week 7

Question 1

What is the cost of capital for a firm?

Answer 1

It’s the minimum return a firm must earn on its projects to meet investor expectations.

Question 2

What is the cost of capital for an investor?

Answer 2

It’s the required return or the minimum they want to earn for providing capital.

Question 3

What does WACC stand for?

Answer 3

Weighted Average Cost of Capital.

Question 4

Why is WACC important?

Answer 4

It’s the average return required by all capital providers; used as a benchmark for project evaluation.

Question 5

What are the components of WACC?

Answer 5

Cost of equity, cost of debt, and cost of preferred stock.

Question 6

What does CAPM estimate?

Answer 6

The required return on equity based on risk.

Question 7

When should a company use CAPM over the Gordon Growth Model?

Answer 7

When the company doesn’t pay consistent dividends.

Question 8

What is the Gordon Growth Model used for?

Answer 8

To estimate the cost of equity when dividends grow at a constant rate.

Question 9

What affects the cost of debt?

Answer 9

Interest rates, credit rating, and tax shields (interest is tax-deductible).

Question 10

What affects the cost of equity?

Answer 10

Market conditions, risk, dividend policy, growth opportunities, and tax policies.

Question 11

What is the Payback Rule?

Answer 11

Accept project if PB ≤ Maximum allowable PB; reject if PB > Maximum allowable PB.

Question 12

What is a limitation of Payback Period?

Answer 12

Ignores time value of money and cash flows beyond the payback period.

Question 13

What is Discounted Payback Period (DPB)?

Answer 13

Time taken to recover investment using discounted cash flows.

Question 14

What is the Discounted Payback Rule?

Answer 14

Accept if DPB ≤ Maximum allowable DPB; reject if DPB > Maximum allowable DPB.

Question 15

What is Net Present Value (NPV)?

Answer 15

The total present value of all future cash flows minus the initial investment.

Question 16

What is the NPV Rule?

Answer 16

Accept project if NPV ≥ 0; reject if NPV < 0.

Question 17

What are strengths of NPV?

Answer 17

Measures value creation directly; works with independent and mutually exclusive projects.

Question 18

What is a weakness of NPV?

Answer 18

It depends heavily on accurately estimating the discount rate.

Question 19

What is IRR?

Answer 19

The discount rate at which NPV = 0.

Question 20

What is the IRR Rule?

Answer 20

Accept project if IRR ≥ Required return (WACC); reject if IRR < Required return.

Question 21

What are strengths of IRR?

Answer 21

No need to specify discount rate; intuitive to interpret.

Question 22

What are weaknesses of IRR?

Answer 22

May give multiple IRRs; assumes reinvestment at IRR; ignores project scale in comparisons.

Question 23

What is Profitability Index (PI)?

Answer 23

PV of future cash flows / Initial investment; shows value created per dollar invested.

Question 24

What is the PI Rule?

Answer 24

Accept project if PI ≥ 1; reject if PI < 1.

Question 25

What are strengths of PI?

Answer 25

Useful under capital rationing; prioritizes projects based on value per dollar invested.

Question 26

What is a weakness of PI?

Answer 26

Can favor smaller projects over larger ones with higher absolute returns.

Question 27

What is the formula for WACC?

Answer 27

WACC = (E/V) * Re + (D/V) * Rd * (1 - Tc), where E = equity, D = debt, V = E + D, Re = cost of equity, Rd = cost of debt, Tc = tax rate.

Question 28

How do you calculate the Cost of Equity using CAPM?

Answer 28

Re = Rf + β(Rm - Rf), where Rf = risk-free rate, β = beta, Rm = expected market return.

Question 29

What is the formula for the Gordon Growth Model (GGM)?

Answer 29

Re = (D1 / P0) + g, where D1 = dividend next year, P0 = current stock price, g = growth rate.

Question 30

What is the Payback Period formula?

Answer 30

Payback Period = Time taken to recover initial investment from cash flows.

Question 31

How to calculate exact Payback Period?

Answer 31

Years before full recovery + (Unrecovered amount / Cash flow in recovery year).

Question 32

What is the Discounted Payback Period formula?

Answer 32

Use: DPB = Number of years until cumulative discounted cash flow turns positive.

Question 33

How to calculate Discounted Payback?

Answer 33

Discount each cash flow: CFn / (1 + i)^n, sum until cumulative ≥ initial investment.

Question 34

What is the formula for NPV?

Answer 34

NPV = ∑ [CFn / (1 + i)^n] - Initial investment.

Question 35

What is the NPV Rule?

Answer 35

Accept if NPV ≥ 0; reject if NPV < 0.

Question 36

What is the formula for IRR?

Answer 36

IRR is the rate (i) where NPV = 0; use financial calculator or trial and error.

Question 37

What is the IRR Rule?

Answer 37

Accept project if IRR ≥ WACC (required return); reject if IRR < WACC.

Question 38

How do you interpret IRR?

Answer 38

It’s the expected rate of return on a project; higher than WACC = value created.

Question 39

What is a problem with IRR for non-normal cash flows?

Answer 39

Multiple IRRs can exist; IRR may be misleading.

Question 40

What is the Profitability Index (PI) formula?

Answer 40

PI = PV of future cash flows / Initial investment = NPV +

Question 41

What is the PI Rule?

Answer 41

Accept if PI ≥ 1; reject if PI < 1.

Question 42

What does a PI of 1.2 mean?

Answer 42

For every $1 invested, the project returns $1.20 in present value.

Question 43

What is the formula for Present Value of a cash flow?

Answer 43

PV = CFn / (1 + i)^n.

Question 44

How does a tax shield affect WACC?

Answer 44

Higher taxes → bigger interest tax deduction → lower effective cost of debt → lower WACC.

Question 45

Why does higher interest rate increase cost of capital?

Answer 45

Investors demand higher returns, increasing cost of equity and debt.

Question 46

Why is NPV preferred over Payback?

Answer 46

NPV accounts for time value of money and total project profitability.

Question 47

Why can PI be misleading?

Answer 47

It may favor smaller projects with high ratios over large projects with higher absolute NPV.