Capital Budgeting and Cost of Capital Quiz
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Questions and Answers

What happens if a single hurdle rate is used for riskier divisions?

  • They are excluded from funding opportunities.
  • They receive more funds for investment projects. (correct)
  • They tend to receive fewer funds for investment projects.
  • Their projects become more profitable.

    • What is a common challenge in estimating the cost of capital for a division?

  • Divisions provide clear financial performance metrics.
  • Estimating the cost of debt is complex.
  • Divisions rarely have their own traded securities. (correct)
  • Divisions often have high trading volumes in securities.

    • What is the appropriate discount rate for projects?

  • The firm's weighted average cost of capital. (correct)
  • The rate implied by the security market line.
  • The cost of equity alone.
  • The average cost of all division projects.

    • How does the firm's cost of debt compare to its cost of equity?

    <p>The cost of debt is generally less than the cost of equity.</p> Signup and view all the answers

    What does beta measure in financial terms?

    <p>The responsiveness of a security's returns to market movements.</p> Signup and view all the answers

    What effects do cyclicality of a firm's revenues have on its beta?

    <p>Greater cyclicality generally results in higher betas.</p> Signup and view all the answers

    What is the relationship between revenues and stock prices during economic changes?

    <p>Stock prices generally rise when the economy expands.</p> Signup and view all the answers

    What does operating leverage measure?

    <p>The percentage change in EBIT for a percentage change in sales.</p> Signup and view all the answers

    What is the weight of debt in the capital structure?

    <p>21.84%</p> Signup and view all the answers

    What does WACC stand for?

    <p>Weighted Average Cost of Capital</p> Signup and view all the answers

    What is the terminal value of the company in Year 5?

    <p>$147,531,250</p> Signup and view all the answers

    What percentage does EBIT grow each year for the next 5 years?

    <p>10%</p> Signup and view all the answers

    What is the cash flow from assets in Year 3?

    <p>$10,842,810</p> Signup and view all the answers

    What is the depreciation percentage of EBIT?

    <p>8%</p> Signup and view all the answers

    What is the formula used to calculate the WACC?

    <p>WACC = Debt weight * Cost of debt + Equity weight * Cost of equity</p> Signup and view all the answers

    How much does the net working capital (NWC) grow in Year 2?

    <p>$1,019,700</p> Signup and view all the answers

    What is the accounts payable weight in the capital structure?

    <p>0.17</p> Signup and view all the answers

    What does the WACC equal when calculated from the provided values?

    <p>0.1096</p> Signup and view all the answers

    What is the formula used to calculate the total amount needed to raise for the new equipment?

    <p>$40,000,000/(1 - 0.0655)</p> Signup and view all the answers

    What is the NPV calculated from the cash flows and WACC?

    <p>$6,453,387.70</p> Signup and view all the answers

    How do you calculate the weight of debt in the capital structure?

    <p>0.65/1.65</p> Signup and view all the answers

    What is the calculated weight of equity in the capital structure?

    <p>0.6061</p> Signup and view all the answers

    What is the flotation cost when raising all equity externally?

    <p>0.0523</p> Signup and view all the answers

    How is the initial cash outflow for the project adjusted?

    <p>Increased by the floatation costs</p> Signup and view all the answers

    What effect does high operating leverage have on EBIT in relation to changes in sales?

    <p>It results in greater fluctuations in EBIT.</p> Signup and view all the answers

    How does financial leverage affect the percentage change in net income compared to EBIT?

    <p>Net income changes are greater than EBIT changes.</p> Signup and view all the answers

    What is a primary disadvantage of the SML method?

    <p>It requires estimating three parameters.</p> Signup and view all the answers

    What does operating leverage magnify in a firm?

    <p>The cyclicality of a firm's revenues.</p> Signup and view all the answers

    How can a firm estimate its after-tax cost of debt?

    <p>By estimating the rate required for new bonds issued today.</p> Signup and view all the answers

    What assumption is made when analyzing the risk of a new project compared to the overall company risk?

    <p>The new project's risk is assumed to be the same as the company's overall risk.</p> Signup and view all the answers

    What characterizes a firm that has low financial leverage?

    <p>It has minimal or no debt in its capital structure.</p> Signup and view all the answers

    What factor can make estimating beta challenging in the SML method?

