FIN 341 FINAL EXAM QUESTIONS & ANSWERS
An overview of what is WACC - Weighted Average Cost of Capital. - Answers -A
weighted average of the component costs of debt, preferred stock, and common equity.
(% of debt)(after tax cost of debt, which is rd x 1-T) + (% preferred stock)(cost of
preferred stock) + (% of common equity)(cost of common equity)
What is rd/ is it tax adjusted/ why? - Answers -After tax component cost of debt,
adjusted for tax. (1-Tax rate). Interest on debt is tax deductible but preferred dividends
and the returns on c.s. are not. We use the after tax cost because we are interested in
maximizing the value of the firm's stock, and the stock price depends on after tax cash
flows.
How would you go about computing rd if you had a bond outstanding already and knew
its market price - Answers -take the bond amount and divide by the market price?
interest/ytm
How is common equity (rs) raised? - Answers -By retaining some of the current years
earnings and by issuing new common stock. Has the highest flotation cost
What is rps/ how do you calculate it/ tax adjustment?/flotation - Answers -marginal cost
of common equity using retained earnings. The rate of return investors require on the
firm's common equity using new equity is re. Most firms, once they have become well
established, obtain all of their new equity as retained earnings so rs is their cost of new
equity. When a company issues new common stock they also have to pay flotation
costs to the underwriter.
Is there a cost to rs/ why/what is the logic here - Answers -No direct cost are
associated with RE but there is still an opportunity cost. RE is cheaper than issuing new
stock. The firm needs to earn at least as much on any earnings retained as the
stockholders could earn on alternative investments of comparable risk
3 ways to determine the cost of common/internal equity (rs) - Answers -1. CAPM: rs =
rRF + (rM - rRF)b
2. DCF: - Answers -rs = (D1/P0) + g
3. Own-Bond-Yield-Plus-Risk-Premium: - Answers -rs = rd + RP
CAPM method, what do you need - Answers -risk free rate or treasury (rRF), beta,
market risk premium (difference bw the return that investors require on an average
stock and the rRF rate) CAPM = (risk prem - rRF)b + rRF
DCF (Discounted Cash Flow) method, what do you need - Answers -rs = (D1/P0) + g;
P0 = current stock price which is found by D1/rs-g. rs = required rate of return
, BYRP(Bond Yield Risk Premium) method, what do you need. - Answers -Estimated risk
prem of 3%-5% + the bond yield
What is the RE break point (p. 362)/ how do you calculate it/ what is the logic behind
such point - Answers -The total amount of capital that can be raise before new stock
must be issued. REBP = addition to RE for the year / equity fraction or % of equity
How do you adjust the cost of capital to account for risk - Answers -If the project has
especially high or low risk, the WACC will be adjusted up or down to account for risk.
Projects should be accepted if and only if their estimated returns exceed their cost of
capital or "hurdle rate". Investor require higher returns on riskier investments
What is the most important but most difficult step in capital budgeting/why - Answers -
Estimating project cash flows; many variables are involved, and many individuals and
departments participate in the process. The capital outlays associated with a new
product are generally obtained from the engineering and product development staffs,
while operating costs are estimated by cost accountants, production experts, personnel
specialists, purchasing agents, and so forth.
Cash flows and accounting income/ same?/what is difference? - Answers -FCF is cash
available for distribution to all investors (which is not equal to net income), making it the
basis of the firm's value. For capital budgeting processes, it is the project's net cash
flows that are relevant, disregard company's net income. Cash flow touches on money
coming in and exiting, while accounting income accounts for some revenue that has not
yet been collected (Accounts Receivable, assets)
What do we mean by incremental cash flows - Answers -A cash flow that will occur if
and only if the firm takes on a project (some specific event occurs); example:
investments in buildings, equipment, working capital, sales revenues and operating
costs associated with the project
sunk costs - Answers -A cash outlay that has already been incurred and that cannot be
recovered regardless of whether the project is accepted or rejected, not relevant to the
capital budgeting analysis because they were incurred in the past and cannot be
recovered regardless of whether the project is accepted or rejected.
opportunity costs - Answers -The best return that could be earned on assets the firm
already owns if those assets are not used for the new project; example: $2mill CF in
sold property that would not be received if Home Depot decided to use the land for a
new store instead
How good are these methods? Is the estimation of rs totally objective? - Answers -
BYRP is subjective because its an estimate; CAPM - difficult to obtain accurate
estimates of the numbers required, DCF - has fluctuations due to changing stock prices,
proper growth rate is difficult to determine
An overview of what is WACC - Weighted Average Cost of Capital. - Answers -A
weighted average of the component costs of debt, preferred stock, and common equity.
