used to motivate managers to operate
in a manner consistent with stock price maximization is
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to tie managers' compensation to the company's performance.
~Such compensation packages should be developed so
that managers are rewarded on the basis of the firm's
performance over a long period of time, not on its performance in any particular year.
All incentive compensation plans should be designed to
accomplish 2 things:
(1) Provide inducements to executives to act on those
factors under their control in a manner that will contribute
to stock price maximization.
(2) Attract and retain top-level executives.
2.) Shareholder Intervention:
When it is determined that action is needed to realign management decisions with the interests of investors, these
institutional investors exercise their influence by suggesting possible remedies to management or by sponsoring
proposals that must be voted on by stockholders at the
annual meeting.
3.) Threat of Takeover:
Hostile takeover.
27. -Agency Problem A potential conflict of interest between outside sharehold(pg.10)
ers (owners) and managers who make decisions about
how to operate the firm.
28. -Hostile Takeover The acquisition of a company over the opposition of its
(pg.11)
management.
~Instances in which management doe snot want the
firm to be taken over. The managers of the acquired firm
generally are fired, and those who stay on typically lose
the power they had prior to the acquisition.
29. 1-4 WHAT ROLES
DO ETHICS
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AND GOVERIn this section, we discuss business ethics and corporate
NANCE PLAY IN governance, and the roles each of these concepts play in
BUSINESS SUC- successful businesses.
CESS?
30. 1-4a Business
The word *ethics* can be defined as "morel behavior" or
Ethics (pg.11-12) "standards of conduct."
Most Executives Believe that there is a positive correlation
Between Ethics and Long-Run Profitability because of
Ethical Behavior:
(1) prevents fines and legal expenses
(2) builds public trust
(3) attracts business form customers who appreciate and
support ethical policies
(4) attracts and keeps employees of the highest caliber
(5) supports the economic viability of the communities
where these firms operate.
31. -Business Ethics A company's attitude and conduct toward its stockholders
(pg.11)
(employees, customers, stockholders, and community).
Ethical behavior requires fair and honest treatment of all
parties.
~Can be thought of as a company's attitude and conduct
toward its employees, customers, community, and stockholders.
32. 1-4b CorpoStudies show firms that practice good corporate goverrate Governance nance generate higher returns to stockholders than those
(pg.12)
that don't have good governance policies.
33. -Corporate Gov- Deals with the set of rules that a firm follows when conernance (pg.12) ducting business; these rules identify who is accountable
for major financial decisions.
34. -Stakeholders
(pg.12)
Those who are associated with a business, including managers, employees, customers, suppliers, creditors, stockholders, and other parties with an interest in the firm's
well-being.
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35. 1-5 FORMS OF
BUSINESSES IN
OTHER COUNTRIES (pg.12-16)
What we do know is that greater concentration of ownership in non-U.S. firms permits greater monitoring and control by individuals or groups than do the more dispersed
ownership structure of U.S. firms.
36. -Proxy Votes
(pg.13)
Voting power that is assigned to another party, such as
another stockholder or institution.
37. -Industrial
Groups (pg.13)
Organizations of companies in different industries with
common ownership interests, which include firms necessary to manufacture and sell products; networks of manufactures, suppliers, marketing organizations, distributors,
retailers, and creditors.
~The objective of an industrial group is to create an organization that ties together all the functions of production
and sales from start to finish by including firms that provide
the materials and serves required to manufacture and sell
the group's products.
-Thus, an industrial group encompasses forms involved
manufacturing, financing, marketing, and distribution of
products, suppliers or raw materials, production organizations, retail stores, and creditors.
38. 1-5a Multination- U.S. and Foreign Companies "go international" for the
al Corporations following major reasons:
(pg.14-15)
1.) To seek new markets
2.) To seek raw materials
3.) To seek new technology
4.) To seek production efficiency
5.) To avoid political and regulatory hurdles
39. -Multinational
Companies
(pg.14)
Firms that operate in two or more countries.
40. 1-5b Multinational Versus Domestic Managerial Finance (pg.15-16)
6 Major Factors Distinguish Managerial Finance as Practiced by Firms Operating Entirely within a Single Country
from Management by Firms that Operate in Several Different Countries:
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1.) Different Currency Denominations
2.) Economic and Legal Ramifications
3.) Language Differences
4.) Cultural Differences
5.) Role of Governments
6.) Political Risk
41. -Exchange Rates The prices at which the currency of one country can be
(pg.15)
converted into the currencies of other countries.
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1. capital structure
The mixture of debt and equity
used by the firm to finance its
operations is called:
2. Maximize the market value of the exist- The fundamental goal of finaning stock
cial management should be:
3. At what rate of interest should a firm
borrow
Which of the following is NOT
considered one of the basic
questions of corporate finance?
4. As a corporation or PLC
You want to pool your resources
with your best friend and start
your own telecommunications
firm. However, you are concerned about the risk this business poses to your accumulated personal wealth. To limit your
exposure, you and your friend
should organize the business:
5. Maximize the market value of the exist- For most financial managers, the
ing stock
correct and fundamental goal of
financial management is to:
6. I, IV, & V only
Which of the following is considered one of the basic questions
of corporate finance?
I. Which projects or assets the
firm should choose.
II. At what rate of interest should
a firm borrow.
III. How the firm should structure
the payment to its employees.
IV. What mixture of debt and equity should the firm use to fund
its operations.
V. How should the firm manage
its day-to-day cash levels.
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7. II, III, & IV only
You are planning to borrow money to buy a Porsche. Which of the
following is a core determinant of
the interest rate the bank might
charge you?
8. but the corporation's income is double
taxed
Limited liability is a big advantage of the corporate form of
business...
9. Corporate shareholders have limited lia- Name two primary differences
bility and are double taxed
between a partnership and a corporation.
10. Corporate shareholders escape liability
for the firm's debts, although this factor may be somewhat offset by the tax
disadvantages of the corporate form of
organization.
Which of the following could
explain why a business might
choose to operate as a corporation rather than as a sole proprietorship or a partnership?
11. D
Which of the following statements is CORRECT?
a. The financial manager's proper goal should be to attempt
to maximize the firm's market
share, since that will add the
most to the individual shareholders' wealth.
b. The financial manager should
seek that combination of assets
that will generate the largest
expected projected after-tax income over the relevant time horizon, generally the coming year.
c. One example of financial managers maximizing value is when
they delay a large investment in
a project so that the firm may
maximize its near-term earnings
per share (EPS).
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d. Potential agency problems
can arise between managers
and stockholders, because managers hired as agents to act on
behalf of the owners may instead make decisions favorable
to themselves rather than the
stockholders.
12. Maximize the stock price per share over The primary goal of a pubthe long run, which is the stock's intrin- licly-owned firm interested in
sic value.
serving its stockholders should
be to
13. A & D
Recall the last time you ate at
an expensive restaurant where
you paid the bill. Now think about
the last time you ate at a similar
restaurant, but your parents paid
the bill. Did you order more food
(or more expensive food) when
your parents paid? Explain how
this relates to the agency problem in corporations.
(Select all the choices that apply.)
A. In both situations there may
be a lack of interest in controlling
costs if those costs are not borne
directly by the person making the
decision.
B. Your situation could never lead
to an agency problem since your
parents would only want the best
for you.
C. While you may be faced with
an agency problem (spending
more when your parents are buying than you would if you were
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paying), corporate managers are
seldom faced with such decisions.
D. The agency problem leads
an individual (in your case) and
corporate managers (in the corporate setting) to put their own
self-interest ahead of the interests of the shareholders (your
parents in your case).
14. A & C
You are the CEO of a company
and you are considering entering
into an agreement to have your
company buy another company.
You think the price might be too
high, but you will be the CEO of
the combined, much larger company. You know that when the
company gets bigger, your pay
and prestige will increase. What
is the nature of the agency conflict here and how is it related to
ethical considerations?
(Select all the choices that apply.)
A. There is an ethical dilemma
when the CEO of a firm has
incentives that are opposite to
those of the shareholders.
B. There is a legal issue when
the CEO of a firm has incentives
that are opposite to those of the
shareholders.
C. In this case, you (as the CEO)
have an incentive to potentially overpay for another company (which would be damaging to
your shareholders) because your
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pay and prestige will improve.
D. In this case, you (as the CEO)
have an incentive to potentially overpay for another company (which would be damaging to
your shareholders) because the
value of the combined company
will improve
15. A & D
Why do all shareholders agree
on the same goal for the financial
manager?
(Select all the choices that apply.)
A. All of the decisions by the financial manager are made within the context of the overriding goal of financial management—to maximize the wealth of
the owners, the stockholders.
B. All of the decisions by the financial manager are made within the context of the overriding goal of financial management—to maximize the wealth of
the corporation.
C. The stockholders have invested in the corporation, putting
their money at risk to become the
managers of the corporation.
D. The stockholders have invested in the corporation, putting
their money at risk to become the
owners of the corporation.
16. The goal of a financial manager is to
Identify the goal of a financial
maximize the wealth of the shareholders manager and justify that goal
(they implement this by maximizing the (why is it the correct goal?).
value of the company's assets). It is the
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correct goal because shareholders are
the owners of the firm. Their money is at
risk.
17. We convert earnings to cash flows because investors care about cash flows.
Earnings can be manipulated (both legally and illegally). Investments are made
with cash, and therefore investors want
cash in return. Book values are historical costs, which are backward-looking.
Market values are forward looking and
represent the true value of the asset to
the firm.
Why must we convert accounting
data (earnings and book values)
when performing financial analysis? Explain.
18. The required rate of return is comprised Explain the determinants of a
of:
required rate of return (interest
rate).
Real (risk-free) rate of interest, aka the
basic time value of money: the price you
charge, or compensation you require,
even if you are certain to get your money back. Optional addition: Captures an
economy's aggregated "time preference
for consumption", which also depends
on production opportunities.
Expected inflation: You must include a
component to cover the expected increase in prices (loss in value of your
currency) over time.
Risk: The riskier is the loan/investment,
the higher the return you will require.
19. From LN 1, we learned that the primary
types of decisions that managers make
is what projects to pick (capital budgeting decision - what to invest in), how to
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What are the main types of decisions that financial managers
make? Explain which one you
think is more critical to firm value.
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finance those investments (capital structure decision), and day-to-day cash management (working capital, or liquidity decision). We discussed in class that the investment (capital budgeting) decision is
the most important one because it fundamentally determines what the firm does
and what its cash flows will be. Financing simply determines how those cash
flows will be split between bondholders
and shareholders. Whereas investing decisions maximize the value today of the
difference between the benefits and the
costs, financing decisions tend to create
less value, typically by minimizing costs.
20. Cash flows determine the value of the
firm. A share of stock is only worth money because it is a claim to future cash
flows, which can be consumed. Market
values are forward-looking and estimate
the value today of an asset based on its
ability to generate cash flows now and
into the future. Earnings are not cash
flows—they start as cash flows and then
make non-cash flow adjustments. Since
they are only a poor representation of
the underlying cash flows, in finance we
instead focus on the cash flows themselves. Book values are historical and
backward looking, often having nothing
to do with the actual value of an asset or
its ability to generate cash flows.
Why do we care so much about
cash flows and market values in
finance and not about earnings
and book values?
21. FALSE. The goal of the financial manager TRUE/FALSE & EXPLAIN: The
is to increase the value of the compagoal of a financial manager is to
ny (increase shareholder wealth). Maxi- maximize earnings
mizing earnings is not the same thing.
First of all, earnings are not cash flows,
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but are accounting constructs instead.
You can't buy anything with earnings, but
you can buy things with cash flows. Second, which earnings should I maximize?
I could maximize this year's earnings by
not spending anything on future production, thus killing next year's earnings.
How should I weight earnings in various
years? Luckily, the computation of Net
Present Value accounts for the size, timing, and risk of all future cash flows!
22. 1. Level (or size) of cash flow: More value What are the three key determiis preferred to less
nants of the value of most any
2. Timing of cash flow: The sooner cash asset? Explain.
is received the more value it has
3. Risk of cash flow: Less risky cash
flows are more valuable than riskier cash
flows (or assets)
23. The financial manager's goal is to maxi- Identify and justify the goal of the
mize shareholder wealth. Why maximize financial manager.
the shareholders' wealth? Because it is
the shareholders that own the company
and it is their wealth most at risk. The
financial manager is the caretaker of the
shareholders' money (i.e., agent for the
stockholders) and his/her job is to make
decisions in the best interest of the owners. In general, an increase in stockholders' wealth means that value has been
added to a firm's assets (and wealth
of society has generally increased.) The
way to do this is to make decisions (particularly investment decisions) that maximize the value of the firm, and therefore
the value of ownership of that firm.
To get full credit you needed to say
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something about the fact that the money
the managers are working with belongs
to the shareholders. This idea motivates
why it is that managers should maximize shareholder wealth. The two italicized sentences above are sufficient for
full credit.
24. Advantages: Unlimited life Easy trans- What are the advantages and
fer of ownership Limited liability Ease of disadvantages of corporations
raising capital
and limited companies?
Disadvantages: Double taxation (Corporation tax and dividends) Cost of set-up
and report filing Often higher agency
costs than other corporate forms
25. Maximizing earnings is an imprecise and
misdirected goal. Earnings are the yearly
accounting numbers created for tax purposes. They differ from cash flows due to
things like depreciation expense. Shareholders care about cash flows, not earnings, so earnings are not the right numbers to maximize. Further, which earnings do we maximize? This year's or next
year's? The value of the assets will appropriately reflect all of the future cash
flows generated by those assets, not
simply near-term earnings.
Maximizing market share is only rarely
the same as maximizing shareholders'
wealth. I can maximize market share by
giving the product away, but that won't
make my shareholders any better off.
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The objective of a financial manager is to maximize the wealth of
the shareholders (also known as
maximizing the market value of
the assets). Why is this a better
objective than maximizing earnings? Why is it better than maximizing market share?
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1.
Identify three responsibilities of
the financial management function
of an entity.
1. Managing the capital and financial structure of the
entity
2. Planning, allocating and controlling an entity's financial resources
3. Identifying and managing financial risks faced by the
entity
2.
What is the ultiThe ultimate objective of financial management is to
mate objective of maximize the value of the entity, usually as reflected by
the financial man- the market price for the firm's stock.
agement function
in a profit-oriented
entity?
3.
How is a firm's
Cost of capital is the rate of return that must be earned
cost of capital de- by prospective investors in order for a firm to attract and
termined?
retain their investments.
Investors' expected rate of return is determined primarily by the rate of return that could be earned on other
opportunities with comparable risk; in other words, it is
investors' opportunity cost.
4.
Define "expired
cost."
The benefit to an entity from the good or service that
has been used up and is of no future value to the entity.
An expired cost is an expense (.e.g., cost of wages and
salaries) or a loss (e.g., cost of goods destroyed by fire).
5.
Define "opportuni- Benefit lost from the next best opportunity as a result of
ty cost."
choosing another opportunity. It is measured as the discounted value of the cash flow or other benefit forgone
and is relevant in making current decisions.
6.
Define "cost" as
used in accounting.
Amount paid or obligation incurred for a good or service;
may be unexpired or expired. An unexpired cost is an
asset. An expired cost is an expense.
7.
Define "differential cost."
Costs that are different between two or more alternatives. Differential costs are relevant in making deci1 / 39
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sions between the alternatives. For example: In deciding
whether to accept a special order for a product, only
the new costs that would be incurred in accepting the
order would be relevant. Fixed costs that would not
change whether the order is accepted or not would not
be relevant.
8.
Define "unexpired An asset; it has future value to the entity (e.g., the cost of
cost."
a three-year insurance policy would be an asset during
the period covered).
9.
Define "weightCost of each element of capital weighted by the proed-average cost of portion (percentage) of total capital provided by each
capital."
element, with the resulting products summed to get the
weighted average cost for all elements of capital.
10. What are the ma- Long-term debt, preferred stock, and common stock
jor elements of a
firm's capital (or
capital structure)?
11. Define "sunk
cost."
Costs incurred in the past that cannot be changed by
current or future decisions and, therefore, are irrelevant
to current decisions.
12. Define the "future Value at some future date of a single amount invested
value" of $1.
now.
It is the amount that will accumulate as a result of
compounding of interest on the single amount invested
at the present.
13. Define "future val- Value at some future date of a series of equal amounts
ue" of an ordinary to be invested at the end of equal intervals over some
annuity.
period of time.
It is the amount that will accumulate as a result of the
amounts invested at the end of each period and the
compounding of interest on those amounts.
