# Corporate Finance, Asset Valuation & Cost of Capital

> Intermediate corporate finance: bond and equity valuation, Enterprise Value vs. Equity Value, CAPM and WACC, Modigliani-Miller Propositions, trade-off and pecking-order theories, DCF terminal value, share repurchases, and working capital policy.

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- **Level:** intermediate
- **Languages:** en → en
- **Total Cards:** 32

## Flashcards (32 Cards)

| # | Front (Term / Prompt) | Back (Definition / Answer) | Example | Multiple-Choice Options |
| :--- | :--- | :--- | :--- | :--- |
| 1 | Why is EV/EBITDA preferred over Price-to-Earnings (P/E) when comparing firms with differing capital structures? | Because Enterprise Value captures all capital sources and EBITDA is independent of debt financing and tax rates, making the ratio capital-structure and tax neutral across peer companies. |  |  |
| 2 | State the formula for the Weighted Average Cost of Capital (WACC). | WACC = (E / V) × r_e + (D / V) × r_d × (1 − t) + (P / V) × r_p, where E, D, and P are the market values of common equity, debt, and preferred stock, and V = E + D + P is total market value of firm capital. |  |  |
| 3 | Explain the fundamental inverse relationship between bond prices and market interest rates (yields). | When market interest rates rise, existing fixed-rate bonds paying lower coupons become less attractive, driving their market prices down until their yield matches prevailing market rates. |  |  |
| 4 | State the Gordon Growth Model (Constant Growth Dividend Discount Model) formula for equity share price. | P_0 = D_1 / (r_e − g) = [D_0 × (1 + g)] / (r_e − g) (valid when r_e > g), where D_1 is expected dividend next period, r_e is required return on equity, and g is the constant perpetual dividend growth rate. |  |  |
| 5 | What is the difference between unlevered beta (asset beta) and levered beta (equity beta)? | Unlevered beta (β_U) measures the pure operating business risk of a firm's assets without debt; levered beta (β_L) reflects both business risk and financial leverage risk. Assuming risk-free debt (the Hamada equation), β_L = β_U × [1 + (1 − t) × (D / E)]. |  |  |
| 6 | How does an aggressive working capital policy differ from a conservative working capital policy? | An aggressive policy minimizes cash and inventory while financing temporary and part of permanent current assets with short-term debt (higher risk, higher profitability); a conservative policy holds large liquid buffers financed with long-term debt (lower risk, lower return). |  |  |
| 7 | State Modigliani-Miller Proposition I in a world without taxes or transaction costs. | The total market value of a firm is independent of its capital structure; firm value is determined entirely by the earning power of its real assets, not how financing is divided between debt and equity (V_L = V_U). |  |  |
| 8 | What threshold separates Investment Grade bonds from High Yield (Junk) bonds according to major rating agencies? | Investment grade is rated BBB- / Baa3 or higher (Moody's, S&P, Fitch); speculative/high yield bonds are rated BB+ / Ba1 or below. |  |  |
| 9 | What is credit spread in bond markets and what does its widening indicate? | The yield difference between a corporate bond and a risk-free sovereign Treasury bond of identical maturity; widening credit spreads signal deteriorating corporate creditworthiness or heightened macroeconomic risk aversion. |  |  |
| 10 | What is the Pecking Order Theory of corporate financing? | Due to information asymmetry between management and outside investors, firms finance investments hierarchically: first through internal cash flows, second through low-risk debt, and as a last resort through new equity issuance. |  |  |
| 11 | In a Discounted Cash Flow (DCF) model, how is the Terminal Value calculated using the Exit Multiple method? | Terminal Value = Terminal Year Forecasted Metric (e.g., Final Year EBITDA) * Selected Benchmark EV/EBITDA Multiple, which is then discounted back to present value. |  |  |
| 12 | Compare coupon rate, current yield, and Yield to Maturity (YTM) for discount, par, and premium bonds. | For discount bonds (Price < Par): Coupon Rate < Current Yield < YTM; for par bonds (Price = Par): Coupon Rate = Current Yield = YTM; for premium bonds (Price > Par): Coupon Rate > Current Yield > YTM. |  |  |
| 13 | What is the after-tax Cost of Debt in corporate finance, and why is it adjusted for taxes? | After-Tax Cost of Debt = r_d × (1 − t), where r_d is the firm's marginal pre-tax borrowing rate (YTM on debt) and t is the marginal corporate tax rate; adjusted because interest expense is tax-deductible (subject to statutory caps such as IRC § 163(j)), creating an interest tax shield. |  |  |
| 14 | Why is WACC the appropriate discount rate for evaluating new corporate projects only if they share typical firm risk? | Because WACC reflects the average risk of the existing asset pool; using WACC for high-risk projects overvalues them, and using it for low-risk projects undervalues and incorrectly rejects them. |  |  |
