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Financial Management Final Exam, Study Guides, Projects, Research of Financial Management

Cambridge Technical InstituteFinancial Management

Financial Management Final Exam

Typology: Study Guides, Projects, Research

2024/2025

Available from 06/26/2025

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Financial Management Final Exam
1. risk premium between stocks and bonds: with in company is fairly
predictable 4-7%
2. not under control factors of WACC: interest rates in the
economy general level of stock prices
tax rates
3. factors we can control of WACC: weights we determine, how much
debt vs equity we want to use
returns on bond loans, stock
risk: high risk projects higher required rate , B goes up thenRd goes up Re goes
up WACC goes up
4. why must firms adjust their costs of capital for risk? how?: different
projects have different risk levels and therefore need to be held to different
standards
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Financial Management Final Exam

  1. risk premium between stocks and bonds: with in company is fairly predictable 4-7%
  2. not under control factors of WACC: interest rates in the economy general level of stock prices tax rates
  3. factors we can control of WACC: weights we determine, how much debt vs equity we want to use returns on bond loans, stock risk: high risk projects higher required rate , B goes up thenRd goes up Re goes up WACC goes up
  4. why must firms adjust their costs of capital for risk? how?: different projects have different risk levels and therefore need to be held to different standards

firms can use project specific costs of capital to adjust for differing risk levels

  1. normal risk projects:: use wacc as discount (hurdle) rate
  2. high risk projects: use r > WACC
  3. low risk projects: use r < WACC
  4. estimating project specific costs pure play approach: use required rate of return of a near substitute investment
  5. estimating project specific costs subjective approach: assign investment to "risk" categories with coresponding risk premiums lower risk : discount rate is WACC - 2% normal risk : discount rate is WACC high risk: discount rate is WACC +2%
  6. managers main concern of capital: MARP estimate in CAPM Re (E(Rm-Rf))
  7. flotation costs: direct cost if issuing securities investment banking fees costs can increase the costs of taking on projects

result of the investment decision

  1. what not to include in estimating project cash flows: sunk costs, financing costs as cfs
  2. what to include in estimating project cash flows: opportunity costs side effects (externalities) changes in net working capital tax effects
  3. internal rate of return: discount rate that makes the pv of the future cfs=initial investment to calc. set NPV=0 and solve for r
  4. rule of irr: accept if irr> required return
  5. npv profile: plot of an investments npv at various discount rates shows ranges of "r" where you would accept, reject or be indifferent
  6. when to accept npv: higher than 0 and r is lower than IRR
  7. when to reject npv: less than 0 and r is higher than IRR
  1. problems with irr: 1. unconventional CF => multiple IRRS possible
  2. mutually exclusive investments=> the project with the highest IRR may not have highest NPV
  3. when can you not use IRR: if unconventional cfs calculating irr doesn't directly depend on required return estimate and some man- agers prefer to deal with rate of return to evaluate projects
  4. cross over rate: discount rate that equates NPVs of 2 projects IRR of differences between cfs
  5. forecasting risk: risk that errors in projected cfs will lead to incorrect decisions
  6. measuring/ reducing forecasting risk: scenario, sensitivity, and simulation analysis
  7. real options: flexibility to make decisions in future to alter a projects expected CF's, life, or future acceptance
  8. capital rationing: limited funds prevent from taking all positive npv projects
  9. real options examples: option to expand, abandon, or postpone

maximizing firm value is equivalent to minimizing the firms WACC

  1. affect of interest rates in the economy on WACC: if interest rates rise the cost of debt increases b/c firm must pay bond holders more when it borrows
  2. affect of stock prices on WACC: if stock prices decline it pulls firms stock price down and the cost of equity will rise
  3. effect of tax rates on WACC: affect cost of capital
  4. graph of optimal capital structure and value with out taxes: VL= Vu straight horizontal line
  5. graph of optimal capital structure and cost of capital without taxes: Re line increases WACC and Rd horizontal line stay constant with D/E
  6. affect of Re on company with no taxes: as increase debt return required by shareholders increases, its more risky to be a shareholder for a company with debt
  7. what is the optimal capital structure for companies with no taxes: no optimal capital structure (can do anything you want)
  1. generally what is bigger Rd or Re: debt is a cheaper source of funding
  2. as D/E increases effect on Re and WACC: both increase
  3. financial leverage: use of debt in capital structure magnifies gains and losses in EPS, ROE
  4. graph of optimal capital structure and value with taxes: vl= vu + d(tc) Vl increases by amount of tax shield the more debt the more tax shield the more value
  5. graph of optimal capital structure and cost of capital with taxes: Re increas- es with D/E and WACC decreases and then levels out
  6. why does WACC decrease with debt use: Rd< Re debt is much cheaper than equity on after tax basis
  7. what is the optimal structure as implied by MM with taxes?: maximize debt use
  8. financial distress costs: period before bankruptcy
  9. bankruptcy and financial distress costs: higher leverage => higher

