Academic Finance Questions and Answers

DCF valuation converts expected future cash flows into today's value using a discount rate that reflects risk.

1. Expected future free cash flows discounted at an appropriate rate
2. Historical revenue only
3. Book value of inventory only
4. Last year's net income with no adjustments

CAPM estimates required equity return as compensation for time value plus systematic risk.

1. Risk-free rate plus beta times market risk premium
2. Dividend divided by total assets
3. Current assets minus current liabilities
4. Coupon divided by par value only

Positive NPV indicates the project is expected to add value after considering the cost of capital.

1. Present value of expected benefits exceeds present value of costs
2. Accounting profit is negative
3. Payback period is always zero
4. Book value equals market value

IRR solves for the rate at which discounted inflows equal discounted outflows.

1. Makes NPV equal zero
2. Maximizes accounting revenue
3. Eliminates all business risk
4. Equals the tax rate

WACC blends the after-tax cost of debt and required equity return based on target capital structure.

1. The required return for providers of capital
2. Only the coupon rate on old debt
3. The inflation rate published by government
4. The gross profit margin

Interest deductibility can reduce the effective cost of borrowing, depending on tax rules.

1. Interest expense may provide a tax shield
2. Debt holders require no return
3. Taxes increase coupon payments
4. Equity becomes risk-free

FCFF is available to debt and equity holders after operating needs and reinvestment.

1. All capital providers before debt payments
2. Only common shareholders after dividends
3. Only suppliers before sales
4. Only tax authorities

FCFE accounts for interest, debt repayment, and new borrowing effects relevant to equity holders.

1. Reflects cash available to common equity after debt effects
2. Ignores net income entirely
3. Always equals revenue
4. Excludes working capital forever

The Gordon growth form assumes stable growth below the discount rate.

1. Next cash flow divided by discount rate minus growth rate
2. Current assets divided by liabilities
3. EBIT multiplied by tax rate
4. Revenue minus depreciation only

Duration summarizes timing of cash flows and interest-rate sensitivity.

1. Sensitivity of price to changes in yield
2. Probability of dividend growth
3. Inventory turnover speed
4. Tax filing frequency

Existing lower-coupon bonds become less attractive when new bonds offer higher yields.

1. Falls
2. Rises without limit
3. Becomes par automatically
4. Has no relation to yields

Duration is a linear approximation, while convexity adjusts for curvature.

1. Curvature in the price-yield relationship
2. Only coupon payment dates
3. Accounting depreciation
4. Dividend payout ratio

YTM is an internal-rate-style estimate based on stated cash flows and reinvestment assumptions.

1. Coupons are reinvested at the YTM and bond is held to maturity
2. Coupons are never received
3. Default is guaranteed
4. Price volatility is zero

Return comes from buying below face value and receiving face value at maturity.

1. It pays no periodic coupon before maturity
2. It has no maturity date
3. It is always default-free
4. It pays dividends monthly

Systematic risk is market-wide risk and is central to CAPM beta.

1. Cannot be fully diversified away in broad markets
2. Disappears by holding one stock
3. Only affects one company's factory
4. Is always zero for equities

Firm-specific risk becomes less dominant in a diversified portfolio.

1. Diversification across securities
2. Increasing concentration in one stock
3. Ignoring correlation
4. Using book value only

Correlation determines how assets move together and affects diversification benefits.

1. Covariances or correlations among returns
2. Only company logos
3. Only dividend dates
4. Only accounting revenue

Perfect negative correlation can create strong risk reduction when combined properly.

1. Perfect negative co-movement
2. No relationship
3. Perfect positive co-movement
4. Guaranteed positive return

Beta estimates systematic risk relative to the market portfolio.

1. Sensitivity to market movements
2. Total sales growth
3. Cash balance only
4. Accounting tax rate

Sharpe ratio compares risk premium to standard deviation.

1. Total volatility
2. Book equity
3. Taxable income
4. Dividend yield only

Efficient portfolios dominate inferior risk-return combinations.

1. Offer maximum expected return for a given risk level
2. Always have zero risk
3. Use only one asset
4. Ignore expected returns

WACC should reflect the opportunity cost of capital at current market values.

1. They reflect current investor-required capital proportions
2. They are easier to hide
3. They equal historical book costs
4. They ignore equity value

Leverage magnifies equity returns when asset returns exceed financing costs.

1. Return on assets exceeds after-tax borrowing cost
2. Debt is always free
3. Assets earn less than debt cost
4. Equity is negative by law

In perfect markets without taxes and frictions, financing mix does not create value by itself.

1. Capital structure under strict assumptions
2. Operating cash flow
3. Investment policy
4. Market competition

Debt can add tax shields but also increases expected distress costs.

1. Tax benefits of debt against distress and agency costs
2. Revenue against inventory only
3. Dividends against depreciation
4. Cash against logo value

Information asymmetry can make managers prefer less information-sensitive financing.

