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Chapter: Chapter 03: Conservation of Value and the Role of Risk
True/False
1. The conservation of value principle states that anything that does not increase cash flows
does not increase value.
2. There are no exceptions to the principle of conservation of value.
3. Changes in accounting techniques that decrease reported profits will necessarily decrease
the value of a firm.
Multiple Choice
4. Which of the following most accurately describes the conclusion of Franco Modigliani and
Merton Miller as it relates to the conservation of value principle?
a) Managers can create value by adjusting the capital structure of a firm, which is congruous
with the conservation of value principle.
b) Managers cannot create value by adjusting the capital structure of a firm, which is congruous
with the conservation of value principle.
c) Managers can create value by adjusting the capital structure of a firm, which is a violation of
the conservation of value principle.
d) Managers cannot create value by adjusting the capital structure of a firm, which is a violation
of the conservation of value principle.
5. If one uses free cash flows to value a firm, then value may be created through a lower cost of
capital.
6. Because interest expense is tax deductible, share repurchases can have the beneficial effect
of increasing earnings per share, which will definitely lead to a share price increase.
7. Firms should engage in share repurchases only if they do not have available investments with
sufficiently high ROIC.
8. Which of the following is true concerning the practice of repurchasing shares when the
managers correctly determine that the price of the stock is low?
a) The practice does not benefit either the stockholders who do not sell or those who do sell.
b) The practice benefits the stockholders who do sell more than those who do not sell.
c) The practice benefits stockholders who do not sell and those who do sell equally.
d) The practice benefits the stockholders who do not sell more than those who do sell.
9. Studies of share repurchases have shown that companies are very good at timing share
repurchases.
10. Which of the following is NOT true concerning application of the conservation of value
principle to acquisitions?
a) An acquisition will create value if it increases cash flows sufficiently by reducing costs.
b) An acquisition will create value if it increases cash flows sufficiently by increasing revenue
growth.
c) An acquisition will create value if it increases cash flows sufficiently by improving the use of
fixed or working capital.
d) An acquisition will create value if it grows revenues.
11. Multiple expansion is one way that firms can create value through acquisitions.
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12. Financial engineering includes the use of derivatives, structured debt, securitization, and
off–balance-sheet financing. In some cases financial engineering can create value.
13. The primary way that financial engineering can create value is by lowering firm taxes.
14. A company cannot create value through sale-leaseback transactions.
15. Risk enters valuation both through a company’s cost of capital and through its cash flows.
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16. Investors demand returns for nondiversifiable risks only.
17. Diversifiable or firm-specific risks, such as the ability to retain talented management and
rising input costs, affect a company’s cost of capital.
18. Since diversifiable risks are not priced into the cost of capital, executives can ignore such
risks.
19. Managers should hedge cash flow risk whenever possible.
20. Managers should hedge risks in their core business, as this helps eliminate some risk to
investors without any reduction in returns.
