Capital Structure and WACC Quiz
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Questions and Answers

What is the primary function of capital structure in a company?

  • To establish the combination of financing used by the organization (correct)
  • To determine the company's pricing strategy
  • To assess the management team's performance
  • To dictate the company's marketing approach

Which statement correctly describes a characteristic of equity financing?

  • Investors in equity financing have secured claims over assets.
  • Equity is a type of financing that generally requires repayment.
  • Equity financing does not provide contractual rights to dividends. (correct)
  • Equity financing results in guaranteed dividends to investors.

What is one of the significant financial risks associated with taking on debt?

  • Potential liquidation if repayments cannot be met. (correct)
  • Equity holders have first claim on assets.
  • High dividends must be paid to shareholders.
  • Creditors receive guaranteed returns.

How does interest on debt financing affect a company's tax situation?

<p>Interest payments are tax deductible. (D)</p> Signup and view all the answers

In the context of capital structure, what would 'WACC' stand for?

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

What defines the cost of capital for a firm?

<p>A weighted average of the returns demanded by debt and equity investors (B)</p> Signup and view all the answers

Which method is NOT used to calculate the cost of equity?

<p>Asset Valuation Method (A)</p> Signup and view all the answers

When a firm has both debt and equity, what happens to the cash flows?

<p>They are divided into a secure stream for debt holders and a riskier stream for shareholders. (D)</p> Signup and view all the answers

What is the primary component of the cost of equity?

<p>The return required by ordinary shareholders (D)</p> Signup and view all the answers

Which of the following is true regarding the cash flows generated by a firm solely financed by equity?

<p>All cash flows generated belong to the ordinary shareholders. (D)</p> Signup and view all the answers

What is the primary tax advantage of debt financing compared to equity financing?

<p>Interest charges on debt can reduce taxable income. (D)</p> Signup and view all the answers

Which statement accurately describes the cost of preference shares?

<p>Dividends paid on preference shares are fixed and do not grow. (C)</p> Signup and view all the answers

When calculating the Weighted Average Cost of Capital (WACC), which is the first step?

<p>Determine the cost of equity, cost of debt, and cost of preference shares. (A)</p> Signup and view all the answers

In a WACC calculation, how are the components of capital proportionally considered?

<p>Utilizing current market values. (A)</p> Signup and view all the answers

What does 'Kd' specifically refer to in financing terms?

<p>The cost of debt. (C)</p> Signup and view all the answers

What characterizes a forward or futures contract?

<p>Both parties are legally obligated to exchange the underlying asset. (C)</p> Signup and view all the answers

Which of the following statements about options is true?

<p>They provide the right to buy or sell without obligation. (D)</p> Signup and view all the answers

How does a swap agreement function?

<p>It involves the exchange of cash flows based on a formula. (B)</p> Signup and view all the answers

What is the primary goal of hedging in finance?

<p>To protect against adverse price movements. (C)</p> Signup and view all the answers

Which best describes speculation in the context of derivatives?

<p>It is a strategy focused on profiting from market movements. (C)</p> Signup and view all the answers

What does the variable $W_A$ represent in the variance formula?

<p>Weight of asset A in the portfolio (A)</p> Signup and view all the answers

In the Capital Asset Pricing Model, what does 'Beta' indicate?

<p>Sensitivity of a stock's return to the market return (C)</p> Signup and view all the answers

If $R_f$ represents the risk-free rate, what does $E(R_m) - R_f$ signify in the CAPM formula?

<p>Market excess return over risk-free rate (D)</p> Signup and view all the answers

Which part of the variance formula accounts for the relationship between assets A and B?

<p>The term $Cov(R_A,R_B)$ (A)</p> Signup and view all the answers

Which of the following correctly describes the Market Portfolio?

<p>A portfolio of all the assets in the economy (D)</p> Signup and view all the answers

What is the main purpose of hedging in finance?

<p>To manage risk associated with price fluctuations (B)</p> Signup and view all the answers

Which of the following describes a future contract?

<p>It is a legally binding agreement for the exchange of an asset at maturity. (C)</p> Signup and view all the answers

What characterizes an options contract?

<p>It provides the owner with a right but not the obligation to trade an asset. (A)</p> Signup and view all the answers

Which statement is true regarding swaps in financial derivatives?

<p>Swaps are agreements to exchange cash flows based on predetermined conditions. (D)</p> Signup and view all the answers

What defines speculation in the context of finance?