1. Internal funds, then debt, then equity
2. Equity, then debt, then cash
3. Only preferred stock
4. Only convertible bonds

The current ratio is a short-term liquidity measure, though quality of assets still matters.

1. Current assets exceed current liabilities
2. Inventory is zero
3. Debt is risk-free
4. Revenue is guaranteed

ROIC helps assess whether operations earn more than the cost of capital.

1. Capital invested in the business
2. Only cash dividends
3. Only sales discounts
4. Only tax credits

EBITDA is a proxy for operating performance before financing, taxes, and non-cash charges.

1. Interest, taxes, depreciation, and amortization
2. Revenue and cash
3. Inventory and sales
4. Assets and liabilities

Accrual accounting separates economic earning from cash timing.

1. Earned under accounting rules, not necessarily when cash is received
2. Cash is always collected first
3. Taxes are paid
4. Inventory is discarded

More working capital often requires cash investment before collection.

1. Cash is tied up in receivables or inventory
2. Depreciation becomes cash income
3. Debt vanishes
4. Revenue is illegal

High fixed costs make profits more sensitive to sales changes.

1. High fixed costs relative to variable costs
2. No fixed costs
3. Only cash sales
4. No break-even point

A put is valuable when downside protection or bearish exposure is desired.

1. Sell the underlying at the strike price
2. Buy the underlying at any price
3. Receive all company dividends
4. Avoid all losses always

A call provides upside exposure with limited premium risk.

1. Buy the underlying at the strike price
2. Sell the underlying at book value
3. Force dividend payment
4. Cancel volatility

Delta is a first-order price sensitivity measure.

1. Change in underlying asset price
2. Change in company inventory
3. Change in accounting policy only
4. Change in tax filing date

Vega estimates how option value changes when implied volatility changes.

1. Implied volatility
2. Dividend payout date only
3. Book value changes
4. Credit score changes

Forwards are usually customized OTC contracts, while futures are standardized and exchange-traded.

1. Private OTC agreements customized between parties
2. Always exchange-traded daily settled contracts
3. Risk-free government securities
4. Equity shares

FX hedging uses instruments or matching cash flows to reduce currency uncertainty.

1. Reducing risk from currency movements
2. Increasing all currency risk
3. Ignoring exchange rates
4. Guaranteeing profit on every trade

Covered interest parity connects spot, forward, and interest rates under no-arbitrage.

1. Interest rate differences between currencies
2. Only stock dividends
3. Only inflation reports
4. Only accounting depreciation

Pure arbitrage is a no-net-investment opportunity in theory, though real markets include frictions.

1. Exploiting price differences without net risk under ideal conditions
2. Taking unlimited directional risk
3. Buying only losing assets
4. Ignoring transaction costs always

Agency theory studies conflicts between principals and agents.

1. Managers and shareholders may have conflicting incentives
2. All firms have no owners
3. Taxes are zero
4. Bonds have no covenants

The ratio shows how much of earnings are distributed rather than retained.

1. Dividends relative to earnings
2. Debt relative to assets only
3. Cash relative to inventory
4. Tax relative to revenue only

Fewer shares can raise earnings per share if net income is unchanged.

1. Shares outstanding decrease, all else equal
2. Revenue becomes zero
3. Debt holders receive equity
4. Taxes disappear

EVA evaluates whether returns exceed the cost of capital.

1. Operating profit exceeds the charge for capital used
2. Accounting revenue is lower than wages
3. Book value equals zero
4. Debt coupon is unpaid

Value creation depends on net benefits, not deal size.

1. Synergy and strategic benefits exceed acquisition premium and integration costs
2. The buyer always pays more
3. Accounting goodwill is large
4. The deal is announced publicly

It identifies which assumptions most affect a model.

1. See how valuation or NPV responds
2. Guarantee the base case
3. Avoid uncertainty
4. Remove all risk

Scenarios combine assumptions such as recession, base, and expansion cases.

1. Changes multiple assumptions together in coherent cases
2. Only changes one input
3. Deletes the model
4. Uses no assumptions

Monte Carlo methods repeatedly sample assumptions to estimate outcome distributions.

1. Model many possible outcomes from uncertain variables
2. Guarantee the correct forecast
3. Replace all data
4. Avoid probability

Illiquid assets can require discounts or time to convert to cash.

1. An asset may be hard to sell quickly without price concession
2. The asset always loses all value
3. Cash is illegal
4. Debt has no maturity

Credit risk concerns default or deterioration in borrower quality.

1. Risk that a borrower or issuer fails to meet obligations
2. Risk that stock prices rise
3. Risk that cash earns interest
4. Risk that taxes are withheld

The sustainable growth model connects profitability and reinvestment under stable assumptions.

1. ROE multiplied by retention ratio
2. Dividend yield divided by price only
3. Debt divided by tax rate
4. Cash divided by coupon