Ch. 3 Financial Management Flashcards
(153 cards)
1
Q
What is market risk, marketability and default risk?
Firms are primarily concerned with the marketability and default risk of the securities they purchase.
A
market risk- risk that is associated with a security that cannot be eliminated by diversification.
marketability- the ability to sell a security for its face market value quickly and in large amounts
default risk- the probability of receiving principal and interest payments in a timely manner
2
Q
What are 3 examples of market risk /systematic risk?
A
- congressional tax reform.
- inflation or recession.
- world energy situation(s).
3
Q
What is company risk? How does it compare to market risk?
A
Company risk can be alleviated or avoided through diversification. It is much more specific than market risk.
4
Q
A ratio that examines the percentage change in earnings available to common stockholders that is associated with a given percentage change in earnings before interest and taxes is a measure of ????
A
the degree of financial leverage.
5
Q
What is Treasury stock?
A
increases a firm’s financial leverage because the debt-to-equity ratio increases
(as a result of the decrease in total stockholders’ equity).
is shares of the firm’s own stock held by the firm.
6
Q
List short-term debt (not credit)
A
Bank loans- secured and unsecured
commercial paper.
Spontaneous financing created through A/P and accruals
7
Q
What is the company’s cost of preferred stock?
A company recently issued 9% preferred stock. The preferred stock sold for $40 a share with a par of $20. The cost of issuing the stock was $5 a share.
A
The annual dividend per share is 9% multiplied by the par value of $20, or $1.80. The stock sold for $40. Subtracting the $5 issue costs gives net proceeds of $35 a share.
The cost of preferred stock is the $1.80 dividend divided by proceeds of $35 a share, which is 5.1%.
8
Q
What is the Gordon growth model?
A
one of the most popular/straightforward dividend discount models.
DDMs are procedures for valuing stock price using
predicted dividends & discounting them back to PV.
It determines the intrinsic (inherent) value of a stock based on a future series of dividends that grow at a constant rate.
9
Q
When determining fair value measurements on a nonrecurring basis, what 3 items need to be disclosed?
A
- The valuation method(s)
- The fair value measurement as of the reporting date
- Reconciliation of the beginning and ending balances when using unobservable inputs
10
Q
According to the hedging approach to financing, seasonal variations in current assets should be financed with ______?
What is long term assets financed with?
A
short-term debt
** Under the hedging approach, the length of financing term is matched to the life or duration of assets financed. Long-term assets are financed with long-term debt and short-term assets (such as current assets) are financed with short-term debt.
11
Q
What is the overall cost of capital?
it is the rate of return on what?
A
rate of return on assets that covers the costs associated with the funds employed
12
Q
What is the effective cost of the loan?
A corporation obtains a loan of $200,000 at an annual rate of 12%. The corporation must keep a compensating balance of 20% of any amount borrowed on deposit at the bank, but normally does not have a cash balance account with the bank.
A
Loan $200,000 x 12% interest = $24,000 per year.
Loan $200,000 less 20% of amount borrowed = $40,000
Loan $200,000 less $40,000 comp balance = $160,000
$24,000 per year divided by $160,000 available = 15% effective cost of the loan
15
Q
The optimal capitalization for an organization usually can be determined by the ????
A
lowest total weighted-average cost of capital (WACC).
16
Q
WACC - What is the weighted-average after-tax cost of capital for this company?
tax rate of 30% has the following capital structure:
Weight Instrument Cost of Capital
40% Bonds 10%
50% Common stock 10%
10% Preferred stock 20%
A
The cost of debt is the before-tax rate. Since interest expense is a tax-deductible item, thus providing a depreciation shield, an after-tax cost must first be determined:
After-tax cost of debt = kd × (1 - T)
After-tax cost of debt = .10 × (1 - 0.30) = 0.07 (7%)
(kd = Pretax cost of debt; T = Tax rate)
Capital Item Weight Cost Weighting Factor
Debt 40% x 7% = 2.8%
Common Stock 50% x 10% = 5.0%
Preferred Stock 10% x 20% = 2.0%
TOTAL 100% WACC = 9.8%
16
Q
A company uses its company-wide cost of capital to evaluate new capital investments. What is the implication of this policy when the company has multiple operating divisions, each having unique risk attributes and capital costs?
