a. Define incremental cash flow.

Answer: This is the firms cash flow with the project minus the firms cash flow without the
project.

a. 1. Should you subtract interest expense or dividends when calculating project cash flow?
Answer: The cash flow statement should not include interest expense or dividends. The return
required by the investors furnishing the capital is already accounted for when we apply the 10%
cost of capital discount rate; hence, including financing flows would be double counting. Put
another way, if we deducted capital costs in the table, and thus reduced the bottom-line cash
flows, and then discounted those CFs by the cost of capital, we would, in effect, be subtracting
capital costs twice.

h. What does the term risk mean in the context of capital budgeting; to what extent can risk
be quantified; and when risk is quantified, is the quantification based primarily on statistical
analysis of historical data or on subjective, judgmental estimates?
Answer: Risk throughout finance relates to uncertainty about future events, and in capital
budgeting, this means the future profitability of a project. For certain types of projects, it is
possible to look back at historical data and to statistically analyze the riskiness of the
investment. This is often true when the investment involves an expansion decision;

i. 1. What are the three types of risk that are relevant in capital budgeting?
2. How is each of these risk types measured, and how do they relate to one another?
Answer: Here are the three types of project risk:
Stand-alone risk is the projects total risk if it were operated independently. Stand-alone risk
ignores both the firms diversification among projects and investors diversification among firms.
Stand-alone risk is measured either by the projects standard deviation of NPV (NPV) or its
coefficient of variation of NPV (CVNPV). Note that other profitability measures, such as IRR and
MIRR, can also be used to obtain stand-alone risk estimates.
Within-firm risk is the total riskiness of the project giving consideration to the firms other projects,
that is, to diversification within the firm. It is the contribution of the project to the firms total risk,
and it is a function of (a) the projects standard deviation of NPV and (b) the correlation of the
projects returns with those of the rest of the firm. Within-firm risk is often called corporate risk, and
it is measured by the projects corporate beta, which is the slope of the regression line formed by
plotting returns on the project versus returns on the firm.

 Market risk is the riskiness of the project to a well-diversified investor, hence it considers the
diversification inherent in stockholders portfolios. It is measured by the projects market beta, which
is the slope of the regression line formed by plotting returns on the project versus returns on the
market.
j. 1. What is sensitivity analysis?
Answer: Sensitivity analysis measures the effect of changes in a particular variable, say revenues,
on a projects NPV. To perform a sensitivity analysis, all variables are fixed at their expected values
except one. This one variable is then changed, often by specified percentages, and the resulting
effect on NPV is noted. (One could allow more than one variable to change, but this then merges
sensitivity analysis into scenario analysis.)

a. Project cash flow, which is the relevant cash flow for project analysis, represents the actual
flow of cash, which includes investments in capital and working capital, but does not include
interest expenses or noncash charges like depreciation (except to the extent that depreciation
affects taxes). In other words, project cash flow is the free cash flow generated by the project.
b. Incremental cash flows are those cash flows that arise solely from the asset that is being
evaluated.
c. Net operating working capital changes are the increases in current operating assets resulting
from accepting a project less the resulting increases in current operating liabilities, or accruals
and accounts payable. A net operating working capital change must be financed just as a firm
must finance its increases in fixed assets. Salvage value is the market value of an asset after its
useful life. Salvage values and their tax effects must be included in project cash flow estimation.
d. Stand-alone risk is the risk a project would have it it were held in isolation. Corporate (withinfirm) risk is the risk that a project contributes to a company after taking into consideration the
cash flows of the companys other projects; because projects are not perfectly correlated,
corporate risk usually will be less than stand-alone risk. Market (beta) risk is the risk that a
company contributes to a well diversified portfolio.
e. It is often difficult to quantify market risk. On the other hand, we can usually get a good idea of
a projects stand-alone risk, and that risk is normally correlated with market risk: The higher the
stand-alone risk, the higher the market risk is likely to be. Therefore, firms tend to focus on
stand-alone risk, then deal with corporate and market risk by making subjective, judgmental
modifications to the calculated stand-alone risk.

CASH FLOW
a. Provide a brief overview of capital structure effects. Be sure to identify the ways in which
capital structure can affect the weighted average cost of capital and free cash flows.
1.
2.
3.
4.
5.

Answer: The basic definitions are:

(1) V = Value Of Firm
(2) FCF = Free Cash Flow
(3) WACC = Weighted Average Cost Of Capital
(4) rs And rd are costs of stock and debt
(5) ws and wd are percentages of the firm that are financed with stock and debt.

b. (1) What is business risk? What factors influence a firm's business risk?
Answer: Businsess risk is uncertainty about EBIT. Factors that influence business risk include:
uncertainty about demand (unit sales); uncertainty about output prices; uncertainty about
input costs; product and other types of liability; degree of operating leverage (DOL).

c. (2) What is operating leverage, and how does it affect a firm's business risk?
Operating leverage is the change in EBIT caused by a change in quantity sold. The higher the
proportion of fixed costs within a firms overall cost structure, the greater the operating
leverage. Higher operating leverage leads to more business risk, because a small sales
decline causes a larger EBIT decline.
d. Explain the difference between financial risk and business risk.
Answer: Business risk increases the uncertainty in future EBIT. It depends on business
factors such as competition, operating leverage, etc. Financial risk is the additional business
risk concentrated on common stockholders when financial leverage is used. It depends on
the amount of debt and preferred stock financing.

