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Finance CH 10 + 11 > chapter 10 + 11 > Flashcards

chapter 10 + 11 Flashcards

0
Q

WACC

A

weighted cost of capital

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1
Q

capital used by firms to raise funds

A

debt
perferred stock
common equity

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2
Q

rd

A

interest rate on firm’s new debt

before taxes

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3
Q

rd(1-t)

A

after tax cost of debt

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4
Q

rp

A

cost of preferred stock

yield investors expect to earn on preferred stock

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5
Q

re

A

cost of common equity raised by retained earnings or exteral equity.
rate of return investors require on firm’s common stock.
*cost of all new equity.

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6
Q

target weights

A

Wd- proportion of debt in capital structure
Wp- proportion of preferred stock in capital structure
Wc- proportion of common equity in capital structure
retained earnings, internal equity, new common stock, and external equity

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7
Q

what WACC unique to a particular company?

A

the weights are what makes WACC unique

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8
Q

What are the 2 processes to determine cost of capital structure?

A
  1. compute the cost of each component of capital

2. compute the weighted average cost of capital

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9
Q

What are the approaches to calculate rs (cost of common equity)?

A

DCF: rs= D1/Po + g = expected rate
CAPM: rs= Rrf +(rm - Rrf)b
bond rate + premium: rs = bond rate + RPm ALSO,
rs = Rrf + Rp = required rate

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10
Q

what is the standard risk premium range?

A

3%-5%

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11
Q

Why is internal equity cheaper than external equity?

A

External equity always pays a commission so it has a flotation cost

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12
Q

What are the 2 assumptions for using WACC as a discount rate?

A
  1. the projects under evaluation has to be in the same risk class
  2. WACC is assumed to have been computed based on optimal capital structure
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13
Q

what is optimal capital structure?

A

capital put together at the minimum possible cost

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14
Q

what kind of relationship does demand for capital and cost of capital have and why?

A

positive relationship
increase demand for capital; increase cost of capital
capital is a scarce resource

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15
Q

WACC > rate of return

A

reject the project

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16
Q

WACC < rate of return

A

accept the project

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17
Q

Project Evaluations (4)

A
  1. expansion into new product
  2. replacement
  3. safety or environmental projects
  4. mergers or acquisitions
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18
Q

What does expansion into new projects or markets involve to evaluate project?

A

takes longer time
need to study demand for project and feasibility to produce it.
need to know how much sales to breakeven and if there is a possibility to make more than that.
estimate cash flow it might generate

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19
Q

What evaluations are necessary for replacement?

A

may not want to keep equipment till end of its life
may want to replace old/ wornout equipment
how much would equipment sell for?
How much will you save with new equipment?
will it add value?

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20
Q

abandonment

A

during life of the project you can abandon if you do not anticipate costs or losses. you count your losses and do an analysis of when you should abandon.

21
Q

Techniques (5) for project evaluation

A
  1. Net Present Value
  2. Internal Rate of Return
  3. Modified Internal Rate of Return
  4. Regular Payback
  5. Discounted Payback
22
Q

Payback Period

A

important consideration for managers
how long it takes to recover the project cost
assumes cash for paying back is evenly distributed throughout the year.

23
Q

Payback Period Weaknesses (2)

A
  1. ignores the time value of money
    interest rate is zero
  2. ignores cash flows after the payback period
    doesn’t consider all the cash flows or salvage value
24
Q

payback: what is the difference if cost is collected at the end of the year versus being collected at the beginning of the year?

A

end of the year takes of longer time than collecting at the beginning of the year.

25
Q

payback period strengths

A

crude measure of risk and liquidity
faster you get your money the more liquid
less time it takes the less risky

26
Q

Discounted Payback Period

A

takes care of ignoring time value of money
discounts cash flow
takes longer time than regular payback period

27
Q

discount payback period weakness

A

ignores cash flows after payback period

28
Q

Net Present Value

A

takes care of weaknesses of payback period

best measure of cost of capital

29
Q

NPV > 0

A

accept the project

30
Q

NPV < 0

A

reject the project

31
Q

NPV = 0

A

marginal - reject the project
other factors come into play
breakeven

32
Q

If projects are mutually exclusive how do you determine which project should you choose using NPV?

A

the one with the highest (+) number

33
Q

What is the appropriate discount rate?

A

the cost of capital WACC

34
Q

NPV strengths

A
  1. doesn’t ignore the time value of money

2. takes into account all the cash flows

35
Q

Internal Rate of Return

A

where PV of cash inflows = PV of cash outflows
the rate of return which equates PV of cash inflows to the PV of cash outflows.
It is not a market return- has no economic rationale
It is a yardstick measure to compare cost of capital

36
Q

Internal Rate of Return weakensses

A
  1. you can have multiple IRRs for project
  2. the assumption that irr is the investment rate is wrong
    it is calculated the same way the investment rate is.
  3. it is not market determined
37
Q

IRR > WACC cost of capital

A

accept project

38
Q

IRR < WACC cost of capital

A

reject the project

39
Q

IRR = WACC

A

marginal; reject the project - other factors come into play

40
Q

How does MIRR compare to IRR?

A

MIRR < IRR always

41
Q

Modified Rate of Return

A

takes care of multiple IRR problem

assumes cash flows are reinvested at cost of capital

42
Q

MIRR > WACC cost of capital

A

accept project

43
Q

MIRR < WACC cost of capital

A

reject project

44
Q

MIRR = WACC

A

reject; marginal; other factors come into play

45
Q

What do you consider when you evaluate a project?

A

incremental cash flows

46
Q

mutually exclusive

A

must choose one project over another

47
Q

independent

A

projects can be under taken concurrently

you can do them all if you have the money

48
Q

if the different techniques conflict which technique do you go by?

A

NPV

49
Q

What determines the difference between NPV and IRR

A

the size or cost of the projects

50
Q

What are 2 ways to solve comparing projects with different lengths?

A
  1. Compare easy multiples
    bring them to the same time period
  2. equivelant annuities

Finance CH 10 + 11 (1 decks)

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