Chapter 11
What does WACC represent?
The firm’s average required return on invested capital (weighted by debt/equity) used to discount free cash flows of average-risk projects.
Define incremental cash flows.
With-project CF − without-project CF (after tax); only changes caused by the project.
True/False: Higher risk can reduce cash flows and therefore financing capacity.
True. Risk can erode CFs and stakeholder support; value is mainly via cash flows.
What’s the core criticism of variance/σ² as “risk”?
It penalizes upside and downside equally; investors care more about shortfalls than windfalls.
Who typically uses the judgmental risk approach?
Firms without reliable market data (private companies/early-stage units) managers adjust the discount rate based on experience.
Pre-tax or after-tax cash flows in capital budgeting? Why?
After-tax, because taxes are real cash outflows that affect investor value.
Why does trust in sustainable firms matter most in downturns?
In downswings, stakeholders’ support is most fragile; trust stabilizes CFs (customers, employees, investors), cushioning shocks.
Define the benchmark B used for downside risk.
A required threshold, typically WACC (or 0% for returns) against which shortfalls are measured.
Name two mistakes to avoid when estimating equity risk premiums.
Mixing nominal vs. real series, using geometric vs. arithmetic in the wrong context, survivorship bias, too short or mismatched sample periods, failing to align market and risk-free definitions.
In which aspect is stand-alone risk reflected?
In the volatility of the project’s CFs/NPV (σ, Coefficient of Variation) — not in the discount rate.
What’s Edmans’ main message for valuation focus?
Focus on growing and protecting cash flows (not just tweaking discount rates); CFs drive value.
Name the two standard downside metrics.
Downside frequency (% of outcomes < B) and average shortfall (mean of B − outcome given outcome < B).
One limitation of CAPM beta.
Unstable/estimation error in beta (depends on window/index), assumes single factor, ignores idiosyncratic frictions, may misprice in practice.
Three “relevance” rules for identifying cash flows.
Exclude sunk costs; include opportunity costs; include externalities (cannibalization/synergies) after tax and at the right timing.
Give two channels through which corporate purpose can protect CFs.
Customer loyalty, employee engagement/retention, supplier resilience, regulator goodwill, investor base breadth.
Decision rule when comparing two similar-NPV projects using downside metrics.
Prefer the project with lower downside frequency and/or smaller average shortfall, consistent with risk appetite.