Chapter 1: Corporate Finance and the Financial Manager (стр. 3 )

10. What pieces of information are needed to forecast dividends?

To forecast future dividends we need to forecast the firm’s earnings, dividend payout rate, and the future share count.

11. How does the total payout model address part of the dividend discount model’s limitations?

The total payout model discounts the total payouts to shareholders, which includes both dividends and share repurchases and then divides by the current number of shares outstanding to determine share price.

12. How does the growth rate used in the total payout model differ from the growth rate used in the dividend-discount model?

In the total payout model, we use the growth rate of earnings, rather than earnings per share when forecasting the growth of the firm’s total payouts.

Chapter 8: Investment Decision Rules

1. What is the NPV decision rule? How is it related to the Valuation Principle?

The NPV decision rule states that when choosing among alternatives, we should take the alternative with the highest NPV. Choosing this alternative is equivalent to receiving its NPV in cash today.

2. Why doesn’t the NPV decision rule depend on the investor’s preferences?

Regardless of our preferences for cash today versus cash in the future, we should always maximize the NPV first. We can then borrow or lend to shift cash flows through time and find our most preferred pattern of cash flows.

3. Explain the NPV rule for stand-alone projects.

The NPV is the difference between the present value of the benefits of a project and the present value of the costs of the project. If the NPV is positive, the project should be accepted. Accepting this project is the same as receiving the NPV in cash today.

4. How can you interpret the difference between the cost of capital and the IRR?

The difference between the cost of capital and a project’s IRR is a measure of the sensitivity of the NPV to an estimation error in the cost of capital.

5. How do you apply the payback rule?

To apply the payback rule you calculate the length of time it takes to recover your initial cash outflow. This tells you how long it is before the project breaks even, but it ignores the time value of money.

6. Under what conditions will the IRR rule lead to the same decision as the NPV rule?

The IRR rule will lead to the same decision as the NPV rule in most cases. The IRR rule may fail to lead to the same decision when mutually exclusive projects are considered, the cash flows of a project change signs more than once, or when the project has an initial cash inflow followed by cash outflows.

7. What is the most reliable way to choose between mutually exclusive projects?

The NPV rule is the most reliable way to choose between mutually exclusive projects.

8. For mutually exclusive projects, explain why picking one project over another because it has a larger IRR can lead to mistakes.

For mutually exclusive projects, one project may have a much higher IRR than another project but be of a much smaller scale. If this is the case, less value may be added for the shareholders by taking the project that has the higher IRR.

9. Explain why choosing the option with the highest NPV is not always correct when the options have different lives.

Suppose you are considering two projects that have an initial cash outflow and a yearly expense associated with them. If the project with the higher NPV lasts for a shorter period of time, the per year cost may actually be higher for that project if we are going to continue the project beyond the life of the shorter alternative.

10. What issues should you keep in mind when choosing among projects with different lives?

You must consider the time period for which you will actually need the project and you need to consider the replacement cost at the end of the project’s life.

11. Explain why picking the project with the highest NPV might not be optimal when you evaluate mutually exclusive projects with different resource requirements.

Choosing the project with the highest NPV might not lead to the greatest amount of value creation for the firm when you are considering mutually exclusive projects with different resource constraints. One project may have a high NPV but use up so much of the constrained resource that two projects with a combined NPV that is higher than the chosen project cannot be done.

12. What does the profitability index tell you?

The profitability index allows us to determine the amount of value that is created relative to the constrained resources that are being used.

Chapter 9: Fundamentals of Capital Budgeting

1. What is capital budgeting, and what is its goal?

Capital budgeting is the process of selecting projects that the firm plans to undertake during future years. The goal of capital budgeting is to choose projects that will add value for the shareholders.

2. Why is computing a project’s effect on the firm’s earnings insufficient for capital budgeting?

Earnings are not equivalent to cash flows. In order to evaluate a project, we must consider both the size and the timing of cash flows.

