BEC 6 - Ops Mgmt: Process, Ops Mgmt: Project, Globalization, Financial Risk Mgmt, Financial Decisions, Financial Valuation, Internal Audit

Question 1

Globalization: How is globalization measured?

Answer 1

World trade as a percent of GDP

Question 2

Globalization: List the factors that drive globalization.

Answer 2

1) reduced barriers to trade
2) improvements in transportation
3) deregulation of international financial markets
4) organizational/operational options for international business

Question 3

Globalization: List the motivation for international business operations.

Answer 3

Goal: maximize shareholder value

1) comparative advantage/specialization
2) imperfect markets
3) product cycle

Question 4

Globalization: List the methods of conducting international business operations

Answer 4

1) international trade (import/export)
2) licensing
3) franchising
4) joint ventures
5) direct foreign investment
6) global sourcing (combination)

Question 5

Globalization: List 3 inherent risks of international business operations.

Answer 5

1) Exchange rate fluctuations
2) Foreign economies
- foreign demand
- interest rates
- inflation
- exchange rate
3) Political Risks
- bureaucracies
- corruption
- host govt/consumer attitude
- war

Question 6

Globalization: List the relevant factors of globalization

Answer 6

1) Political and legal
2) Asset expropriation potential
3) Taxes and Tariffs
4) Limits on asset ownership or joint venture
5) Content or value-added limits (Sourcing Requirements)
6) Foreign trade zones
7) Economic systems
8) Culture

Question 7

Globalization: List the complications of global sourcing

Answer 7

1) multiple sources for materials
2) multiple exchange rates
3) international accounting practices

Question 8

Globalization: Define “National Power”

Answer 8

1) geography
2) population
3) resources
4) economy (% of world GDP)
5) military
6) diplomacy
7) identity

Question 9

Globalization: List the 2 types of interdependencies created by globalization

Answer 9

1) functional (participation)

2) systemic

Question 10

Globalization: Describe “Balance of Power” Theory

Answer 10

• No single nation or group dominates
• Unipolar shifts to multi-polarity
• bandwagon behavior shifts to balancing
• Emerging nations: (BRIC) trade surplus (export > import) and artificially low foreign currency value
• Developed nations: trade deficit (export < import)

Question 11

Globalization: List the key factors of Economic Systems within globalization

Answer 11

1) centrally planned economies
2) market economies
3) conglomerates (illegal in U.S.)

Question 12

Globalization: List the issues of Culture within globalization

Answer 12

1) individualism vs. collectivism
2) uncertainty
3) short-term vs. long-term orientation
4) acceptance of leadership hierarchy (trust)
5) technology and infrastructure

Question 13

Globalization: List the impact of the following within globalization -

1) foreign demand
2) interest rates
3) inflation
4) exchange rate

Answer 13

1) foreign demand: weakening may lead to increased tariffs
2) interest rates: higher IR indicate slower economic growth and reduced demand
3) inflation: high local inflation -> reduced purchasing power -> imported goods are more expensive -> reduced local demand
4) exchange rate: weak local currency reduced demand for imported goods

Question 14

Globalization: List the 4 emerging nations (BRIC)

Answer 14

Brazil, Russia, India, China

Question 15

Financial Risk Mgmt: List the 5 types of Financial Risk and specify if non/diversifiable

Answer 15

Nondiversifiable:

• Interest Rate (Yield/Maturity)
• Market (inherent)
• Purchasing Power/Inflation

Diversifiable:
- Liquidity (lender)
- Default (lender)
or Credit (borrower) (inability to secure financing or favorable credit terms)

Question 16

Financial Risk Mgmt: List the 3 risk-approaches and the value of the “certainty equivalent”

Answer 16

1) indifferent (seeks highest return) = certainty equivalent
2) averse: certainty equivalent < expected return
3) seeking: certainty equivalent > expected return

