Set of flashcards Corporate Finance (Page 3 of 4)

Flashcards	136
Language	Deutsch
Category	Finance
Level	University
Created / Updated	02.12.2024 / 15.12.2024
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The idea that managers who perceive the firm’s equity is under-priced will have a preference to fund investment using retained earnings,
or debt, rather than equity is known as the:

signaling theory of debt.

lemons principle.

pecking order hypothesis.

credibility principle.

The idea that when a seller has private information about the value of a good, buyers will discount the price they are willing to pay due to adverse selection is known as the:

pecking order hypothesis.

signaling theory of debt

lemons principle.

credibility principle.

Which of the following statements is FALSE?

The most important insight regarding capital structure goes back to Modigliani and Miller: With perfect capital markets, a firm’s security choice alters the risk of the firm’s equity, but it does not change its value or the amount it can raise from outside investors

When agency costs are significant, short-term debt may be the most attractive form of external financing

During non-distress times, too much debt can motivate managers and equity holders to take excessive risks or over-invest in a firm

Of all the different possible imperfections that drive capital structure, the most clear-cut, and possibly the most significant, is taxes

Which of the following influences a firm’s choice of capital structure?

Taxes

Agency costs and benefits of leverage

Signaling and adverse selection

All of the above influence capital structure decisions

Which of the following methods are used in capital budgeting decisions?

WACC method

Adjusted Present Value method

Flow-to-Equity method

All of the above are used in capital budgeting decisions

Which of the following statements is FALSE?

Because the WACC incorporates the tax savings from debt, we can compute the levered value of an investment, which is its value including the benefit of interest tax shields given the firm’s leverage policy, by discounting its future free cash flow using the WACC

The WACC incorporates the benefit of the interest tax shield by using the firm’s before-tax cost of capital for debt.

The intuition for theWACC method is that the firm’s weighted average cost of capital represents the average return the firm must pay to its investors (both debt and equity holders) on an after-tax basis

The WACC can be used throughout the firm as the company wide 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.

Which of the following is NOT a step in the WACC valuation method?

Compute the value of the investment, including the tax benefit of leverage, by discounting the free cash flow of the investment using the WACC.

Compute the weighted average cost of capital

Determine the free cash flow of the investment.

Adjust the WACC for the firm’s current debt/equity ratio

Which of the following is NOT a step in the adjusted present value method?

Deducting costs arising from market imperfections

Calculating the unlevered value of the project

Calculating the after-tax WACC

Calculating the value of the interest tax shield

Which of the following statements is FALSE?

The firm’s unlevered cost of capital is equal to its pre-tax weighted average cost of capital - that is, using the pre-tax cost of debt, rd, rather than its after-tax cost, rd (1−τc).

A firm’s levered cost of capital is a weighted average of its equity and pre-tax debt costs of capital.

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.

The first step in the APV method is to calculate the value of free cash flows using the project’s cost of capital if it were financed without leverage.

Which of the following statements is FALSE?

The APV approach explicitly values the market imperfections and therefore allows managers to measure their contribution to value.

To compute the present value of the interest tax shield, we need to determine the appropriate cost of capital.

A target leverage ratio means that the firm adjusts its debt proportionally to the value of assets.

Because we don’t value the tax shield separately, with the APV method we need to include the benefit of the tax shield in the discount rate as we do in the WACC method

Which of the following statements is FALSE?

In the flow-to-equity valuation method, the cash flows to equity holders are then discounted using the weighted average cost of capital.

In the WACC and APV methods, we value a project based on its free cash flow, which is computed ignoring interest and debt payments

In the flow-to-equity (FTE) valuation method, we explicitly calculate the free cash flow available to equity holders taking into account all payments to and from debt holders

The project’s free cash flow to equity shows the expected amount of additional cash the firm will have available to pay dividends (or conduct share repurchases) each year

Which of the following statements is FALSE?

As a general rule, theWACC method is the easiest to use when the firm will maintain a fixed debt-to-value ratio over the life of the investment

When debt levels are set according to a fixed schedule, we can discount the predetermined interest tax shields using the debt cost of capital, rD.

The FTE approach does not have the same disadvantage associated with the APV approach. We don’t need to compute the project’s debt capacity to determine interest and net borrowing before we can make the capital budgeting decision

When used consistently, the WACC, APV, and FTE methods produce the same valuation for the investment.

Which of the following is NOT a step in valuation using the flow to equity method?

Determine the equity cost of capital, rE

Compute the equity value, E, by discounting the free cash flow to equity using the equity cost of capital

Determine the free cash flow to equity of the investment.

Determine the before-tax cost of capital, rU

Which of the following statements is FALSE?

Not all insurable risks have a beta of zero. Some risks, such as hurricanes and earthquakes, create losses of tens of billions of dollars and may be difficult to diversify completely

When a firm buys insurance, it transfers the risk of the loss to an insurance company. The insurance company charges an upfront premium to take on that risk.