    <p>Beta values are typically unobservable and require estimation.</p> Signup and view all the answers

    What is the correct amount raised when accounting for flotation costs at 5.23%?

    <p>$152,997,602</p> Signup and view all the answers

    What is the flotation cost percentage when using 60% internally generated equity?

    <p>2.68</p> Signup and view all the answers

    What is the relevant cash flow for the land situation 5 years from now?

    <p>$7.4 million</p> Signup and view all the answers

    What is the total market value of the company as calculated?

    <p>$1,042,950,000</p> Signup and view all the answers

    What is the weight of equity financing in the company's capital structure?

    <p>0.6859</p> Signup and view all the answers

    When 100% of internally generated equity is used, what is the flotation cost?

    <p>0.0098</p> Signup and view all the answers

    What is the initial cash flow when 60% internally generated equity is used?

    <p>$148,995,796</p> Signup and view all the answers

    What is the amount raised when the flotation cost of 2.68% is applied?

    <p>$148,995,796</p> Signup and view all the answers

    Study Notes

    Capital Budgeting and Cost of Capital

    • Single hurdle rate can lead riskier divisions to receive more funds, possibly funding unprofitable projects.
    • The cost of capital is typically difficult to estimate for divisions due to a lack of traded securities; alternatives include using pure play proxies or subjective adjustments.
    • The discount rate for projects should be lower than the rate derived from the Security Market Line (SML).
    • The firm's weighted average cost of capital (WACC) serves as the appropriate discount rate for projects.

    Understanding Beta

    • Beta indicates a security's return sensitivity relative to market movements, influenced by revenue cyclicality, operating leverage, and financial leverage.
    • Companies with revenues that respond strongly to economic changes tend to have higher betas.
    • High operating leverage results in greater fluctuations in Earnings Before Interest and Taxes (EBIT) relative to sales, hence increasing beta.
    • Financial leverage, through fixed interest payments, further magnifies revenue cyclicality, affecting the stock returns' responsiveness to market movements.

    Key Cost of Capital Concepts

    • Overall capital cost is determined by the risk of the project rather than financing sources.
    • Tax implications make interest expenses deductible, typically assessed at the firm's after-tax cost of debt.
    • New project's risk is often assumed to align with the company's overall risk, which can be misleading if the project has unique risks.
    • The SML model requires estimating the risk-free rate, expected market return, and beta, often relying on historical data.

    WACC Calculation

    • Example WACC calculation illustrates outcomes based on the proportionate weight of equity and debt in a capital structure.
    • WACC is computed through specific formulas considering the firm’s equity and debt costs, leading to precise financial decision-making.

    Cash Flow Analysis

    • EBIT growth projected at 10% annually for five years impacts cash flow and overall financial health.
    • Key elements impacting cash flows include tax liabilities, depreciation, and adjustments for net working capital and capital expenditures.
    • Terminal value can be calculated for year 5 cash flows, providing long-term cash flow projections post-initial analysis.

    Financing and Flotation Costs

    • Flotation costs vary depending on financing strategies (externally raised vs. internally generated equity).
    • Accurate initiation of cash flow projections incorporates flotation costs to ensure financial planning reflects real costs.
    • Variations in flotation costs affect how much capital must be raised to cover project expenses due to different sources of equity financing.

    Relevant vs. Irrelevant Costs

    • Historical costs (e.g., land purchase) are deemed irrelevant when assessing the current project; only opportunity costs provide real financial considerations.
    • Calculating market value capitalizations ensures precise understanding of the firm's financial structure, facilitating informed investment decisions.

    Capital Structure Weights

    • Understanding the weights of debt, equity, and preferred shares in the capital structure is crucial for calculating the overall cost of capital accurately.
    • The method of calculating weights emphasizes the proportion of each financing source relative to the company’s total market value.

    Summary of Key Financial Metrics

    • Present value calculations and NPV assessments highlight the importance of future cash flows relative to current investment choices.
    • The depth of financial analysis encourages accurate predictions of profitability and project viability in corporate finance.

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    Description

    Test your understanding of capital budgeting and the cost of capital. This quiz covers key concepts such as hurdle rates, weighted average cost of capital (WACC), and beta's influence on investment decisions. Assess your knowledge on how these financial metrics impact project funding and valuation.

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