D365 Financial Management II - Set 2 - Part 1

Correct Answer: The average return required by all of the firm's investors, weighted by capital source

WACC is the average rate of return required by all of a firm's capital providers (debt and equity), weighted by each source's proportion of total capital. It is commonly used as the discount rate for evaluating projects of average risk.

Correct Answer: Positive

A positive NPV means the present value of a project's cash inflows exceeds its costs, adding value to the firm. Projects with positive NPV should be accepted; those with negative NPV should be rejected.

Correct Answer: Maximizing shareholder wealth

The primary goal of financial management is to maximize shareholder wealth, typically reflected in the firm's share price. This aligns managers' decisions with the long-term interests of the owners.

Correct Answer: Risk-free rate plus beta times the market risk premium

CAPM computes the cost of equity as the risk-free rate plus beta multiplied by the market risk premium (market return minus risk-free rate). Beta measures the stock's sensitivity to overall market movements.

Correct Answer: Payback period

The simple payback period sums undiscounted cash flows to find when the initial cost is recovered, ignoring the time value of money. NPV, IRR, and the profitability index all discount future cash flows.

Correct Answer: Its debt and equity financing

Capital structure is the combination of debt and equity a firm uses to finance its assets and operations. The optimal structure balances the tax benefits of debt against the increased risk of financial distress.

Correct Answer: The tax shield of debt against the costs of financial distress

The trade-off theory states that firms choose a debt level that balances the tax advantage of interest deductibility against the rising expected costs of financial distress and bankruptcy as leverage increases.

Correct Answer: To manage short-term assets and liabilities to ensure liquidity

Working capital management focuses on managing current assets and current liabilities, such as cash, receivables, inventory, and payables, to ensure the firm can meet short-term obligations while operating efficiently.

Correct Answer: Larger swings in operating income when sales change

High operating leverage means a large proportion of fixed costs. As a result, a given percentage change in sales produces a larger percentage change in operating income, amplifying both gains and losses.

Correct Answer: Constant payout ratio policy

Under a constant payout ratio policy, the firm pays a fixed percentage of each period's earnings as dividends, so the dividend amount rises and falls directly with earnings.

Correct Answer: Interest rate risk

Interest rate risk is the risk that rising market interest rates will reduce a bond's price, since existing bonds with lower fixed coupons become less attractive relative to newly issued bonds.

Correct Answer: The stock's sensitivity to overall market movements

Beta measures systematic risk, the sensitivity of a stock's returns to movements in the overall market. A beta greater than 1 means the stock is more volatile than the market; less than 1 means less volatile.

Correct Answer: Greater than the required rate of return

A project is acceptable when its IRR exceeds the required rate of return (hurdle rate), because that implies a positive NPV. If the IRR is below the hurdle rate, the project should be rejected.

Correct Answer: Bonds and common stock

Bonds and common stock are long-term sources of financing. Accounts payable, accrued wages, and commercial paper are short-term liabilities used to fund working capital needs.

Correct Answer: Paying for inventory and collecting cash from sales

The cash conversion cycle is the time between a firm paying cash for inventory and receiving cash from customers. A shorter cycle indicates more efficient use of working capital.

Correct Answer: Market-wide risk that affects all securities and cannot be diversified away

Systematic risk stems from market-wide factors such as interest rates, inflation, and economic cycles. It affects all securities and cannot be removed through diversification, unlike unsystematic (firm-specific) risk.

Correct Answer: The last dollar of new capital the firm raises

The marginal cost of capital is the cost of raising the next (or last) dollar of new capital. It tends to rise as a firm raises larger amounts because cheaper financing sources are used first.

Correct Answer: Funding all acceptable capital investment projects

A residual dividend policy pays out only the earnings left over after financing all positive-NPV investment projects with the firm's target mix of retained earnings. Dividends therefore vary from year to year.

Correct Answer: An increase in the risk-free rate of interest

An increase in the risk-free rate raises both the cost of debt and, through CAPM, the cost of equity, which increases the WACC. Lower debt costs, lower beta, or higher tax rates would tend to reduce WACC.

Correct Answer: A situation where accepting one project means rejecting the others

Mutually exclusive projects are alternatives where selecting one automatically rules out the others, such as two competing designs for the same facility. Only the project that adds the most value should be chosen.