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14. Define the "future Value at some future date of a series of equal amounts
value" of an annu- to be invested at the beginning of equal intervals over
ity due.
some period of time.
It is the amount that will accumulate as a result of the
amounts invested at the beginning of each period and
the compounding of interest on those amounts.
15. Define the "present value" of an
ordinary annuity.
Value now of a series of equal amounts to be received
at the end of equal intervals over some future period.
Equal amounts to be received at the end of a number of
equal periods are discounted using an interest rate to
get the present value of those amounts.
16. Define the "preValue now (at present) of a single amount to be received
sent value" of $1. in the future.
The amount to be received in the future is discounted
using an interest rate to get the present value of that
amount.
17. Distinguish between an "ordinary annuity (also
called an annuity
in arrears)" and an
"annuity due (also
called an annuity
in advance)."
Ordinary annuity: Series of equal amounts received or
paid at the end of each equal period
Annuity due: Series of equal amounts received or paid
at the beginning of each equal period
18. Define "annual
percentage rate
(APR)."
The annualized effective interest rate(without compounding) on loans that are for a fraction of a year. In
effect, the effective interest rate for a portion of a year is
grossed up to an annual rate.
Computed as the effective interest rate for the fraction
of a year multiplied by the number of such fractions in a
whole year.
Basis of interest rate disclosure in U.S.
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19. Define "simple in- Interest computed on the principal only; there is no comterest."
pounding in the interest computation (i.e., no interest
paid on interest)
20. Define "compound interest."
Interest computed not only on the principal but also on
any accumulated unpaid interest (i.e., interest is paid on
interest).
21. Define the "present value of a
perpetual annuity"
and how it is computed.
Value now of a series of equal amounts to be received at the end of equal intervals with no ending date;
the amounts continue indefinitely into the future. Computed as: PV of perpetual annuity = Annual payment
amount/Interest (discount) rate.
22. Define "stated rate The annual rate of interest specified in a debt instru(of interest)" (also ment or other contract/agreement; it does not take into
used interchange- account the compound effects of payment frequency.
ably with "nominal rate" or "quoted rate").
23. Define a "fixed in- The percentage rate of interest does not change over
terest rate."
the life of the loan or parts of that life.
24. Define a "variable The percentage rate of interest can change over the life
interest rate."
of the related debt instrument.
25. Define "effective Annual percentage rate with compounding on loans that
annual percentage are for a fraction of a year
rate" (also called
the "annual percentage yield").
26. Define "interest." Cost of the use of money. It is expressed as a percentage rate, almost always as an annual percentage rate,
and applied to the principal to determine dollar amount.
27. Define "effective
interest rate".
The annual interest rate implicit in the relationship between the net proceeds of a borrowing (or other arrangement) and the dollar cost of the borrowing (or other
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arrangement).
Computed as: Dollar cost of borrowing / Net proceeds
of borrowing.
28. Identify and briefly
describe the three
component levels
of the U.S. generally accepted accounting principles (GAAP) hierarchy of inputs
used for determining fair value.
Level 1: Quoted prices in active markets for identical
items
29. Identify and briefly
describe the three
approaches to determining fair value as specified by
U.S. generally accepted accounting
principles (GAAP).
1. Market approach: Information generated by market
transactions for identical or similar items
2. Income approach: Converts future amounts of benefit
or sacrifice to determine current value
3. Cost approach: Determines the amount required to
acquire or construct a comparable item
30. How is "fair value" defined and
determined for
U.S. generally accepted accounting
principles (GAAP)
purposes?
Fair value for the purposes of U.S. generally accepted
accounting principles (GAAP) is the price that would be
received to sell an asset or paid to transfer a liability in
an orderly transaction between market participants.
31. What are some of
the factors that
must be considered in assigning
value?
These factors must be considered in assigning value:
- The specific item or items (asset, liability, equity, etc.)
being valued
- The condition of the item(s)
- The location of the item(s)
- The time at which the valuation is occurring
- The economic environment in which the valuation is
occurring
Level 2: Quoted prices in inactive markets or for items
similar (but not identical) to those being valued; observable inputs other than quoted prices relevant to the item
being valued
Level 3: Unobservable inputs relevant to valuing an item
(e.g., assumptions, estimates, etc.)
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32. Identify ways in
which professional judgment must
be used in carrying out a valuation.
Professional judgment is used in valuation to develop an
understanding of the purpose and context of a valuation,
the selection of appropriate quantitative techniques and
data, and ultimately, the assignment of a value
33. Briefly describe
Level 3 of the U.S. GAAP fair value framework consists
the nature of lev- of inputs that are not observable but are based on an
el 3 inputs identi- entity's assumptions and estimates.
fied in the fair value framework of
U.S. generally accepted accounting
principles (GAAP).
34. Briefly describe
the nature of level 2 inputs identified in the fair
value framework
of U.S. Generally Accepted Accounting Principles (GAAP).
Level 2 of the U.S. GAAP fair value framework consists
of inputs that are either directly or indirectly observable,
including:
- Quoted prices for similar items in active markets and
in inactive markets
- Quoted prices for identical items in inactive markets
- Observable inputs other than quoted prices
- Inputs not directly observable but that are derived from
or corroborated by observable market data
35. Briefly describe
Level 1 of the U.S. GAAP fair value framework consists
the nature of lev- of quoted market prices in active markets for identical
el 1 inputs identi- assets or liabilities.
fied in the fair value framework of
U.S. generally accepted accounting
principles (GAAP).
36. What are the major assumptions
and limitations of
the capital as-
- All investors have equal access to all investments and
are using a one period time horizon.
- Asset risk is measured solely by its variance from the
asset class benchmark.
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set pricing model - There are no external cost—commissions, taxes, and
(CAPM)?
so on.
- There are no restrictions on borrowing or lending at the
risk-free rate of return.
- There is a market and market benchmark for all asset
classes.
- CAPM uses historical data.
37. Identify and describe the three
possible alternative values of beta.
Beta (B) = 1: The individual asset being valued changes
in the same proportion as the entire class of the asset
being valued; the asset has average systematic risk for
the entire class.
Beta (B) > 1: The individual asset being valued changes
greater than the entire class of the asset being valued;
the asset is more volatile than the entire class.
Beta (B) < 1: The individual asset being valued changes
less than the entire class of the asset being valued; the
asset is less volatile than the entire class.
38. Define "beta."
Beta is a measure of the systematic risk associated with
an investment as reflected by its volatility as compared
with the volatility of the entire class of the investment.
39. Give the capital
asset pricing model formula and describe its components.
RR = RFR + B(ERR - RFR)
where:
RR = Required rate of return
RFR = Risk-free rate of return
B = Beta, a measure of volatility
ERR = Expected rate of return for a benchmark for the
entire class of the asset being valued
40. Define/describe
the capital asset
pricing model
(CAPM).
The capital asset pricing model (CAPM) is an economic
model that determines the relationship between risk and
expected return and uses that measure in assigning
value to securities, portfolios, capital projects, and other
assets.
41. What are some
- It assigns a probability factor to the likelihood that the
major advantages price of the stock will pay off within the time to expiration.
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of the original
- It assigns arobability factor to the likelihood that the
Black-Scholes op- option will be exercised.
tion pricing mod- - It discounts the exercise price to present value.
el?
42. What is the
Black-Scholes optionpricing model?
The Black-Scholes model is a mathematical formula for
valuing stock options, which are derivative instruments
(and certain other instruments). The original model was
developed to value European-style options, which permit exercise only at the expiration date of the option.
43. What are some
major limitations
of the original
Black-Scholes option pricing model?
- It is appropriate only for European call options, which
permit exercise only at the expiration date.
- It assumes options are for stocks that pay no dividends.
- It assumes options are for stocks whose price increases in small increments.
- It assumes the risk-free rate of return remains constant
during life of the option.
- It assumes there are no transaction costs or taxes
associated with the options.
44. Briefly describe
the methodology
of the binomial option pricing model.
The binomial option pricing model is a method that
can be generalized for the valuation of options. It uses
a tree or network diagram to represent points in time
between the present (valuation date) and the expiration
of the option and uses probabilities to work backward in
assigning value to each branch in the tree to derive a
value at the present (valuation date).
45. Describe the asset The asset approach to valuing a business determines
approach to valu- the value of a business by adding (summing) the values
ing a business.
of the individual asset that comprise the business. The
sum of those asset values constitutes the value of the
entire business. This approach is particularly appropriate when the business being valued has little or no cash
flows and/or earnings, or when the business will not
continue as a going concern.
46. Describe the inThe income approach to valuing a business determines
come approach to the value of a business by calculating the present val8 / 39
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valuing a business.
47. Describe the market approach to
valuing a business.
ue of the expected benefit stream to be generated by
the business. This approach may use discounted cash
flows, capitalization of earnings, multiple of earnings or
other similar approaches that develop a fair value based
on income/earnings.
The market approach to valuing a business determines
the value of a business by comparing it to other entities
with highly similar characteristics for which a fair value
can be more readily determined.
48. Identify the three 1. Market approach
basic approaches 2. Income approach
to valuing a busi- 3. Asset approach
ness.
49. Identify and describe three classes of qualitative
business forecasting methods.
1. Executive opinion: The collective judgments and opinions of executives and managers are used to develop a
forecast.
2. Market research: Surveys of customers and others
are done to determine preferences and other factors as
a basis for formulating a forecast.
3. Delphi method: Uses a consensus developed by a
group of experts using a multistage process for converging on a forecast.
50. Identify and describe the two major classes of business forecasting
methods.
1. Qualitative: Methods that are subjective in nature and
based on judgment and opinion
2. Quantitative: Methods that are objective in nature and
based on mathematical calculations and determinations
51. Identify and describe the two
major classes of
quantitative business forecasting
methods.
Time-series models: Use patterns from past data to
predict a future value or values. These methods are not
concerned with causes of patterns, just with the patterns
in the data.
Causal models: Use assumed relationships between
the variable being forecasted and other variables to
make projections based on those relationships
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52. Identify and briefly
describe major
time-series patterns.
Level: Data are relatively constant or stable over time.
Seasonal: Data reflect up- and down-swings over short
or intermediated periods of time; each swing is of about
the same timing and level of change.
Cycles: Data reflect up- and down-swings over a long
period of time.
Trend: Data reflect a steady and persistent up or down
movement over a long period of time.
Random: Data reflect unpredictable, erratic variations
over time.
53. Identify and briefly
describe the major types of causal
models used for
forecasting.
Regression: Uses an equation to relate a dependent
variable to one or more independent variables to forecast the dependent variable.
Input-output models: Describe the flow from one stage,
sector, or other component to another in order to forecast values for either the predecessor or successor
stage, sector or other component.
Economic models: Specify a statistical relationship between various economic quantities to forecast the value
of one using the value of another.
54. Identify the major Regression models (linear or non-linear)
forms of causal
Input-output models
models used for Economic models
forecasting.
55. Identify eight major forms of
time-series models (mathematical
methods) used for
forecasting.
Naive
Simple mean (average)
Simple moving average
Weighted moving average
Exponential smoothing
Trend-adjusted exponential smoothing
Seasonal indexes
Linear trend line
56. Describe the
risk/reward relationship.
The greater the perceived risk of an undertaking, the
higher the expected reward from the undertaking.
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57. Describe the rela- The rate of return earned on a firm's capital projects
tionship between must be equal to or greater than the rate of return
a firm's capital
required to attract and maintain investors' capital.
projects and the
firm's capital that
funds those projects.
58. Define "capital
budgeting."
The process of measuring, evaluating, and selecting
long-term investment opportunities, primarily in the form
of projects or programs
59. Define "risk premi- The rate of return expected above the risk-free rate
um."
based on the perceived level of risk inherent in an investment/undertaking
60. Define "risk-free
rate of return."
The rate of return expected assuming virtually no risk;
rate of return expected solely for the deferred current
consumption that results from making an investment.
In the U.S., it is measured by the rates paid on U.S.
Treasury obligations.
61. Define "risk."
The possibility of loss or other unfavorable results that
derives from the uncertainty implicit in future outcomes
62. Give examples of
risk associated
with investments
in capital projects.
Incomplete or incorrect analysis of a project
Unanticipated actions of customers, suppliers, and competitors
Unanticipated changes in laws, regulations, and so on
Unanticipated macroeconomic changes (e.g., interest
rates, inflation/deflation, tax rates, currency exchange
rates, etc.)
63. Identify the advan- It is easy to use and understand.
tages of the pay- It is useful in evaluating liquidity of a project.
back period apUse of a short payback period reduces uncertainty.
proach to project
evaluation.
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64. Identify the disadvantages of the
payback period
approach to project evaluation.
It ignores the time value of money.
It ignores cash flows received after the payback period.
It does not measure total project profitability.
The maximum payback period may be arbitrary.
65. Under what
circumstances
would the
payback period
approach to
project evaluation
be most
appropriate?
When:
- Used as a preliminary screening technique
- Used in conjunction with other evaluation techniques
- Recovery of cash (liquidity) is of critical importance
66. Describe the payback period approach to project
evaluation.
It determines the number of years (or other periods)
needed to recover the initial cash investment in the
project and compares the resulting time with a preestablished maximum payback period. It uses undiscounted
expected future cash flows.
67. Identify five different techniques
for evaluating capital budgeting projects.
Payback period approach
Discounted payback period approach
Accounting rate of return approach
Net present value approach
Internal rate of return approach
68. Identify a techThe profitability index (PI)
nique that is intended to rank
capital budgeting
projects in terms
of desirability.
69. Identify the disIt ignores cash flows received after the payback period.
advantages of the It does not measure total project profitability.
discounted pay- Maximum payback period may be arbitrary.
back period approach to capital
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budgeting evaluation.
70. Describe the dis- A variation of the payback period approach that takes
counted payback the time value of money into account by discounting
period approach expected future cash flows.
to capital budgeting evaluation.
71. Identify the advantages of the discounted payback
period approach
to capital budgeting evaluation.
It is easy to use and understand.
It uses the time value of money approach.
It is useful in evaluating liquidity of a project.
Use of a short payback period reduces uncertainty.
72. Will the payback
period from using the discounted payback period approach be
longer or shorter
than using undiscounted payback
period approach
(to capital budgeting)?
The discounted payback period will be longer than the
undiscounted payback period because the present value of cash flows will be less than the undiscounted
values.
73. Describe the
accounting
rate-of-return
(also called the
simple rate of
return) approach
to capital project
evaluation.
Measures the expected average annual incremental accounting income from a project as a percentage of the
initial (or average) investment and compares that with
the established minimum rate required
74. In computing
Because the average investment gives a smaller dethe accounting
nominator, the accounting rate of return will be higher
rate-of-return ap13 / 39
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proach (to capiwhen the average investment is used than when the
tal budgeting), will initial investment is used.
using the initial investment or
the average investment give the
higher rate of return?
75. What alternative
investment bases
can be used
in the accounting
rate-of-return approach (to capital
budgeting)?
Two alternative investment bases may be used:
1. Initial investment
2. Average investment (i.e., the average book value of
the asset over its life)
76. What are the
It ignores the time value of money.
disadvantages of It uses accrual accounting values, not cash flows.
the accounting
rate-of-return approach to project
evaluation?
77. What are the
It is easy to use and understand.
advantages of
It is consistent with financial statement values.
the accounting
It considers the entire life and results of the project.
rate-of-return approach to project
evaluation?
78. Identify the advantages of
the net-present-value approach to capital
project evaluation.
It uses the time value of money concept.
It relates project rate of return to cost of capital.
It considers the entire life and results of project.
It is easier to compute than the internal rate of return
approach.
79. Describe the
It compares the present value of expected cash inflows
net-present-value of a project with cash outflows, including initial cash
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approach to
capital project
evaluation.
investment in project.
It is derived by discounting future cash inflows (or savings) and determining whether or not the resulting present value is more or less than the present value of
outflows, including cost of the investment.
80. How is the net pre- It is the difference (net) between the present value of
sent value deter- expected cash inflows from a project and expected cash
mined?
outflows, including the initial cost of the project.
81. Identify the disadvantages of
the net-present-value approach to capital
project evaluation.
It requires estimation of cash flows over entire life of the
project, which could be very long.
It assumes cash flows are immediately reinvested at the
discount rate.
82. Using the net-pre- If the net present value is zero or positive, the project is
sent-value apconsidered economically feasible; otherwise, the project
proach (to capiis not considered economically feasible.
tal budgeting), under what conditions would a project be considered
economically feasible?
83. Under what condi- When future cash flows of a project are both positive
tions is the inter- and negative, the internal rate of return method should
nal rate of return not be used because it can result in multiple solutions.
approach (to capital budgeting) not
appropriate?