By its very nature, insurance for non-diversifiable hazards is generally a positive beta asset; the insurance payment to the firm tends to be larger when total losses are low and the market portfolio is high.

Because insurance provides cash to the firm to offset losses, it can reduce the firm’s need for external capital and thus reduce issuance costs.

Which of the following statements is FALSE?

Because insurance reduces the risk of financial distress, it can relax this trade-off and allow the firm to increase its use of debt financing.

Similar the equity issuance decision, purchasing insurance may signal to the capital markets that the firm has below-average risk and insurance companies should be compensated for this adverse selection problem by lower premiums

A proper risk management strategy ensures that companies have the cash when they need it for investment, but it does not seek to eliminate risks of all kinds.

In a perfect market without other frictions, insurance companies should compete until they are just earning a fair return and the NPV from selling insurance is zero. The NPV is zero if the price of insurance equals the present value of the expected payment; in that case, we say the price is actuarially fair.

A company’s cash flow is related to a specific risk in the following way:

Using an appropriate hedging policy, the company would like to generate the most constant cash flow possible. Which of the following hedging strategies would you most recommend to the company?

Hedging with long calls

Hedging with short puts

Hedging with long puts

Hedging with long puts and long calls

Hedging with short puts and long call

Which of the following statements is FALSE?

Insurers might require a company to retain some fraction of the insured risk, taking potential moral hazard into account

Insurers usually offer a “menu” of contracts with different coverage and premium levels, accounting for different risk types and the resulting adverse selection problem.

Hedging only a single risk of a firm may actually increase cash flow volatility if this risk is positively correlated with another risk

Assuming perfect capital markets, hedging financial risks is a zero NPV venture and does not increase firm value

A Portuguese family business that manufactures mobile homes is considering hedging its dollar sales against exchange rate fluctuations. The company develops three scenarios in which it estimates sales depending on the exchange rate:

Which of the following strategies would you recommend to the company?

Hedging with short calls

Hedging with short puts

Hedging with long puts

Hedging with futures

No hedging.

Which of the following statements is FALSE?

Because a corporation is a separate legal entity, when it fails to repay its debts the people who lent to the firm, the debt holders, are entitled to seize the assets of the corporation in compensation for the default.

The Board of Directors will hold the ultimate decision-making authority in a corporation.

The Principal-Agent Problem always arises whenever there is the separation of ownership and control in a corporation

The Principal-Agent Problem arises because managers have little incentive to work in the interest of shareholders when this means working against their own self-interest.

Consider two mutually exclusive investment projects, between which you must decide. Project A has an Internal Rate of Return (IRR) of 32%, requiring an initial investment of 2000 euros and yielding two consecutive cash inflows of 1500 euros in the subsequent two years. Project B, on the other hand, has an IRR of 10% and entails a cash inflow of 5000€, with the condition that you make two payments of 2900€ in the following two years. Given a required rate of return of 17%, which of the two projects should you pursue?

Project A because the IRR is higher than in Project B

Project B because the IRR is higher than in Project A

Project A because the NPV is higher than in Project B

Project B because the NPV is higher than in Project A

Identify a scenario under which the Internal Rate of Return (IRR) for an investment remains unchanged:

When the initial investment cost decreases.

When the cash flows occur at different time intervals.

When the required rate of return decreases.

When future cash flows increase two-fold.

Consider two mutually exclusive projects with similar risk profile and the following cash flows:

Unfortunately, the analyst responsible for delivering the report was unable to estimate the cost of capital. Knowing that the incremental IRR is 26% (L-S), please comment on the following statements:

i) If the appropriate cost of capital is lower than 26%, then project L should be chosen

ii) If the appropriate cost of capital is lower than 7%, project S should be chosen

iii) If the appropriate cost of capital is higher than 7%, project L should be chosen

Only i) and iii) are true

Only ii) is true

Only iii) is true

None of the above are true

You are offered a riskless investment opportunity in which you will receive $23,750 today in exchange for paying $25,000 in one year. Suppose the risk-free rate is 6% per year and suppose that you can borrow or lend at the competitive rate. Should you take this project? The NPV for this project is closest to:

Accept, because NPV=$165.09.

Accept, because NPV=$2594.34

Reject, because NPV=-$165.09.

Reject, because NPV=-$2594.34

You are considering investing in a riskless security that will pay you $80 in interest-only at the end of each of the next 10 years. This security is currently being traded in a normal market and you expect no transaction costs. Moreover, the appropriate discount rate is 5%. Then, the Internal Rate of Return (IRR) for investing in this security is closest to:

5%

6%

7%

8%

Suppose that on top of the pool of 15 available scientists, the company could now hire additional researchers for $6 million per scientist. In this case, how many more scientists should the company hire to maximize its total NPV?

0

2

3

None of the other options

Which of the following statements if FALSE?

