WACC, CAPM, Modigliani-Miller, trade-off theory, leverage and dividend policy.
40 cards · basic cards · AI-written, checked twice. Edit anything.
- What is the weighted average cost of capital (WACC)?
Show answer
The average return required by all investors (debt and equity holders) in a firm, weighted by the market value proportions of each.- State the WACC formula.
Show answer
WACC = (E/V) * Re + (D/V) * Rd * (1-Tc), where E is equity value, D is debt value, V is total value, Re is cost of equity, Rd is cost of debt, and Tc is the tax rate.- How does WACC serve as a discount rate in capital budgeting?
Show answer
It is the minimum required return a project must generate to satisfy both debt and equity investors and justify acceptance.- What happens to WACC when a firm takes on more debt at different leverage levels?
Show answer
Initially WACC may decline (due to the tax benefit of debt), but beyond an optimal point it rises as financial distress and agency costs increase.- Why is WACC used as a hurdle rate for project evaluation?
Show answer
Projects earning returns above WACC create value for the firm; those below WACC destroy value.- State the Capital Asset Pricing Model (CAPM) formula.
Show answer
Expected Return = Risk-free Rate + Beta * (Market Return - Risk-free Rate), or E(Ri) = Rf + Bi(E(Rm) - Rf).- What does the risk-free rate represent in CAPM?
Show answer
The return on a zero-risk investment, typically approximated by long-term government bond yields.- Define the market risk premium.
Show answer
The difference between the expected return on the market portfolio and the risk-free rate, compensating investors for bearing systematic risk.- What does beta measure?
Show answer
A stock's systematic risk relative to the overall market, indicating its volatility compared to market volatility.- How should a beta of 2.0 be interpreted?
Show answer
The stock is twice as volatile as the market; a 1 percent market movement corresponds to an expected 2 percent movement in the stock.- What is systematic risk?
Show answer
Risk that cannot be eliminated through diversification and is related to economy-wide factors affecting all securities.- Why does CAPM ignore unsystematic risk?
Show answer
Unsystematic risk can be diversified away in a well-constructed portfolio, so it should not be compensated.- What does Modigliani-Miller Proposition I state (no taxes)?
Show answer
A firm's value is independent of its capital structure; the choice between debt and equity does not change total firm value.- What does Modigliani-Miller Proposition II state (no taxes)?
Show answer
The cost of equity increases linearly with the debt-to-equity ratio; financial leverage raises equity risk but keeps WACC constant.- How does the introduction of corporate taxes modify MM Proposition I?
Show answer
A leveraged firm is worth more than an unleveraged firm by the present value of the tax shield on interest payments.
FlashKeepers