84. Describe the inter- It evaluates a project by determining the discount rate
nal rate of return that equates the present value of a project's cash inflows
(also called time with the present value of the project's cash outflows.
adjusted rate of
return) approach
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to capital project
evaluation.
85. Compare the internal rate of return
(IRR) approach
with the net-present-value (NPV)
approach (to capital budgeting).
The IRR approach computes the discount rate that
would make the present value of a project's cash inflows
and outflows equal to zero.
The NPV approach uses an assumed discount rate to
determine whether the net of the present value of a
project's cash inflows and outflows is positive or not.
86. Identify the
It recognizes the time value of money.
advantages of the It considers the entire life and results of the project.
internal-rate-of-return approach to
capital project
evaluation.
87. Identify the disadvantages of the
internal rate of
return approach
to capital project
evaluation.
It is difficult to compute.
It requires estimation of cash flows over the entire life of
project, which could be very long.
It requires all future cash flows be in the same direction,
either inflows or outflows.
It assumes cash flows resulting from the project are
immediately reinvested at the project's internal rate of
return.
88. Describe the profitability index
(PI; also called
cost/benefit ratio
or present value
index).
It ranks projects by taking into account both the net
present value (NPV) of each project and the cost of each
project.
Computed as: PI = NPV / Project cost
89. When using the
profitability index
(PI), how are projects ranked relative to each other?
The projects are ranked according to the computed
profitability index (i.e., NPV / Project cost) for each for
each project; the higher the PI, the higher the rank of
the project.
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90. Will the profitability index (PI)
and the net-present-value (NPV)
approaches (to
capital budgeting)
result in the same
ranking of multiple
projects?
No. Since the NPV approach does not explicitly consider
the differences in initial cost of one project compared to
another project, it does not give the same ranking as the
profitability index, which considers both the net present
value and the initial cost of the project by getting an NPV
per dollar invested.
91. Describe the con- Limiting the number of economically feasible projects
cept of capital ra- that are undertaken and selecting those that will be
tioning.
undertaken
92. Give three rea1. Insufficient funds to undertake all economically feasisons for capital ra- ble projects
tioning.
2. Insufficient management capacity to take on all economically feasible projects
3. Perceived instability in the market/economy
93. In what circumWhen liquidity issues are a major concern in selecting
stance might the from a set of projects
use of the payback period approach be useful
in ranking capital
projects?
94. In ranking economically feasible projects, what
is the primary shortcoming
of the net-present-value approach?
It fails to take into account differences in the initial cost
of economically feasible projects. Each project is evaluated independently of each other project; therefore, differences in initial cost among projects is not considered.
95. What is the preThe profitability index, which takes into account both the
ferred method of net present value and the initial cost of each project
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cally feasible projects?
96. Describe the com- All elements of liabilities (current and noncurrent) and
ponents of a firm's owners' equity of a firm constitute its financial structure.
financial structure.
97. Which is more
inclusive, capital
structure or financial structure?
Financial structure, which includes current and noncurrent liabilities as well as owners' equity. Capital structure
does not include current liabilities, only long-term debt
and owners' equity.
98. Describe the com- All elements of long-term debt and owners' equity
ponents of a firm's
capital structure.
99. What are financing The alternative ways that funding may be obtained to
options?
carry out capital projects and other undertakings of an
entity
100. Describe the con- Short-term financing involves:
cept of short-term 1. Obtaining funding through obligations (debt) that must
financing.
be repaid within one year (current liabilities), or
2. The use of current assets to obtain funding.
101. Identify at least
five forms of
short-term financing.
1. Trade accounts payable
2. Accrued accounts payable
3. Short-term notes
4. Lines of credit, revolving credit, or letter of credit
5. Commercial paper
6. Pledging accounts receivable
7. Factoring accounts receivable
8. Inventory secured loans
102. Define "compensating balance."
An amount that a borrower may be required to maintain
in a demand deposit account with a lender as a condition
of receiving a loan or other bank services
103.
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What are the
- Poor credit rating = High interest rate
disadvantages of - Requires satisfaction in the short term
using short-term - May require compensating balance or security
notes for
short-term financing purposes?
104. List the disadvantages of using short-term
payables (for financing purposes).
Requires payment in the short term
Use specific
Lost discounts increase cost
105. Why are cash dis- Cash discounts are offered to encourage early payment
counts offered on of amounts due on trade accounts.
trade accounts?
106. List the advantages of
short-term notes
(for financing purposes).
Commonly available for creditworthy firms
Flexible—amounts and periods (within one year) can be
varied
Generally, no collateral required
Provide cash
107. What is the meaning of cash discount terms of
"2/10, n/30"?
The term "2/10, n/30" is a typical credit term.
- The first digit (2) is the percentage discount offered by
the seller.
- The second digit (10) is the number of days within
which the discount is available.
- n/30 indicates that if the buyer does not pay the (full)
invoice amount within the 10 days to qualify for the
discount, then the net amount is due within 30 days after
the sales invoice date.
108. Describe trade ac- Defers payment for goods or services provided by supcounts payable
pliers in the normal course of business. May carry the
(also called trade offer of a cash discount for early payment of obligation.
credit) as a means
of short-term financing.
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109. List the advantages of using short-term
payables (for financing purposes).
Ease of use
Flexible
Usually interest free
Usually no security required
Discounts may be offered for early payment
110. Identify the advantages of commercial paper for
financing purposes.
Large amounts can be obtained.
Interest rate generally lower than other short-term
sources.
No collateral is required.
It provides cash for general use.
111. Define "letter of
credit."
A conditional commitment by a bank to pay a third party
in accordance with specified terms and commitments
(e.g., bank payment to a supplier upon proof that goods
have been shipped to bank client).
112. Identify the disadvantages of
stand-by credit for
financing purposes.
Poor credit rating = High interest rate
Usually involves a fee
Compensating balance may be required
Requires satisfaction in the short term
113. Define a "revolving credit agreement."
A revolving line of credit is a legal agreement between a
borrower and a financial institution whereby the financial
institution agrees to provide an amount of credit to the
borrower. The line of credit may be borrowed, repaid,
and then reborrowed in a "revolving" or recurring manner.
114. Define "commercial paper."
Short-term unsecured promissory notes sold by large,
highly creditworthy firms as a form of short-term financing (i.e., 270 days or less)
115. Identify the advantages of stand-by
credit for financing purposes.
Commonly available for creditworthy firms
Highly flexible (debt is incurred only when needed)
No collateral required
May provide cash for general use
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116. Define "line of
credit."
An informal agreement between a borrower and a financial institution whereby the financial institution agrees to
a maximum amount of credit that it will extend to the
borrower at any one time. It is not legally binding on
financial institution.
117. Describe a" float- The borrower gives a lien against all of its inventory to
ing loan agreethe lender but retains control of its inventory, which it
ment."
continuously sells and replaces.
118. Describe the use A firm pledges part or all of its inventory as collateral for
of an inventory-se- a short-term loan.
cured loan for
short-term financing.
119. Describe a "terIn such an agreement, the inventory used as collateral is
minal warehouse moved to a public warehouse where it is held as security.
agreement."
120. Identify the disadvantages of using inventory-secured loans for
short-term financing.
It is not available for all inventory.
Pledged inventory may not be available when needed.
It is more costly than certain other forms of short-term
financing.
It requires repayment in the short term.
121. Define "pledging
of accounts receivable."
The use of trade accounts receivable as collateral for
a short-term loan, usually from a commercial bank or
finance company
122. Distinguish between factoring
accounts receivable "with recourse" and "without recourse."
If accounts receivable are factored "without recourse,"
the factor (buyer) bears the risk associated with collectability (unless fraud is involved).
If accounts receivable are factored "with recourse", the
factor (buyer) has recourse against the selling firm for
some or all of the risk associated with uncollectability.
123.
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Define "factoring
of accounts receivable."
The sale of trade accounts receivable to a commercial
bank or other financial institution, called a "factor." Sale
may be "with recourse" or "without recourse."
124. Identity major
Long-term notes
forms of long-term Financial (capital) leases
financing.
Bonds
Preferred stock
Common stock
125. Describe the con- Long-term financing involves obtaining funding through
cept of long-term sources for which repayment is not due within one year,
financing.
including sources that do not require any "repayment"
(e.g., common or preferred stock). These sources of
funding constitute the capital structure of a firm.
126. Identify the disadvantages of leasing for long-term
financing purposes.
Not all assets available for leasing.
Lease terms may prove different from the period of asset
usefulness.
This method is often chosen over buying for noneconomic reasons (e.g., convenience).
127. Describe the use
of long-term notes
for long-term financing purposes.
Long-term notes are used for borrowings normally of
from one to 10 years, but some may be of longer duration. Such borrowings usually require collateral and may
have restrictive covenants but often permit repayment in
installments over some period of time.
128. Identify the advantages of leasing for long-term
financing purposes.
Limited immediate cash outlay
Possible lower cost than purchasing
Possible scheduling of payments to coincide with cash
flows
Debt (lease payments) is specific to amount needed.
129. Define a net lease. Lessee (using party) assumes the cost associated with
ownership during the life of the lease, including maintenance, taxes, insurance, and so on.
130. Define "long-term Financing provided by those sources of capital fundfinancing."
ing that do not mature within one year (e.g., long-term
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notes, financial leases, bonds, preferred stock and common stock)
131. Define a net-net
lease.
Lessee (using party) assumes not only the cost associated with ownership during the life of the lease, including
maintenance, taxes, insurance, and so on., but also the
obligation for a residual value at the end of the lease.
132. Identify the disadvantages of
long-term notes,
for financing purposes.
Poor credit rating results in higher interest rate, greater
security requirements, and more restrictive covenants.
Violation of restrictive covenants can trigger serious
consequences.
133. Define "bond ma- The time at which the issuer repays the par value to the
turity."
bondholders
134. Describe the yield
to maturity for
bonds (also called
the expected rate
of return).
The rate of return required by investors as implied by
the current market price of the bonds; determined as the
discount rate that equates present value of cash flows
from the bonds with the current price of the bonds.
135. How is the selling As the sum of the present value (PV) of future cash flows
price of a bond de- from:
termined?
1. Periodic interest - PV of an annuity.
2. Maturity face value - PV of $1.
Both are discounted using the market rate of return.
136. Define "bonds."
Long-term promissory notes wherein the borrower, in
return for buyers'/lenders' funds, promises to pay the
bondholders a fixed amount of interest each year and
to repay the face value of the note at maturity
137. Define "bond indenture."
The bond contract, which sets forth such terms as face
amount of bond, coupon or stated interest rate, maturity
date, and so on
138. Define "market
rate risk."
The risk of loss in the market value of outstanding
bonds and other fixed rate instruments as a result of an
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increase in the market rate of interest during the life of
the outstanding instrument. If the market rate of interest
increases after an instrument is issued, the market value
of the instrument will decrease.
139. Describe the cal- The ratio of annual interest payments to the current
culation of the cur- market price of the bond. It is computed as:
rent yield on a
bond.
Annual interest payment/Current market price
140. List the advantages of using preferred stock (for
long-term financing).
No legally required periodic payments (i.e., dividends)
Lower cost of capital than common stock
Does not dilute common stock voting strength
No maturity date
No security required
141. How is the theoretical value of a
share of preferred
stock (PSV) determined?
PSV = Annual preferred dividend / Investors' required
rate of return
Note:
- The annual dividend is assumed to exist in perpetuity.
- The investors' required rate of return is a "discount
rate."
142. How is the
currently expected rate of return on preferred
stock (PSER) determined?
PSER = Annual preferred dividend / Market price of
preferred stock
143. Distinguish between convertible
preferred stock
and nonconvertible preferred
stock.
- With convertible preferred stock, preferred shareholders can exchange (convert) preferred stock for common
stock according to a specified exchange plan.
- With nonconvertible preferred stock, preferred shareholders cannot exchange (convert) their preferred stock
to common stock.
Note: This expected rate of return is the current cost of
preferred stock capital.
144. Define "preferred Ownership interest in a corporation that has certain prefstock."
erences over common stock; often described as having
characteristics of both bonds and common stock
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145. Distinguish between cumulative
preferred stock
and noncumulative preferred
stock
- With cumulative preferred stock, the dividend preference amount not paid in any year accumulates and must
be paid before common dividends are paid.
- With noncumulative preferred stock, the dividend preference amount not paid in any year does not accumulate; it is "lost" to the preferred shareholder for that
period.
146. Define "callable
preferred stock."
The issuing firm has the right to buy back the preferred
stock, normally at a premium.
147. Distinguish between participating preferred
stock and nonparticipating preferred stock.
- With participating preferred stock, preferred shareholders can "participate" with common shareholders in receiving dividends in excess of the preferred preference
rate.
- With nonparticipating preferred stock, preferred shareholders cannot "participate" with common shareholders
in receiving dividends in excess of the preferred preference rate; each period they receive only their preference
rate of dividends.
148. Identify the disadvantages of using
common stock for
long-term financing.
Higher cost of capital that other sources
Dividends paid are not tax deductible
Additional shares issued dilute ownership and earnings
per share
149. Identify the adNo legally required periodic payments (i.e., dividends)
vantages of using No maturity date
common stock for No security required
long-term financing.
150. Describe the limit- Common shareholders' liability is limited to their invested liability of com- ment in a corporation.
mon stock.
151. How is the theo- CSV = Dividend in 1st year / (Investors' required rate of
retical value deter- return - Dividend growth rate)
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mined for a share
of common stock Note: Dividends are assumed to grow at a constant rate
(CSV) that is to be indefinitely.
held for multiple
periods?
152. Describe the pre- The right of first refusal to acquire a proportionate share
emptive right of
of any new common stock issued by a corporation
common stock.
153. Define the hedging principle of
financing (also
called the principle of self-liquidating debt).
Principle that focuses on matching cash flows from
assets with the cash requirements needed to satisfy
the related financing. Thus, long-term assets should
be financed with long-term sources of capital, and
short-term assets should be financed with short-term
sources of financing.
154. Define "business The risk of loss or other unfavorable outcome that rerisk."
sults as variability in operating results increases; the
higher the variability in a firm's expected operating earnings, the greater the business risk (i.e., the increased
chance that it may not be able to meet its debt obligations)
155. What are some
factors that influence the cost of
capital to a firm?
Macroeconomic conditions (e.g., interest rates, tax rates
and inflation/deflation rates, etc.)
Past performance of the firm
Amount of total financing used
Relative level of debt financing
Length of debt maturity
Relative level of collateral provided
156. Generally, how do
the costs compare of financing
using long-term
debt, preferred
stock, and common stock?
Generally, the cost of long-term debt is lower than the
cost of either preferred stock or common stock, and the
cost of preferred stock is lower than the cost of common
stock. However, as the level of long-term debt increases
relative to equity, the cost of marginal debt increases
due to the increased risk of default.
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157. Define "crowdfunding."
Crowdfunding is the raising of funds for an undertaking
by obtaining many small amounts from a large number
of sources, usually carried out through Internet solicitation.
Identify the requirements and
restrictions on the - Not permitted by certain firms (e.g., companies that
use of crowdfund- report under Exchange Act).
ing by an entity.
- Must take place through broker-dealer or funding portal registered with the Securities and Exchange Commission.
- No more than $1 million can be raised through crowdfunding in 12-month period.
- Firms using crowdfunding are required to make certain
specific reporting.
158. What macroeco- Market conditions and expectations concerning economic conditions nomic factors such as interest rates, tax rates, and
affect the cost of inflation/deflation rates
capital?
159. What is the obTo minimize a firm's aggregate cost of capital financing
jective of optimum by using an optimum mix of debt and equity compocapital structure? nents; to achieve the lowest possible weighted average
cost of capital
160. What is the objective of working capital management?
To maintain adequate working capital so as to:
- Meet ongoing operating and financial needs of the firm
- Not over-invest in net working capital, which provides
low returns or increases costs.
161. Define "current as- Cash and other resources expected to be converted to
sets."
cash, sold, or consumed within one year (e.g., areceivable, inventory, some prepaid items, etc.)
162. Define "current lia- Obligations due to be settled within one year or that
bilities."
will require the use of current assets to satisfy (e.g.,
accounts payable, other short-term payables, some unearned revenue, etc.)
163.
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Define "workThe difference between a firm's current assets and its
ing capital" (also current liabilities; expressed as:
called net working Current assets - Current liabilities = Working capital
capital).