If there is a fixed supply of a resource available, you should rank projects by the profitability index, selecting the project with the lowest profitability index first and working your way down the list until the resource is consumed.

If there is a fixed supply of resources available, so that you cannot undertake all possible opportunities, it might be suboptimal to choose the projects with the highest NPV.

The IRR can provide information on how sensitive your analysis is to errors in the estimate of your cost of capital.

As opposed to the IRR, an NPV will always exist for an investment opportunity

Which of the following statements is FALSE?

We should not use the constant growth dividend discount model to value the stock of a firm with rapid growth

A common approximation is to assume that that in the long run, dividends will grow at a constant rate

The dividend discount model values the stock based on a forecast of the future dividends paid to shareholders

During periods of high growth, it is unusual for these firms to retain 100% of their earnings to exploit profitable investment opportunities

MM Motors has a share price of $25 today. Moreover, MM Motors is expected to pay a dividend of $0.75 at the end of this year, which is expected to grow at a constant rate. If the equity cost of capital is equal to 10%, then the dividend yield and capital gain rate (both in annual terms) are expected to be:

3% and 10%

3% and 7%

10% and 7%

7% and 10%

Company X expects earnings in the coming year to be €4.00 per share and will always retain 25% of its earnings to reinvest in new projects. The equity cost of capital is 10.5%. Knowing that you are willing to pay €45.00 for a share in this company, what is the expected return on new projects (assume all growth comes from retained earnings)? (Rounded to decimals)

7.1%

12.2%

15.3%

Impossible to know

Suppose that a given firm operates in perfect capital markets and will generate cash flows just for one year (received one year from now) as follows:

Outcome A: $1,600 with a 60% probability.
Outcome B: $3,100 with a 40% probability.

The risk-free interest rate is 5%, and the project's cost of capital is 10%. Assume perfect capital markets.

What is the value of the unlevered firm?

2200

2095.24

2000

1913.04

What is the maximum level of debt that the firm may issue at the risk-free rate (rounded to decimals)?

1523.8

2000

1904.8

1600

What is the expected return of debt if the company is currently financed by $1,700 in debt?

7.18%

5%

26%

3.56%

Which of the following statements is FALSE?

When a firm issues new shares that account for a significant percentage of its outstanding shares, the transaction is called a leveraged recapitalization.

MM Proposition I applies to capital structure decisions made at any time during the life of the firm.

By choosing positive-NPV projects, the firm can enhance its value.

In perfect capital markets, holding fixed the cash flows generated by the firm's assets, however, the choice of capital structure does not change the value of the firm.

Galt Industries has 50 million shares outstanding and a market capitalization of $1.25 billion. It also has $750 million in debt outstanding. Galt Industries has decided to delever the firm by issuing new equity and completely repaying all the outstanding debt. Assume perfect capital markets.

The number of shares that Galt must issue is closest to:

15 million

25 million

30 million

40 million

What is the assets’ beta for ABC Industries, which has no debt, $25 billion in cash and risk-free securities, a total equity capitalization of $128 billion, and an equity beta of 1.7? Assume a risk-free rate of interest at 5% and a market risk premium of 4%.

2.11

2.18

1.70

None of the above

You are evaluating a new project and need an estimate for your project's beta. You have identified the following information about three firms with comparable projects:

Which of the following statements is correct about the unlevered equity betas?

βNod>βLincoln>βBlinkin

βLincoln>βNod>βBlinkin

βBlinkin>βLincoln>βNod

None of the other options

Based upon the three comparable firms, what asset beta would you recommend using for your firm's new project?

0.90

1.60

1.00

None of the other options

Consider a project with free cash flows in one year of $90,000 in a weak economy or $117,000 in a strong economy, with each outcome being equally likely. The initial investment required for the project is $80,000, and the project's cost of capital is 15%. The risk-free interest rate is 5%.

Suppose that you borrow only $45,000 in financing the project. Calculate the firm's equity cost of capital, assuming perfect capital markets.

15%

25%

35%

None of the other options

Assume that Rose Corporation's (RC) EBIT is not expected to grow in the future and that all earnings are paid out as dividends. RC is currently an all equity firm. It expects to generate earnings before interest and taxes (EBIT) of $6 million over the next year. Currently RC has 5 million shares outstanding and its stock is trading for a price of $12.00 per share. RC is considering borrowing $12 million at a rate of 6% and using the proceeds to repurchase shares at the current price of $12.00.

Prior to any borrowing and share repurchase, the equity cost of capital for RC is closest to:

11%

10%

12%

9%

Consider the following three statements:

A real option is always present if there is uncertainty about the future development of the market (e.g., demand)
The option to abandon a project is akin to a call option
Real options are usually easier to identify and value than financial options

Only 1 is correct

Only 3 is correct

Only 1 and 2 are correct

All statements are correct

All statements are incorrect

Corporate Finance

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