| 15 | State the formula for the Cash Conversion Cycle (CCC). | CCC = DIO + DSO - DPO (Days Inventory Outstanding + Days Sales Outstanding - Days Payables Outstanding). |  |  |
| 16 | What is Operating Leverage and how is the Degree of Operating Leverage (DOL) calculated? | The extent to which fixed operating costs are used in a firm's cost structure; DOL = % change in EBIT / % change in Sales = (Sales - Variable Costs) / EBIT. |  |  |
| 17 | What is the mathematical definition and formula for Beta in the Capital Asset Pricing Model? | Beta = Cov(R_i, R_m) / Var(R_m) = ρ_(i,m) * (σ_i / σ_m); it quantifies the sensitivity of an asset's returns relative to the overall market portfolio's returns. |  |  |
| 18 | What does Days Sales Outstanding (DSO) measure and how is it calculated? | DSO = (Accounts Receivable / Total Credit Sales) * 365; it measures the average number of days required to collect cash payments after a credit sale is made. |  |  |
| 19 | In a DCF model, how is Terminal Value calculated using the Perpetual Growth Method? | Terminal Value = [FCFF_n * (1 + g)] / (WACC - g), where FCFF_n is final projection year cash flow, g is long-term sustainable GDP growth rate, and WACC > g. |  |  |
| 20 | How does corporate taxation modify Modigliani-Miller Proposition I? | With corporate taxes and tax-deductible interest (and no distress costs or personal tax offset), levered firm value equals unlevered firm value plus the present value of the interest tax shield: for permanent constant debt D, V_L = V_U + t × D. |  |  |
| 21 | What is Financial Leverage and how is the Degree of Financial Leverage (DFL) calculated? | The extent to which contractual fixed financial costs (debt interest) are used in capital structure; DFL = % change in EPS / % change in EBIT = EBIT / (EBIT - Interest Expense). |  |  |
| 22 | In corporate valuation, how does Enterprise Value (EV) differ from Market Capitalization (Equity Value)? | Market Cap is the value of common equity (Share Price * Shares Outstanding); EV reflects the entire operating enterprise: EV = Market Cap + Total Debt + Preferred Stock + Minority Interest - Cash and Cash Equivalents. |  |  |
| 23 | What is the Yield to Maturity (YTM) of a bond, and when does an investor's realized return equal YTM? | YTM is the internal rate of return (discount rate) that equates the present value of a bond's promised future coupon and principal payments to its current market price. An investor's realized compound yield equals the stated YTM only if the bond is held to maturity without default and all interim coupons are reinvested at the YTM rate. |  |  |
| 24 | What does Days Payables Outstanding (DPO) measure and how is it calculated? | DPO = (Accounts Payable / Cost of Goods Sold) * 365; it measures the average number of days a company takes to pay its trade creditors and suppliers. |  |  |
| 25 | State the Capital Asset Pricing Model (CAPM) formula for the expected return on asset i. | E(R_i) = R_f + β_i * [E(R_m) - R_f], where R_f is the risk-free rate and [E(R_m) - R_f] is the market risk premium. |  |  |
| 26 | How does a share repurchase program affect shares outstanding and Earnings Per Share (EPS)? | A share repurchase reduces common shares outstanding. Because funding the buyback reduces cash (forgoing interest income) or increases debt (adding interest expense), EPS increases (is accretive) if and only if the stock's earnings yield (EPS / Price = 1 / [P/E]) exceeds the after-tax interest rate on the cash or debt used. |  |  |
| 27 | What is the Degree of Total Leverage (DTL)? | The combined effect of operating and financial leverage on earnings per share: DTL = DOL * DFL = % change in EPS / % change in Sales. |  |  |
| 28 | What is the Trade-Off Theory of Capital Structure? | Firms choose an optimal capital structure by trading off the tax shield benefits of debt financing against the increasing marginal costs of potential financial distress and bankruptcy. |  |  |
| 29 | What is the difference between systematic risk and unsystematic (idiosyncratic) risk? | Systematic risk is non-diversifiable macroeconomic market risk affecting all assets (measured by Beta); unsystematic risk is firm-specific risk (e.g., strikes, product failures) that can be eliminated through portfolio diversification. |  |  |
| 30 | What is the Sustainable Growth Rate (SGR) formula for a company? | SGR = ROE * (1 - Dividend Payout Ratio) = ROE * Retention Rate (b); it represents the maximum rate of growth a firm can achieve without issuing new external equity or altering financial leverage. |  |  |
| 31 | What is zero-coupon bond pricing formula and why does it have no reinvestment risk? | Price = Face Value / (1 + y/m)^(m*t); it carries zero reinvestment risk because it pays no interim coupons, so its yield to maturity is completely locked in if held to redemption. |  |  |
| 32 | What are the four primary risks faced by fixed income bond investors? | Interest rate risk (duration risk), Credit/default risk, Reinvestment risk (reinvesting coupons at lower yields), and Call/prepayment risk. |  |  |

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