164. Give examples of Maintaining excess cash in low-return accounts
overinvesting in Having excessive (large/old) accounts receivable that
working capital.
don't earn interes
Maintaining more inventory than needed and thus incurring storage costs and increasing the risk of obsolete
inventory
165. Identify the advan- Cash is available for use sooner than it would be if
tages of using a receipts were routed through the firm.
lockbox system. Firm's handling of collections is greatly reduced.
There is a reduced likelihood of dishonored checks and
earlier identification of those that are dishonored.
166. Define "incoming The time between when a payment is initiated and when
float."
the related cash is available for use by the recipient
167. Describe the use Payment/collection of an amount due through the use of
of preauthorized checks or debit/credit card charges that are authorized
checks and preau- in advance
thorized debit/credit cards.
168. Describe concen- Funds collected in multiple local banks are transferred
tration banking.
regularly and (usually) automatically to the firm's primary bank; used to accelerate the flow of cash to a firm's
principal bank.
169. Describe the oper- Customers remit payments to a firm's post office box,
ation of a lockbox where they are collected and then processed and desystem.
posited by the firm's bank; may reduce the float by
several days.
170. Describe the uses A bank account with no real balance. Two variations
of zero-balance
exist:
accounts.
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1. Checks written on account overdraw the account, but
by agreement with the bank, the overdrawn amount is
paid automatically from another account.
2. Only the known amount of payments from an account
is deposited into the account (e.g., payroll account).
171. Describe a payment through
draft.
Payment is made with a legal instrument, called a draft,
that is drawn on an account of a bank and is guaranteed
payment by the bank. Examples include bank drafts,
cashier's checks, certified checks, and money orders.
172. Define "banker's
acceptance."
A draft (or order to pay) drawn on a specific bank by a
firm that has an account with the bank. If bank "accepts"
the draft, it becomes a negotiable debt instrument of the
bank.
173. What are United States Treasury
Bills (also called
T-Bills)?
Debt investment instruments that are the direct obligation of the U.S. government. They are considered to be
virtually risk-free and are commonly used as the basis
for the risk-free rate of return in many financial analyses.
174. Define "default
risk."
A measure of the likelihood that the issuer will not be
able to make future contracted interest and/or principal
payments to a security holder
175. What are the
- Safety of principal
major considera- - Price stability of the investment
tions in select- Marketability or liquidity of the investment
ing short-term securities as investments?
176. Define "repurchase agreement"
(also called a
repo).
A debt investment instrument with a commitment by
the buyer to resell the instrument to the seller at a
specified price, which includes the original principal plus
an interest or fee factor, at a specified time
177. Identify some
measures (averages and ratios)
- Average collection period
- Day's sales in accounts receivable
- Accounts receivable turnover
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useful in assess- - Accounts receivable to current or total assets
ing accounts-re- - Bad debt to sales
ceivable management.
178. Identify the general credit-related
factors that must
be determined by
an entity if it sells
on account.
- Total period for which credit will be extended for sales
on account
- Discount terms, if any, granted for early payment of
credit sales
- Penalty for failure to pay according to credit terms
- Nature and extent of documentation required for sales
on account
179. Identify two major 1. Use of credit-rating service
approaches to de- 2. Financial analysis of prospective credit customer
termining a customer's creditworthiness.
180. Describe an agA schedule that shows, for each credit customer, how
ing of accounts re- long each amount due from the customer has been
ceivable schedule. owed. For example, amounts may be classified as being:
not due, 1-30 days overdue, 31-60 days overdue, 61-90
days overdue, over 90 days overdue.
181. Describe the
Management functions concerned with the conditions
accounts-receiv- leading to the recognition and collection of accounts
able management receivables
function.
182. What assumptions are inherent
in using the economic order quantity (EOQ) model?
Demand is constant during the period.
Unit cost and carrying cost are constant during the
period.
Delivery is instantaneous.
183. Identify some
measures (averages and ratios)
useful in assess-
Inventory turnover
Number of days' sales in inventory
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ing inventory management.
184. Identify the central To determine and maintain an optimum investment in
objective of inven- all inventories. Under investing in inventory can result in
tory management. shortages and lost sales; over investing in inventory can
result in incurring excessive cost for inventory.
185. Identify the
benefits of a
just-in-time
inventory system
(when compared
with a traditional
materials-requirement-planning
inventory system).
- Reduced investment in inventory
- Lower cost of inventory transportation, warehousing,
insurance, taxes, and related costs
- Reduced lead time in acquiring inputs
- Lower cost of defects
- Less complex and more relevant accounting and performance measurement
186. Describe the reorder point.
The level of an inventory item on hand at which that inventory item should be reordered. It takes into account:
- Inventory needed while ordered items are delivered.
- Inventory need as "safety stock" to cover unexpected
demand.
187. Identify the characteristics of a
just-in-time inventory system.
- Demand pull—goods are produced only when there is
an end user demand.
- Excess inventory is minimized.
- Production occurs in work centers that carry out a full
set of production processes.
- Relationships with suppliers are close and coordinated.
- Quality standards = Total control of input quality and
production process quality.
- Simplified cost accounting is used.
188. Describe the eco- A model (formula) for determining the size of an inventonomic order quan- ry order that will minimize total inventory cost, both cost
tity (EOQ).
of ordering and cost of carrying inventory. The formula
uses:
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- Total demand for the inventory item
- Cost of each order
- Cost of carrying each unit of inventory
189. Identify the
characteristics of
a traditional
materials-requirement-planning
inventory system.
Supply push—goods are produced in anticipation of
there being a demand for the goods.
Inventory buffers are maintained.
Setup times and production runs are long.
Relationships with suppliers are impersonal; suppliers
are selected through a bidding process.
Quality standards = Acceptable levels; allows for some
defects.
Traditional cost accounting is used.
190. What is the impact of being required to maintain a compensating balance on the
cost of short-term
borrowing?
Required compensating balances result in:
- Less funds available than the amount borrowed. Therefore,
- The effective cost of borrowing is greater than the
stated cost.
191. Describe the characteristics of
short-term borrowing.
Financing (borrowing or deferred payment) with payment due within one year or less; generally does
not require collateral and does not impose restrictive
covenants.
192. Under what circumstances is the
use of short-term
financing most appropriate?
The use of short-term liabilities for financing purposes is
most appropriate when the related assets financed will
generate cash in the short run to be able to repay the
liabilities.
193. Give examples of
short-term financing that is available only as needed.
- Trade accounts
- Line of credit
- Revolving credit
- Letter of credit
194.
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Describe the bene- - Provides measures and enables comparisons of a
fits provided by ra- firm's operating and financial activities and position for
tio analysis.
a single firm over time and across firms.
- Facilitates identification of a firm's operating and financial strengths and weaknesses.
195. Define "ratio
analysis" (for financial management).
The development of quantitative relationships between
various elements of a firm's financial, operating and
other information.
196. When a ratio requires using a balance sheet value
together with an
income statement
value, how should
the balance sheet
value be determined?
When a balance sheet value is used together with an income statement value in a ratio, the balance sheet value
must be an average balance for the period covered by
the income statement, not the balance at year-end (or
other point in time).
197. What does
the "defensive-interval ratio" measure? How is it expressed as a formula?
Measures the relationship between highly liquid assets
and the average daily use of cash; expressed as: Defensive-Interval Ratio = (Cash [Cash Equivalents] + Net
Accounts Receivable + Marketable Securities)/Average
Daily Cash Expenditures.
198. What does
the "times-interest-earned ratio"
measure? How is
it expressed as a
formula?
Measures the ability of current earnings to cover interest
payments for a period; expressed as: (Net Income +
Interest Expense + Income Tax Expense)/Interest Expense.
199. What does "working capital" measure? How is it expressed as a formula?
Measures the extent to which current assets exceed
current liabilities and, thus, are uncommitted in the short
term; expressed as: Working Capital = Current Assets Current Liabilities.
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200. Define "liquidity
measures."
Measurements of the ability of a firm to pay its obligations as they become due; useful in working capital
management.
201. What does the
"acid test ratio"
(also called the
"quick ratio") measure? How is it expressed as a formula?
Measures the relationship between highly liquid assets
and current liabilities; expressed as: Acid Test Ratio =
(Cash [Cash Equivalents] + Net Accounts Receivable +
Marketable Securities)/Current Liabilities
202. What does
the "working-capital ratio" (also
called the "current ratio") measure? How is it expressed as a formula?
Measures the quantitative relationship between current
assets and current liabilities in terms of the "number
of times" current assets can cover current liabilities;
expressed as: Working Capital Ratio = Current Assets/Current Liabilities.
203. Describe operational activity
measures.
Ratios (and other measures) that measure the efficiency
with which a firm carries out its operating activities.
204. What does the
"operating cycle
length" measure?
How is it expressed as a formula?
Measures the average length of time to acquire inventory, convert the inventory to receivables, and collect the
receivables; it can be measured as:
Operating cycle length = Number of days' sales in average receivables + Number of days' supply in inventory
205. What does the "accounts receivable
turnover ratio"
measure? How is
it expressed as a
formula?
Measures the number of times that accounts receivable
turnover (are incurred and collected) during a period;
expressed as: Accounts Receivable Turnover = Credit
Sales/Average Net Accounts Receivable. Useful in assessing credit policies and collection efficiency.
Note: Inventory is excluded from the numerator.
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Financial Management
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206. What does the "inventory turnover
ratio" measure?
How is it expressed as a formula?
Measures the number of times that inventory is acquired
and sold or used during a period; expressed as: Inventory Turnover = Cost of Goods Sold/Average Inventory.
Useful in assessing overstocking/understocking of inventory and obsolete inventory.
207. What does the
"number of days'
sales in average
receivables ratio"
measure? How is
it expressed as a
formula?
Measures the average number of days required to collect receivables; measures the average age of receivables. Number of Days Sales in Average Receivables =
365 (or other days)/Accounts Receivable Turnover.
208. What does the
"number of days'
supply in inventory ratio" measure? How is it expressed as a formula?
Measures the number of days inventory is held before
it is sold or used; indicates the efficiency of inventory
management. Number of Days Supply in Inventory =
365 (or other days)/Inventory Turnover.
209. What does the
"economic value
added (EVA)" measure? How is it expressed as a formula?
Measures an entity's economic profit (not its accounting
profit) as accounting earnings before deducting interest
less the dollar value of opportunity cost associated with
long-term debt and shareholders' equity; expressed as:
EVA = Earnings before interest - [Opportunity cost rate
x (L-T debt + SE)].
210. What does
the "price-earnings ratio" ("P/E
ratio"; also called
the "multiple")
measure? How is
it expressed as a
formula?
Measures the price of a share of common stock relative to its latest earnings per share; expressed as:
P/E Ratio = Market price per common share/Earnings
per common share. Notice, it measures the number of
times ("multiples") earnings per share is reflected in the
market price.
211.
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Financial Management
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What does the
Measures how much (percentage) of each sales dollar
"net profit marthat ends up as net income; expressed as: Profit Margin
gin on sales" mea- = Net Income/Net Sales.
sure? How is it expressed as a formula?
212. What does the
"gross profit margin ratio" measure? How is it expressed as a formula?
Measures how much (percentage) of each sales dollar
that is available to cover operating expenses and provide a profit; expressed as: Gross Profit Margin = Gross
Profit/Net Sales
213. What does the
"residual income"
measure? How is
it expressed as a
formula?
Measures the excess of an entity's dollar amount of
income over the dollar amount of its required return on
average investment (based on its hurdle rate of return);
expressed as: Residual Income = Net Income - (Average
Invested Capital x Hurdle Rate).
214. Describe profRatios (and other measures) that measure aspects of a
itability measures. firm's operating (profit/loss) results on a relative basis.
215. What does the "return on total assets" (also called
the "return on investment") measure? How is it expressed as a formula?
Measures the rate of return on total assets and indicates
the efficiency with which invested resources (assets
or total equity) are used; expressed as: Net Income +
Interest Expense + Income Taxes/Average Total Assets.
(NOTE: Some versions may not add back Interest Expense and/or Income Taxes.)
216. Describe the
"Common Stock
dividend payout
rate" measure.
Measures the extent (percent) of earnings distributed
to common shareholders; expressed as: C/S Dividend
Payout Rate = C/S Cash Dividends/Net Income Available for Common Shareholders. Also, can be computed
on a per share basis.
217. What does the "return on owners'
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Financial Management
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(all stockholders') Measures the rate of return (earnings) on all stockholdequity ratio" mea- ers' investment; expressed as: ROE = Net Income/Aversure? How is it ex- age Stockholders' Equity.
pressed as a formula?
218. What does the
"owners' equity
ratio" measure?
How is it expressed as a formula?
Measures the proportion of assets provided by shareholders; expressed as: Owners' Equity Ratio = Shareholders' Equity/Total Assets.
219. What does the
"debt ratio" measure? How is it expressed as a formula?
Measures the proportion of assets provided by creditors
and indicates the extent of leverage used in funding the
entity; expressed as: Debt ratio = Total liabilities / Total
assets
220. What does the
Measures the relative amounts of assets provided by
"debt to equicreditors (debt) and shareholders; expressed as: Debt
ty ratio" measure? to Equity = Total Liabilities/Total Shareholders' Equity.
How is it expressed as a formula?
221. Describe equity or Measures of relative sources of equity and equity value.
investment-leverage measures.
222. What does the
"book value per
common share"
measure? How is
it expressed as a
formula?
Measures the per share amount of common shareholders' claim to assets; expressed as: BV per CS = Common Shareholders' Equity/Number of Common Shares
Outstanding. (Can be similarly computed for Preferred
Stock.)
223. Describe liquidation risk (also
The risk associated with the possibility that an asset
cannot be readily sold for cash equal to its fair value.
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called marketability risk).
224. Describe inflation The risk that a rise in the general price level (inflation)
risk (also called
will result in reduced purchasing power of a fixed sum
purchasing power of money
risk).
225. Describe currency Risk that derives from changes in exchange rates beexchange risk.
tween currencies; may affect foreign currency transactions, foreign currency investments and/or future foreign
currency economic activity.
226. Describe interest Risk to investors associated with the effects of changes
rate risk.
in the market rate of interest on outstanding fixed-rate
debt instruments. If the market rate of interest increases,
the market value of already outstanding fixed-rate debt
instruments will decrease.
227. Describe default
risk.
The risk associated with the possibility that the issuer
of a security will not be able to make future interest
payments and/or principal repayment.
228. Describe financial Risk to common shareholders that derives from a firm's
risk.
use of debt financing, which requires interest payment
regardless of the firm's operating results, and its use
of preferred stock, which requires payment of dividends
before common shareholders receive dividends.
229. Describe nondiversifiable risk
(also called systematic risk
or market-related
risk).
Elements of risk that cannot be eliminated through diversification of investments; usually derive from general
economic and political factors (e.g., general level of
interest rate, new taxes, inflation/deflation, etc.)
230. Describe diversi- Elements of business risk that can be eliminated
fiable risk (also
through diversification of investments; for example divercalled unsystem- sification of projects or securities investments.
atic risk, firm-spe38 / 39
Financial Management
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cific risk, or company-unique risk).
39 / 39
1.2 Goal Of The Firm
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1. What is the
The primary goal is to maximize the wealth of the firm's
goal of the firm owners-the stockholders. The simplest and best measures
and, therefore,
of stockholder wealth is the firms share price.
of all managers
and employees?
Discuss how
one measures
achievement of
this goal?
2. For What three
basic reasons is
profit maximization inconsistent
with wealth maximization?
Timing-Because the firm can earn a return on funds it
receives, the receipt of funds sooner rather than later is
preferred.
Cash Flows-Profits and cash flows are not identical. The
profit that a firm reports is simply an estimate of how it
is doing, an estimate that is influenced by many different
accounting choices that firm make. Cash flow is a more
straightforward measures of the money flowing into and
out of the company.Companies have to pay their bills with
cash, not earnings.
Risk-Risk matters. A firm that earns a low but reliable profit
might be more valuable than another firm with profits that
fluctuate a great deal
3. What is risk? Why
must risk as well
as return be considered by the financial manager
who is evaluating
a decision alternative or action?
Risk is the chance that actual outcomes may differ from
those expected. Risk and return must be considered by
financial managers because they are the key determinants
of share price, which represents the wealth of the owners
in the firm.
4. Describe the
role of corporate ethics policies and guide-
Business Ethics are standards of conduct or moral judgment that apply to persons engaged in commerce. It will
reduce potential litigation, and build corporate image and
shareholder confidence. Such actions maintain and en1/2
1.2 Goal Of The Firm
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lines, and dishancing cash flow and reducing perceived risk, can affect
cuss the relation- the firm's share price.
ship that is believed to exist between ethics and
share price.