(% of debt)(after tax cost of debt, which is rd x 1-T) + (% preferred stock)(cost of
preferred stock) + (% of common equity)(cost of common equity)
What is rd/ is it tax adjusted/ why? - Answers -After tax component cost of debt,
adjusted for tax. (1-Tax rate). Interest on debt is tax deductible but preferred dividends
and the returns on c.s. are not. We use the after tax cost because we are interested in
maximizing the value of the firm's stock, and the stock price depends on after tax cash
flows.
How would you go about computing rd if you had a bond outstanding already and knew
its market price - Answers -take the bond amount and divide by the market price?
interest/ytm
How is common equity (rs) raised? - Answers -By retaining some of the current years
earnings and by issuing new common stock. Has the highest flotation cost
What is rps/ how do you calculate it/ tax adjustment?/flotation - Answers -marginal cost
of common equity using retained earnings. The rate of return investors require on the
firm's common equity using new equity is re. Most firms, once they have become well
established, obtain all of their new equity as retained earnings so rs is their cost of new
equity. When a company issues new common stock they also have to pay flotation
costs to the underwriter.
Is there a cost to rs/ why/what is the logic here - Answers -No direct cost are
associated with RE but there is still an opportunity cost. RE is cheaper than issuing new
stock. The firm needs to earn at least as much on any earnings retained as the
stockholders could earn on alternative investments of comparable risk
3 ways to determine the cost of common/internal equity (rs) - Answers -1. CAPM: rs =
rRF + (rM - rRF)b
2. DCF: - Answers -rs = (D1/P0) + g
3. Own-Bond-Yield-Plus-Risk-Premium: - Answers -rs = rd + RP
CAPM method, what do you need - Answers -risk free rate or treasury (rRF), beta,
market risk premium (difference bw the return that investors require on an average
stock and the rRF rate) CAPM = (risk prem - rRF)b + rRF
DCF (Discounted Cash Flow) method, what do you need - Answers -rs = (D1/P0) + g;
P0 = current stock price which is found by D1/rs-g. rs = required rate of return
, BYRP(Bond Yield Risk Premium) method, what do you need. - Answers -Estimated risk
prem of 3%-5% + the bond yield
What is the RE break point (p. 362)/ how do you calculate it/ what is the logic behind
such point - Answers -The total amount of capital that can be raise before new stock
must be issued. REBP = addition to RE for the year / equity fraction or % of equity
How do you adjust the cost of capital to account for risk - Answers -If the project has
especially high or low risk, the WACC will be adjusted up or down to account for risk.
Projects should be accepted if and only if their estimated returns exceed their cost of
capital or "hurdle rate". Investor require higher returns on riskier investments
What is the most important but most difficult step in capital budgeting/why - Answers -
Estimating project cash flows; many variables are involved, and many individuals and
departments participate in the process. The capital outlays associated with a new
product are generally obtained from the engineering and product development staffs,
while operating costs are estimated by cost accountants, production experts, personnel
specialists, purchasing agents, and so forth.
Cash flows and accounting income/ same?/what is difference? - Answers -FCF is cash
available for distribution to all investors (which is not equal to net income), making it the
basis of the firm's value. For capital budgeting processes, it is the project's net cash
flows that are relevant, disregard company's net income. Cash flow touches on money
coming in and exiting, while accounting income accounts for some revenue that has not
yet been collected (Accounts Receivable, assets)
What do we mean by incremental cash flows - Answers -A cash flow that will occur if
and only if the firm takes on a project (some specific event occurs); example:
investments in buildings, equipment, working capital, sales revenues and operating
costs associated with the project
sunk costs - Answers -A cash outlay that has already been incurred and that cannot be
recovered regardless of whether the project is accepted or rejected, not relevant to the
capital budgeting analysis because they were incurred in the past and cannot be
recovered regardless of whether the project is accepted or rejected.
opportunity costs - Answers -The best return that could be earned on assets the firm
already owns if those assets are not used for the new project; example: $2mill CF in
sold property that would not be received if Home Depot decided to use the land for a
new store instead
How good are these methods? Is the estimation of rs totally objective? - Answers -
BYRP is subjective because its an estimate; CAPM - difficult to obtain accurate
estimates of the numbers required, DCF - has fluctuations due to changing stock prices,
proper growth rate is difficult to determine
