Corporate Finance and Behaviour
notes on homework and practice
Week 1:
- Practice:
a. The company cost of capital is the correct discount rate for all projects because the high risks of some
projects are offset by the low risk of other projects.
False. The company cost of capital is the correct discount rate for new projects only if the new
projects have the same risk level as the existing business. If a new project is riskier, a higher cost
of capital should be used. If the new project is less risky, a lower cost of capital should be used.
b. Distant cash flows are riskier than near-term cash flows. Therefore long-term projects require higher
risk-adjusted discount rates.
False. In order to account for the riskiness inherent in distant cash flows, it is necessary to
account for several possible outcomes in cash flows and calculate the probability-weighted cash
flow for each scenario. The discount rates should not be adjusted based on uncertainty in cash
flows.
c. Adding fudge factors to discount rates undervalues long-lived projects compared with quick-payoff
projects.
True. A fudge factor applied to a discount rate would compound over time thereby undervaluing
a project.
Week 2:
- Practice:
a. Psychologists have found that once people have suffered a loss, they are more relaxed about
false
the possibility of incurring further losses.
b. Psychologists have observed that people tend to put too much weight on recent events when
true
forecasting.
c. Behavioral biases open up the opportunity for easy arbitrage profits. false
Indicate whether the following statements are true or false.
a. MM’s propositions assume perfect financial markets, with no distorting taxes or other
imperfections.
o true
b. MM’s proposition 1 says that corporate borrowing increases earnings per share but reduces the
price–earnings ratio. Assume the return earned by the company exceeds the interest payment.
o true
1
, c. MM’s proposition 2 says that the cost of equity increases with borrowing and that the increase is
proportional to D/V, the ratio of debt to firm value.
o false
d. MM’s proposition 2 assumes that increased borrowing does not affect the interest rate on the
firm's debt.
o false
e. Borrowing does not increase financial risk and the cost of equity if there is no risk of bankruptcy.
o false
f. Borrowing always increases firm value if there is a clientele of investors with a reason to prefer
debt.
o False
- Homework
Questions about MM1
Week 3
- Practice
When shareholders pursue strategies such as taking excessive risks or paying excessive dividends, these
will result in:
- positive agency costs, as bondholders act on various restrictions and covenants, which will
diminish firm value
MM Proposition I with corporate taxes states that:
1. I) capital structure can affect firm value by an amount that is equal to the present value of the
interest tax shield
2. II) by raising the debt-to-equity ratio, the firm can lower its taxes and thereby increase its total
value
Assuming that bonds are sold at a fair price, the benefits from the interest tax shield go to the:
- Stockholders of the firm
What signal is sent to the market when a firm decides to issue new stock to raise capital?
- Stock price is too high
- Homework
2
notes on homework and practice
Week 1:
- Practice:
a. The company cost of capital is the correct discount rate for all projects because the high risks of some
projects are offset by the low risk of other projects.
False. The company cost of capital is the correct discount rate for new projects only if the new
projects have the same risk level as the existing business. If a new project is riskier, a higher cost
of capital should be used. If the new project is less risky, a lower cost of capital should be used.
b. Distant cash flows are riskier than near-term cash flows. Therefore long-term projects require higher
risk-adjusted discount rates.
False. In order to account for the riskiness inherent in distant cash flows, it is necessary to
account for several possible outcomes in cash flows and calculate the probability-weighted cash
flow for each scenario. The discount rates should not be adjusted based on uncertainty in cash
flows.
c. Adding fudge factors to discount rates undervalues long-lived projects compared with quick-payoff
projects.
True. A fudge factor applied to a discount rate would compound over time thereby undervaluing
a project.
Week 2:
- Practice:
a. Psychologists have found that once people have suffered a loss, they are more relaxed about
false
the possibility of incurring further losses.
b. Psychologists have observed that people tend to put too much weight on recent events when
true
forecasting.
c. Behavioral biases open up the opportunity for easy arbitrage profits. false
Indicate whether the following statements are true or false.
a. MM’s propositions assume perfect financial markets, with no distorting taxes or other
imperfections.
o true
b. MM’s proposition 1 says that corporate borrowing increases earnings per share but reduces the
price–earnings ratio. Assume the return earned by the company exceeds the interest payment.
o true
1
, c. MM’s proposition 2 says that the cost of equity increases with borrowing and that the increase is
proportional to D/V, the ratio of debt to firm value.
o false
d. MM’s proposition 2 assumes that increased borrowing does not affect the interest rate on the
firm's debt.
o false
e. Borrowing does not increase financial risk and the cost of equity if there is no risk of bankruptcy.
o false
f. Borrowing always increases firm value if there is a clientele of investors with a reason to prefer
debt.
o False
- Homework
Questions about MM1
Week 3
- Practice
When shareholders pursue strategies such as taking excessive risks or paying excessive dividends, these
will result in:
- positive agency costs, as bondholders act on various restrictions and covenants, which will
diminish firm value
MM Proposition I with corporate taxes states that:
1. I) capital structure can affect firm value by an amount that is equal to the present value of the
interest tax shield
2. II) by raising the debt-to-equity ratio, the firm can lower its taxes and thereby increase its total
value
Assuming that bonds are sold at a fair price, the benefits from the interest tax shield go to the:
- Stockholders of the firm
What signal is sent to the market when a firm decides to issue new stock to raise capital?
- Stock price is too high
- Homework
2
