CFM4 Solns Chap 08


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CORPORATE FINANCIAL MANAGEMENT, Fourth Edition Solutions Manual , Chapter 8 Chapter 8 Questions 1. The financing decision refers to how a firm will pay for its assets, with debt or equity. The investment decision is which assets a firm chooses to invest in. The other side of the financing decision consists of equity holders and debtholders. The other side of the investing decision is made up of the entities that have sold assets to the firm. 2. If the IRR of a project exactly equals the cost of capital, the NPV will be zero. 3. Present value depends on the amount of the future cash flows and the cost of capital. 4. Operating leverage is the mix of fixed and variable costs required to produce a product or service. Financial leverage is the mix of debt and equity used in financing an asset. 5. A firm may be able to raise the expected future cash flows of a project by switching to a heavily automated process with a higher operating leverage than the current process. The new process would be more risky and the present value of the cash flows could be exactly the same given the raise in the cost of capital. 6. The firm is selecting projects that have an IRR greater than the single discount rate. The projects with higher IRRs are riskier projects. If the firm is only selecting these projects, it will become riskier over time. 7. Operating risk is the risk associated with a firm’s choice between fixed and variable production costs. It is different from financial risk in that it is unique for each of the firm’s investments and affects both the diversifiable and nondiversifiable risk of the firm. It therefore affects a project’s beta and its cost of capital. Sometimes a firm has little choice in choosing its operating leverage, thus making operating risk very difficult to manage. 8. In order to compute the NPV of a project, it is first necessary to compute the required return for the project. The required return can be found by looking at firms with operations similar to the project. The stock betas of these firms should be adjusted to asset betas and averaged. The required return can then be found using the average asset beta and the project market line. Finally, the NPV is calculated by discounting the project’s future cash flows by the required return. Challenging Questions 9. Even though the expected return is less than the weighted average cost of capital, the project does not have a negative NPV. In fact, this purely financial investment would have a zero NPV because of the principle of capital market efficiency. The problem is that the project’s cost of capital must be adjusted for the risk of the project. It should not be based on the weighted average cost of capital of the entire firm unless the project’s risk is similar to the risk of the firm as a whole. In this case, the WACC is irrelevant. 10. The firm should go ahead with the investment.
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