<p>An attempt to predict and profit from price movements of assets. (D)</p> Signup and view all the answers

What does the return on an investment include?

<p>Change in asset value plus cash distributions (A)</p> Signup and view all the answers

What does a probability of 0 signify?

<p>The event is not going to occur (C)</p> Signup and view all the answers

How is the expected return on a portfolio calculated?

<p>As a weighted average of returns based on asset allocation (D)</p> Signup and view all the answers

What is distribution in the context of probability?

<p>A graphical expression of the range of possible outcomes and their probabilities (A)</p> Signup and view all the answers

Which formula correctly represents the return on investment?

<p>$R_{it} = rac{P_{it} - P_{it-1} + C_{it}}{P_{it-1}}$ (B)</p> Signup and view all the answers

Flashcards

Capital Structure

How a company finances itself using a mix of long-term (LT) capital and short-term (ST) liabilities.

WACC (Weighted Average Cost of Capital)

The average cost of all the capital a company uses, calculated by weighting the cost of each source of capital by its proportion in the capital structure.

Equity Financing

Raising capital from owners (shareholders) who receive dividends based on company performance.

Debt Financing

Raising capital through loans or bonds, with interest payments and guaranteed repayment.

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Financial Risk of Debt

The potential for a company to struggle with debt repayments, leading to liquidation and potential loss for creditors and shareholders.

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Cost of Capital

The average return a company must earn to satisfy its investors, taking into account both debt and equity.

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Cost of Equity

The minimum return a company must earn on its investments to satisfy its shareholders.

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Dividend Yield Model

A method to calculate the cost of equity using the dividend per share and the current stock price.

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Gordon's Model

A model that uses the expected growth rate of dividends and the current dividend to calculate the cost of equity.

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Cost of Debt (Kd)

The interest rate a company pays on its debt financing. It represents the cost of borrowing money from lenders.

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Cost of Preference Shares (Kp)

The fixed dividend rate paid to preference shareholders. It represents the cost of raising capital through preference shares.

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Tax Deductible Interest

Interest paid on debt is an expense that can be deducted from a company's taxable income, resulting in tax savings.

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Why is Kd important?

Kd is crucial in calculating WACC, as it reflects the cost of debt financing, which is a major component of the capital structure.

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WACC calculation steps

The process of calculating the weighted average cost of capital (WACC) involves three steps: 1. Determine the cost of each capital component (Ke, Kd, Kp), 2. Determine the weight (proportion) of each component, and 3. Calculate the weighted average of all components.

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Derivative

A financial instrument whose value is based on the price of an underlying asset such as stocks, bonds, or commodities.

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Forward/Future Contract

An agreement to buy or sell an asset at a specific price on a future date. Both parties are legally obligated to complete the transaction.

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Option Contract

Gives the owner the right, but not the obligation, to buy or sell an underlying asset at a predetermined price before or on a specified date.

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Swap Agreement

A derivative where two parties exchange cash flows based on a pre-determined formula, typically linked to interest rates or currencies.

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Hedging

Using derivatives to reduce financial risk by offsetting potential losses from price fluctuations of an asset.

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Forward Contract

A binding agreement to buy or sell an asset at a predetermined price on a future date.

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Speculation

Using derivatives to bet on the future price movement of an asset, aiming to profit from its increase or decrease.

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Expected Return

The total gain or loss on an investment over a period, expressed as a percentage of the initial investment value. It includes both capital appreciation and income.

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Probability

The likelihood of an event occurring, ranging from 0 (impossible) to 1 (certain).

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Distribution

A mathematical or graphical representation showing the range of possible outcomes and their corresponding probabilities.

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Portfolio Return Calculation

The return of a portfolio is calculated as a weighted average of the returns of the individual assets within it, considering the proportion of each asset in the portfolio.

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Risk of an Asset

The uncertainty surrounding the potential outcomes of an investment, measured by the variability of its returns.

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Variance Formula

A mathematical formula that calculates the total risk of an investment portfolio, considering the variances and covariances of individual assets.

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Market Portfolio

A hypothetical portfolio that includes all assets in the economy, representing the entire market.

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Beta

A measure of how a particular stock's returns move in relation to the overall market.

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Capital Asset Pricing Model (CAPM)

A model that calculates the expected return on an investment based on its risk relative to the market.

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What does CAPM mean?

CAPM stands for Capital Asset Pricing Model, a formula used to calculate the expected return on an investment based on its risk relative to the market.

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