Corporate Finance & Capital Budgeting - Valuation & Investment Analysis Flashcards

Question 1

What is Corporate Finance?

Accepted Answer

Corporate finance is the branch of finance dealing with the funding, capital structuring, and investment decisions of a business. Its primary goal is to maximize shareholder wealth.

Question 2

What is Capital Budgeting?

Accepted Answer

Capital budgeting is the process of evaluating and selecting long-term investments (projects) that are consistent with the firm's goal of maximizing shareholder wealth. It involves analyzing potential projects to decide which ones to undertake.

Question 3

What is Net Present Value (NPV)?

Accepted Answer

NPV is the difference between the present value of cash inflows and the present value of cash outflows over a period of time. It measures the value added to the firm by undertaking a project.

Question 4

What is the formula for Net Present Value (NPV)?

Accepted Answer

The NPV formula is given by $NPV = \sum_{t=1}^{n} rac{C_t}{(1+r)^t} - C_0$, where $C_t$ is the net cash inflow during period $t$, $C_0$ is the initial investment, $r$ is the discount rate (typically WACC), and $n$ is the number of periods.

Question 5

What is the NPV Decision Rule?

Accepted Answer

Accept projects with $NPV > 0$, as they are expected to increase shareholder wealth. Reject projects with $NPV < 0$. If $NPV = 0$, the project is indifferent (it earns exactly the required rate of return).

Question 6

What is the Internal Rate of Return (IRR)?

Accepted Answer

IRR is the discount rate that makes the Net Present Value (NPV) of all cash flows from a particular project equal to zero. It represents the project's expected rate of return.

Question 7

What is the IRR Decision Rule?

Accepted Answer

Accept projects if $IRR > 	ext{Cost of Capital (WACC)}$, as the project's return exceeds the cost of financing it. Reject if $IRR < 	ext{Cost of Capital}$. If $IRR = 	ext{Cost of Capital}$, the project is indifferent.

Question 8

Compare NPV and IRR for mutually exclusive projects.

Accepted Answer

NPV is generally preferred for mutually exclusive projects because it directly measures the value added to the firm and avoids issues like multiple IRRs or scale differences. NPV always leads to the correct decision for maximizing shareholder wealth.

Question 9

What is the Weighted Average Cost of Capital (WACC)?

Accepted Answer

WACC is the average rate of return a company expects to pay to finance its assets. It's the average cost of all sources of financing (debt and equity), weighted by their proportion in the company's capital structure.

Question 10

What is the formula for WACC?

Accepted Answer

The WACC formula is $WACC = rac{E}{V}r_e + rac{D}{V}r_d(1 - T_c)$, where $E$ is the market value of equity, $D$ is the market value of debt, $V = E+D$ is the total market value of the firm's financing, $r_e$ is the cost of equity, $r_d$ is the cost of debt, and $T_c$ is the corporate tax rate.

Question 11

What is the Cost of Equity ($r_e$)?

Accepted Answer

The cost of equity ($r_e$) is the return required by equity investors given the risk of the cash flows from the firm. It can be estimated using models like the Capital Asset Pricing Model (CAPM) or the Dividend Growth Model.

Question 12

What is the Capital Asset Pricing Model (CAPM) equation for the Cost of Equity?

Accepted Answer

The CAPM equation is $r_e = r_f + eta(r_m - r_f)$, where $r_f$ is the risk-free rate, $eta$ (beta) is the equity's systematic risk, and $(r_m - r_f)$ is the market risk premium.

Question 13

Explain the components of the CAPM equation.

Accepted Answer

The components are:
*   $r_f$: Risk-free rate (e.g., U.S. Treasury bond yield).
*   $eta$: Beta, a measure of a stock's volatility in relation to the overall market.
*   $r_m$: Expected return of the market.
*   $(r_m - r_f)$: Market Risk Premium, the additional return investors expect for taking on market risk.

Question 14

What is the Cost of Debt ($r_d$)?

Accepted Answer

The cost of debt ($r_d$) is the effective interest rate a company pays on its debt. It's typically the yield to maturity (YTM) on existing debt or the interest rate on new debt. It's tax-deductible, so the after-tax cost is used in WACC.

Question 15

Why is the cost of debt adjusted for taxes in the WACC formula?

Accepted Answer

Interest payments on debt are tax-deductible, creating a "tax shield" that reduces the effective cost of debt for the company. The after-tax cost of debt is $r_d(1 - T_c)$, reflecting this tax benefit.

Question 16

What is Discounted Cash Flow (DCF) Modeling?

Accepted Answer

DCF modeling is a valuation method used to estimate the value of an investment (e.g., a company or project) based on its expected future cash flows. These cash flows are discounted to their present value using a discount rate (WACC) to arrive at the valuation.

Question 17

What is Free Cash Flow to Firm (FCFF)?

Accepted Answer

FCFF is the cash flow available to all capital providers (both debt and equity holders) after all operating expenses and necessary investments in working capital and fixed assets have been paid. It's a key input for DCF valuation.

Question 18

How is Terminal Value (TV) calculated in a DCF model?

Accepted Answer

Terminal Value represents the value of a company's cash flows beyond the explicit forecast period. It is often calculated using the Gordon Growth Model: $TV = rac{FCF_{n+1}}{(WACC - g)}$, where $FCF_{n+1}$ is the first cash flow beyond the forecast period, and $g$ is the perpetual growth rate.

Question 19

What is Capital Structure?

Accepted Answer

Capital structure refers to the specific mix of a company's long-term debt, common equity, and preferred equity used to finance its assets. It determines the firm's financial leverage and overall risk profile.

Question 20

What is the Debt-to-Equity Ratio?

Accepted Answer

The Debt-to-Equity Ratio is a capital structure metric that indicates the relative proportion of shareholders' equity and debt used to finance a company's assets. Formula: $rac{	ext{Total Debt}}{	ext{Total Equity}}$. A higher ratio indicates higher financial leverage.

Question 21

What is the Debt-to-Capital Ratio?

Accepted Answer

The Debt-to-Capital Ratio is a capital structure metric that shows the proportion of a company's total capital (debt plus equity) that is financed by debt. Formula: $rac{	ext{Total Debt}}{	ext{Total Debt + Total Equity}}$. It provides a broader view of leverage than D/E.

Question 22

What is the Times Interest Earned (TIE) Ratio?

Accepted Answer

The TIE Ratio is a solvency ratio that measures a company's ability to meet its debt obligations (interest payments) based on its operating income. Formula: $rac{	ext{EBIT}}{	ext{Interest Expense}}$. A higher ratio indicates better solvency and lower risk of default.

Question 23

What is the concept of Optimal Capital Structure?

Accepted Answer

The optimal capital structure is the mix of debt and equity that maximizes the market value of the firm's stock while minimizing the Weighted Average Cost of Capital (WACC). It balances the benefits of debt (tax shield) against the costs (financial distress and agency costs).

Question 24

What are the primary advantages of using NPV for capital budgeting decisions?

Accepted Answer

NPV directly measures the increase in shareholder wealth, considers the time value of money, uses the appropriate discount rate (WACC), and provides a clear accept/reject rule without issues like multiple IRRs or reinvestment rate assumptions.

Question 25

What are the primary advantages of using IRR for capital budgeting decisions?

Accepted Answer

IRR is intuitive and easy to understand as a percentage return, making it appealing to non-finance managers. It does not require an external discount rate for its calculation (though one is needed for the decision rule), which can be seen as an advantage in some contexts.

Corporate Finance & Capital Budgeting - Valuation & Investment Analysis

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