High-risk, low-risk ….invest in new projects
A
High-risk divisions will OVER-invest in new projects and
low-risk divisions will UNDER-invest in new projects.
16
Q
Which of the following is the company’s cost of capital?
cost of debt is currently 8% based on the company’s
debt ratio of 40%.
The company complies with this requirement and has determined that a stock issuance would require a 10% return in order to attract investors.
A
40% cost of debt is given
100% − 40% cost of debt = 60% cost of equity
WACC = (.40 × .08) + (.60 × .10)
= .032 + .06
= .092, or 9.2% company’s cost of capital
Note: Be sure to review the final answer for reasonableness: the result must be between 8% and 10%, and be a bit closer to 10% since equity carries more than half the weighting.
17
Q
What is the market rate of interest on a 1-year U.S. Treasury bill? Given: Risk-free rate of interest 2% Inflation premium 1% Default risk premium 3% Liquidity premium 2% Maturity risk premium 1%
A
Risk-free rate of interest 2% + Inflation premium 1% = 3%
Ignore:
Default risk premium 3%
Liquidity premium 2%
Maturity risk premium 1%
18
Q
what is the net present value?
Given a 10% discount rate with cash inflows of $3,000 at the end of each year for five years and an initial investment of $11,000
A
The present value of the payment in the first year is $3,000 ÷ 1.1, or $2,727.
The present value of the payment in the second year is $3,000 ÷ (1.1 × 1.1), or $2,479.
The present value of the payment in the third year is $3,000 ÷ (1.1 × 1.1 × 1.1), or $2,254.
The present value of the payment in the fourth year is $3,000 ÷ (1.1 × 1.1 × 1.1 × 1.1), or $2,049.
The present value of the payment in the fifth year is $3,000 ÷ (1.1 × 1.1 × 1.1 × 1.1 × 1.1), or $1,863.
The sum of the present value of the five future payments is $11,372. The cost of the investment is $11,000, so the net present value is $11,372 - $11,000, or $372, rounded to $370.
19
Q
What is the net present value?
What is the formula?
A
The net present value is the excess of the discounted present value of future cash returns less the investment cost.
The formula to calculate present value for any single future payment is PV = Payment ÷ (1 + r)n, where r is the interest rate and n is the number of periods.
20
Q
What are the 3 appropriate value assumptions?
A
Price, worth, and value
“Price” is the actual observed exchange price
“Worth” defines the advantages of ownership based upon the perceived benefits at a particular point in time and for a particular use.
“Value” is the amount that would be received in exchange for an asset between willing parties in an arm’s-length transaction.
21
Q
Solvency is the organization’s ability to meet long-term obligations. What is it closely related to?
A
the use of leverage.
Leverage is created when a portion of the company’s assets are acquired by issuing debt rather than using equity to finance the purchase; therefore, solvency is related to the use of leverage.
22
Q
What are Solvency ratios?
A
- Related to long-term viability of firm
- Related to financial risk. A lack of solvency could lead to a greater risk of defaulting on current maturities that could ultimately lead to bankruptcy and liquidation.
23
Q
When analyzing the capital asset pricing model, which of the following risks can be diversified away?
A
Stock price is an unsystematic risk and can be diversified away.
Systematic risks cannot be diversified away and include interest rates, recessions, and wars.
24
Q
In determining cash flows from a proposed investment, the amount of the investment’s depreciation tax savings (shield) in a given year is equal to:
A
the depreciation times the tax rate.
Many items in capital budgeting have related tax effects. Items that do not affect cash flows such as depreciation must be taken into consideration when income taxes are relevant or the present value of the cash flows related to taxes is relevant.
Noncash items are adjusted for the tax impact by multiplying by the tax rate;
cash items (such as revenues) are adjusted by multiplying by (1 − tax rate).
25
What does The net present value method determine?
the discounted rate of return.
26
What does The net present value method predict?
What does NPV adjust for?
What does NPV seek to determine?
1. the present value of money in the future
2. adjusts for the time value of money.
3. whether the present value of the estimated net future cash inflows at a desired (or required) rate of return will be greater or less than the cost of the proposed investment.
