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FIN435 Second Midterm Part I — Concept Review Guide

This version is designed for study use. It focuses on the ideas students should understand, not on giving away the actual exam wording.

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Study the idea first.
Then check what you should know.
Then review the common confusion.
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Focus: WACC, capital budgeting, project cash flow, terminal value, and simulation ideas that match the second midterm Part I topics.

Chapter 10 WACC and Cost of Capital

Big picture

Know what WACC measures, why debt gets an after-tax adjustment, how capital structure can affect WACC, and why discount rates and values move in opposite directions.

Key terms

WACC
Cost of debt
After-tax cost of debt
Cost of equity
Capital structure
Tax shield
Credit quality
Market-value weights
Coupon rate vs current yield

Main equations

Idea	Equation / meaning
WACC	`WACC = wd·Kd(1 − T) + we·Ke`
After-tax debt cost	`Kd,after-tax = Kd(1 − T)`
Value effect	Lower discount rate → higher PV; higher discount rate → lower PV

1) What WACC really represents

Students should understand this as the firm’s blended required return from long-term financing.

What to know

WACC is not just one rate taken from nowhere. It combines debt and equity costs using financing weights, and it is commonly used to discount average-risk project cash flows.

Common confusion

Treating WACC as only the borrowing rate, or forgetting that equity is part of the cost of capital too.

2) Why debt is adjusted for taxes

Students should be able to explain the debt tax shield in words.

What to know

Interest expense usually reduces taxable income, so the effective cost of debt to the firm is lower than the before-tax borrowing rate.

Common confusion

Using debt cost before tax inside WACC when the setting is standard corporate finance.

3) Current cost of debt versus old coupon rate

Students should know that investors care about today’s required return, not the historical coupon printed on an old bond.

What to know

The coupon rate is a contract rate from issuance. The relevant debt cost for WACC is the current yield required for the firm’s debt risk.

Common confusion

Plugging the coupon rate directly into WACC without checking whether the question is asking for the current cost of debt.

4) Debt, equity, and risk

Students should be comfortable with the usual ranking of financing costs and why it happens.

What to know

Equity usually has a higher required return than debt because shareholders take greater risk as residual claimants.

Common confusion

Assuming equity should be cheaper because no interest payment is legally required.

5) Capital structure and WACC

Students should know that financing mix matters.

What to know

Changing the debt-equity mix can change WACC. Using more debt can lower WACC for a while because debt is often cheaper and gets a tax shield, but too much debt raises financial risk.

Common confusion

Thinking more debt always helps, or thinking the financing mix has no effect on WACC.

6) Credit quality and borrowing cost

Students should connect better credit to lower debt cost.

What to know

If the firm’s credit quality improves, lenders usually require a lower return, so the debt portion of WACC tends to fall.

Common confusion

Reversing the direction and assuming better credit must increase WACC.

7) WACC as a discount rate

Students should know when it is appropriate to use WACC.

What to know

WACC is the standard discount rate for average-risk projects. It represents the required return investors demand from the firm’s normal operations.

Common confusion

Using the same WACC for a project that is much safer or much riskier than the firm’s normal business.

8) Discount rates and valuation

Students should be able to explain the direction of the relationship without doing a full computation.

What to know

When the discount rate rises, present values fall. When the discount rate falls, present values rise.

Common confusion

Forgetting that the relationship is inverse.

Chapter 11 Capital Budgeting Rules

Big picture

Know what NPV, IRR, MIRR, payback, discounted payback, and crossover rate mean. The key logic is value creation, not just a percentage return.

Key terms

Net present value (NPV)
Internal rate of return (IRR)
Modified IRR (MIRR)
Independent projects
Mutually exclusive projects
Payback
Discounted payback
Crossover rate

Main equations

Idea	Equation / meaning
NPV	`NPV = Σ [CFt / (1+r)^t]`
IRR	Discount rate that makes NPV equal zero
MIRR	`(FV of positives / PV of negatives)^(1/n) − 1`
Crossover rate	Discount rate where two projects have the same NPV

1) Why NPV gets special emphasis

Students should see NPV as the main value-creation rule.

What to know

A positive NPV means the project earns more than the required return and adds value to the firm. A negative NPV means value is destroyed.

Common confusion

Thinking a project should be rejected just because the NPV is small in dollar size even though it is positive.

2) What IRR means

Students should know IRR as a break-even required return.

What to know

IRR is the discount rate that makes NPV equal zero. For a normal independent project, NPV and IRR often lead to the same accept-reject decision.

Common confusion

Treating IRR as a dollar amount, or assuming NPV and IRR can never disagree.

3) NPV versus IRR for mutually exclusive choices

Students should understand why the project with the higher percentage return is not always the better choice.

What to know

When only one project can be chosen, NPV is usually preferred because it directly measures total dollar value added.

Common confusion

Automatically picking the project with the larger IRR.

4) MIRR and reinvestment thinking

Students should know why MIRR is sometimes used instead of IRR.

What to know

MIRR handles reinvestment assumptions more cleanly and avoids some of the interpretation problems associated with IRR.

Common confusion

Saying IRR and MIRR must always be the same measure.

5) Payback versus discounted payback

Students should distinguish these two rules clearly.

