chapter 10 + 11

Question 0

WACC

Answer 0

weighted cost of capital

Question 1

capital used by firms to raise funds

Answer 1

debt
perferred stock
common equity

Question 2

rd

Answer 2

interest rate on firm’s new debt

before taxes

Question 3

rd(1-t)

Answer 3

after tax cost of debt

Question 4

rp

Answer 4

cost of preferred stock

yield investors expect to earn on preferred stock

Question 5

re

Answer 5

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.

Question 6

target weights

Answer 6

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

Question 7

what WACC unique to a particular company?

Answer 7

the weights are what makes WACC unique

Question 8

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

Answer 8

1. compute the cost of each component of capital

2. compute the weighted average cost of capital

Question 9

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

Answer 9

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

Question 10

what is the standard risk premium range?

Answer 10

3%-5%

Question 11

Why is internal equity cheaper than external equity?

Answer 11

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

Question 12

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

Answer 12

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

Question 13

what is optimal capital structure?

Answer 13

capital put together at the minimum possible cost

Question 14

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

Answer 14

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

Question 15

WACC > rate of return

Answer 15

reject the project

Question 16

WACC < rate of return

Answer 16

accept the project

Question 17

Project Evaluations (4)

Answer 17

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

Question 18

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

Answer 18

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

Question 19

What evaluations are necessary for replacement?

Answer 19

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?

Question 20

abandonment

Answer 20

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.

Question 21

Techniques (5) for project evaluation

Answer 21

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

Question 22

Payback Period

Answer 22

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

Question 23

Payback Period Weaknesses (2)

Answer 23

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

Question 24

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

Answer 24

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

Question 25

payback period strengths

Answer 25

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

Question 26

Discounted Payback Period

Answer 26

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

Question 27

discount payback period weakness

Answer 27

ignores cash flows after payback period

Question 28

Net Present Value

Answer 28

takes care of weaknesses of payback period | best measure of cost of capital

Question 29

NPV > 0

Answer 29

accept the project

Question 30

NPV < 0

Answer 30

reject the project

Question 31

NPV = 0

Answer 31

marginal - reject the project other factors come into play breakeven

Question 32

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

Answer 32

the one with the highest (+) number

Question 33

What is the appropriate discount rate?

Answer 33

the cost of capital WACC

Question 34

NPV strengths

Answer 34

1. doesn't ignore the time value of money | 2. takes into account all the cash flows

Question 35

Internal Rate of Return

Answer 35

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

Question 36

Internal Rate of Return weakensses

Answer 36

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

Question 37

IRR > WACC cost of capital

Answer 37

accept project

Question 38

IRR < WACC cost of capital

Answer 38

reject the project

Question 39

IRR = WACC

Answer 39

marginal; reject the project - other factors come into play

Question 40

How does MIRR compare to IRR?

Answer 40

MIRR < IRR always

Question 41

Modified Rate of Return

Answer 41

takes care of multiple IRR problem | assumes cash flows are reinvested at cost of capital

Question 42

MIRR > WACC cost of capital

Answer 42

accept project

Question 43

MIRR < WACC cost of capital

Answer 43

reject project

Question 44

MIRR = WACC

Answer 44

reject; marginal; other factors come into play

Question 45

What do you consider when you evaluate a project?

Answer 45

incremental cash flows

Question 46

mutually exclusive

Answer 46

must choose one project over another

Question 47

independent

Answer 47

projects can be under taken concurrently | you can do them all if you have the money

Question 48

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

Answer 48

NPV

Question 49

What determines the difference between NPV and IRR

Answer 49

the size or cost of the projects

Question 50

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

Answer 50

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