27
The gross margin ratio can be subjected to detailed analysis by a firm's _______?
management
detailed information on gross margin ratio is only available to management
28
Formula for gross margin ratio
divide gross margin by net sales revenue
29
Discount is a ____ bond
| Premium is a ____ bond
```
Discount = bad
Premium = good
```
30
Net means ____ is involved
subtraction
31
More fixed cost means a business risk is higher or lower?
higher
32
List 3 lockbox system examples
1. checks collected several times/day by local banks (not sent to corporate headquarters)
2. checks deposited in company's local accounts
3. lockbox system reduces the time required to receive funds
33
Costs to procure inventory are ____ cost for a reseller and ______ _____ costs for a manufacturer
ordering cost for reseller
production setup costs for manufacturer
34
What is the formula for # of days sales in inventory
Sales - Gross Profit = COGS
COGS / Average Inventory = Inventory turnover
360 / Inventory turnover = # of days sales in inventory
35
Calculate # of days sales in inventory
```
Sales $ 2.1M
Gross profit 600K
Inventories (beginning) 240K
Inventories (ending) 300K
Days in the year 360
```
$2.1 M sales - 600K gross profit = $1.5M COGS
$1.5M / (0.5 x ($240K+$300K)) = 5.56 times Inventory Turnover =
360 days / 5.56 times = 64.75 = 65 days
36
What is the formula for acid-test (quick) ratio?
What are quick assets?
quick assets / current liabilities
cash, marketable securities, and accounts receivable (excludes inventory & prepaid exp)
37
What term refers to a performance measurement that is calculated as an = after-tax operating income - total assets x WACC?
Economic value added
38
What is Economic value added (EVA) ?
What does it focus on?
the economic profit of a project
the earnings above the required cost of capital for shareholders
39
What does Return on Investment (ROI) focus on?
What is it also called?
What is the formula?
the optimal use of invested capital
also called Return on Total Assets
operating income divided by average invested capital
40
What is the formula for # of days in cash conversion cycle?
Days inventory outstanding + days sales outstanding - days payable outstanding
41
What is formula for Days inventory outstanding?
DIO = Ave inventory / COGS per day
42
What is formula for days sales outstanding?
What does the ratio evaluate?
It is the average what?
Ave AR / Revenue per day = DSO
evaluates A/R
average collection period
43
What is formula for days payable outstanding
DPO = Ave AP / COGS per day
44
What is the formula for COGS per day?
= COGS / 365 days in year
45
Can DTC be deposited in any bank?
No, DTC is sent to a concentration bank serving as a clearinghouse
46
What is the recommended technique to evaluate projects when capital is rationed?
What is the formula?
given: cash inflows & outflows
Profitability index
also called Excess PV index
Total PV of all future net cash inflows / total cash outflow = profitability index
47
What does the economic order quantity formula assume?
1. the periodic demand for the good is known
2. TOTAL carrying costs vary with quantity ordered
3. Costs of placing an order are UNAFFECTED by quantity ordered
4. Purchase costs per unit are NOT affected by quantity discounts
48
What is the capital structure?
the percentage of debt, preferred stock and common stock used for financing a firm's assets
49
The cost of equity is ____ than the cost of debt
Firms must have the _____ to pay dividends to kept stockholders happy
higher since stockholders are subject to more risk than debt holders
cash
50
What is a business risk in capital structure decisions?
cash flow
Capital structure is defined as the percentage of debt, preferred stock, and common stock used for financing a firm's assets.
51
Data file security is intended to prevent ______ changes to data files
unauthorized
52
The level of safety stock does not depend on the cost to _______ stock.
reorder
53
When sales forecasts are uncertain, a HIGHER OR LOWER level of safety stock is needed.
higher
54
How should company improve it's accounts receivable turnover ratio?
Should enter into Factoring agreement to sell its A/R at a discount, thus immediate receipt of cash.
By reducing the discount to 1/10 or 3/20, the customers are less likely to pay quickly.
Pledging is using the accounts receivable balance to secure a loan. This would have no effect on the accounts receivable turnover ratio.
55
Name 3 ways to speed up collections
Wire transfers, concentration banks, and lockboxes
56
The gross margin ratio can be subjected to detailed analysis by a firm's ________.
