D076 Finance Skills for Managers - Set 4 - Part 3

Correct Answer: Increasing the use of debt financing

Debt financing is typically less expensive than equity financing because interest payments on debt are tax-deductible. Therefore, increasing the use of debt financing can lower the firms overall cost of capital.

Correct Answer: Systematic risk

Beta measures a firms sensitivity to market movements, which is also referred to as systematic risk. A beta greater than 1 indicates that the firm is more volatile compared to the overall market. Liquidity, default, and credit risks are not directly measured by beta.

Correct Answer: Reducing inventory

Reducing inventory would free up cash, thereby improving liquidity. Increasing long-term debt or issuing more equity could help with financing but would not directly improve short-term liquidity. Increasing dividend payouts would reduce cash reserves.

Correct Answer: 12.4%

WACC is calculated by weighting the cost of equity and cost of debt by their respective proportions in the capital structure. WACC = (0.6 * 15%) + (0.4 * 8%) = 9% + 3.2% = 12.4%.

Correct Answer: Net Present Value (NPV)

NPV explicitly incorporates the time value of money by discounting future cash flows to the present. The Payback Period method ignores the time value of money. IRR and PI also consider time value, but NPV is generally the most reliable for decision-making.

Correct Answer: Reducing long-term debt

Reducing long-term debt would lower the firms financial leverage and reduce financial risk. Increasing short-term debt or reducing equity financing would further increase risk, and increasing dividend payouts would not directly affect leverage.

Correct Answer: Reject the project

Since the projects IRR is lower than the companys cost of capital, it is expected to generate returns below the required rate, meaning the company should reject the project.

Correct Answer: The company has issued more equity

An increase in equity without a proportional increase in net income will reduce ROE because ROE is calculated as net income divided by equity. Increasing debt financing would typically increase ROE, and reducing dividends does not affect equity.

Correct Answer: The project has low risk

A beta of less than 1 indicates that the project is less volatile and risky compared to the market, meaning it is expected to have lower risk relative to the broader market.

Correct Answer: The company's cost of capital

The companys cost of capital is used as the discount rate when calculating the present value of future cash flows. It represents the minimum return the company expects to earn on the project. The risk-free rate and market risk are components of the cost of capital, but the overall cost of capital is the key factor.