Week 5

Question 1

Risk

Answer 1

Uncertainty of cash flows; in timing and magnitude.

Question 2

How is risk measured?

Answer 2

Through the standard deviation of cash flows.

Question 3

Are both assets and liabilities considered to have risk?

Answer 3

Yes!

Question 4

For asset holders, where is the uncertainty?

Answer 4

Uncertainty in earnings (cash inflow).

Question 5

For liability holders, where is the uncertainty?

Answer 5

Uncertainty in cost.

Question 6

Risk upside

Answer 6

Uncertainty in timing and magnitude of future cash flows that provides benefit.

Question 7

Risk downside

Answer 7

Uncertainty in timing and magnitude of future cash flows that provides disadvantages or added cost.

Question 8

Asset upside risk

Asset downside risk

Answer 8

Upside: receiving greater future earnings than expected or receiving future earnings sooner than expected.
Downside: receiving less future earnings than expected or receiving future earnings later than expected.

Question 9

Liability upside risk

Liability downside risk

Answer 9

Upside: paying lesser future cost than expected or paying future cost later than expected.
Downside: paying greater future cost than expected or paying future cost sooner than expected.

Question 10

When considering the risk of future cash flows our expectation of risk needs to be …. (2)

Answer 10

Nuanced and specific.

Question 11

What can help us form perceptions of risk?

Answer 11

Historical and recent cash flows or return pattern of assets/liabilities.

Question 12

When downside risk increases, what is needed to compensate for the added risk burden?

Answer 12

A greater return.

Question 13

As risk increases, return ….?

Answer 13

Increases

Question 14

When future CFS become more uncertain (risk increases) the present value of their worth ______

Answer 14

Falls.

Question 15

Greater downside risk = _____ value

Answer 15

Less

Question 16

Greater downside risk = ______ value = _______ price

Answer 16

Less value, lower price

Question 17

Capital budgeting

Answer 17

The process by which organisations determine whether their long term investments, such as new machinery, are worth pursuing.

Question 18

Objective of capital budgeting decisions (2)

Answer 18

To select investments in assets that will increase the value of the company and will maximise shareholders’ wealth.

Question 19

3 reasons why capital budgeting is important

Answer 19

1. These investments involve large cash outlays.
2. They create value when cash flows they generate are worth more than they cost.
3. Once made, these investments are not easily reversed.

Question 20

Why does higher risk = higher return? 4 steps

Answer 20

1. Higher risk means higher uncertainty of future CFS.
2. = lower value as future CF of greater risk are worth less today.
3. = lower price as buyers will pay less for lower value.
4. = higher return to compensate for higher risk.

Question 21

A project is accepted if NPV …. and/or IRR ….

Answer 21

NPV > 0

IRR > discount rate (usually WACC)

Question 22

2 project types

Answer 22

1. Independent.

2. Mutually exclusive.

Question 23

NPV

Answer 23

The dollar value added by the project.

Question 24

IRR

Answer 24

The periodic yield/return of the project.

Question 25

Net Present Value NPV = present value - ?

Answer 25

Price

Question 26

A negative NPV implies? | Should you invest?

Answer 26

That the cost > worth; do not invest.

Question 27

A positive NPV implies ...? | Should you invest?

Answer 27

Cost < worth; invest if possible.

Question 28

0 NPV implies?

Answer 28

Cost = worth

Question 29

RRoR (required rate of return)

Answer 29

The minimum return that a project must earn in order to be acceptable.

Question 30

What is often used as the RRoR?

Answer 30

WACC

Question 31

^ WACC = __ NPV

Answer 31

^ WACC = deceased NPV

Question 32

Decreased WACC = __ NPV

Answer 32

Decreased WACC = ^ NPV

Question 33

Through what 2 ways might WACC change?

Answer 33

1. Through changes in capital. | 2. Through changes in the cost of debt and/or cost of equity.

Question 34

When the credit worthiness of a company improves (the credit rating goes from BB to AA, what is the impact on Kd and the flow on impact opon WACC?

Answer 34

Kd goes down, WACC goes down.

Question 35

Ke

Answer 35

Cost of equity

Question 36

Kd

Answer 36

Cost of debt

Question 37

For any given company Ke is greater than or less than Kd?

Answer 37

Ke > Kd

Question 38

Who are the last 2 stakeholders to be paid in a company?

Answer 38

Debt holders (capital creditors) and finally equity holders.

Question 39

Why are equity investors' risk higher than that of debt capital creditors?

Answer 39

Because they are paid last, or not at all.

Question 40

So why is Ke > Kd?

Answer 40

A rational investor would always require a higher rate of return of the company's equity.

Question 41

Is it cheaper to finance capital through debt or equity?

Answer 41

Debt

Question 42

A capital structure favouring debt = ___ WACC

Answer 42

Decreased WACC

Question 43

However, when debt repayments increase (^ D/V) there is greater risk of less residual cash flow left to pay equity holders, so equity holders require .... ^ Ke = ____ WACC

Answer 43

A greater return. | ^ Ke = ^ WACC

Question 44

If there is a lower weighting on the cheaper form of capital (decreased D/V) WACC ___, but then Ke ____ as equity holders face less risk with less debt in the company, so WACC ___

Answer 44

WACC ^, Ke decreases, WACC decreases.

Question 45

What 2 negative side effects can an ^ in WACC have?

Answer 45

1. A decrease in valuation. | 2. A much higher risk.

Question 46

Invest if IRR > or < than RRoR (WACC)

Answer 46

Invest if IRR > RRoR