What is the gross margin ratio formula?
What is gross margin formula?
management
detailed information below would only be available to management
= gross margin / net sales revenue = gross margin ratio
= (unit price - unit cost) x number of units = gross margin
57
If the time-adjusted rate of return, or internal rate of return, is higher than the rate of return required by the company, then the net present value of the project is _______.
positive
58
The acid-test ratio shows the ability of a company to pay its current liabilities without having to ______ its inventory.
liquidate
59
A bond that is issued at a discount will have a coupon rate that is ______ than the required market rate
less
60
The cost of capital used in this analysis should be ________ weighted average cost of capital
marginal
61
delete
delete
62
What is working capital?
What is net working capital?
What is purpose of adequate working capital reserves?
Working capital (WC) is short-term assets such as cash, receivables, and inventory.
Net working capital is current assets less current liabilities.
** To mitigate liquidity risk **
63
What is the relationship between the allowance for doubtful accounts and working capital?
When bad debts expense is recorded for the period, working capital decreases.
An increase in bad debt expense results in a corresponding increase in the Allowance for Doubtful Accounts. Since the Allowance account is a contra-current asset, any increase results in a decrease to current assets, which leads to a decrease in WC. Bad debt expense and account write-offs do not affect cash. Writing an account receivable off against the allowance is a wash entry: the decrease in accounts receivable decreases WC while the decrease in the Allowance account increases WC
64
What is window dressing?
A limitation or adverse effect of ratio analysis occurs when managers seek to improve their performance through window dressing
the intentional alteration of elements of the financial statements to improve performance measures and account balances
65
If industry ave A/R turnover is 24 times and company is 22, is the company effectively managing its receivables?
No, it should be higher than industry ave
66
What is solvency?
Solvency is the organization’s ability to meet long-term obligations (not short term).
67
What is the effective rate of interest also called?
Yield to maturity
68
If state rate of interest is higher than the effective rate, then the bonds are issued at a premium or discount?
10% stated rate of interest
9% effective rate
What if the rates are equal?
the bond is issued at a premium when
stated > effective
bonds are issued at par when both rates are equal
69
What type of covenants obliges the borrower to repay the bonds if a large quantity of common stock is held by a single investor and the bond rating is downgraded?
Poison put clause
70
What is the least expensive approach to financing working capital needs?
Trade credit is created when goods and services are purchased on account in the normal course of business.
71
What is an unsecured promissory note that is issued by large banks and big corporations to meet short-term cash needs?
Commercial paper
Although rates for these loans are normally lower than for bank loans, there is no flexibility in the repayment date as might be received with a bank loan.
72
What is an agreement with a bank to have up to a specific amount of funds available as a short-term loan during a particular period; interest is charged on the amount borrowed?
A line of credit
Additionally, an increase in a line of credit will have a negative effect on (i.e., decrease) the current ratio.
73
A potential problem indicated by a higher than industry average inventory turnover is risk of what?
What is the inventory turnover formula?
stockouts - A very high inventory turnover could be the result of very low inventory levels.
costs of goods sold / average inventory = inventory turnover
74
The average collection period is a measure of how long it takes to collect accounts receivable after a sale is made. What does this help determine?
how efficient company is in collecting their A/R and converting that receivable to cash
75
What 3 factors does a company consider in cash collection and disbursement process?
Name 3 floats
collection float - checks that have been deposited but have not been credited to the customer's account by the bank
disbursement float - payments that have been announced but not yet distributed
net float - the difference between the firm's checkbook & bank balance
deposit float doesn't exist
76
What type of relationship exists between risk and rate of return on investments?
positive
77
What are characteristics of preferred stock?
hybrid = some of the characteristics of debt & equity
riskier than debt, but less risky than common stock
carries no voting rights
dividends are not tax deductible
may not be callable at the option of the investor
Convertible preferred stock can be converted into common stock
78
What is the percentage change in
earnings available to common shareholders
related to the change in
earnings before interest and taxes (EBIT) called?
For a firm using debt financing, a decrease in EBIT will result in a proportionally larger decrease in ____?
Degree of financial leverage
EPS
If EBIT goes up, earnings per share (EPS) will go up.