Question 17

Financial Risk Mgmt: List the relevant risk in Financial Risk Management

Answer 17

Nondiversifiable Risk

Question 18

Financial Risk Mgmt: List the 7 types of returns/yield measurements

Answer 18

1) Stated IR = rate shown in agreement

2) Effective IR (Periodic Rate)
= Interest Paid Per Period/Net Proceeds of Loan OR
Interest Paid Per Period = Principal x Periodic Rate

3) Annual Percentage Rate (multiply)
= Effective Periodic Rate x # Compounding Periods
= Annual Interest Paid / Net Proceeds of Loan

4) Effective Annual Percentage Rate (raise)
= [(1 + (i/p))^p] - 1 where
p = compounding periods per year and
i = stated interest rate

5) Simple Interest (only original amount)
= principal x annual rate per period x # of periods

6) Compound Interest
= principal x (1+rate)^# periods

7) Required Rate of Return: add the following to the risk free rate
- Maturity Risk Premium (MRP) (IR risk that increases with term to maturity)
- Purchasing Power Risk or Inflation Premium (IP) (used to calculate nominal RF)
- Liquidity Risk Premium (LP): risk demanded by lenders in case asset sold on short notice at deep discount
- Default Risk Premium (DRP): demanded by lenders

Question 19

Financial Risk Mgmt: List the factors influencing Exchange Rates

Answer 19

1) Trade:
- Relative Inflation Rates: currency with higher inflation loses values and thus demand for that currency and that currency’s value decreases
- Relative Income Levels: higher income increases demand for foreign currencies
- Government Controls: trade and exchange barriers

2) Financial
- Interest Rates and Capital Flows: investors seek fixed returns, currency with higher IR attracts investment and increases demand for that currency and the value of that currency

Question 20

Financial Risk Mgmt: Define the 3 types of risk associated with Exchange Rate Risk

Answer 20

1) Transaction Exposure: potential that an org. could suffer economic loss or gain upon the settlement of an individual transaction as a result of changes in economic rates
- currency variability

2) Economic Exposure: potential that present value of an organization’s cash flows could increase or decrease as a result of a change in exchange rate
- foreign currency appreciation or depreciation

3) Translation Exposure: risk that assets/liabilities/equity/income of consolidated organization that includes foreign subsidiaries will change as a result of changes in exchange rates
- degree of foreign involvement
- locations of foreign investments

Question 21

Financial Risk Mgmt: List the techniques for transaction exposure mitigation

Answer 21

1) Adjust invoice policies (time payments for imports with collections from exports)
2) Futures Hedge (AP buy/AR sell)
3) Forward Hedge (larger transactions, non-private)
4) Money Market Hedge (invest current value in foreign markets and let foreign market interest rates make up for difference or AR factoring)

5) Currency Option Hedge
- add premium to calculate AP net savings
- subtract premium to calculate AR net preserved value

6) Long-term transations:
- Forward Contracts
- Currency Swaps (2 firms w/ financial intermediary)
- Parallel Loan

7) Alternative Hedging Techniques
- Leading and Lagging (alter billing time)
- Cross-hedging (no derivative or illiquid)
- Currency diversification

Question 22

Financial Risk Mgmt: List the method for managing Economic and Translation Exposure

Answer 22

Restructuring:

• Decreases in sales (revenue) denominated in a foreign currency (if expect FC depreciate)
• Increase in expenses if denominated in foreign currency (if expect FC appreciate)

Note: more difficult to manage

Question 23

Financial Risk Mgmt: Describe Transfer Pricing

Answer 23

Goal: minimize local taxes while remaining in guidelines of law

Transfer prices (selling prices) set up to maximize consolidated benefit, reduce income in countries with higher taxes, maximize tax shield in countries with lower taxes.

Transfer selling prices in countries with higher taxes increases tax burden but also increase tax protection afforded to foreign subsidiaries operating in other countries, even if those subs have lower rates.

