Finance Chapter 5 Quiz

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Questions and Answers

Which condition indicates that a company is creating value?

ROIC > WACC (correct)

ROIC = WACC

ROIC < WACC

ROIC = 0

What does WACC stand for in financial terms?

Widespread Average Cost of Credit

Weighted Average Cost of Capital (correct)

Weighted Average Cash Component

World Average Cost of Capital

Which of the following factors is not considered when estimating a project's cost of capital?

Historical cash flows (correct)

Future cash flow projections

Type of financing

Risk (discount rate)

Which formula correctly represents the calculation of WACC?

WACC = Ke × (V) + Kd × (1 - t) × (V) / V Signup and view all the answers

Which of the following components is essential in determining cash flow in the context of cost of capital?

Free Cash Flow (FCF) Signup and view all the answers

What does increasing the proportion of debt do to equity beta?

Increases the risk for equity investors Signup and view all the answers

How is asset beta defined in relation to operational risk?

It denotes the operational risk of the underlying business asset Signup and view all the answers

Given 𝛃𝛃𝐞 = 0.72, debt 20%, and equity 80%, how is asset beta 𝛃𝛃𝐚 calculated?

Using the formula 𝛃𝛃𝐚 = 𝛃𝛃𝐞 × (1 + D/E) Signup and view all the answers

What is the main characteristic of debt in a company's financial structure?

It has a priority call and fixed payments Signup and view all the answers

Which type of risk does observable beta primarily include?

Both operational risk and financial leverage Signup and view all the answers

What is meant by the 'cost of capital' for a firm?

The return expected by investors for their capital. Signup and view all the answers

How does the cost of capital relate to the risk profile of a project?

It reflects the return expected from an alternative investment with the same risk profile. Signup and view all the answers

Which components of capital structure are included when calculating the total cost of capital?

Equity and interest-bearing debt. Signup and view all the answers

What do providers of interest-bearing debt and equity expect from their investment?

A return based on their own investment risk profile. Signup and view all the answers

Why do investors consider the type of security they hold when assessing expected returns?

Because different securities have varying risk and return profiles. Signup and view all the answers

In terms of capital employed, what role does free cash flow play?

It indicates the available cash for investment after costs. Signup and view all the answers

What does WACC stand for?

Weighted Average Cost of Capital. Signup and view all the answers

Which term describes the return investors expect from an investment matching the risk profile of a project?

Expected return. Signup and view all the answers

How is the underlying real risk-free rate calculated using the Fisher equation?

By adjusting the nominal risk-free rate for projected inflation Signup and view all the answers

What does the beta (ß) represent in the context of stock returns?

The expected percentage change in a stock's return given a 1% change in the market index Signup and view all the answers

What is a common proxy for a risk-free investment?

Government securities from OECD countries Signup and view all the answers

How does nominal risk-free rate relate to expected inflation?

It compensates fully for the expected inflation rate Signup and view all the answers

Using the Fisher equation, what is the real rate of return if the nominal risk-free rate is 6% and projected inflation is 3%?

2.9% Signup and view all the answers

What does the WACC formula indicate about capital costs?

It represents the total return required from every capital source Signup and view all the answers

What can be misleading about nominal figures in finance?

They do not consider inflation impact on purchasing power Signup and view all the answers

The systematic risk of a stock is measured by which of the following?

Its beta (ß) Signup and view all the answers

What does the cost of capital represent in financial terms?

The opportunity cost of potential returns from alternative investments Signup and view all the answers

Which statement about the cost of debt is true?

It is always lower than the cost of equity. Signup and view all the answers

Which factor can increase the cost of equity?

Increased competition for capital Signup and view all the answers

What is a key characteristic of the cost of equity?

Returns to equity holders are achieved after debt payments. Signup and view all the answers

How is the total cost of capital determined?

It is the weighted average of the cost of debt and equity. Signup and view all the answers

What does the principle of substitution imply for investors?

Investors will prefer more attractive alternatives at the same price. Signup and view all the answers

Which component is included in the calculation of WACC?

Market value of equity and market value of debt Signup and view all the answers

Which of the following statements accurately reflects the cost of capital’s importance?

It shapes corporate strategy and impacts company valuation. Signup and view all the answers

In determining the cost of capital, what does 'r' represent?

The discount rate or cost of capital Signup and view all the answers

What does opportunity cost represent in equity investment decisions?

The return on the best alternative investment Signup and view all the answers

How does risk affect an investor's expected return?

