Saint Leo University Business Corporate Finance Questions

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In Chapter 18, Berk and DeMarzo (2020) illustrate the differences between the three main methods that corporations use for capital budgeting with leverage and within imperfect markets, which are: (a) The Weighted Average Cost of Capital (WACC) method, (b) The Adjusted Present Value (APV) Method, and (c) The Flow-to-Equity (FTE) Method. Compare and contrast the three different methods that we use for capital budgeting and highlight each method’s strengths and weaknesses.

In Berk and DeMarzo (2020) the authors’ interview David Holland, who at the time was a Senior Vice President and Treasurer of Cisco, in that interview he states that Cisco uses ‘robust NPV analysis,’ which means that the company integrates sensitivity and scenario analysis into their NPV calculations. Provide a simple example of a project and indicate how you might implement both a sensitivity and scenario analysis into your project’s evaluation.  Include at least two citations that support your response.

Figures 15.7 and 15.9 in Berk and DeMarzo (2020) highlight a couple of interesting findings. The first is that certain industries are more likely two have firms that utilize more debt or leverage in their capital structures when compare against others, why is this? Second, firms tend to underutilize debt, which led some to believe that they are not acting in the firm’s best interest and maximizing firm value; the counterpoint is that increased leverage leads to greater financial distress and by avoiding financial distress they are maximizing firm value. Take one side of this argument and defend that perspective.

1. Two other interesting points brought up by Miller and Modigliani, as highlighted in Berk and DeMarzo (2020) were that “In perfect capital markets, investors are indifferent between the firm distributing funds via dividends or share repurchase” (p. 612) and that “In perfect capital markets, holding fixed the investment policy of a firm, the firm’s choice of dividend policy is irrelevant and does not affect the initial share price” (p. 614). Respond to this question by focusing on either dividend payout policy or the decision between stock repurchases and dividend payouts and illustrate how the assumptions made to support these axioms tend to oversimplify what occurs.
2. When exploring the Weighted Average Cost of Capital (WACC) we were introduced to the fundamental components that firms use to estimate their hurdle rate. Berk and DeMarzo (2020) interviewed Shelagh Glaser, the then VP of finance and the controller at the Client Computing Group at Intel about their WACC estimates (see page 434). In this interview, she highlighted the inputs that her firm uses to calculate their WACC and provides numerous examples of inputs that they must consider when they re-estimate their WACC each year. Highlight two of these inputs and indicate how changes in these inputs are likely to impact Intel’s hurdle rate; in addition, illustrate how these changes impact the projects that a firm accepts. Include at least two citations that support your response.
3. Two of the ‘workhorses’ of capital budgeting are the Net Present Value (NPV) and the Internal Rate of Return (IRR) calculation. In practice, we rely on the NPV calculation to make our decisions; however, the IRR calculation is a useful calculation to employ when we attempt to compare projects. Highlight the three potential pitfalls that Berk and DeMarzo (2020) outline and illustrate with an example how each of these issues would lead managers to make incorrect decisions about accepting a project. Include at least two citations that support your response.
4. In Chapter 18, Berk and DeMarzo (2020) illustrate the differences between the three main methods that corporations use for capital budgeting with leverage and within imperfect markets, which are: (a) The Weighted Average Cost of Capital (WACC) method. Compare and contrast the three different methods that we use for capital budgeting and highlight each method’s strengths and weaknesses.
5. Berk and DeMarzo (2020) indicate that “With perfect capital markets, financial transactions neither add nor destroy value, but instead represent a repackaging of risk (and therefore return)” (p. 515). Outline the general ideas embedded in the Miller and Modigliani propositions I and II and defend them but highlight any noteworthy caveats. Include at least two citations that support your response.