Pricing options:

1) cost (actual, standard, full (absorption))
2) market price (adjust if cost savings due to internal sale)
3) negotiated (floor = transferring divisions outlay + opportunity cost; ceiling = lowest external market price)

Inter-company cash transfers:

• strong cash position: leading (pay early)
• weak cash position: lagging (pay later)

Question 24

Financial Decisions: Define the 2 types of capitalization needs

Answer 24

1) Permanent Working Capital: long-term minimum needs

2) Temporary Working Capital: seasonal needs

Question 25

Financial Decisions: List the strategy, advantages, and disadvantages of short-term financing

Answer 25

Strategy: Anticipate higher levels of temporary working capital that require greater agility and flexibility. Advantages: 1) Increased liquidity (presume short-term financing used to buy short-term/highly liquid assets) 2) Increased profitability (rapid conversion of operating cycle) 3) decreased financing costs Disadvantages: 1) Increased Interest Rate Risk (not locked in) 2) Increased Credit Risk (lender evaluation of creditworthiness may change)

Question 26

Financial Decisions: List the strategy, advantages, and disadvantages of long-term financing

Answer 26

Strategy: anticipate higher levels of permanent working capital Advantages: 1) Decreased Interest Rate Risk 2) Decreased Credit Risk (reduced risk that refinancing may be denied) Disadvantages: 1) Decreased Profitability 2) Decreased Liquidity 3) Increased Financing Costs (higher rates) - Lenders face more risk of changing IR - Borrowers eliminate risk

Question 27

Financial Decisions: List 6 common financing intstruments

Answer 27

1. Working Capital Financing through Trade AP or Accrued Liabilities ("spontaneous: with expectation of maturity matching) 2. Letter of Credit (3rd party guarantee) 3. Line of Credit (loan from bank) 4. Leasing - Operating: off balance-sheet financing - Capital: seller finances "sale" of asset, asset/liability on B/S (a) sales agreement/legal: ownership changes hand or subject to bargain purchase option (b) in-substance: lessee uses up 75% life or pays 90% fair value 5. Debentures (unsecured) and Bonds - subordinated debentures: high risk, behind senior creditors - income bond: interest not fixed - junk bond: highest risk - mortgage bonds: protected from default by lien on asset 6. Equity - Preferred Stock (cumulative, participating, voting) - Common Stock: voting rights, last claim

Question 28

Financial Decisions: List the impact of new debt vs. new equity financing

Answer 28

1. Debt: - fixed cost with maturity date - decreases creditworthiness - no new owners, EPS increases 2. Equity - variable cost with no maturity (no guaranteed payment) - risk of financial distress decreases - increases creditworthiness - increased # owners = reduced EPS

Question 29

Financial Decisions: Why do borrowers agree to debt covenants? Why do lender require them?

Answer 29

Borrowers: secure a lower cost of borrowing on new debt Lenders: protect value of debt by protecting credit rating on debtor

Question 30

Financial Decisions: List 7 common debt covenants

Answer 30

1. limitations on issuing additional debt 2. restrictions on dividend payment 3. limitations on disposal of certain assets 4. minimum working capital requirements 5. collateral requirements 6. limitations on how the borrowed money can be used 7. maintenance of specific financial ratios: - Debt-to-Equity - Debt-to-Total-Capital (debt ratio) - Interest Coverage Ratio (Times Interest Earned)

Question 31

Financial Decisions: Define "Expected Value" and how it is used

Answer 31

Expected Value is a weighted average of all values and variables. It is used to address the issue of appropriate course of action in an environment of uncertainty. - Don't forget to include costs in calculation.