2/2
Finance Exam 1
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1. One of the most important disadvan- Double taxation.
tages of the corporate form of business is:
2. Profit maximization:
Does not consider future cash flows
or risk.
3. Wealth maximization:
Takes a long-run perspective that focuses on the owners
4. An agent has _____ to the principals:
A fiduciary responsibility.
5. The primary goal of the business
Stock price.
firm is to maximize the wealth of
the firm's owners." For a corporation, this statement means that managers should focus on maximizing
the wealth of its shareholders or its:
6. Larger corporate profit and cash in- Mean a higher stock price.
flows than what had been expected
usually:
7. Which of the following claimants is Owners.
paid last?
8. An example of a principal of a firm
is:
The owner.
9. A corporation is a(n) _________ un- Artificial person.
der the law
10. The sole proprietor:
Has unlimited liability relating to the
business
11. The articles of partnership:
Define the terms of the partnership
12. All of the following are true about Corporations are natural persons uncorporations with the exception of: der the law
1/7
Finance Exam 1
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13. Stakeholders include which of the
following?
A) employees
B) suppliers
C) creditors
D) owners
All of the above.
14. Hillary Rotteneggs wishes to form A corporation due to its limited liabilia company that will specialize in
ty.
toxic waste removal and storage.
Which type of business form would
be most advantageous?
15. Which of the following statements is Corporate earnings are subject to the
false?
same tax as partnership earnings.
16. Who is entitled to the "residual income" of the firm?
The owners.
17. An example of a capital market secu- A bond.
rity would be:
18. Money market securities include:
A) commercial paper
B) Treasury bills
C) negotiable certificates of deposit
All of the above.
19. Financial institutions:
A) assist net surplus economic units
and net deficit economic units.
B) analyze and absorb credit risk.
Both a & b.
20. The process of managing a firm's
long-term investments is called:
Capital budgeting.
21.
Working capital.
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Finance Exam 1
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A firm's current assets and current liabilities are referred to as the
firm's:
22. A sole proprietorship is defined as a Owned by a single individual.
business:
23. A business organization owned by General partnership.
two or more individuals or entities,
each of whom has unlimited liability
for the firm's debts, is called a:
24. A firm created as a separate and dis- Corporation.
tinct legal entity that may be owned
by one or more individuals or entities is called a:
25. If you accept a job as a portfolio
Investments.
manager, you are working in which
one of the following financial areas?
26. Which one of the following jobs best Commercial loan officer.
fits into the area of finance classified
as financial institutions?
27. When analyzing alternative capital
structures for a firm, a financial manager must consider which of the following?
I. type of loan
II. amount of funds needed
III. cost of funds
IV. mix of debt and equity
E. I, II, III, and IV
28. The capital structure of a firm refers Long term debt and equity.
to the firm's:
29. The daily financial operations of a Working capital.
firm are primarily controlled by managing the:
30.
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Finance Exam 1
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Which one of the following stateEach limited partnership must have at
ments about a limited partnership is least one general partner.
correct?
31. The advantage of being a limited
partner in a limited partnership is
the ability to:
Limit your losses to the amount invested in the firm.
32. The primary goal of financial management is to maximize the:
Market value of the existing stock.
33. An agency problem is prone to exist Management is frequently separated
in public corporations because:
from ownership.
34. Which of the following are potenI. company creditors
tial stakeholders of a public corpo- II. company employees
ration?
III. federal and state government
IV. company suppliers
E. I, II, III, and IV
35. Which one of the following transac- Valerie purchased newly issued
tions occurred in the primary mar- shares of Velcro, Inc.
ket?
36. The primary market is:
The market where all new issues of
debt and equity securities are sold to
the public.
37. Theresa sold 300 shares of MNO
The secondary market.
stock on the NYSE today. This transaction occurred in:
38. The major topics in corporate finance are:
a. capital budgeting.
b. capital structure.
c. working capital management.
d. only (a) and (b).
e. all (a), (b), and (c).
Answer: E
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Finance Exam 1
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39. From a finance viewpoint, the firm is True.
a bundle of risky cash flows.
40. Wealth maximization as the goal
of the firm implies enhancing the
wealth of:
The firm's stockholders.
41. Which of the following statement(s) A. The financial system consists of a
is (are) true?
network of financial markets and institutions to bring savers and borrowers
together and provide key services.
B. Financial markets are markets for
buying and selling bonds, stocks, foreign exchange, and other financial
assets.
C. Financial intermediaries are go-betweens for savers and borrowers.
D. Services provided by the financial
system include risk-sharing, liquidity,
and information services.
All of the above.
42. __________ consists of the institu- Money markets.
tions and procedures that provide
for transactions in short-term debt
instruments.
43. Finance can be defined as the study True.
of the valuation and management of
risk.
44. Unethical behavior eliminates trust, True.
and without trust businesses cannot
interact.
45. Depreciation:
Is a non cash expense.
46.
True.
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The book value of common equity
for a company can be negative.
47. Common-size financial statements Total assets.
present all balance sheet account
values as a percentage of:
48. The equity multiplier is equal to:
One plus the debt equity ratio.
49. What is an IPO?
An initial public offering. Twitter sold
70 million shares of its stock to the
general public for the first time for $26
per share.
50. What are finance's three main career Financial management, Financial
paths?
markets/institutions, and Investments.
51. What does a financial manager do? Forecast a firm's finances
Assess risk
Evaluate investment opportunities
Decide when and where to find money sources and how much money to
raise
Decide how much money to return to
the firm's investors
52. Bankers, stockbrokers, and others The flow of money through financial
who work in markets/institutions fo- institutions and the markets in which
cus on
financial assets are exchanged. Also
track impact of interest rates on the
flow of that money.
53. People who work in investments
Locate, select, and manage income
producing assets.
54. First, financial managers use
Accounting information (balance
sheets, income statements, statement of cash flows) to analyze, plan,
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and allocate financial resources for
business firms.
55. Second, financial managers use
Economic principles to guide them in
making financial decisions that are in
the best interest of the firm.
56. Finance is an applied area of economics that relies on
Accounting for input.
57. What do financial managers do?
Financial managers measure the
firm's performance, determine what
the financial consequences will be if
the firm maintains its present course
or changes it, and recommend how
the firm should use its assets.
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FINA 3770
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1. Financial management deals with the maintenance
and creation of economic value or wealth
TRUE
2. Each financial decision made by a corporate manager FALSE
can be evaluated by its direct impact on the corporation's stock price.
3. The fundamental goal of a business is to maximize
the retained earnings available to the corporation's
shareholders.
FALSE
4. Shareholder wealth maximization means maximizing TRUE
the price of the existing common stock.
5. It is important to evaluate a corporate manager's fi- TRUE
nancial decision by measuring the effect the decision
should have on the corporation's stock price if everything else were held constant.
6. Corporate managers should accept investment projects that maximize profits in the short run because
of the time value of money.
FALSE
7. The goal of the firm's financial managers should be TRUE
the maximization of the total value of the firm's stock.
8. The payment of a dividend to current shareholders FALSE
will have no impact on a corporation's share price because the cash paid is not available to future potential
shareholders who may want to buy the corporation's
stock.
9. One problem with maximization of shareholder wealth FALSE
as a goal is that it ignores risk taken by the firm's
financial decisions.
10. The goal of profit maximization ignores the risk of
financial decisions
TRUE
11.
TRUE
1/3
FINA 3770
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Shareholders react to poor investment or dividend
decisions by causing the total value of the firm's stock
to fall, and they react to good decisions by bidding the
price of the stock up.
12. The primary goal of a publicly owned corporation is to B) maxi________.
mize shareholder
A) maximize dividends per share
wealth
B) maximize shareholder wealth
C) maximize earnings per share after taxes
D) minimize shareholder risk
13. Maximization of shareholder wealth
A) represents a zero sum game in which one corporation gains at the expense of others.
B) provides benefits to society as scarce resources
are directed to their most productive use.
C) is not a practical goal since it cannot be measured
effectively.
D) is achieved only if cash flows exceed accounting
profits.
A) represents a
zero sum game in
which one corporation gains at the
expense of others.
14. A financial manager is considering two projects, A
and B. A is expected to add $2 million to profits this
year while B is expected to add $2 million to profits
this year while B is expected to add $1 million to
profits this year. Which of the following statements is
MOST correct?
A) The manager should select project A because it
maximizes profits.
B) The manager should select the project that maximizes long-term profits, not just one year of profits.
C) The manager should select project A or he is irrational.
D) The manager should select the project that causes
the stock price to increase the most, which could be
A or B.
D) The manager
should select the
project that causes the stock price
to increase the
most, which could
be A or B.
15. Shareholder wealth maximization means
A) maximizing earnings per share.
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FINA 3770
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B) maximizing dividends per share.
C) maximizing the price of existing common stock.
D) maximizing stockholders equity.
16. The goal of the firm should be
A) maximization of profits (net income per share).
B) maximization of shareholder wealth.
C) maximization of market share.
D) maximization of sales.
3/3
C) maximizing the
price of existing
common stock.
B) maximization
of shareholder
wealth.
Corporate Finance: Unit 1 "Corporate Governance"
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1. Who can be shareholders of a Individuals, Pension funds, and Insurance
company?
companies.
2. A corporation has infinite life
because it:
Is a legal entity
3. A firm's investment decision is Capital budgeting decision
also called its:
4. The treasurer is usually responsible for the following
functions of a corporation:
Investor relationships, cash management,
and raising new capital.
5. In the principal-agent framework:
Shareholders are the principals and Managers are the agents
6. Costs associated with the con- Agency costs.
flicts of interest between the
bondholders and the shareholders of a corporation are
called:
7. A corporation may incur
agency costs because...
managers may not attempt to maximize the
value of the firm to shareholders., shareholders incur monitoring costs., of the separation of ownership and management.
8. The controller usually overpreparation of financial statements, intersees the following functions of nal accounting, and taxes.
a corporation:
9. Which of the following is an
providing financing, providing liquidity, reimportant function of financial ducing risk, providing information.
markets?
10. The following groups are some shareholders, bondholders, employees,
of the claimants to a firm's in- mgmt, and government.
come stream:
11.
1 / 12
Corporate Finance: Unit 1 "Corporate Governance"
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The financial goal of a corpora- Maximize the value of the firm for the sharetion is to:
holders
12. The firm's purchase of real as- Investment decision.
sets is also referred to as the:
13. The sale of financial assets by financing decision.
a corporation is also referred to
as the:
14. The choice of the proper mix- capital structure decision.
ture of debt and equity, used to
finance a corporation, is also
referred to as the:
15. Which of the following is not a Hiring the firm's CEO
common function of the firm's
chief financial officer?
16. Which of the following groups Employees, customers, shareholders, and
are referred to as stakeholdsuppliers.
ers?
17. How do you calculate NPV?
=(CF/1+r) - initial investment
18. The following are agency prob- Empire building, entrenching investments,
lems in capital budgeting:
and avoiding risks.
19. The following are agency prob- Reduced effort, perks or private benefits,
lems associated with capital
empire building, entrenching investments,
budgeting:
and avoiding risks.
20. What are capital expenditures Investment in training employees.
that may not appear in a firm's
capital budget?
21. What are examples of overinvestment by managers?
Entrenching investments, empire building,
investing beyond the point where NPV falls
to zero.
2 / 12
Corporate Finance: Unit 1 "Corporate Governance"
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22. Generally, firms should attempt Verifiable results.
to base managers' compensation on:
23. Monitoring is typically done by: Shareholders, board of directors, independent accountants, and lenders.
24. The ultimate responsibility for Shareholders.
monitoring a firm rests with
the:
25. The free-rider problem, when
referring to monitoring of the
firms' performance, often results in:
Ineffective monitoring by the shareholders,
monitoring being delegated by shareholders to boards of directors, and no monitoring by a large number of small individual
investors.
26. When firms award stock opStock price on the day the options are
tions to managers as incengranted.
tives, they typically set the exercise price of these options
equal to the firms:
27. Companies buy ______ assets real
28. These include both tangible as- Executive airplanes, brand names
sets such as _____ and intangible assets such as ______
29. To pay for these assets, they
sell ____ assets such as $.
Financial
30. The decision about which assets to buy is usually termed
the (f) or (g) decision.
Investment, capital budgeting
31. The decision about how to
raise the money is usually
termed the ____ decision
Financing
3 / 12
Corporate Finance: Unit 1 "Corporate Governance"
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32. Is A personal IOU a real asset Real
or financial asset?
33. Is A trademark a real asset or
financial asset?
Real
34. Is A share of stock a real asset Financial
or financial asset?
35. Is A factory a real asset or financial asset?
Real
36. Is Undeveloped land a real as- Real
set or financial asset?
37. Is the balance in the firm's
Financial
checking account a real asset
or financial asset?
38. Is An experienced and hardReal
working sales force a real asset
or financial asset?
39. Is A corporate bond a real asset Financial
or financial asset?
40. Real Assets
Claims on assets that are identifiable items
with intrinsic value. (can be intangible)
41. Financial Assets
Claims held by investors. on assets such as
stocks, or bank loans
42. Name three real assets:
Trademark, factory, undeveloped land, and
your work force
43. Name three financial assets:
Stocks, bank loans, and bonds.
44. Capital Budgeting
Investment in real assets
45. Financing
4 / 12
Corporate Finance: Unit 1 "Corporate Governance"
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Raising the cash for investment into real
assets
46. Shares of public corporations Traded on stock exchanges and can be
purchased by a wide range of investors.
47. Shares of closely held corpora- Not publicly traded and are held by a small
tions
group of private investors.
48. Unlimited liability
Investors are responsible for all the firm's
debts. A sole proprietor has unlimited liability.
49. Limited liability
Investors (shareholders) in a limited company can only lose their investment in the
business if it fails; they cannot be forced to
sell assets to pay off the firm's debts.
50. What are the main implications Corporations have perpetual life, therefore
of separate ownership & man- ownership can be transferred without afagement?
fecting operations, and managers can be
fired with no effect on ownership. Other
forms of business may have unlimited liability and limited life.
51. What are the main implications Separation of ownership and management
of separate ownership & man- typically leads to agency problems, where
agement?
managers prefer to consume private perks
or make other decision for their private
benefit - rather than maximize shareholder
wealth.
52. What goal will shareholders al- Maximizing shareholder wealth. Shareways vote for?
holders can modify their pattern of consumption through borrowing and lending,
match risk preferences, and hopefully balance their own checkbooks (or hire a qualified professional to help them with these
tasks).
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53. Is a financial scandal or
fines/settlements worse for a
firm?
The firm's reputation suffers in a financial
scandal, and this can have a much larger
effect than the fines levied. Investors may
also wonder whether all of the misdeeds
have been contained.
54. Why might one expect manManagers would act in shareholders' inagers to act in shareholders' in- terests because they have a legal duty to
terest? Give some reasons.
act in their interests. Managers may also
receive compensation, either bonuses or
stock and option payouts whose value is
tied (roughly) to firm performance. Managers may fear personal reputation damage that would result from not acting in
shareholder's interests. And managers can
be fired by the board of directors, which
in turn is elected by shareholders. If managers still fail to act in shareholders' interest, shareholders may sell their shares,
lowering the stock price and potentially creating the possibility of a takeover, which
can again lead to changes in the board of
directors and senior management.
55. How might defenses against
takeovers affect the firm's
agency problems? Are managers of firms with formidable
takeover defenses more or less
likely to act in the shareholders' interests rather than their
own? What would you expect to
happen to the share price when
management proposes to institute such defenses?
Mgrs. that are insulated from takeovers
may be more prone to agency problems
and therefore more likely to act in their own
interests rather than in shareholders'. If a
firm instituted a new takeover defense, we
might expect to see the value of its shares
decline as agency problems increase and
less shareholder value maximization occurs. The counter argument is that defensive measures allow managers to negotiate
for a higher purchase price in the face of a
takeover bid - to the benefit of shareholder
value.
56.
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Agency costs in capital invest- Value lost when managers do not act
ment:
to maximize value. This includes costs of
monitoring and control.
57. Private benefits:
Perks or other benefits enjoyed by managers.
58. Empire Building:
Investing for size, not NPV.
59. Entrenched Investment
Mgrs. choose or design investment projects
that increase the managers' value to the
firm, or buying just for the opportunity to
have a larger size.
60. Delegated Monitoring:
Monitoring on behalf of principals. (Monitoring management performance on behalf of
stockholders).
61. Monitoring alone can never
completely eliminate agency
costs in capital investment.
Briefly explain why:
Monitoring is costly and encounters diminishing returns. Also, completely effective
monitoring would require perfect information.
