MGT 6201 Finance - General

The minimum rate of return a corporation must earn on its invested capital to break even in economic terms is called the _____.

Cost of Capital

Why is the cost of debt multiplied by (1 - Tax Rate) when calculating WACC?

Interest paid on debt is tax-deductible.

What two primary components determine a firm's cost of debt capital?

The risk-free Treasury bond rate and a default risk premium.

How is a 'basis point' defined in terms of percentage?

One basis point equals 0.01% (or 100 basis points equal 1%).

In bond ratings, any rating below _____ is considered a junk bond or speculative grade.

Triple B (BBB/Baa)

Term: Cost of Equity Capital

Definition: The rate of return shareholders expect the firm to earn on its equity capital.

According to the Capital Asset Pricing Model (CAPM), what is the formula for the cost of equity (R(e))?

R(e) = R(f) + [β × (R(m) - R(f))]

In the CAPM formula, what does the term (R(m) - R(f)) represent?

The Market Risk Premium.

Concept: Beta (β)

Definition: A measure of a stock's sensitivity to macroeconomic or market risk.

What is the defined Beta (β) of the S&P 500 index?

1.0

What is the defined Beta (β) of a risk-free Treasury Bond?

0

How does a Beta of 0.5 affect a stock's expected movement relative to a 10% market increase?

The stock is expected to increase by 5%.

Why can investors eliminate firm-specific risk but not market risk through diversification?

Market risk is driven by unavoidable macroeconomic factors like recessions or interest rate changes.

Which specific type of risk is eliminated when a stock is held in a large, well-diversified portfolio?

Firm-specific (or idiosyncratic) risk.

If a company's cash flows are not impacted by the business cycle, its Beta is likely to be _____.

Less than 1.0

Formula: Weighted Average Cost of Capital (WACC)

WACC = [(D/V) × R(d) × (1 - T)] + [(E/V) × R(e)]

What is the 'Market Cap' (Market Value of Equity) of a firm?

The share price multiplied by the number of shares outstanding.

The valuation method that estimates the present value of projected free cash flows discounted at the WACC is the _____ approach.

Discounted Cash Flow (DCF)

In firm valuation, how is the Value of Equity derived from the Total Firm Value?

Subtract the market value of debt from the total firm value.

What is the fundamental formula for Free Cash Flow (FCF)?

FCF = (EBIT × (1 - Tax Rate)) + Depreciation - CapEx - Δ(Working Capital)

What is the primary difference in time horizons between project valuation and firm valuation?

Projects have finite lives, while firms are generally assumed to have infinite lives.

Formula: Terminal Value (TV(T)) using the Perpetual Growth Model

TV(T) = (FCF(T+1)) / (WACC - g)

In the Comparable Firms Method, what must be done to the value of a private firm if the multiples are derived from public firms?

Apply a liquidity discount (typically 20% to 25%).

Concept: Enterprise Value (EV)

Definition: The sum of the market value of equity and the market value of long-term debt.

When using the 'With-Without' principle for capital budgeting, which cash flows are considered relevant?

Only the incremental cash flows that differ between accepting and rejecting the investment.

Why are sunk costs excluded from capital investment analysis?

They are past outlays that cannot be recovered and do not change regardless of the current decision.

Term: Erosion Costs (Side Effects)

Definition: Cash flow transferred to a new project from the sales of existing products within the same firm.

How should Working Capital be treated at the end of a project's life?

It is treated as a cash inflow (recovery of the initial investment).

Concept: Opportunity Cost

Definition: The lost revenue or value from the best alternative use of an asset already owned by the firm.

Formula: Economic Value Added (EVA)

EVA = NOPAT - (WACC × Total Capital)

How is the 'Spread' defined in the context of economic profits?

The difference between the Return on Total Capital (ROTC) and the Cost of Capital (r).

To create economic value, a project's return must exceed its _____.

Opportunity cost of capital (or WACC).

Formula: Market Value Added (MVA)

MVA = Market Value of Equity - Book Value of Equity

What does a positive MVA represent to shareholders?

The amount of wealth management has created in excess of the capital provided by stockholders.

Concept: Capital Turnover

Definition: A measure of capital efficiency calculated as Sales divided by Total Capital.

What are the two primary components of Return on Total Capital (ROTC)?

Return on Sales (operating efficiency) and Capital Turnover (capital efficiency).

The present value of all future expected Economic Value Added (EVA) is equivalent to the _____.