If EBIT goes down, EPS will go down also.
79
What are Bonds backed by the full faith and credit of the issuing firm called?
debentures
A bond is generally a publicly offered form of long-term debt where the borrower agrees to makes payments of interest and principal on specific dates to the bond holder. A debenture is a type of debt instrument that is not secured by physical assets or collateral. Debentures are backed only by the full faith, general creditworthiness, and reputation of the issuer. Both corporations and governments frequently issue this type of bond to secure capital.
80
What are examples of debt covenants?
What is not?
Limitations of the disposal of assets,
maintenance of a minimum current ratio, and
restrictions on dividend payments
Restrictions on the number of EFTs (electronic funds transfers) are not a debt covenant.
81
What is black-scholes?
What are the 5 imputs?
Black-Scholes is a price variation model of financial instruments that can be used to determine the price of a European call option by incorporating five input variables:
the current stock price,
the related stock option's strike (exercise) price,
the time to the option's expiration,
the risk-free rate, and
the volatility (measure of risk).
82
What method should be used if capital rationing needs to be considered when comparing capital projects?
Profitability index
83
What risks deal with debt?
financial risk and interest rate risk deal with the concept of financial leverage and the cost of debt
Financial risks are caused by a company’s decision regarding whether to finance operations with short-term debt, long-term debt, or equity.
84
What is marginal risk?
Marginal risk is the risk that is assumed by the issuer of a foreign exchange contract or debt (forward contract) in the event that the investor goes bankrupt. It is related to the risk of the last dollar of a transaction defaulting.
85
Which risk is inherent in a firm's operations if it utilizes only equity financing?
Business risk is the uncertainty associated with the ability to forecast EBIT (earnings before interest and taxes) due to such factors as sales variability and operating leverage. This risk is inherent in equity financing.
86
Firms strive to _________ the weighted-average cost of capital.
minimize
87
Which tool would most likely be used to determine the best course of action under conditions of uncertainty?
Expected value (EV) applies estimated percentages of occurrence to estimated values such as sales or costs. Expected value can be used to determine the best estimate or course of action under uncertainty.
88
What is most useful when risk is being prioritized?
Expected value is the sum of the outcomes (payoff) of each event multiplied by the probability of each event occurring. It combines the likelihood of each outcome with the payoff of that outcome, and so is a way of prioritizing alternatives while considering risk. None of the other answer choices consider both the likelihood and payoff of each alternative course of action.
89
What is a cornerstone investment philosophy in developing an investment portfolio?
Understanding human nature and how it relates to the investment process
90
A key disadvantage of long-term financing by the borrower compared to short-term financing is:
_______ decreases
profitability decreases.
Long-term debt has higher financing costs than short-term debt, which reduces profitability.
91
What would decrease the internal rate of return of a proposed asset purchase?
Decrease tax credits on the asset available when an asset is purchased.
Taxes in general will lower the IRR of a proposed asset purchase
92
Bond sells at premium when?
```
market value (i.e. interest rates) were higher when bond was issued
and the coupon rate would also be higher
```
93
Highly liquid investments are safer than those with lower liquidity and therefore have less risk. Do they have high or low interest rates?
Lower interest rates
Inflation drives interest rates up, so if investors are expecting reduced inflation in the future, interest rates and returns would also be lower.
94
Long-term investments are often perceived to have greater risk and therefore higher or lower rates of return?
lower rates of return
95
What best describes the accounting rate of return (ARR)?
The annual accounting income divided by investment
The annual net cash inflow is adjusted for depreciation to arrive at annual accounting income and divided by the investment (i.e., cost of the fixed asset). It focuses on the average income generated by a project in relation to the investment, not cash flows.
96
Is disclosure needed when using fair value on a recurring basis?
No, only with unobservable inputs. Reconciliation of beginning and ending balances is required only when using Level 3 unobservable inputs.
97
In determining cash flows from a proposed investment, the amount of the investment's depreciation tax savings (shield) in a given year is equal to:
the depreciation times the tax rate.