62. Who monitors the top manage- Shareholders are ultimately responsible for
ment of public U.S. corporamonitoring of top management of public
tions?
U.S. corporations. However, unless there
is a dominant shareholder (or a few major shareholders), monitoring is generally
delegated to the board of directors elected
by the shareholders. The board of directors
of a large public company also retains an
independent accounting firm to audit the
company's financial statements. In addition, lenders often monitor the company's
management in order to protect lender's
interests in the loans they have extended;
in the process, monitoring by lenders can
also protect stockholders' interests.
63.
TRUE
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True or False: U.S. CEOs are
paid much more than CEOs in
other countries.
64. True or False: A large fracTRUE
tion of compensation for U.S.
CEOs comes from grants of restricted shares or performance
shares.
65. True or False: Stock-option
grants give the manager a certain number of shares delivered at annual intervals, usually over five years.
FALSE. Stock options give managers the
right (but not the obligation) to buy their
company's shares in the future at a fixed
price.
66. True or False: U.S. accountTRUE
ing rules now require recognition of the value of stock-option grants as a compensation
expense.
67. Compare typical compensation
and incentive arrangements for
(a) top management (e.g., the
CEO or CFO) and (b) plant or division managers. What are the
chief differences? Can you explain them?
The typical compensation and incentive
plans for top management include salary
plus profit sharing and stock options. This
is usually done to align as closely as possible the interests of the manager with the
interests of the shareholders. These managers are usually responsible for corporate
strategy and policies that can directly affect
the future of the entire firm
Plant and divisional managers are usually
paid a fixed salary plus a bonus based
on accounting measures of performances.
This is done because they are directly responsible for day-to-day performance, and
this valuation method provides an absolute
standard of performance, as opposed to
a standard that is relative to shareholder
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expectations. Further, it allows for the evaluation of junior managers who are only responsible for a small segment of the total
corporate operation.
68. Suppose all plant and division
managers were paid only a
fixed salary - no other incentives or bonuses:
Managers act suboptimally when paid a
fixed salary without incentives to act in
shareholders' best interests.
1: They may reduce their efforts to find and
implement projects that add value.
Describe the agency problems 2: They may extract benefits-in-kind from
that would appear in capital in- the corporation in the form of a more lavish
vestment decisions.
office, tickets to social events, overspending on expense accounts, etc.
3: They may expand the size of the operation just for the prestige of running a larger
company
4: They may choose second-best investments in order to reward existing employees, rather than the alternative that requires outside personnel but has a higher
NPV.
5: In order to maintain their comfortable
jobs, mgrs. may invest in safer rather than
riskier projects.
69. Suppose all plant and division
managers were paid only a
fixed salary - no other incentives or bonuses:
Tying a manager's compensation to EVA
attempts to ensure that assets are deployed efficiently and that earned returns
exceed the cost of capital. Hence, actions
taken by the manager to shirk the duty of
How would tying the manager's maximizing shareholder wealth generally
compensation to EVA alleviate result in a return that does not exceed the
these problems?
minimum required rate of return (cost of
capital). The more the manager works in
the interests of shareholders, the greater
the EVA.
70.
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We noted that mgmt. compensation must, in practice, rely on
results rather than on effort.
Why? What problems are introduced by not rewarding effort?
Since mgmt. effort is not observable, management compensation must in practice
rely on results. The major problem introduced by rewarding results rather than effort is the fact that, in the corporate setting,
results are a consequence of numerous
factors, including the manager's efforts. It is
generally very difficult, if not impossible, to
precisely identify the extent to which a manager's efforts contributed to a particular
outcome. Therefore, it is difficult to create
the kinds of incentives that are most likely
to reward the manager for her contribution,
and therefore appropriately motivate the
mgr.
71. Today's stock price depends
on investors' expectations on
investors expectations of future performance.
If a firm announces the hiring of a new
manager who is expected to increase the
firm's value, this information should be immediately reflected in the stock price. If the
manager then performs as expected, there
What problems does this cre- should not be much change in the share
ate?
price since this performance has already
been incorporated in the stock value
72. Stock returns depend on factors outside the managers'
control - for example, changes
in interest rates or prices of raw
materials. Could this be a serious problem? If so, can you
suggest a partial solution?
This could potentially be a very serious
problem since the mgr. could lose money
for reasons out of her control. One solution
might be to index the price changes and
then compare the actual raw material price
paid with the indexed value.
Another alternative would be to compare
the performance with the performance of
competitive firms.
73. Compensation schemes that It is not necessarily an advantage to have
depend on stock returns do not a compensation scheme tied to stock redepend on accounting data. Is turns.
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that an advantage? Why or why
not?
For example, in addition to the problem of
expectations discussed in Part a, there are
numerous factors outside the manager's
control, such as federal monetary policy or
new environmental regulations.
However, the stock price does tend to increase or decrease depending on whether
the firm does or does not exceed the required cost of capital. To this extent, it is a
measure of performance.
74. A conventional stock-option
plan, with the exercise price
fixed at today's stock price.
What are the advantages/disadvantages of this plan with
aligning the CEO's motivations
and compensation with those
of the shareholders?
75. An alternative plan in which
the exercise price depends on
the future market value of a
portfolio of the stocks of other copper-mining companies.
This plan pays off for the CEO
only if Androscoggin's stock
price performs better than its
competitors'. The second plan
sets a higher hurdle for the
CEO, so the # of shares should
be higher than in the conventional plan.
The CEO will be compensated if the price
of Androscoggin increases, regardless of
whether the increase is a result of the
CEO's actions or a consequence of a situation which is beyond the CEO's control
(such as an increase in copper prices).
The CEO would be compensated if his actions lead to the result that the stock outperforms the portfolio of copper-mining company shares; however, the CEO would also
be rewarded if other companies performed
poorly leading to the result that their stock
is just relatively better.
What are the advantages/disadvantages of this plan with
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aligning the CEO's motivations
and compensation with those
of the shareholders?
76. In recent years, several large
banks have paid mgmt. bonuses partly in bonds and partly
in stock. What do you think is
the reason for this? Is it a good
idea?
Banks are highly leveraged entities with
huge stakes in the financial and economic system. This combined with the
too-big-to-fail bailouts during the financial
crisis has created a substantial risk of
moral hazard. Equity stakes for bank executives have large upside potential and may
encourage risk-seeking behavior. Therefore, providing bonds as an incentive may
help balance a bank executive's focus on
generating profits with avoiding solvency
and liquidity risks. The counter-argument
is that an executive is no longer strictly aligned with the shareholders and may
make decisions adverse to equity holders
in favor of creditors.
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1. An Overview of Financial
Management: Introduction
Finance grew out of economics and accounting, and it is generally divided into three areas. Financial Management, also called corporate finance, focuses on decisions about
acquiring assets, raising capital, and running
the firm so as to maximize its value. Capital
Markets relate to the markets where interest
rates and stock and bond prices are determined. Investments involve decisions concerning stocks and bonds and include security analysis, portfolio theory, and market
analysis. These areas are closely interconnected.
2. An Overview of Financial Management: Shareholder Wealth Maximization, Intrinsic Values, and Ethics
The primary financial goal of a corporation
is Shareholder Wealth Maximization, which
involves maximizing the long-run value of the
firm's stock and requires taking a long-run
view of a firm's operations. To achieve their
financial goals, firms must develop products
that consumers want, produce the products
efficiently, sell them at Competitive prices,
and observe laws relating to corporate behavior.
Apart from their financial goals, companies
also focus on a wide number of non-financial goals including maximizing the welfare of
their employees, efficiently and fairly serving
their customers, and respecting their local
community and environment.
3. Select the statement that
Important and generally (but not always conbest completes the followsistent) with achieving their financial goals.
ing statement: Most managers recognize that being
socially responsible is _____.
4. Business Ethics
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As a result of financial scandals during the
past decade, there has been a strong push to
improve business ethics. Managers have an
obligation to behave ethically, and they must
follow the laws and other society-imposed
constraints. Most managers recognize that
being ethical is Consistent with the corporation's primary goal.
Definition of Business Ethics: A company's
attitude and conduct toward its employees,
customers, community, and stockholders.
5. Stock
A stock's intrinsic value is an estimate of a
stock's "true" value based on accurate risk
and return data. It can be estimated but not
measured precisely. When a stock's actual
market price is equal to its intrinsic value,
the stock is in Equilibrium. The Marginal investor's views determine a firm's actual stock
price.
6. An Overview of Financial
Management: Agency Conflicts
Firms must provide the right incentives if
they are to get Managers to focus on
long-run value maximization. Conflicts exist between managers and stockholders and
between stockholders (represented by managers) and Debtholders. Managers' personal
goals may compete with shareholder wealth
maximization. However, managers can be
motivated to act in their stockholders' best
interests through (1) reasonable Compensation packages, (2) firing managers, and
(3) the threat of hostile takeovers. If a firm's
stock is undervalued, corporate raiders will
see it as a bargain and will attempt to capture
the firm in a hostile takeover.
Bondholders generally receive fixed pay2/6
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ments regardless of how the firm does, while
Stockholders earn higher returns when the
firm's earnings are higher. Investments in
Risky ventures, that have great payoffs to
stockholders if successful but threaten bankruptcy if they fail, create conflicts. In addition,
the use of additional Debt increases stockholder- debtholder conflicts. Consequently,
bondholders attempt to protect themselves
by including Covenants in bond agreements
that limit firms' use of additional Debt and
constrain Managers' actions.
7. Corporate Raiders
Individuals who target corporations for
takeovers because they are undervalued.
8. Hostile Takeover
The acquisition of a company over the opposition of its management.
9. True or False?
True
Finance prepares students
for jobs in banking, investments, insurance, corporations, and government. It is
important for all business students, no matter what their
major is, to understand finance concepts. In addition,
finance is useful to all individuals regardless of their
jobs as we encounter finance
in our everyday lives, such
as decisions regarding consumer loans and mortgages.
10. Which of the following is NOT D. More favorable tax treatment
an advantage of the corporate
form of organization versus
partnerships and proprietorships?
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a. Limited liability.
b. Ease of transferring ownership among investors.
c. Ability to attract large
amounts of capital.
d. More favorable tax treatment.
e. Liquidity of investors' holdings in the business.
11. True or False?
False
Stocks have market prices,
and they also have intrinsic
values. If the market price
is below the intrinsic value
as estimated by marginal investors, and if the intrinsic
value remains stable in the future, then there will be a tendency for the stock's price to
fall over time.
12. True or False?
True
Managers should try to forecast the effects of different
decisions on the firm's intrinsic value and then take
actions designed to maximize this value. Management
should provide information
that helps investors make better estimates of the firm's intrinsic value, which will keep
the stock price closer to
the equilibrium level. However, there are times when management cannot divulge the
true situation because doing
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so would provide information
that helps its competitors.
13. Which of the following helps D. All of these help keep management foensure that managers oper- cused on stockholders' interests as reflected
ate in their stockholders' in- in maximizing the long-run stock price.
terests rather than their own
personal interests?
a. The threat of firing by the
board of directors.
b. The threat of a hostile
takeover possibly resulting
in top managers losing their
jobs. If the stock price is below its intrinsic value, this
threat is magnified.
c. Compensation packages
designed to provide incentives for management to
maximize the long-run stock
price.
d. All of these help keep management focused on stockholders' interests as reflected in maximizing the long-run
stock price.
14. True or False?
False
Conflicts between stockholders and debtholders arise because stockholders are less
willing than debtholders to
take on risky projects because stockholders are more
"at risk" of losing their investment.
15.
True
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True or False?
If a firm's managers narrowly focused on creating
shareholder value, but in the
process the company was unresponsive to its employees
and customers, hostile to its
local community, and indifferent to the effects its actions had on the environment;
then in all likelihood society
would impose a wide range
of costs on the company, and
this would ultimately lead to a
reduction in shareholder value.
16. True or False?
True
If a company practices "good
business ethics," then it will
treat its customers, employees, and stockholders "fairly," and this will cause it to
have a good reputation. Such
behavior may increase costs
and thus hurt profits in the
short run, but this is often
offset by long-run benefits in
the form of customer loyalty, more dedicated employees, and stockholders who
will support management in
the event of a downturn in the
business.
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1.
This book is mainly about
financial decisions made by corporations
2.
Shareholders of a corporation
may be among others
individuals, pension funds, and insurance companies
3.
Generally, a corporation is
owned by:
shareholders
4.
A corporation, potentially, has in- is a legal entity
finite life because it
5.
Limited liability is an important
feature of
corporations
6.
The firm's purchase of real assets is also referred to as the
capital investment decision
7.
The sale of financial assets is
also referred to as the:
financing decision
8.
The choice of the proper mixture capital structure decision
of debt and equity, used to finance a corporation is also referred as the
9.
Which of the following groups
Employees, customers, shareholders,
are referred to as stakeholders? and suppliers
10. The following are examples of
tangible assets except
training courses for employees
11. The ultimate financial goal of a
corporation is to
maximize the value of the corporation to
the stockholders
12. As a legal entity, a corporation vote
can perform the following functions except
13.
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Which of the following assets is ExxonMobil's corporate headquarters
tangible?
building
14. Which of the following types of
assets are intangible?
Trademarks
15. A firm's investment decision is
also called its
capital budgeting decision
16. Which of the following is not a
financial asset?
buildings
17. Which of the following is an im- providing financing, providing liquidity,
portant function of financial mar- reducing risk, and providing information
kets?
18. Disadvantages of the corporate cost of managing the corporation,
form include
agency costs, double taxation
19. In the principal agent framework Shareholders are the principals and
managers are the agents
20. Costs associated with the con- agency costs
flicts of interest between the
bondholders and the shareholders of a corporation are called
21. A corporation may incur agency of the separation of ownership and mancosts because
agement, managers may not attempt to
maximize the value of the firm to shareholders, shareholders incur monitoring
costs
22. The following groups are some of shareholders, bondholders, employees,
the claimants to a firm's income management, and government
stream
23. The financial goal of a corpora- Maximize the value of the firm for the
tion is to
shareholders
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24. An annuity is defined as a set of equal cash flows occurring at equal intervals of the time for a specified period
25. You are considering investing in future value of annuity
a retirement fund that requires
you to deposit $5,000 per year,
and you want to know how much
the fund will be worth when you
retire. What financial technique
should you use to calculate this
value?
26. The managers of a firm can max- taking all projects with positive NPVs
imize stockholder wealth by
27. If you are paid $1,000 at the end an annuity
of each year for the next five
years, what type of cash flow did
you receive?
28. Which of the following stateAccept project if its rate of return > 0
ments regarding the NPV rule is
false?
29. According to the net present val- net present value is positive
ue rule, an investment in a project should be made if the:
30. Which of the following stateAccept project if NPV > cost of investments regarding the net present ment
value and the rate of return rule
is false?
31. The opportunity cost of capital
for a risky project is
the expected rate of return on a security
of similar risk as the project
32. A perpetuity is defined as a sequence of
equal cash flows occurring at equal intervals of time forever
33.
Interest payment on a consol
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Which of the following is generally considered an example of a
perpetuity?
34. Present value is defined as
future cash flows discounted to the present by an appropriate discount rate
35. The rate of return is also called
the
I) discount rate; II) hurdle rate; III) opportunity cost of capital
36. The net present value formula for PV = C1 / (1+r)
a cash flow expected one period
from now is
37. The net present value formula for NPV = C0 + [C1/(1+r)]
one period is
38. Generally, a bond can be valued an annuity & single payment
as a package of:
39. If a bond pays interest semiannu- every six months
ally, then it pays interest
40. Which of the following statements about the relationship between interest rates and bond
prices is true?
There is an inverse relationship between
bond prices and interest rates, and the
price of long-term bonds fluctuates more
than the price of short term bonds for a
given change in interest rates (assuming
that the coupon rate is the same for both)
41. One can best describe the term spot interest rates and time
structure of interest rate as the
relationship between
42. The interest rate represented by spot rate on a two year investment
r2 is the
43. A CEO of your corporation, you increase, indicating that the bond inwould prefer (all else equal) to vestors view your firm as less risky
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see the price of your corporation's bonds
44. Which of the following bonds has 10 year, zero-coupon bond
the longest duration?
45. The valuation of a common stock its expected future dividends and its distoday primarily depends on
count rate
46. The constant dividend growth
that dividends grow at a constant rate g,
formula P0 = Div1/(r-g) assumes forever, and r > g only
47. One can estimate the expected dividend yield + expected rate of growth
rate of return or the cost of equity in dividends
capital as follows:
48. One can estimate the dividend
growth rate for a stable firm as
plowback rate X return on equity (ROE)
49. The growth rate in dividends is a ROE and the plowback ratio
function of two ratios. They are
50. Which of the following formulas EPS/P0 = r[1-PVGO/P0]
regarding the earnings to price
ratio is true?