3. How are operating expenses and capital expenditures treated differently when calculating incremental earnings?

Operating expenses are considered an expense in the year that they occur. The cost of a capital expenditure is spread out over the life of the asset in the form of a depreciation expense.

4. Why do we focus only on incremental revenues and costs, rather than all revenues and costs of the firm?

In capital budgeting, we want to determine how a particular project impacts the firm. Therefore, we want to focus on the changes in revenues and the changes in costs that will occur if the project is accepted.

5. If depreciation expense is not a cash flow, why do we have to subtract it and add it back? Why not just ignore it?

Although depreciation is not a cash outflow, it is considered an expense when calculating taxable income. Therefore, there is a depreciation tax shield that impacts the earnings of a project.

6. Why does an increase in net working capital represent a cash outflow?

Net working capital reflects a short-term investment that ties up cash flow that could be used elsewhere. Thus, whenever net working capital increases it represents a reduction in cash flow that year.

7. Should we include sunk costs in the cash flows of a project? Why or why not?

No, we should not include sunk costs in the cash flows of a project because sunk costs must be paid regardless of the decision to proceed or not with the nk costs are not incremental with respect to the current decision.

8. Explain why it is advantageous for a firm to use the most accelerated depreciation schedule possible for tax purposes.

Because depreciation contributes positively to the firm’s cash flow through the depreciation tax shield, it is in the firm’s best interest to use the most accelerated method of depreciation that is allowable for tax doing so, the firm will accelerate its tax savings and increase its present value.

9. What is sensitivity analysis?

Sensitivity analysis breaks the NPV calculation into its component assumptions, and shows how the NPV varies as the underlying assumptions change. In this way, sensitivity analysis allows us to explore the impact of estimate errors for the project.

10. How does scenario analysis differ from sensitivity analysis?

Sensitivity analysis considers one parameter at a time. Scenario analysis considers the effect on NPV of changing multiple project parameters simultaneously.

11. What are real options?

Real options are options to take a business action, often after gathering more information.

12. Why do real options increase the NPV of the project?

The presence of real options in a project increases the project’s NPV. Because real options allow a decision maker to choose the most attractive alternative after new information has been learned, the presence of real options adds value to an investment opportunity. Because the decision maker has the option, but not the obligation, to take the action, he or she will choose to take the action only if it increases NPV.

Chapter 10: Stock Valuation: A Second Look

1. How does the growth rate used in the total payout model differ from the growth rate used in the dividend-discount model?

In the total payout model, we use the growth rate of earnings, rather than earnings per share when forecasting the growth of the firm’s total payouts.

2. Why do we ignore interest payments on the firm’s debt in the discounted free cash flow model?

We ignore interest payments on the firm’s debt in the discounted free cash flow model because the financing costs are captured in the discount rate.

3. What are some common valuation multiples?

Valuation multiples commonly used to value stocks include the price-earnings ratio, the ratio of enterprise value to EBIT, the ratio of enterprise value to EBITDA, the ratio of enterprise value to free cash flow, the ratio of enterprise value to sales, and the ratio of price to book value.

4. What implicit assumptions are made when valuing a firm using multiples based on comparable firms?

Using valuation multiples based on comparable firms assumes that comparable firms have the same risk and future growth as the firm being valued.

5. State the efficient markets hypothesis.

The efficient markets hypothesis states that competition eliminates all positive-NPV trades, which is equivalent to stating that securities with equivalent risk have the same expected rate of return.

6. What are the implications of the efficient market hypothesis for corporate managers?

In an efficient market, to raise the stock price, corporate managers should (1) focus on NPV and free cash flow from the firm’s investments, (2) avoid accounting illusion, and (3) use financial transactions to support investments.

7. What are several systematic behavioral biases that individual investor fall prey to?

Individual investors display overconfidence in their trading ability which leads to overtrading. Individual investors tend to sell winners too soon and hold losers too long, known as the disposition effect. Also, individual investors are influenced by their mood, their past experiences, news reports, and events.