Many items in capital budgeting have related tax effects. Items that do not affect cash flows such as depreciation must be taken into consideration when income taxes are relevant or the present value of the cash flows related to taxes is relevant. Noncash items are adjusted for the tax impact by multiplying by the tax rate; cash items (such as revenues) are adjusted by multiplying by (1 − tax rate).
98
The economic order quantity formula assumes that:
periodic demand for the good is known.
99
What formula do you use for yield on common stock?
dividend yield formula
100
An increase in interest rates will ______ the prices of bonds that are outstanding as they pay less interest than newer bonds with a higher interest rate.
Decrease.
A bond is generally a publicly offered form of long-term debt where the borrower agrees to makes payments of interest and principal on specific dates to the bondholder. The bonds have a coupon rate (rate of interest) that is generally fixed.
A sinking fund requires the issuer to retire a portion of the bond issue each year or deposit funds into a restricted account to be accumulated for the retirement of the bonds; creation of a sinking fund will increase the value of a bond.
101
Preferred stock is often referred to as a
hybrid
in that it has some of the characteristics of debt and some of the characteristics of equity. Preferred stock is more risky than debt; however, it is less risky than common stock.
Preferred dividends are not a deductible expense; therefore, the cost of preferred stock is not affected by its income tax rate. The equity position of the company is increased, thus improving the creditworthiness of the firm.
102
Treating dividends as an active policy strategy assumes that:
dividends provide information to the market.
Treating dividends as an active policy strategy assumes that dividends provide information to the market. If a firm chooses to use dividend policy as an active policy strategy (rather than as a residual part of a financing decision), the firm is more concerned about the announcement effects of the dividend than the available investment opportunities (alternative uses of the retained earnings). This is particularly important when management wants to signal improved prospects to the outside investors.
103
Interest paid on a bond is a
tax-deductible expense; the tax shield lowers the effective after-tax cost of the debt.
A call feature is not a feature preferred by bond holders. The indenture does not require the investor to pay an amount greater than par; that is determined by the bond marketplace and interest rates. A debenture bond may or may not have a higher yield than a mortgage.
104
Which of the following are considered to be advantages of short-term financing?
Decreased financing costs and increased profitability
105
Capital originates from two primary sources: lenders and shareholders.
- Debt capital is derived from what?
- Equity capital originates from what?
* Debt capital is derived from the issuance of interest-bearing obligations such as bonds and long-term notes.
* Equity capital originates from investments by shareholders (stock) and through retained earnings.
106
Why would the company finance using long-term financing instead of short-term financing?
To reduce its exposure to interest rate risk
Borrowers like to lock an interest rate for the long term in order to reduce their exposure to the possibility of rates increasing in the future.
Interest rates on long-term debt are usually higher than short-term debt, increasing expenses and decreasing profitability. Liquidity relates to short-term financing, not long-term financing (solvency relates to long-term financing). Interest rate exposure risk exists with any debt.
107
The use of an accelerated method instead of the straight-line method of depreciation in computing the net present value of a project has the effect of:
increasing the present value of the depreciation tax shield.
108
The binomial model is
- a variation of the Black-Scholes model of pricing options
- differing from Black-Scholes in that it incorporates the underlying security for a period, rather than a point in time.
109
The higher the risk, the higher the discount rate, and the ________ the present value of the subject company.
Higher or lower
Lower
110
The price-earnings (P/E) ratio indicates the relationship of common stock to net earnings.
If forward P/E ratio of 2.2x with a current selling price of $21.50 per share. Earnings per share (EPS) is $1.15 currently but anticipated at $1.26 in the coming year. What information does this provide?
The company’s current stock is 2.2 times the anticipated EPS of $1.26.
The price-earnings (P/E) ratio indicates the relationship of common stock to net earnings. The market price is the investors’ perception of the future; therefore, this ratio combines the performance measure of the past (earnings per share) to perceptions of the future.
A forward P/E ratio reflects expected future earnings over the next year. It is calculated by dividing today’s stock price by the EPS expected in one year.
111
In fair value hierarchy, which of the following is the most desirable?
Observable inputs
112
Key assumptions related to finding compatible guideline companies include
diversification of operations, markets served, geographic diversification, size of the organization, operating leverage, comparability of products (services) sold, financial leverage, liquidity, profitability, and growth.
113
Which of the following is a limitation of the profitability index?