51. Generally, high growth stocks
pay
low or no dividends
52. A high proportion of the value of PVGO (present value of a growth oppora growth stock typically comes tunity)
from
53. Which of the following investthe payback period
ment rules does not use the time
value of money concept?
54. Suppose a firm has $100 million buy another firm, pay high dividends to
in excess cash. It could
the shareholders, invest the funds in projects with positive NPVs
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55. The following are measures used P/E ratio
by firms (IRR, Payback period,
NPV) when making capital budgeting decisions except
56. Which of the following investNPV method
ment rules has the value additivity property?
57. You are given a job to make a de- break up the project into its components:
cision on project X, which is com- accept A and C but reject B
posed of 3 independent projects
A, B and C that have NPVs of
+70, -40, +100, respectively. How
would you go about making the
decision about whether to accept
or reject the project?
58. The net present value of a project project's cash flows and opportunity cost
depends upon the
of capital
59. Which of the following investPayback period
ment rules may not use all possible cash flows in its calculations?
60. The payback period rule
requires an arbitrary choice of a cut-off
point
61. The payback period rule accepts less than the cut-off value
all projects for which the payback
period is
62. The following are disadvantages is easy to calculate and use
of using the payback rule (ignores all cash flow after the
cut-off date, does not have the
value additivity property, does
not use the time value of money)
except the rule
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63. Which of the following stateThe discounted payback measure uses
ments regarding the discounted the time value of money concept
payback period measure is true?
64. If the cash flows for project A
Two years
are C0 = -1,000; C1 = +600; C2 =
+400; and C3 = +1,500, calculate
the payback period.
65. If an investment project (normal zero
project) has an IRR equal to the
cost of capital, the NPV for that
project is
66. The IRR is defined as
the discount rate that makes a project's
NPV equal to zero
67. The following are some of the
IRR is conceptually easy to communishortcomings ( IRR cannot dis- cate
tinguish between a borrowing
project and a lending project,
projects can have multiple IRRs,
it is very cumbersome to evaluate mutually exclusive projects
using the IRR method) of the IRR
method except
68. If the sign of the cash flows for a two IRRs
project changes two times, then
the project likely has
69. A project will have only one inter- there is a one-sign change in the cash
nal rate of return if
flows
70. One can use the profitability in- When capital rationing exists
dex most usefully for which situation?
71.
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The profitability index is the ratio net present value of cash flows to investof the
ment
72. The Important point(s) to remem- are cash flow is relevant, always estiber while estimating the cash
mate cash flows on an incremental baflows of a project
sis, and
be consistent in the treatment of inflation
73. Preferably, a financial analyst es- cash flows after taxes
timates cash flows for a project
as
74. When a firm has the opportunity Incremental costs
to add a project that will utilize
excess factory capacity (that is
currently not being used), which
costs should be used to help determine if the
added project should be undertaken?
75. A reduction in the sales of exist- incidental effects
ing products caused by the introduction of a new product is an
example of
76. When Honda develops a new en- demand for replacement parts, profits
gine, the incidental effects might from the sale of repair services, and offer
include the following:
modified or improved versions of the
new engine for other uses
77. The cost of a resource that may opportunity cost
be relevant to an investment
decision even when no cash
changes hand is called a(n)
78. Net working capital is best repre- short-term assets and short-term liabilisented as
ties
79.
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Accountants do not depreciate it is recovered during or at the end of the
investment in net working capital project; thus it is not a depreciating asset
because
80. One should consider net work- typically firms must invest cash in
ing capital (NWC) in project cash short-term assets to produce finished
flows because
goods
81. Investment in inventories includes investment in
raw material, work-in-progress, and finished goods
82. The principal short-term assets cash, accounts receivable, and inventoare
ries
83. The current market value of a pre- opportunity cost
viously purchased machine proposed for use in a project is an
example of a(n)
84. Money that a firm has already
sunk cost
spent, or committed to spend regardless of whether a project is
taken, is called a(n)
85. Costs incurred as a result of
sunk costs
past irrevocable decisions and irrelevant to future decisions are
called
86. For the case of an electric car
Tax savings resulting from the depreciaproject, which of the following
tion charges
costs or cash flows should be
categorized as incremental when
analyzing whether to invest in the
project?
87. An analyst wishes to determine Market values
the value of resources used by
a proposed project. Which values
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should the analyst use to approximate opportunity costs?
88. If the discount rate is stated in cash flows be estimated in nominal
nominal terms, then in order to terms
calculate the NPV in a consistent
manner, the project requires that
89. Working capital is a frequent
source of errors in estimating
project cash flows. These errors
include
forgetting about working capital entirely, forgetting that working capital may
change during the life of the project, and
forgetting that working capital is recovered at the end of the project
90. Which of the following portfolios A portfolio of Treasury bills
has the least risk?
91. For long-term U.S. government
bonds, which risk concerns investors the most?
Interest rate risk
92. What has been the average an- Less than 2 percent
nual real rate of interest on Treasury bills over the past 114 years
(from 1900 to 2014)?
93. What has been the average an- Greater than 3 percent
nual nominal rate of interest on
Treasury bills over the past 114
years (1900 to 2014)?
94. What has been the average an- Greater than 11 percent
nual nominal rate of return on a
portfolio of U.S. common stocks
over the past 114 years (from
1900 to 2014)?
95. What has been the average annu- Greater than 8 percent
al rate of return in real terms for a
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portfolio of U.S. common stocks
between 1900 and 2014?
96. A statistical measure of the de- correlation coefficient
gree to which securities' returns
move together is called a
97. The type of the risk that can be
eliminated by diversification is
called
unique risk
98. Unique risk is also called
firm-specific risk
99. Market risk is also called
systematic risk and undiversifiable risk
100. As the number of stocks in a
portfolio is increased,
unique risk decreases and approaches
zero
101. What range of values can corre- -1 to + 1
lation coefficients take?
102. For a two-stock portfolio, the
-1.0
maximum reduction in risk occurs when the correlation coefficient between the two stocks
equals
103. For a portfolio of N-stocks, the
formula for portfolio variance
contains
N variance terms
104. For a portfolio of N-stocks, the
formula for portfolio variance
contains
N(N - 1)/2 different covariance terms
105. Beta is a measure of
market risk
106. The beta of the market portfolio +1.0
is
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107. The distribution of returns, mea- normal distribution
sured over a short interval of
time, such as daily returns, is
best approximated by the
108. The distribution of returns, mea- lognormal distribution
sured over long intervals, like annual returns, is best approximated by the
109. Normal and lognormal distribu- mean and standard deviation
tions are completely specified by
their
110. An efficient portfolio
provides the highest expected return for
a given level of risk and provides the
least
risk for a given level of expected return
111. By combining lending and borrowing at the risk-free rate with
efficient portfolios, we can
extend the range of investment possibilities, change the set of efficient portfolios
from being curvilinear to a straight line,
and provide a higher expected return for
any level of risk, except for the tangential
portfolio and the risk-free asset
112. f the covariance of Stock A with -100
Stock B is -100, what is the covariance of Stock B with Stock
A?
113. The correlation coefficient mea- degree to which the returns of two stocks
sures the
move together
114. If the correlation coefficient be- +0.6
tween Stock A and Stock B is
+0.6, what is the correlation coefficient between Stock B with
Stock A?
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115. The correlation coefficient be0.0
tween the efficient portfolio and
the risk-free asset is
116. The presence of a risk-free asset borrow or lend at the risk-free rate and
enables the investor to
form portfolios having greater Sharpe
ratios
117. The Sharpe ratio is defined as
(rP - rf)/P
118. The beta of Treasury bills is
0.0
119. The capital asset pricing model The expected risk premium on an invest(CAPM) states which of the fol- ment is proportional to its beta
lowing?
120. The graphical representation of security market line
the CAPM (capital asset pricing
model) is called the
121. A stock return's beta measures the change in the stock's return for a
given change in the market return
122. The security market line (SML) is expected rate of return on investment vs.
the graph of
beta
123. One would expect a stock with
a beta of zero to have a rate of
return equal to
the risk-free rate
124. One would expect a stock with a 25 percent more than the market in up
beta of 1.25 to increase in returns markets
125. A common criticism of the CAPM requires only a single measure of sysis that it
tematic risk
126. If a stock were overpriced, it
would plot
below the security market line
127.
above the security market line
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If a stock were underpriced, it
would plot
128. A factor in APT is a variable that correlates with the returns of risky assets in a systematic manner
129. Which of the following is includ- Market factor, book-to-market factor,
ed in the Fama-French three-fac- and size factor
tor model
130. How can an investor earn more Borrow at the risk-free rate and invest in
than the return generated by the the tangency portfolio
tangency portfolio and still stay
on the security market line?
131. The company cost of capital is average-risk projects
the appropriate discount rate for
a firm's
132. The cost of capital is the same as entirely by equity
the cost of equity for firms that
are financed
133. Using a company's cost of capi- correct for projects that have average
tal to evaluate a project is
risk compared to the firm's other assets
134. If a firm uses the same company The firm will reject good low-risk procost of capital for evaluating all jects, accept poor high-risk projects, and
projects, which situation(s) will accept poor high-risk projects
likely occur?
135. Which of the following types of Expansions of existing business
projects have average total risk?
136. The hurdle rate for capital budgeting decisions is
the cost of capital
137. The company cost of capital,
weighted average cost of capital
when the firm has both debt and (WACC)
equity financing, is called the
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138. One calculates the after-tax
WACC = (rD) (1 - TC) (D/V) + (rE) (E/V),
weighted average cost of capital where V = D + E
(WACC) using which of the following formulas?
139. A firm's cost of equity can be es- discounted cash-flow (DCF) approach,
timated using the
capital asset pricing model (CAPM), and
arbitrage pricing theory (APT)
140. A firm's cost of equity can be es- capital asset pricing model (CAPM),
timated using the
Fama-French three-factor model, arbitrage pricing theory (APT).
141. Generally, for CAPM calculations, the value to use for the
risk-free interest rate is the
short-term U.S. Treasury bill rate
142. Which of the following informational updates would prompt a financial manager to use a higher
cost of capital to analyze a project?
Recent estimates indicate the project
has a greater percentage of fixed costs
than
previously thought
143. An example of diversifiable risk risks of government nonapproval of the
that a financial manager should project
ignore when analyzing a project's risk would include
144. An analyst computes a beta coef- this particular beta is more reliable than
ficient with a low standard error. most
This implies that
145. If capital markets are efficient, a zero-NPV transaction
then the sale or purchase of any
security at the prevailing market
price is generally
146. Financing decisions differ from Markets for financial assets are more
investment decisions for which active than for real assets
of the following reasons?
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147. Financing decisions differ from financing decisions are easier to reinvestment decisions because verse, markets for financial assets are
generally
more competitive than real asset markets, and markets for financial assets
are generally more competitive than real
asset markets
148. The statement that stock prices successive price changes are indepenfollow a random walk implies that dent of each other
149. The statement that stock prices the correlation coefficient between sucfollow a random walk implies that cessive price changes (auto correlation)
is
not significantly different from zero
150. Which of the following is a state- If markets are efficient in the weak form,
ment of weak-form efficiency? then it is impossible to make
consistently superior profits by using
trading rules based on past returns
151. The different forms of market ef- weak form, semistrong form, and strong
ficiency are
form
152. Which of the following stateStock prices reflect all available informaments is (are) true if the
tion
strong-form efficient market hypothesis holds?
153. Strong-form market efficiency
states that the market incorporates all information into stock
prices. Strong-form efficiency
implies that
professional investors cannot consistently outperform the market
154. If the weak form of market efficiency holds, then
technical analysis is useless, stock
prices reflect all information contained in
past
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prices, and stock price returns follow a
random walk
155. Which of the following is a state- Stock prices will adjust immediately to
ment of semistrong form efficien- public information
cy?
156. If the efficient market hypothesis to receive a fair price for their security
holds, investors should expect and to earn a normal rate of return on
their
investments
157. Informational efficiency in finan- fairer
cial markets results in stock
prices being
158. Weak-form efficiency implies
that past stock returns
do not help to predict future returns
159. If markets are efficient, which of None of the options are correct
the following investors should
achieve superior returns over
time?
160. One important implication of the should avoid active trading
efficient markets hypothesis is
that most investors
161. The semistrong form of efficien- publicly available information
cy focuses on the economic ineffectiveness of the following type
of information:
162. For most stocks, a scatter plot a shotgun pattern centered close to the
chart of stock returns versus
origin
past stock returns will appear as
163. In order to test the semistrong
form of the efficient-market hy-
measurement of how rapidly security
prices adjust to different news items
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pothesis, researchers have mostly relied on the
164. Suppose that a lawyer works
strong-form hypothesis of market effifor a firm that advises corpociency
rate firms planning to sue other corporations for antitrust damages. He finds that he can "beat
the market" by short selling the
stock of firms that will be sued.
This hypothetical finding would
violate the
165. Strong-form efficiency implies
that mutual fund managers
should
buy the index that maximizes diversification and minimizes the cost of managing
portfolios
166. Firms can pay out cash to their
shareholders in the following
way(s):
dividends and share repurchases
167. Which of the following answer is Firms have long-run target dividend paytrue?
out ratios, dividend changes follow shifts
in long-term sustainable earnings, and
managers are reluctant to make dividend
changes that might have to be reversed
168. Generally, firms engage in stock good news, and the stock price increasrepurchases during
es
169. Generally, investors view the an- good news, and the stock price increasnouncement of an open-market es
repurchase program as
170. The following are indicators that Competitors' stock prices are dropping,
the firm has a cash surplus:
the firm has a low debt ratio compared
to
similar firms, and the firm has sufficient
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debt capacity to cover unexpected opportunities or setbacks
171. Company X has 100 shares out- $100
standing. It earns $1,000 per year
and expects to pay all of it as
dividends. If the firm expects to
maintain this dividend forever,
calculate the
stock price today. (The required
rate of return is 10 percent.)
172. The capital structure of the firm the firm's mix of different securities used
can be defined as
to finance assets
173. When a firm has no debt, then
such a firm is known as a(n)
unlevered firm and an all-equity firm
174. The total market value (V) of the V = D + E
securities of a firm that has both
debt (D) and equity (E) is
175. If a firm is financed with both
levered equity
debt and equity, the firm's equity
is known as
176. Modigliani and Miller's Proposi- the market value of any firm is indepention I states that
dent of its capital structure
177. If firm U is unlevered and firm L is VU = EU and VL = EL + DL
levered, then which of the following is true?
178. If an investor buys a portion
(X) × (profits)
(X) of an unlevered firm's equity,
then his/her payoff is
179. If an investor buys a portion (X) (X) × (profits - interest)
of the equity of a levered firm,
then his/her payoff is
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180. The law of conservation of value he value of any asset is preserved reimplies that
gardless of the nature of the claims
against it
181. Value additivity works for
combining assets, splitting up of assets,
and the mix of debt securities issued by
the firm
182. Capital structure is irrelevant if
capital markets are efficient, each investor can borrow/lend on the same
terms as
the firm, and there are no tax benefits to
debt
183. An EPS-operating income graph, greater risk associated with debt financsuch as Figure 17.1, shows the ing, which is evidenced by a greater
slope,
the break-even point where EPS of two
different debt ratios are equal, and the
minimum operating income needed to
pay the interest for a given level of debt
184. When comparing levered vs. un- stay fixed, leaving more income to be
levered capital structures, lever- distributed over fewer shares
age works to increase EPS for
high levels of operating income
because interest payments on
the debt
185. In an EPS-operating income
a fixed interest charge must be paid
graph, such as Figure 17.1, the even at low earnings
slope of the line is steeper when
the debt ratio is higher. The debt
line has a negative intercept because
186. The effect of financial leverage
on the performance of the firm
depends on the
firm's level of operating income
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187. The cost of capital for a firm,
equal to the market value weighted averrWACC, in a tax-free environment age of the return on equity and the return
is
on debt; equal to rA, the rate of return for
that business risk class; and equal to the
overall rate of return required on the levered firm
188. For a levered firm where bA =
bE = bA + (D/E) × [bA - bD]
beta of assets and bD = beta of
debt, the equity beta (bE) equals
189. Generally, which of the following rE > rA > rD
is true?
