Finance Chapter 11 / 12

Question 1

To evaluate investment opportunities, financial managers must determine the relevant cash flows:

Answer 1

A project’s net cash flows are the net incremental after-tax cash flows over a project’s life.

The incremental cash flows represent the additional after-tax cash flows (outflows or inflows) that will occur only if the firm makes the investment

Question 2

The cash flows of any project may include three basic components:

Answer 2

1:Initial investment: the relevant cash outflow for a proposed project at time zero.

2: Operating annual net cash flows: the incremental net cash inflows resulting from implementation of a project during its life.

3: Terminal cash flow: the after-tax nonoperating cash flow occurring in the final year of a project.

Question 3

For expansion decisions

Answer 3

Developing relevant cash flow estimates is most straightforward.

In this case, the initial investment, operating cash inflows, and terminal cash flow are merely the after-tax net cash outflow and inflows associated with the proposed capital expansion expenditure.

Question 4

For replacement decisions

Answer 4

Identifying relevant cash flows for replacement decisions is more complicated, because the firm must identify the incremental cash outflow and inflows that would result from the proposed replacement

Question 5

Sunk costs are

Answer 5

cash outlays that have already been made (past outlays) and therefore have no effect on the cash flows relevant to a current decision.

(Sunk costs should not be included in a project’s incremental cash flows)

Question 6

Opportunity costs are

Answer 6

cash flows that could be realized from the best alternative use of an owned asset.

(Opportunity costs should be included as cash outflows when one is determining a project’s incremental cash flows).

Question 7

The cost of new asset is

Answer 7

the net outflow necessary to acquire a new asset

Question 8

What categories fall under debt capitcal?

Answer 8

Long Term Debt

Question 9

What categories fall under equity capital?

Answer 9

Stockholders Equity, Preferred Stock, Common Stock Equity, Common Stock, Retained Earnings.

Question 10

5 Factors that influence the formulation of capital structure.

Answer 10

(Firm’s) Risk, Tax Position, financial flexibility, managerial attitude, long term strategy. (3-5 years from now).

Question 11

The optimal mix of debt, preferred stock, and common equity can…

Answer 11

change over time,

Question 12

How does a company determine it’s optimal capital structure?

Answer 12

Maximize the price of the firm’s stock price.

Question 13

What are characteristics of maximizing firm stock price?

Answer 13

-Changes in the use of debt will cause changes in earnigs per share, afecting stock price.

-Cost of debt varies with capital structure

-Higher percentage/weights of debt increases risk.

Question 14

Signal Theory Characteristics

Answer 14

Basic Assumption:
-Managers have better information about their firm’s prospects than do outside investors.

So we look for a “signal” from management action:
-An action taken by a firm’s management that provides clues to investors about how management views the firm’s
capital prospects

The firm builds Reserve borrowing capacity
-The ability to borrow money at a reasonable cost when good investment opportunities arise
-Firms often use less debt than “optimal” to ensure that they can obtain debt capital later if it is needed