FINC303 Final Exam
As the level of debt increases, what will happen to the cost of debt? - correct answer-Default
risk will go up and bond ratings will go down as debt goes up, the cost of debt will increase.
As the level of debt increases, what will happen to the cost of equity? - correct
answer-Equity will become riskier, beta will increase, cost of equity will increases.
As you borrow more, what happens to the probability of bankruptcy? - correct answer-It
increases
Capital expenditures can usually be categorised into two groups: - correct answer-• New (or
growth) capital expenditures are capital expenditures designed to create new assets and
future growth.
• Maintenance capital expenditures refer to capital expenditures designed to keep existing
assets.
Does amortization of goodwill have an impact on cash flows? - correct answer-Non-cash
charges that are not tax deductible (such as amortization of goodwill) and thus provide no
tax benefits have no effect on cash flows.
Financial synergy can come from: - correct answer-Diversification, tax savings, increased
debt capacity, or cash slack
For an investment to be risk-free, two conditions must be met: - correct answer-1. There has
to be no default risk, which generally implies that the security has to be issued by the
government. Note that not all governments can be viewed as default free.
2. There can be no uncertainty about reinvestment rates, which implies that is it is a
zero-coupon security with the same maturity as the cash flow being analysed.
For most firms, will the book debt ratio be higher or lower than the market debt ratio? -
correct answer-For most firms, the book debt ratio will be much higher than the market debt
ratio. Using the book debt ratio will therefore yield a lower cost of capital
How are tax benefits a type of financial synergy? - correct answer-The tax paid by two firms
combine together may be lower than the taxes paid by them as individual firms.
How can you protect your analysis from downside risk? - correct answer-Use the standard
deviation approach, and reduce the base case scenario by one standard deviation or more.
Use the past recession approach, and reduce current operating income by the amount
operating income dropped in the last recession.
How do comparable firms impact a firm's financing mix? - correct answer-Many firms seem
to choose a debt ratio that is similar to that used by comparable firms in the same business.
,How do you calculate beta? - correct answer-The standard procedure for estimating beta is
to regress stock returns against market returns. The slope of the regression corresponds to
the beta of the stock and measures the riskiness of the stock.
How do you calculate FCFE? - correct answer-FCFE: NI + Dep - CAPEX - Change in NWC -
Preferred dividends - Debt principal repayment + Proceeds from new debt issue
How do you calculate FCFF? - correct answer-FCFF: Free cash flows to the firm: EBIT(1 -
Tax) + Dep - CAPEX - Change in NWC
How do you calculate the effect of moving to the optimal capital structure on firm value? -
correct answer-Re-estimate the firm value at each debt ratio using the new cost of capital.
• For a stable growth firm, use a growing perpetuity.
• For a high growth firm, this would require that the cash flows during the high growth phase
be estimated and discounted back.
How do you estimate betas for non-traded assets? - correct answer-The conventional
approaches of estimating betas from regressions do not work for assets that are not traded.
There are two ways in which betas can be estimated for non-traded assets:
• Using comparable firms
• Using accounting earnings
How do you estimate bottom-up beta? - correct answer-• Finding out the business that a firm
operates in
• Finding the unlevered betas of other firms in these businesses
• Take a weighted average (by sales or operating income) average of those unlevered betas
• Lever up using the firm's debt-equity ratio
How do you get from forecasts to accounting earnings? - correct answer-Separate projected
expenses into operating and capital expenses
Depreciate or amortise the capital expenses over time
Allocate fixed expenses that cannot be traced to specific projects
Consider the tax effect
How does debt add discipline to managers? - correct answer-If you are managers of a firm
with no debt, and you generate high income and cash flows each year, you tend to become
complacent. The complacency can lead to inefficiency and investing in poor projects. There
is little or no cost borne by the managers.
Forcing such a firm to borrow money can be an antidote to the complacency. The managers
now have to ensure that the investments they make will earn at least enough return to cover
the interest expenses. The cost of not doing so is bankruptcy and the loss of such a job.
How does financing hierarchy impact a firm's financing mix? - correct answer-Firms also
seem to have strong preferences on the type of financing used, with retained earnings being
the most preferred choice. They seem to work down the preference list, rather than picking a
financing mix directly.
, How does life cycle impact a firm's financing mix? - correct answer-Some firms choose a
financing mix that reflects where they are in their life cycle; start-up firms use more equity,
and mature firms use more debt.
How does operating leverage impact beta? - correct answer-Other things remaining equal,
higher operating leverage results in greater earnings variability which in turn results in higher
betas.
How does the type of business determine beta? - correct answer-• Cyclical companies have
higher betas than non-cyclical firms
• Firms which sell more discretionary products will have higher betas than firms that sell less
discretionary products.
How is cash slack a type of financial synergy? - correct answer-When a firm with significant
excess cash acquires a firm with great projects but insufficient capital, the combination can
create value.
The additional value of combining these two firms lies in the present value of the projects
that would not have been taken if they had stayed apart, but can now be taken because of
the availability of the cash.
How is debt capacity a type of financial synergy? - correct answer-By combining two firms,
each of which has little or no capacity to carry debt, it is possible to create a firm that may
have the capacity to borrower money and create value.
It has to be weighted against the immediate transfer of wealth that occurs to existing
bondholders in both firms from the shareholders.
How is diversification a type of financial synergy? - correct answer-Acquiring another firm as
a way of reducing risk cannot create wealth for two publicly traded firms with diversified
stockholders, but it could create wealth for private firms or closely held publicly traded firms.
A takeover motivated only by diversification considerations has no effect on the combined
value of the two firms involved in the takeover. The value of the combined firms will always
be the sum of the values of the independent firms.
If a firm is not rated and has no bonds outstanding that are traded, how do you estimate the
cost of debt? - correct answer-• And it has recently borrowed long-term from a bank, use the
interest rate on the borrowing
• Or, estimate a synthetic rating for the company and use the synthetic rating to arrive at a
default spread and a cost of debt.
If bondholders believe there is a significant chance that stockholder actions might make
them worse off, they can build this expectation into bond prices by - correct
answer-demanding much higher rates on debt (known as risk shifting).
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