STOCK VALUATION
a) Intrinsic value () is the present value of the expected future cash flows. The market price
(P0) is the price at which an asset can be sold.0P
b) The required rate of return on common stock, denoted by rs, is the minimum acceptable
rate of return considering both its riskiness and the returns available on other investments.
The expected rate of return, denoted by, is the rate of return expected on a stock given its
current price and expected future cash flows. If the stock is in equilibrium, the required rate
of return will equal the expected rate of return.
c) The capital gains yield results from changing prices and is calculated as (P1 - P0)/P0, where P0
is the beginning-of-period price and P1 is the end-of-period price. For a constant growth
stock, the capital gains yield is g, the constant growth rate.
d) Normal, or constant, growth occurs when a firms earnings and dividends grow at some
constant rate forever.
e) Preferred stock is a hybrid--it is similar to bonds in some respects and to common stock in
other respects. Preferred dividends are similar to interest payments on bonds in that they
are fixed in amount and generally must be paid before common stock dividends can be paid.

a. Describe briefly the legal rights and privileges of common stockholders.

Answer: The common stockholders are the owners of a corporation, and as such, they
have certain rights and privileges as described below.
1. Ownership implies control. Thus, a firms common stockholders have the right to elect
its firms directors, who in turn elect the officers who manage the business.
2. Common stockholders often have the right, called the preemptive right, to purchase
any additional shares sold by the firm. In some states, the preemptive right is
automatically included in every corporate charter; in others, it is necessary to insert it
specifically into the charter.
b. 2. What is a constant growth stock? How are constant growth stocks valued?
Answer: A constant growth stock is one whose dividends are expected to grow at a
constant rate forever. Constant growth means that the best estimate of the future growth
rate is some constant number, not that we really expect growth to be the same each and
every year. Many companies have dividends which are expected to grow steadily into the
foreseeable future, and such companies are valued as constant growth stocks.

COST OF CAPITAL
a. The weighted average cost of capital, WACC, is the weighted average of the aftertax component costs of capital-debt, preferred stock, and common equity. Each
weighting factor is the proportion of that type of capital in the optimal, or target,
capital structure. The after-tax cost of debt, rd(1 - T), is the relevant cost to the firm
of new debt financing. Since interest is deductible from taxable income, the aftertax cost of debt to the firm is less than the before-tax cost. Thus, rd(1 - T) is the
appropriate component cost of debt (in the weighted average cost of capital).
b. The cost of preferred stock, rps, is the cost to the firm of issuing new preferred
stock. For perpetual preferred, it is the preferred dividend, Dps, divided by the net
issuing price, Pn.
c. The target capital structure is the relative amount of debt, preferred stock, and
common equity that the firm desires. The WACC should be based on these target
weights.
1. What sources of capital should be included when you estimate Harry Daviss
weighted average cost of capital (WACC)?
Answer: The WACC is used primarily for making long-term capital investment decisions,
i.e., for capital budgeting. Thus, the WACC should include the types of capital used to
pay for long-term assets, and this is typically long-term debt, preferred stock (if used),
and common stock. Short-term sources of capital consist of (1) spontaneous,
noninterest-bearing liabilities such as accounts payable and accruals and (2) short-term
interest-bearing debt, such as notes payable.

2. Harry Daviss preferred stock is riskier to investors than its debt, yet the
preferred's yield to investors is lower than the yield to maturity on the debt. Does
this suggest that you have made a mistake?
Answer: Corporate investors own most preferred stock, because 70% of preferred
dividends received by corporations are nontaxable. Therefore, preferred often has a
lower before-tax yield than the before-tax yield on debt issued by the same company.
Note, though, that the after-tax yield to a corporate investor, and the after-tax cost to
the issuer, are higher on preferred stock than on debt.

3. What are the two primary ways companies raise common equity?

Answer: A firm can raise common equity in two ways: (1) by retaining earnings and
(2) by issuing new common stock.

4. Could the DCF method be applied if the growth rate was not constant? How?
Answer: Yes, you could use the DCF using nonconstant growth. You would find the
PV of the dividends during the nonconstant growth period and add this value to the
PV of the series of inflows when growth is assumed to become constant.

5. Should the company use the overall, or composite, WACC as the hurdle rate for
each of its divisions?
Answer: No. The composite WACC reflects the risk of an average project undertaken by
the firm. Therefore, the WACC only represents the hurdle rate for a typical project
with average risk. Different projects have different risks. The projects WACC should be
adjusted to reflect the projects risk.

6. What are three types of project risk? How can each type of risk be considered
when thinking about the new divisions cost of capital?
Answer: The three types of project risk are:
a) Stand-Alone Risk
b) Corporate Risk
c) Market Risk
Market risk is theoretically best in most situations. However, creditors, customers,
suppliers, and employees are more affected by corporate risk. Therefore, corporate
risk is also relevant. Stand-alone risk is the easiest type of risk to measure.
Taking on a project with a high degree of either stand-alone or corporate risk will
not necessarily affect the firms market risk. However, if the project has highly
uncertain returns, and if those returns are highly correlated with returns on the
firms other assets and with most other assets in the economy, the project will have
a high degree of all types of risk.