A project’s cash flow = Net income of project + Depreciation

In the DCF (discounted cash flow) equation, CFo is the cash inflow from the financing source at t=0, CFt is the cash outflow at time to the investors. The cash outflows can be interest or coupon payments, principal repayments and dividend payments according to the capital component employed. The cost of the capital component is denoted by k, which is the discount rate in the above equation. The correct answer is A.

Firms can either borrow from financial intermediaries such as banks or they can issue corporate bonds to raise debt financing. Debt financing occurs when a firm raises money for working capital or capital expenditures by issuing corporate bonds to raise debt financing. 

Debt securities are typically called notes, debentures, or bonds depending on their peculiarities. Despite the fact that a bond is a secured debt, it generally refers to all kinds of secured and unsecured debt. The difference between notes and bonds is the original maturity. Issues with an original maturity of 10 years or less are often called notes, longer-term issues are called bonds.

As can also be understood from the information given the statements “Debt securities are typically called notes, debentures, or bonds depending on their peculiarities.”, “Long-term debt can be issued in two different forms, public-issue and privately-placed.” and “Although the major terms and conditions are the same, under privately placed issues all of the bonds are sold to a single lender, not offered to the public.” are correct, so the correct answer is C.

The statements “Issues with an original maturity of 10 years or less are often called bonds” and “Longer-term issues are called notes.” are not correct. . Issues with an original maturity of 10 years or less are often called notes, longer-term issues are called bonds.

Every business requires capital to invest. Therefore, capital is the most important factor of production and the cost of capital is the most significant determinant in investment decisions. The cost of capital is the average cost of the capital mix (the mix of debt and equity in financing decisions). The correct answer is A.

The main medium and long term funding provided by banks are in the form of Project Finance. Project finance is the process of financing a specific economic unit that the sponsors create, in which creditors share much of the venture’s business risk and funding is obtained strictly for the project itself. Therefore, the correct option is B.

The net income approach advocates that a firm can boost its value by lowering its WACC, which is possible by increasing financial leverage in its capital structure. In this approach, it is assumed that the cost of debt is always less than the cost of equity and that the increase in the debt ratio does not lead to a change in the risk perception of the investors. The correct answer is C.

The net income approach advocates that a firm can boost its value by lowering its he weighted average cost of capital-WACC, which is possible by increasing financial leverage in its capital structure. In this approach, it is assumed that the cost of debt is always less than the cost of equity and that the increase in the debt ratio does not lead to a change in the risk perception of the investors.

The cost of each capital component is weighed at the proportions in the capital structure to quantify the firm’s WACC.

, where wD is the weight of debt financing in the capital structure, kD is the cost component of debt funds, T is the tax rate, accordingly wPS is the weight of preferred stocks, kPS is its cost component, wCE is the weight of common equity and kCE is the cost of equity capital. Therefore;

WACC=0.40*0.10*(1-0.35)+0.30*0.20+0.60*0.12=0.1580

As it can be seen from the above calculation the WACC for A & B is 15.80%. The correct answer is A.

If this corporation raises $100,000 as equity, there is no interest payment and the company pays $3,000 corporate taxes. However, in case of borrowing $100,000 at an interest rate of 5%, ABC pays $5,000 of interest which is deducted from the earnings which results in $1,500 of tax payments. By paying $5,000 interest, ABC waives from $1,500 tax payment. Therefore, the real cost of borrowing is $5,000-$1,500 which is $3,500. This can also be observed by the difference in the net income between the two financing options:

To measure a project’s risks coming from various sources rather than in general manner, further analysis is needed. Sensitivity, scenario and simulation and decision tree analyses are used for this purpose. Real options approach, however, refers to the options of managers about capital investment projects which can be priced by using stock option-pricing. The correct answer is B.

Preferred stocks;

• are issued without a maturity (I),
• resemble to bonds in some ways, in others to common stocks (III),
• require preferred dividends to be paid out before the dividends to common stockholders (IV).

However, in preferred stocks, the stockholder receives fixed preferred dividends that are not deductible. The correct answer is D.

A traditional approach is an intermediate model, compromising between the net income approach and the net operating income approach. Traditional approach assumes an optimal capital structure where the WACC is minimized and the value of the firm is maximized. The model suggests that up to a certain level of leverage, the use of debt financing reduces the WACC, but after that optimal level, the WACC escalates depressing the firm value. The cost of debt remains constant more or less up to a certain level, however, above that level, interest rate rises with the increase in the likelihood of financial distress.

With revolving credits, a limit of credit is set on the credit account of the borrower and both limits of credit and the due date are determined in a loan agreement. From concluding a loan contract till maturity date the borrower can draw the credit repeatedly within the limit. The bank overdraft is based on the same principle as the revolving loans, but the limit of the credit is set as a debit of a company’s current account. The correct answer is D.

Pre-emptive right: Equity shareholders have pre-emptive rights. The pre-emptive right is the legal right of the existing shareholders. It is attested by the company in the first opportunity to purchase additional equity shares in proportion to their current holding capacity. The correct answer is A.

Banks borrow from international bank loans at floating rates and the index is almost always the LIBOR (London Interbank Offered Rate). LIBOR is a benchmark rate that represents the interest rate at which banks offer to lend funds to one another in the international interbank market for short-term loans. LIBOR is an average value of the interestrate which is calculated from estimates submitted by the leading global banks on a daily basis. The correct answer is D.

In order to fund those uses, there exist two types of cash sources. Internal cash flow is generated from retained earnings and depreciation. External cash flow is generated from short-term borrowings and long-term debt and equity finance. As a general principle, short-term uses are proposed to be financed by short-term sources and vice versa. Long-term uses of cash are basically for funding the future of the company by new investments. Therefore, the correct option is E.

Firms may also raise external equity capital by issuing new shares. In this case, the firm will have to incur some flotation (transaction) costs which will eventually raise the cost of equity. In order to adjust the cost of equity to flotation costs, we use the following equation:

where F shows the flotation costs incurred during the issue of the new shares. By incorporating the flotation costs in the model, the rise in the cost of equity after new stock offerings is accounted for. The correct answer is B.

Advantages of Common Stock Common stock is the most common security to provide finance for the corporate. This way of financing has the following advantages:

Permanent sources of finance: Common stock is a long-term permanent nature of sources of finance; hence, it can be used for long-term or fixed capital requirement of the business.

No fixed dividend payment obligation: The issuance of common stock does not create any obligation to pay a fixed rate of dividend. If the company earns a profit, owners are eligible for profit, they are eligible to get dividend otherwise, and they cannot claim any dividend from the company.

Lower cost of capital: Cost of capital is the major factor, which affects the value of the company. A company with a strong capital base can secure funding less costly as the capital base is considered as a buffer for risks buy the debtors.

Retained earnings: When the company have more share capital, it will be suitable for retained earning which is the fewer cost sources of finance while compared to other sources of finance. 

The correct answer is C.