sharehold- ers debt is a cheaper source of funding than equity

  1. high leverage can be bad if:: it decreases financial slack having the effect of worsening an underinvestment problem it decreases financing slack having the effect of forcing the firm to raise funds by a stock issue under unfavorable conditions it increases expected bankruptcy costs too much it leads to financial distress side effects firm can't use interest tax shield to full extent
  2. over investment problem: when firms invest in -NPV projects because they have so much extra cash
  3. under investment problem: when firms fail to invest in available +NPV projects b/c it is cash constrained
  4. when firms can't use interest tax shield to full extent: firms with lower income (don't have enough taxes) have depreciation expense which creates tax shield so don't need debt
  1. business risk: risk of daily operations if higher operating leverages (higher fixed costs) newer firms, new industries
  2. financial risk: risk related to high debt use, bankruptcy
  3. what do firms with high business risk tend to do?: take less financial risk
  4. leverage decrease: anything that would decrease D/E like decrease D or in- creasing E retiring debt, issuing stock
  5. negative reaction of leverage decreases: if issue stock people might think you can't make payments on debt
  6. effect of leverage decrease on stocks? increase?: stock prices fall stock prices rise
  7. debt or equity used more?: use debt less than equity
  8. cfo survey: 80% of firms have a target debt ratio or range
  9. reaction of leverage increase: positive, repurchasing stock
  10. regular dividends: usually paid quarterly
  1. Solve for Re (3 ways): 1. Dividend pricing approach Re= [(D(t+1)/Pt]+g
  2. CAPM approach: Re= Rf+[E(Rm) - Rf] x B
  3. Bond-Yield-Plus-Risk-Premium Approach
  4. What is the cost of preferred stock?: Return required by preferred stockhold- ers.
  5. Solve for Rp: Rp= Dp/Po
  6. What is the cost of debt? How to solve?: Return required by debtholders For Bonds: Find YTM For Loans: Use stated interest rate
  7. 2 Controllable aspects of WACC: 1. Weights - We decide capital structure
  8. Firm Risk - Risk of Operations
  9. 2 Uncontrollable aspects of WACC: 1. Interest Rate environment
  10. Stock Market Performance
  1. What is capital budgeting?: An investment decision to determine which pro- jects should be undertaken.
  2. What are the 3 aspects of Capital Budgeting?: 1. Est. project cash flows
  3. Est. cost of capital, if needed
  4. Apply a decision rule
  5. After-tax formula (revenues and expenses): $(1-Tc)
  6. No: When BV=MV, there is tax effect
  7. Capital Gain: When MV>BV, tax bill on. (Subtract from CF's)
  8. Capital Loss: When MV<BV, tax bill on. (Add to CF's)
  9. Formula to calculate sale of an asset: +MV +/- tax effect
  10. Internal Rate of Return (IRR): The discount rate that makes the PV of the future CF's equal the initial investment. *Accept a project if this is > than req. rate of return.
  11. 2 Problems with IRR: 1. Unconventional CF's may have multiple IRR's
  12. Mutually exclusive investments The project w/ the highest IRR may not have the highest NPV.
  1. Stock split
  2. Why might higher dividends reduce firm volume (4 reasons): 1) Personal Taxes are immediate
  1. Flotation costs of raising external funds
  2. Info/asymmetry costs of raising external funds
  3. Good Investment opportunity
  1. Why might higher dividends increase firm value? (4 reasons): 1) Bird in the hand theory
  1. No transactional costs (like w/ homemade dividends)
  2. Some only invest in div. paying firms
  3. poor investment opportunity
  4. Possibly single strong prospects
  1. Residual Dividend Apprach: Fund all the +NPV projects, meet target D/E ratio, pay out any leftover earnings *Dividends tend to be volatile
  2. Constant DPR: Constant Dividend Payout Ratio

*But div. will be volatile if NI is volatile

  1. Small regular dividend, plus ":extras" policy: Payout extra div. at any time when firm has extra cash
  2. Dividend Stability Approach: Pay stable $ dividends. Increase w/ a lag rela- tive to earnings ever 4-8 quarters.
  3. Stock Repurchase: Buy back shares from shareholders when firm has extra cash and wants to pay shareholders w/o increasing expectations for future divi- dends.