190. Generally, which of the following bD < bA < bE
is true? (b = beta)
191. If the debt beta is zero, then the equity beta = (1 + debt-equity ratio)(beta
relationship between the equity of assets)
beta and the asset beta is given
by
192. If MM's Proposition I holds, min- market value of the firm
imizing the weighted average
cost of capital (WACC) is the
same as maximizing the
193. The after-tax weighted average
cost of capital (WACC) is given
by (corporate tax rate = TC):
WACC = (rD)(1 - TC)(D/V) + (rE)(E/V)
194. The main advantage of debt financing for a firm is that
interest expenses are tax deductible
195. In order to find the present val- cost of debt
ue of the tax shields provided by
debt, the discount rate used is
the
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196. Why does MM Proposition I not Levered firms pay lower taxes when
hold in the presence of corporate compared with identical unlevered firms
taxes?
197. Given corporate taxes, why does Extra cash flow goes to the firm's inadding debt to the capital struc- vestors rather than the tax authorities
ture increase firm value?
198. MM Proposition I with corporate capital structure can affect firm value by
taxes states that
an amount that is equal to the present
value of the interest tax shield; and, by
raising the debt-to-equity ratio, the firm
can lower its taxes and thereby increase
its total value
199. MM's Proposition I corrected for VL = VU + (TC)(D)
the inclusion of corporate income taxes is expressed as
200. Assuming that bonds are sold at stockholders of the firm
a fair price, the benefits from the
interest tax shield go to the
201. Which of the following entities A pharmaceuticals development compalikely has the highest cost of fi- ny
nancial distress?
202. Although the use of debt provides tax benefits to the firm,
debt also puts pressure on the
firm to
meet interest and principal payments,
which if not met can put the company
into financial distress
203. The costs of financial distress
depend on the
probability of financial distress and the
magnitude of costs encountered if
financial distress occurs
204. Which of the following is not
a potential result from financial
distress?
Due to interest tax shields, the firm's
effective tax rate is very low
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205. When financial distress is a pos- value of the firm if all-equity-financed
sibility, the value of a levered firm plus the present value of tax shield miis a function of the
nus
the present value of costs of financial
distress
206. According to the trade-off theory optimal capital structure occurs when
of capital structure,
the present value of tax savings on account
of additional borrowing just offsets the
increase in the present value of costs of
distress
207. Which of the following stateFirms can postpone bankruptcy for
ment(s) regarding financial dis- many years, and, ultimately, the firm may
tress is (are) true?
recover from financial distress and avoid
bankruptcy altogether
208. What are some of the possible
consequences of financial distress?
Equity investors would like the firm to
shift toward riskier lines of business
209. What does "risk shifting" imply? When faced with bankruptcy, managers
tend to invest in high-risk, high-return
projects
210. The trade-off theory of capital
structure predicts that
safe firms should borrow more than risky
ones
211. The pecking order theory of cap- if two firms are equally profitable, the
ital structure predicts that
more rapidly growing firm will end up
borrowing more, other things equal
212. The pecking order theory of cap- firms prefer internal finance and firms
ital structure implies that
prefer debt to equity when external financing is required
213. According to Rajan and Zingales, size: Large firms have higher debt ratios;
debt ratios of individual compa- tangible assets: Firms with high ratios
nies depend on
fixed assets to total assets have higher
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debt ratios; profitability: More profitable
firms have lower debt ratios; and market
to book: Firms with higher ratios of market-to-book value have lower debt ratios.
214. Financial slack includes
cash, marketable securities, readily salable real assets, and ready access to
debt
markets or bank loans
215. What signal is sent to the market Stock price is too high
when a firm decides to issue new
stock to raise capital?
216. To calculate the total value of the market values of debt and equity
firm (V), one should rely on the
217. One should determine the afadding the weighted average after-tax
ter-tax weighted average cost of cost of debt to the weighted average cost
capital by
of
equity
218. One calculates the after-tax
WACC = rD (1 - TC)(D/V) + rE (E/V);
weighted average cost of capital (where V = D + E)
(WACC) as
219. When using the weighted average cost of capital (WACC) to discount cash flows from a project,
we assume the following:
The project's risks are the same as
those of the firm's other assets and remain so for the life of the project, and
the project supports the same fraction of
debt to value as the firm's overall capital
structure, and that fraction remains constant for the life of the project
220. When one uses the after-tax
weighted average cost of capital
(WACC) to value a levered firm,
the interest tax shield is
automatically considered because the
after-tax cost of debt is included within
the
WACC formula
221. The flow-to-equity method uses
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cash flows to equity, after interest and
after taxes, and the cost of equity capital
as
the discount rate
222. If a firm has preferred stock, the rD (1 - TC)(D/V) + rP (P/V) + rE (E/V);
after-tax weighted average cost (where V = D + P + E)
of capital (WACC) equals
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1. Overview of Financial Management: Introduction
Finance grew out of economics and accounting, and it is
generally divided into three areas. Financial management,
also called corporate finance, focuses on decisions about
acquiring assets, raising capital, and running the firm so
as to maximize its value. Capital markets relate to the
markets where interest rates and stock and bond prices
are determined. Investments involve decisions concerning
stocks and bonds and include security analysis, portfolio
theory, and market analysis. These areas are closely interconnected.
2. Forms of Business Organization
The basic concepts of financial management are the same
for all businesses, regardless of how they are organized.
However, a firm's legal structure affects its operations. The
main forms of business organizations are: (1) proprietorships, (2) partnerships, (3) corporations, and (4) limited
liability companies (LLCs) and limited liability partnerships
(LLPs). In terms of numbers, most businesses are proprietorships. However, based on the dollar value of sales,
most business is done by corporations. Businesses are
frequently started as proprietorships and then converted
to corporations when their growth results in disadvantages
outweighing advantages.
A partnership has two important advantages: (1) It is easily
and inexpensively formed and (2) its income is allocated
on a pro rata basis to partners and taxed on a(n) individual
basis so the partnership avoids higher corporate income
taxes. A partnership has four important disadvantages: (1)
unlimited personal liability, (2) limited life, (3) difficulty of
transferring ownership, and (4) difficulty of raising large
amounts of capital.
A corporation has the following advantages: (1) unlimited
life, (2) ownership that is easily transferred through the exchange of stock, (3) limited liability, and (4) can easily raise
large amounts of capital to operate large businesses. Its
disadvantages are: (1) Corporate earnings may be subject
to double taxation and (2) setting up a corporation and
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filing required state and federal reports is complex. Large
corporations are known as C corporations. However, as an
aid to small businesses Congress created S corporations.
Limited liability corporations (LLCs) and limited liability
partnerships (LLPs) have limited liability protection like
corporations but are taxed like partnerships. Investors in
an LLC or LLP have votes in proportion to their ownership
interest. LLCs and LLPs have been gaining in popularity,
but large companies still find it advantageous to be C
corporations because of advantages in raising capital for
growth.
3. Shareholder
Wealth
Maximization,
Intrinsic Values,
and Ethics
The primary financial goal of a corporation is shareholder wealth maximization, which involves maximizing the
long-run value of the firm's stock and requires taking a
long-run view of a firm's operations. To achieve their financial goals, firms must develop products that consumers
want, produce the products efficiently, sell them at prices,
and observe laws relating to corporate behavior.
Apart from their financial goals, companies also focus on
a wide number of non-financial goals including maximizing
the welfare of their employees, efficiently and fairly serving
their customers, and respecting their local community and
environment.
Select the statement that best completes the following
statement: Most managers recognize that being socially
responsible is important and generally (but not always
consistent) with achieving their financial goals.
As a result of financial scandals during the past decade,
there has been a strong push to improve business ethics.
Managers have an obligation to behave ethically, and
they must follow the laws and other society-imposed constraints. Most managers recognize that being ethical is
consistent with the corporation's primary goal.
A stock's intrinsic value is an estimate of a stock's "true"
value based on accurate risk and return data. It can be
estimated but not measured precisely. When a stock's actual market price is equal to its intrinsic value, the stock is
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in equilibrium. The marginal investor's views determine a
firm's actual stock price.
4. Agency Conflicts Firms must provide the right incentives if they are to
get managers to focus on long-run value maximization.
Conflicts exist between managers and stockholders and
between stockholders (represented by managers) and
debtholders. Managers' personal goals may compete with
shareholder wealth maximization. However, managers can
be motivated to act in their stockholders' best interests
through (1) reasonable compensation packages, (2) firing
managers, and (3) the threat of hostile takeovers. If a firm's
stock is undervalued, corporate raiders will see it as a
bargain and will attempt to capture the firm in a hostile
takeover.
Bondholders generally receive fixed payments regardless
of how the firm does, while stockholders earn higher returns when the firm's earnings are higher. Investments
in risky ventures, that have great payoffs to stockholders
if successful but threaten bankruptcy if they fail, create
conflicts. In addition, the use of additional debt increases
stockholder/debtholder conflicts. Consequently, bondholders attempt to protect themselves by including covenants
in bond agreements that limit firms' use of additional debt
and constrain managers' actions.
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FRL 300 Homework 6 (Chapter 8)
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1. 1.value:
10.00 points
The Jackson-Timberlake Wardrobe Co. just paid a
dividend of $1.30 per share on its stock. The dividends are expected to grow at a constant rate of
4 percent per year indefinitely. Investors require a
return of 14 percent on the company's stock.
A)
P1 = D(1+g) / [R-g]
PV
= 1.30 x (1.04) / [.14
- 4]
= *13.52*
What is the current stock price? (Do not round inB)
termediate calculations and round your answer to 2 PV = 13.52
decimal places, e.g., 32.16.)
I /Y = 4
N=3
A) Current price $
CPT, *FV = 15.21*
C)
What will the stock price be in three years? (Do not N = 12
round intermediate calculations and round your an- CPT, *FV = 21.65*
swer to 2 decimal places, e.g., 32.16.)
B) Stock price $
What will the stock price be in 12 years? (Do not
round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)
C) Stock price $
HintsReferenceseBook & Resources
Hint #1
2. 2.value:
10.00 points
The next dividend payment by Halestorm, Inc., will
be $1.72 per share. The dividends are anticipated to
maintain a growth rate of 4 percent forever. If the
stock currently sells for $33 per share, what is the
required return? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2
1/6
R = [D0 ( 1 + g) / P0]
+g
R = [D1/P0] + g
A)
R
= 1.72/33 + .04
FRL 300 Homework 6 (Chapter 8)
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decimal places, e.g., 32.16.)
= 0.0921
= *9.21%*
A) Required return
%
3. 3.value:
10.00 points
The next dividend payment by Halestorm, Inc., will
be $1.56 per share. The dividends are anticipated to
maintain a growth rate of 4 percent forever. The stock
currently sells for $29 per share.
R = D1 / P0 + g
Required return =
(Dividends / Selling Price Now) +
(Growth rate or
Capital gains yield)
What is the dividend yield? (Do not round intermediate calculations. Enter your answer as a percent
rounded to 2 decimal places, e.g., 32.16.)
A)
Dividend yield
= D1 / P0
A) Dividend yield
= Div per share /
%
Current price per
share
What is the expected capital gains yield? (Enter your = 1.56 / 29
answer as a percent.)
= *5.38%*
B) Capital gains yield
%
B) Capital gains
yield
=g
= *4%*
4. 4.value:
10.00 points
Caan Corporation will pay a $3.02 per share dividend
next year. The company pledges to increase its dividend by 5.5 percent per year indefinitely. If you require a return of 10 percent on your investment, how
much will you pay for the company's stock today?
(Do not round intermediate calculations. Round your
answer to 2 decimal places, e.g., 32.16.)
A) Stock price $
2/6
P0
= D0 ( 1 + g) / [R g]
= D1 / [R - g]
A) Stock price
= P0
= 3.02 / (.1 - .055)
= *67.11*
FRL 300 Homework 6 (Chapter 8)
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5. 5.value:
10.00 points
Tell Me Why Co. is expected to maintain a constant 4
percent growth rate in its dividends indefinitely. If the
company has a dividend yield of 5.8 percent, what is
the required return on the company's stock? (Do not
round intermediate calculations. Enter your answer
as a percent rounded to 2 decimal places, e.g., 32.16.)
Dividend yield
= D1 / P0
= 0.058
R = D1 / P0 + g
= 0.058 + 0.04
= *9.8%*
Required return
%
6. 6.value:
10.00 points
Suppose you know that a company's stock currently
sells for $64 per share and the required return on the
stock is 14 percent. You also know that the total return
on the stock is evenly divided between a capital gains
yield and a dividend yield. If it's the company's policy
to always maintain a constant growth rate in its dividends, what is the current dividend per share? (Do
not round intermediate calculations and round your
answer to 2 decimal places, e.g., 32.16.)
Current dividend per share $
Dividend yield %
is a % of the total stock per share
price
P0
= D0 (1+g) / [R-g]
= D1 / [R-g]
14% = Capital
gains yield + dividend yield
= 7% + 7%
g = 0.07
7% =D1 =
0.07x64= 4.48
P0 = 64
Dividend yield
= D1 = D0 (1+g)
= 4.48=D0(1.07)
D0 = 4.48/1.07
D0 = *4.19*
7. 7.value:
10.00 points
3.15/92
= *3.42%*
3/6
FRL 300 Homework 6 (Chapter 8)
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Moraine, Inc., has an issue of preferred stock outstanding that pays a $3.15 dividend every year in
perpetuity. If this issue currently sells for $92 per
share, what is the required return? (Do not round
intermediate calculations. Enter your answer as a
percent rounded to 2 decimal places, e.g., 32.16.)
Required return
%
8. 8.value:
P0
10.00 points
= D0 (1+g) / [R-g]
Metallica Bearings, Inc., is a young start-up company. = D1 / [R-g]
No dividends will be paid on the stock over the next
nine years because the firm needs to plow back its P9
earnings to fuel growth. The company will pay a $14 = D10 / [R-g]
per share dividend 10 years from today and will in- = 14 / [.14-.08]
crease the dividend by 8 percent per year thereafter. = 14 / 0.06
If the required return on this stock is 14 percent, what = 233.33
is the current share price? (Do not round intermediate calculations and round your answer to 2 decimal FV = 233.33
places, e.g., 32.16.)
I = 14
N=9
CPT, PV = *$71.75*
9. 9.value:
10.00 points
Lohn Corporation is expected to pay the following
dividends over the next four years: $17, $13, $12, and
$7.50. Afterward, the company pledges to maintain a
constant 5 percent growth rate in dividends forever. If
the required return on the stock is 15 percent, what is
the current share price? (Do not round intermediate
calculations and round your answer to 2 decimal
places, e.g., 32.16.)
Current share price $
P0
= D0 (1+g) / [R-g]
= D1 / [R-g]
P4
= D5 / [R-g]
= (7.50x1.05) /
[.15-.05]
= 7.875/.1
= 78.75
Fv 4
= Stock price + Dividend
4/6
FRL 300 Homework 6 (Chapter 8)
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= 78.75 + 7.50 =
86.25
Fv 3 = dividend =
12
Fv 2 = dividend =
13
Fv 1 = dividend =
17
FV 83.25, I/Y =
15%, N = 4, CPT
PV = 49.31
FV 12, I/Y = 15%, N
= 3, CPT PV = 7.89
FV 13, I/Y = 15%, N
= 2, CPT PV = 9.83
FV 17, I/Y = 15%,
N = 1, CPT PV =
14.78
sum = current share price=
*$81.81*
10. 10.value:
10.00 points
Synovec Co. is growing quickly. Dividends are expected to grow at a rate of 25 percent for the next
three years, with the growth rate falling off to a constant 4 percent thereafter. If the required return is
10 percent, and the company just paid a dividend of
$2.95, what is the current share price? (Do not round
intermediate calculations and round your answer to
2 decimal places, e.g., 32.16.)
Current share price $
5/6
D0 = 2.95
D1 = 2.95 x 1.25 =
3.69
D2 = 3.69 x 1.25 =
4.61
D3 = 4.61 x 1.25 =
5.76
P3
= D3 (1+g) / [R-g]
= 5.76 x (1.04) /
[.1-.04]
= 5.99 / .06
= 99.83
FRL 300 Homework 6 (Chapter 8)
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Fv 3
= Stock price + Dividend
= 99.83 + 5.76 =
105.59
Fv 2 = dividend =
4.61
Fv 1 = dividend =
3.69
N = 3, I/Y = 10%,
FV = 105.59, CPT
PV = 79.33
N = 2, I/Y = 10%,
FV = 4.61, CPT PV
= 3.81
N = 1, I/Y = 10%,
FV = 3.69, CPT PV
= 3.35
sum = current
share price =
*$86.49*
6/6
Chapter