Risk-averse investors demand higher expected returns to compensate for taking on risk. Signup and view all the answers

Which type of risk can be eliminated through portfolio diversification?

Unsystematic risk Signup and view all the answers

What defines systematic risk in the context of investments?

Risk that cannot be diversified away. Signup and view all the answers

Which statement accurately reflects the Capital Asset Pricing Model (CAPM)?

CAPM assesses the relationship between expected return and systematic risk. Signup and view all the answers

What happens to the overall risk of a portfolio as more investments are added?

Overall risk decreases as diversification takes place. Signup and view all the answers

Which of the following options is an example of unsystematic risk?

A competitor going out of business. Signup and view all the answers

What is the relationship between expected future rewards and risk in the context of investing?

Investors require higher expected future rewards to compensate for higher risk. Signup and view all the answers

What component is NOT part of total risk in equity investments?

Business model risk Signup and view all the answers

Which of the following statements is true regarding the cost of equity?

Cost of equity increases with higher levels of systematic risk. Signup and view all the answers

Study Notes

Strategic Financial Management - Lecture 7: Risk and Return & Estimating the Cost of Capital

Cash has a cost, the cost of capital, presented as the expected return investors demand for the funds they supply.
Investor expectations for project returns are based on return expectations for comparable-risk investments.
Investor return expectations are affected by the type of security (bonds or shares).
The weighted average cost of capital (WACC) reflects the risk inherent in the capital structure.
The capital structure's components include interest-bearing debt and equity.
Investors of interest-bearing debt and equity expect a return on their investment.
Free cash flow (FCF) is the cash flow available for all financial investors. WACC reflects the return for each investor.

Highlights

Methods for estimating the cost of equity and debt capital.
Combining these costs to calculate a project's weighted average cost of capital (WACC).
The topic of distress and bankruptcy.

Estimating the Cost of Capital

Value is a function of cash flows, risk, and time.
Discounted cash flow (DCF) calculates the present value of future cash flows to determine the value of an investment.

Cost of Capital (r)

The cost of capital is an opportunity cost, equal to the return that could be earned in alternative, similar investments.
Investors will not invest if a more lucrative opportunity exists at the same price.

Importance of the Cost of Capital

It is a crucial business and financial tool.
It helps in determining company valuation and defining corporate strategy.
Businesses use it for investment decision-making.
Capital is the financial resources needed to run a business or pursue a project.
Capital commitments are made upfront, expecting them to payoff.

Types of Costs

Cost of Debt: This cost is contractually determined and relatively straightforward; interest rates vary over time and between companies.
Cost of Equity: This is more complex, as it reflects the expectation that the return on equity will match other similar opportunities, and it takes longer to realize. This varies significantly and payments are not specified in advance.

Cost of Capital (r) - Total Cost of Capital

The overall cost of a company's capital.
Weighted average of the cost of debt and equity.
Weighted according to their proportional financing.

Cost of Equity (Ke)

Opportunity Cost: The cost of equity is determined when there is no contractual cost, therefore the investor weighs the return of the equity against other potential investments, which are in the same risk class and have a similar liquidity level.
Expected/Required Return: The return for the investment, also considering investor risk tolerance. This is not the actual, achieved return. For risky investments, investors demand higher returns to compensate for risk. No certain returns, thus a risk-free rate of interest has to be added.
Risk Affecting Cost of Capital: Risk averse people prefer the certain level of income; however, to accept a certain risk reward higher return must be offered. There is a correlation between risk and return.

Cost of Equity (Ke) - Risks

Investors with diversified portfolios only need compensation for portfolio-wide risk (systematic risk)
Specific risks aren't significant because they get diversified away in a portfolio.
Systematic or undiversifiable risk remains.
Risk can be evaluated through a probability distribution.

Cost of Equity (Ke) - CAPM

CAPM estimates the cost of equity.
Risk-free rate combined with equity return premium (EMRP)
EMRP is a product of EMRP (average market risk) and the beta for that investment (measure of the systematic risk of that particular investment)

Cost of Equity (Ke) - Systematic and Unsystematic Risk

Investing in various stocks help to diversify systematic risks away.
Unsystematic risk relates to company-specific components of risk.

Cost of Equity (Ke) - Specific Risks

Company-specific risk can be diversified away, but these risks are still essential in practice.
Managerial competence is crucial given company-specific risks.