Question 32

Valuation: List the annuity formula and the key assumptions

Answer 32

``` Annuity PV = = FCF x (1 - Present Value Factor/Rate of Return) = FCF x (1 - [1/((1+r)^t)]/r) where FCF = equal future cash flows r = rate of return t = # of years ``` Assumptions: 1. recurring amount of the annuity (as payment increases = PV increases) 2. appropriate discount rate (as risk increases = PV decreases) 3. duration of the annuity (as # payments increases = PV increases) 4. timing of the annuity

Question 33

Valuation: List the perpetuity (zero growth stock) formula and the key assumptions

Answer 33

Per Share Value = stock value per share = P = D/R where P = price D = dividend (par x fixed %) R = required return Assumptions: 1. dividend will never change 2. specify required return

Question 34

Valuation: List the constant growth (dividend discount model) formula and the key assumptions

Answer 34

``` Per Share Value = P1 = D(t+1) / (R-G) Pt = current price (price period at t) D(t+1) = dividend one year after period "t" R = required return G = growth rate ``` Assumptions: 1. specify dividends one year beyond year in which you are determining price 2. specify required return 3. specify constant growth rate of dividend 4. implies stock price will grow at same RATE as dividend (valid) 5. assumes required rate of return > growth

Question 35

Valuation: List the P/E Ratio formula and how to calculate current stock price using this ratio

Answer 35

P/E ratio = P0 / E1 where P0 = price or value today based on future performance E1 = expected earnings in one year = E0 x (1 + G) Current Stock Price = E1 x P0/E1 Note: earnings must > 0 Note: high P/E ratio = low yield = implies high growth potential not reflected in today's earnings

Question 36

Valuation: List PEG ratio formula and how to calculate current stock price

Answer 36

``` PEG = (P0/E1)/G where P0 = price or value today E1 = expected earnings in one year G = growth rate = 100 x expected growth rate (note: NOT a %) ``` Current Stock Price = PEG x E1 x G

Question 37

Valuation: List the Price-to-Sales Ratio Formula and how to calculate current stock price. List when this ratio is used.

Answer 37

Use: earnings are low (negative), start-ups Price-to-Sales Ratio = P0 / S1 where P0 = price or value today S1 = expected sales in one year = S0 x (1 + G) Current Stock Price = (P0/S1) x S1

Question 38

Valuation: List the Price-to-Cash-Flow Ratio and how to calculate current stock price

Answer 38

Price-to-Cash-Flow Ratio = P0/CF1 where P0 = price or value today CF1 = expected cash flow in on year Current stock price = (P0/CF1) x CF1

Question 39

Valuation: List the assumptions associated with price-multiple valuation method

Answer 39

1. price multiple ratios can be influenced by management behavior - future earnings = forecasted - future growth rate = compounded rate - future sales = forecasted - duration of sales or earnings trend

Question 40

Valuation: Define Behavioral Finance

Answer 40

examines investor (individual) behavior and how this behavior affects the financial markets

Question 41

Valuation: list the 3 Generalized Rules of Thumb in Behavioral Finance and why their impact

Answer 41

Generalized Rules of Thumb: distort the objective evaluation of evidence 1. Tendency to use stereotyped characterizations - historical relationships - P/E ratios less rigorous (i.e. use more stereotypes) than detailed DCF methods 2. Use adjustments from presumed baselines: adjustments made are insufficient 3. Use of intuition rather than analysis

Question 42

Valuation: List the 4 types of behavioral biases that distort judgment in Behavioral Finance

Answer 42

1. Excessive Optimism: overestimation of positive results, irrational exuberance 2. Confirmation Bias: ignore challenging data 3. Overconfidence: overemphasize ability to process and interpret information 4. Illusion of Control: financial manager has control over valuation outcomes that are ultimately result of market forces

Question 43

Valuation: describe the impact of Loss Aversion in Behavioral Finance

Answer 43

1. losses are more distracting than gains: riskier behavior comes when losses are higher (managers try to beat odds to restore profitability) 2. managers generally averse to sure losses: even knowing likelihood of reversing projected losses is remote will not motivate managers to take sure loss (refuse to cut losses)

Question 44

Financial Decisions: what is "technical default"?

Answer 44

Technical default: when debt covenants are violated - creditor can demand repayment of entire principal - most of time concessions are negotiated and real default is avoided (change interest rate, change terms, etc.)