Chapter 13 Flashcards
(40 cards)
What causes operating leverage to increase?
Higher fixed costs and lower variable costs in a firm’s cost structure.
What happens to project evaluation if the wrong discount rate is used?
It can lead to rejecting good projects or accepting bad ones.
What kind of projects should an all-equity firm accept?
Projects with IRRs that exceed the cost of equity capital.
Why might a firm use an industry beta?
When a firm’s operations are similar to others in the industry.
What does it mean if a project’s IRR is above the firm’s cost of capital?
The project adds value and should be accepted.
What is the purpose of using project-specific betas?
To more accurately reflect the risk of individual projects.
What is the main assumption when using CAPM in capital budgeting?
Investors are well-diversified, so only systematic risk matters.
What happens to equity beta when a firm adds debt?
It increases, assuming the firm’s asset beta stays constant.
What does the Security Market Line (SML) show?
The relationship between expected return and beta (systematic risk).
What does financial leverage refer to?
The use of debt to finance operations, increasing equity beta.
What determines the value of a risky capital-budgeting project?
The present value of its expected cash flows, discounted at an appropriate rate.
What financial information is used to estimate a firm’s cost of debt via YTM?
Yield to maturity on the firm’s existing bonds.
What’s one reason to use bond ratings instead of YTM for debt cost?
Bond ratings offer a simplified estimate when bond market data is limited or inconsistent.
Why is using the same discount rate for all projects risky?
It can result in taking on too much risk and reducing firm value.
What affects a firm’s beta?
Business risk, operating leverage, and financial leverage.
What is the cost of debt?
The interest rate the firm must pay to issue new debt.
What does the term “marginal tax rate” refer to in WACC?
The tax rate applied to the next dollar of taxable income.
What is the hurdle rate in capital budgeting?
The minimum required rate of return for a project to be accepted.
Why is market value preferred over book value in WACC calculations?
Market value reflects current investor expectations and asset values.
What does beta measure?
A stock’s sensitivity to market movements or systematic risk.
What is operating leverage?
The degree to which a firm’s cost structure is fixed versus variable.
What is the cost of equity capital?
The expected return required by equity investors for investing in a firm’s equity.
What are two methods for estimating the market risk premium?
Historical returns and the Dividend Discount Model.
How can betas vary over time?
Due to changes in a firm’s operations, industry conditions, or capital structure.