Market Value Added (MVA)

In stock valuation, what is the formula for the value of a Zero Growth stock?

P(0) = Div/R

Formula: Constant Growth Stock Valuation (Gordon Growth Model)

P(0) = Div(1)/ (R - g)

In the Gordon Growth Model, how is Div(1) calculated from the most recent dividend (Div(0))?

Div(1) = Div(0) × (1 + g)

Formula: Dividend Retention Ratio

Retention Ratio = 1 - (Dividend per Share / Earnings per Share)

How is a firm's internal growth rate (g) estimated using the retention ratio?

g = Retention Ratio × Return on Retained Earnings (ROE)

Concept: NPVGO

Definition: The Net Present Value of Growth Opportunities.

How is the value of a firm's stock divided in the NPVGO model?

The value as a 'cash cow' (EPS/R) plus the NPV of future growth opportunities.

If a firm's Return on Equity (ROE) is less than its cost of capital (R), increasing the retention ratio will _____ the stock price.

Decrease

What is the relationship between a firm's P/E ratio and its risk (R)?

They are negatively related (higher risk leads to a lower P/E ratio).

Formula: Real Return (r) given Nominal Return (R) and Inflation (h)

1 + r = (1 + R) / (1 + h)

What is the Fisher Effect equation?

1 + R = (1 + r) × (1 + h)

When conducting capital budgeting during high inflation, if cash flows are expressed in nominal terms, the discount rate must be _____.

Nominal

In a replacement decision, the initial cash outflow is the cost of the new machine minus the _____.

After-tax proceeds from the sale of the old machine.

Why is depreciation added back to Net Income when calculating After-Tax Cash Flow (ATCF)?

Depreciation is a non-cash expense that was subtracted to calculate taxes but does not involve an actual cash outflow.

Sensitivity analysis involves changing _____ variable(s) at a time to see the effect on NPV.

One

Which valuation technique uses probability distributions and repeated trials to address uncertainty in forecasts?

Simulation (or Monte Carlo Simulation).

A firm's operating efficiency is commonly measured by the ratio of _____ to sales.

Net Operating Profit After Tax (NOPAT)

Total Capital employed by a company should always be equal to its _____.

Total Assets

Which specific risk factor is represented by 100% of an investor's risk if they only own one stock?

The firm's total risk (both firm-specific and market risk).

Why does the government borrowing rate affect the cost of equity?

It serves as the risk-free rate (R(f)), which is the baseline for all required returns.

In the DCF model, what is FCF(T+1) often assumed to be?

FCF(T) × (1 + g)

A company with high operating leverage or stable cash flows in a mature industry can typically support _____ debt levels.

Higher

Which financial statement provides the 'Book Value' used in MVA calculations?

The Balance Sheet (specifically Stockholders' Equity).

True or False: Accounting profit is sufficient to conclude that value is being created.

False; economic profit (EVA) must be positive to create value.

What does a 'negative spread' imply about a business unit?

The unit's return on capital is less than the cost of the capital it uses, destroying value.

In the context of DCF, the 'Terminal Value' represents the value of all cash flows occurring _____.

Beyond the explicit forecast period.

What is the first principle of recording cash flows in capital budgeting?

Record them when the money actually moves, not based on accounting accruals.

If a project has a positive NPV, its IRR must be _____ the discount rate.

Greater than

In simulation analysis, the 'Coefficient of Variation' is calculated as the standard deviation divided by the _____.

Expected Value (Mean)

What is the tax rate's effect on the cost of equity capital?

None; dividends are not tax-deductible, so the cost of equity is not tax-adjusted.

What does NOPAT stand for and how is it calculated?

Net Operating Profit After Tax; calculated as EBIT × (1 - Tax Rate).

How does an increase in the cost of capital (R) affect the current stock price (P0)?

It decreases the stock price.

When a firm identifies 'undervalued' stocks, it is using valuation techniques to find cases where the estimated value is _____ the market price.

Greater than

What is the primary goal of managing for value creation?

To maximize the market value of the business (and thereby shareholder wealth).

In the EVA framework, what is 'Capital Charge'?

The dollar cost of using capital, calculated as WACC × Total Capital.

What happens to the calculated value of a firm if the expected growth rate (g) is increased in the Gordon Growth Model?

The firm's value increases.

Why is 'Liquidity' a challenge for private firm valuation?

Private shares cannot be immediately sold in an open market, making them less valuable than identical public shares.

The sum of a firm's value as a cash cow and its NPVGO equals its total _____.

Market Price per Share