Finance
Jehlifisch Universität, Herbstsemester 2013
Jehlifisch Universität, Herbstsemester 2013
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Flashcards
A project’s cost of capital is equivalent to the company’s cost of capital
CAPM is a model postulating that an asset's expected return is proportional to a measure of the asset's systematic risk
According to the CAPM, the risk premium on a security is directly proportional to its covariance with the market portfolio
The SMB variable reflects return differences in high and low book-tomarket firm stocks
Fama and French (1993) SMB and HML factors are founded in theory
The cost of capital is the discount rate for the firm’s average-risk projects
When estimating the weighted-average cost of capital, debt and equity enter at market value
For firms rated above BBB, the debt beta is often assumed to be zero
The cost of debt is commonly estimated using the CAPM
The market risk premium is difference between the return on the market and the interest rate
Investors require a risk premium to hold bills as compared to long-term bonds
CAPM is a long-term model
Historic betas are often good indicators for future betas
“Pure plays” are firms in the same line of business as the project considered, not involved in any other type of business, and privately held
Projects with high “earnings betas” or “cash-flow betas” should also have high asset betas
Projects with long-term cash flows are less sensitive to changes in the risk-free rate or market risk premium
The certainty equivalent method makes separate adjustments for time and risk.
If the CAPM holds, stocks which are below the security market line should be sold as they are considered to be overvalued
The company cost of capital is the correct discount rate for all projects, because high risks of some projects are offset by the low risk of other projects
Modigliani and Miller postulate that with perfect capital markets and, accounting for taxes, the value of the firm is independent of its capital structure
Increasing the amount of debt also increases the debt holder risk
The amount or risk of the cash flows of a firm’s operations depend on the capital structure
As the firm borrows more, more of the business risk is transferred from stockholders to bondholders
Higher leverage increases expected equity return, risk, and shareholder value
In reality, capital markets are perfect and complete
Corporate governance mechanisms are important to overcome conflicts between equity holders and management
The trade-off theory relaxes the assumptions of no taxes and no costs of financial distress
The combination of equity capital and debt capital in financing is called capital structure.
There are conflicts of interest in the relationship between creditors, management and investors, because creditors like to increase the enterprise value whereas investors like to avoid risks.
The leverage is determined as equity capital divided by debt capital.
The terms debt ratio and leverage are the same.
The WACC formula assumes that the part of debt is constant during the life cycle of a project.
An increase in leverage results only then in a lower return on equity when the return on assets exceeds the cost of debt.
The tax shield is the difference between the value of the firm as if it were fully equity financed and fully taxed and the value of the firm as if it had debt capital and lower taxes.
According to the adjusted present value approach, the value of the firm is the sum of the value of the firm if it had no debt and the tax shield.
The equity value is the value of the firm from the perspective of all investors.
Interest payments and dividends are tax deductible
The after-tax cost of debt is rD*Tc
WACC is based on a firm’s future characteristics
When using the WACC one assumes that risks remain unchanged for the life of the project
