D365 Financial Management II - Set 2 - Part 3

Correct Answer: Limits the amount of capital available for new investments

Capital rationing exists when a firm places a limit on its investment budget, so it cannot fund every positive-NPV project. Managers must then select the combination of projects that maximizes total value within the constraint.

Correct Answer: Ability to meet interest obligations

Times interest earned (EBIT divided by interest expense) measures how comfortably a firm can pay its interest costs from operating earnings. A higher ratio indicates a greater margin of safety for lenders.

Correct Answer: A bond the issuer can redeem before maturity at a specified price

A callable bond gives the issuer the right to redeem it before maturity, usually at a call price. Issuers often call bonds when interest rates fall so they can refinance at lower rates, which is a disadvantage to investors.

Correct Answer: Equivalent annual annuity (EAA)

The equivalent annual annuity converts each project's NPV into a constant annual cash flow over its life, allowing valid comparison of mutually exclusive projects that have unequal durations.

Correct Answer: Minimizes the firm's WACC and maximizes firm value

The target capital structure is the debt-equity mix that minimizes the firm's weighted average cost of capital and therefore maximizes firm value. Firms aim to raise new financing to move toward this target over time.

Correct Answer: A firm buying back its own shares from the market

In a stock repurchase, a company buys back its own shares, reducing shares outstanding. It returns cash to shareholders as an alternative to dividends and can increase earnings per share and signal management confidence.

Correct Answer: One input variable is changed at a time

Sensitivity analysis varies one key input (such as sales volume or cost) at a time while holding others constant, to identify which variables most affect a project's NPV and where the greatest risk lies.

Correct Answer: Annual dividend divided by the preferred stock's price

Because preferred stock typically pays a fixed dividend indefinitely, it behaves like a perpetuity. Its required return equals the annual dividend divided by the current market price of the preferred share.

Correct Answer: Providing liquidity to meet obligations and unexpected needs

Holding cash and marketable securities provides liquidity, allowing a firm to meet routine payments, handle emergencies, and take advantage of opportunities. The trade-off is the low return earned on these liquid assets.

Correct Answer: Rise

According to the Fisher effect, nominal interest rates rise with expected inflation, because lenders demand higher returns to preserve their real purchasing power. The nominal rate approximates the real rate plus expected inflation.