D365 Financial Management II - Set 2 - Part 2

Correct Answer: Its expected future dividends

The dividend discount model prices a stock as the present value of all expected future dividends, discounted at the required rate of return. The Gordon growth version assumes dividends grow at a constant rate.

Correct Answer: Debt financing with fixed interest costs

Financial leverage rises with the use of debt that carries fixed interest costs. More leverage magnifies changes in earnings per share for a given change in operating income, increasing both potential returns and risk.

Correct Answer: The return forgone by choosing one investment over the next best alternative

Opportunity cost is the value of the next best alternative that is given up when a resource is committed to a particular project. Relevant opportunity costs should be included in project cash flow analysis.

Correct Answer: Set aside money periodically to repay the bond

A sinking fund provision requires the issuer to retire portions of a bond issue on a scheduled basis, reducing default risk by ensuring funds are set aside gradually rather than a single large repayment at maturity.

Correct Answer: Firm's cost of capital

MIRR assumes intermediate cash flows are reinvested at the firm's cost of capital rather than the project's IRR, which addresses a key criticism of the traditional IRR method and gives a more realistic return estimate.

Correct Answer: A product recall at a single company

Unsystematic risk is specific to a particular firm or industry, such as a product recall, labor strike, or management change. It can be reduced through diversification, unlike market-wide systematic risk.

Correct Answer: Internal funds (retained earnings)

The pecking order theory holds that firms prefer internal financing (retained earnings) first, then debt, and issue new equity only as a last resort, largely because of information asymmetry and issuance costs.

Correct Answer: Retained earnings decrease

A higher payout ratio means a larger share of earnings is distributed as dividends, leaving less to be reinvested. This reduces retained earnings and can lower the firm's internally funded growth.

Correct Answer: A financing decision

The lease-versus-buy analysis is a financing decision, comparing the cost of leasing an asset against the cost of purchasing it (often with borrowed funds), including tax and cash flow effects.

Correct Answer: The market risk premium

The market risk premium is the additional return investors demand for holding the market portfolio instead of a risk-free asset. It equals the expected market return minus the risk-free rate and is a key input to CAPM.

Correct Answer: Uncorrelated or negatively correlated

Diversification works best when assets have low or negative correlation, because losses in one asset tend to be offset by gains or stability in another, reducing overall portfolio volatility.

Correct Answer: Present value of future cash flows divided by initial investment

The profitability index equals the present value of a project's future cash flows divided by the initial investment. A value above 1.0 indicates a positive NPV and a value-creating project.

Correct Answer: Ties up more cash in working capital

A longer collection period means customers take more time to pay, tying up more cash in receivables and increasing the firm's working capital needs, which can strain liquidity.

Correct Answer: Credit (default) risk

Credit or default risk is the risk that a borrower will not make scheduled interest or principal payments. Lenders manage it through credit analysis, collateral, covenants, and risk-based pricing.

Correct Answer: Independent of its capital structure

In the original Modigliani-Miller proposition without taxes, a firm's total value depends on its assets and earning power, not on how it is financed, so capital structure is irrelevant to firm value under those idealized assumptions.

Correct Answer: Interest payments are tax-deductible, reducing taxable income

Interest expense is deductible when computing taxable income, which lowers a firm's tax bill and creates the interest tax shield. This tax benefit is a key reason debt can reduce a firm's overall cost of capital.

Correct Answer: Inventory order size that minimizes total inventory costs

The EOQ model determines the order quantity that minimizes the sum of ordering costs and carrying costs of inventory, helping firms manage inventory efficiently as part of working capital management.

Correct Answer: A bond whose coupon adjusts periodically with a reference interest rate

A floating-rate note has a coupon that resets periodically based on a reference rate (such as a benchmark index) plus a spread, so its interest payments rise and fall with market rates.

Correct Answer: Conflicts of interest between managers and shareholders

Agency costs arise when managers (agents) pursue their own interests instead of maximizing shareholder (principal) wealth. Monitoring, incentive compensation, and governance mechanisms are used to reduce these costs.

Correct Answer: A decrease in the firm's beta

Under CAPM, a lower beta reduces the firm's required return on equity because the stock is less sensitive to market risk. Higher beta, higher market premium, higher risk-free rate, or more leverage would raise the cost of equity.