Cost of Equity (Ke): Summary

Cost of equity relates to the perceived risk of the investment.
Calculating the cost of equity is intricate.
CAPM can be used to determine equity returns beyond a risk-free rate
Calculating Cost of Equity is forward-looking to determine future cash flow values.

Risk-Free Rate (Rf)

The minimum return an investor expects for investing in a risk-free asset.
Guaranteed return.
Time preference—attaching lower value to future money. -Expected inflation rate is also a part of risk free rates

Risk-Free Rate - Calculation

Conversions can be done from nominal to real rates of return.

Risk-Free Rate - Examples

Government securities (e.g., bonds) frequently used as risk-free proxy in the OECD countries.

Beta (β)

Beta quantifies the relative volatility of a specific stock/asset compared to the market index.
A measure of systematic risk, representing how sensitive a security's returns are to changes in the market index.
Beta above 1.0 indicates higher volatility, and beta less than 1.0 implies lower volatility than the market.

Beta Historical Data

Historical covariance of firm equity and market return is a good proxy for future risk.
Regression analysis determines beta values from historical data.
Interpreting historical beta requires caution, as it's not a perfect predictor.

Beta - Factors that Drive Beta

Cyclicality of revenue: Degree to which a company's cash flows are affected by overall market conditions.
Operational leverage: Degree to which fixed costs are part of total costs.
Financial Leverage: additional risk when a portion of the company is funded by debt.

Beta - Observable Betas

Beta incorporates operational and financial leverage impacts.
There are different betas; asset beta relates only to operational risk.
Company-specific risks can be mitigated through diversification.

Equity Market Risk Premium (EMRP)

The extra return investors demand for putting money into equities of average risk.
Calculated using historical data (arithmetic/geometric averages).
Forward-looking approach also used in practice.

Cost of Debt

Calculating borrowing costs for companies.
Includes direct method (using firm data) and indirect method (examining similar companies).
Credit ratings and default risk are significant factors in cost of debt evaluation.

Cost of Debt - Debt Margin

Calculating the expense on borrowed funds involves using market data, like bond prices and yields, or comparing the firm to similar companies.
The spread between the firm's bond yield and a government bond yield is considered the default risk margin.

Weighted Average Cost of Capital (WACC)

Calculating WACC involves the cost of equity, and the percentage of equity in the capital structure, alongside the after-tax cost of debt, combined with the percentage that debt composes the capital structure.

Weighted Average Cost of Capital (WACC) - Steps

Determine target capital structure.
Calculate cost of debt (Kd).
Calculate cost of equity (Ke).
Calculate the WACC.

Capital Structure Effects

Financing policies affect company value.
Static trade-off between the tax shield advantage of debt and bankruptcy costs.
Pecking order preferences among managers.

What are the major causes of business failure?

Business failures are typically because of the combination of economic factors, industry trends, consumer habits, obsolescence of technology and demographical change, and, also economic factors such as excessive debt and unanticipated interest rate hikes
Combining these failure reasons makes businesses unsustainable.

What Size Firm is Prone to Business Failure?

Bankruptcy occurs more frequently in smaller firms when compared with larger ones.
Larger companies are more likely to receive external help to avert a potential bankruptcy.

What Key Issues Must Managers Face in the Financial Distress Process?

Identifying if the problem is temporary or permanent.
Evaluating who bears the losses.
Determining if it is better to liquidate the business or maintain operations.
Identifying if bankruptcy proceedings are necessary or if informal processes might be used.
Establishing who takes control during liquidation or reorganization.

Bankruptcy Terminology

Voluntary Bankruptcy - A petition filed by management itself.
Involuntary Bankruptcy - A petition filed by the company's creditors.

Typical Priority of Claims

Secured creditors get first priority.
Trustee and administrative costs are later.
Worker wages, customer deposits, and taxes have priority over unsecured creditors.
General unsecured creditors are next, followed by preferred, and then common stockholders.

What Informal Remedies Are Available to Firms in Financial Distress?

Informal reorganization and informal liquidation.

Informal Bankruptcy Terminology

Workout: A voluntary informal reorganization strategy.
Restructuring: Modifying current debt terms.
Assignment: An informal procedure for liquidating assets.

General Conclusion

No return exists without risk.

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Description

Test your knowledge with this Finance Chapter 5 quiz that focuses on important concepts such as WACC and cost of capital. Answer questions about value creation and key formulas used in financial decision-making. Perfect for students looking to reinforce their understanding of core finance principles.