What to know

Regular payback ignores time value of money. Discounted payback uses discounted inflows, so it does reflect time value of money.

Common confusion

Saying both methods ignore discounting, or forgetting that both still ignore later cash flows after the recovery point.

6) What payback leaves out

Students should be able to explain the main weakness in plain language.

What to know

Payback focuses on how quickly the initial outlay is recovered. It does not reward large cash flows that happen after the cutoff has been reached.

Common confusion

Using payback as if it were a full measure of value creation.

7) Crossover rate

Students should know what becomes equal at that rate.

What to know

The crossover rate is the discount rate at which two projects have the same NPV.

Common confusion

Confusing “same NPV” with “same IRR.”

8) Discount rate and NPV direction

Students should know the usual slope for a conventional project.

What to know

For a conventional project, increasing the discount rate usually lowers NPV because future cash inflows are discounted more heavily.

Common confusion

Thinking a higher discount rate should automatically make NPV larger.

Chapter 12 Project Cash Flow, Terminal Value, and Simulation

Big picture

Know how to build project cash flows correctly, what belongs in terminal year cash flow, how free cash flow works, and what simulation results are trying to show.

Key terms

Initial outlay
Operating cash flow (OCF)
Free cash flow (FCF)
Depreciation tax shield
Net working capital
Terminal cash flow
Salvage value
Terminal value
Operating leverage
Monte Carlo simulation
Histogram

Main equations

Idea	Equation / meaning
Operating cash flow	`OCF = EBIT(1 − T) + Depreciation`
Initial outlay idea	Equipment + installation + required net working capital
Terminal year cash flow	After-tax salvage + recovery of working capital
Terminal value idea	`TV = FCF(next year) / (r − g)` in a constant-growth setting

1) Free cash flow and who it belongs to

Students should know the audience for FCF.

What to know

Free cash flow is the cash left from operations after necessary operating and investment needs. It is available to all investors in the firm, not just shareholders.

Common confusion

Treating free cash flow as the same thing as net income or dividend cash flow.

2) What belongs in the initial outlay

Students should know the major up-front pieces.

What to know

Initial outlay usually includes equipment cost, installation cost, and any additional working capital needed at the start of the project.

Common confusion

Leaving out installation or working capital because those items do not look like part of the asset price.

3) Operating cash flow versus capital spending

Students should separate operating performance from investment outlays.

What to know

Operating cash flow measures after-tax operating cash generation. Capital expenditures reduce total project cash flow, but they are not part of operating cash flow itself.

Common confusion

Subtracting capital spending inside OCF as if it were an operating expense.

4) Why depreciation still matters

Students should understand the non-cash but tax-relevant role of depreciation.

What to know

Depreciation is not a cash outflow, but it lowers taxable income. That is why it is added back when computing OCF after tax.

Common confusion

Dropping depreciation entirely and forgetting the tax shield effect.

5) Working capital through the life of the project

Students should know both the up-front use of cash and the final recovery.

What to know

When a project ties up cash in inventory, receivables, or operating balances, that is a cash outflow. When the project ends, that working capital is usually recovered.

Common confusion

Including the initial working-capital investment but forgetting the final recovery.

6) Terminal year cash flow

Students should know the main pieces that often appear at the end.

What to know

Terminal year cash flow often includes after-tax salvage value plus recovered working capital.

Common confusion

Including only the sale of the asset and leaving out working-capital recovery.

7) Terminal value in a DCF setting

Students should understand the constant-growth idea conceptually.

What to know

If cash flows are assumed to continue beyond the explicit forecast period at a constant growth rate, terminal value is often estimated with the Gordon growth idea using next-period cash flow.

Common confusion

Using the wrong cash flow year or forgetting that the growth version requires a stable long-run growth assumption.

8) Operating leverage and forecast sensitivity

Students should connect fixed costs to cash-flow risk.

What to know

Higher fixed costs make project outcomes more sensitive to changes in sales, so operating leverage affects cash-flow estimation and risk.

Common confusion

Thinking operating leverage has no effect on project risk or forecast variation.

9) What Monte Carlo simulation is trying to do

Students should understand the purpose before worrying about mechanics.

What to know

Monte Carlo simulation explores uncertainty by allowing key inputs to vary over many trials. It helps show a range of possible outcomes rather than one single forecast.

Common confusion

Thinking simulation gives one guaranteed answer or replaces judgment about assumptions.

10) Random sampling, histograms, and result ranges

Students should know how to interpret the output at a basic level.

What to know

Simulation uses random draws for uncertain inputs. A histogram shows how often results fall into different ranges, and minimum/maximum values help show the spread of possible outcomes.

Common confusion

Treating the minimum or maximum result as a forecast instead of as part of a broader risk picture.

Last review What students should be ready to explain

In words:
What WACC is, why debt is after tax, why NPV is preferred for value creation, how payback differs from discounted payback, and what terminal cash flow includes.

In logic:
Why higher discount rates lower values, why more debt does not always lower WACC forever, why depreciation matters even though it is non-cash, and why simulation does not guarantee a prediction.

In formulas:
WACC, NPV, IRR meaning, MIRR idea, OCF, and the constant-growth terminal value idea.