It requires detailed long-term forecasts of the project's cash flows.
The profitability index is the present value of the cash flows after the initial investment divided by the amount of that investment. Since it is based on the present value of future cash flows, it does require detailed forecasts of the related cash flows.
114
Ownership based upon the perceived benefits at the particular time and for a particular use is the concept of
Ownership based upon the perceived benefits at the particular time and for a particular use is the concept of
115
Assumption of the dividend discount model:
1. The dividend growth rate is constant.
2. The required rate of return is greater than the dividend growth rate.
3. The stock price will grow in perpetuity.
116
Black-Scholes is a price variation model of financial instruments that can be used to determine the ?
What is the one assumption/limitation?
price of a European call option.
trading has no associated fees.
117
The beta coefficient measures a stock’s volatility (i.e., how much a stock’s price increases or decreases compared to movement in the stock market). If the coefficient is 1, then the price of the stock or security does what?
moves with the market.
118
If the Beta coefficient is less than one, then the security’s returns are what?
less likely to respond to movements in the market.
119
If the β coefficient is greater than 1, then what?
the security’s returns are more likely to respond to movements in the market and will be more volatile.
120
What is the purpose of adequate working capital reserves?
To mitigate risk
121
What is net float?
The net float is the difference between the firm’s checkbook balance and the balance of the account in the bank’s records.
122
Price multiple ratios are all based on an assumption that:
management’s behavior has an influence on the ratios.
123
What is price multiple ratio?
A price multiple is any ratio that uses the share price of a company in conjunction with some per-share metric to form a ratio.
124
When valuing options under the Black-Scholes model, it is assumed that: risk-free rates are what?
constant over the life of the option.
125
Black-Scholes model assumes:
The model assumes that stock prices follow a lognormal distribution given that asset prices cannot be negative; there are no transaction costs or taxes; the risk-free interest rate is constant for all maturities; short selling of securities with use of proceeds is permitted; and there are no riskless arbitrage opportunities.
126
Accounts receivable turnover will normally decrease as a result of:
a change in credit policy to lengthen the period for cash discounts; a longer cash discount period will result in a longer collection period and will likely bring about an increased average AR balance.
127
What is the operating cycle?
The operating cycle is the time from receipt of inventory to receipt of cash from the sale.
the average number of days to sell inventory plus the average number of days to collect accounts receivable
128
The return on equity ratio can essentially be broken down into which of the following ratios?
Profit margin × Asset turnover × Leverage
Profit margin = (net income - preferred dividends) / sales
Asset turnover = sales / average assets
Leverage = average assets / average common equity
129
When evaluating an individual’s credit risk, which of the following is the least relevant factor?
An individual’s perceived wealth is subjective. It does not take the individual’s ability to repay a loan into account. An individual’s actual wealth would be relevant.
Lenders examine character, creditworthiness, capital position, and collateral positions to determine an individual’s credit risk.
130
How can a manager improve the performance of an investment center that is evaluated using return on investment? By decreasing what?
By decreasing invested capital
Return on investment (ROI) focuses on optimal use of invested capital. Net income is divided by invested capital from the balance sheet. Increases to the numerator or decreases to the denominator will increase ROI; therefore, decreasing invested capital will increase ROI.
131
Colonie, Inc., expects to report net income of at least $10 million annually for the foreseeable future. Colonie could increase its return on equity by taking which of the following actions with respect to its inventory turnover and the use of equity financing?
Inventory turnover ____ and use of equity financing ____
Inventory turnover increases and use of equity financing decreases
132
Price multiple ratios are all based on an assumption that:
management’s behavior has an influence on the ratios.
A price multiple is any ratio that uses the share price of a company in conjunction with some per-share metric to form a ratio. Price multiples are based on the assumption that management is able to manipulate or influence the components of the price multiple ratios, including future earnings, future growth rates, future sales, future cash flows, and trends of these amounts over time.
133
Business risk is driven by the creation of revenues. Which of the following is not a basic element affecting revenues?
An increase in fixed costs relative to variable costs
An increase in fixed costs is an operating risk, not a business risk. It also affects profits and expenses, not revenues.
134
Business risks include
1. sensitivity to the business cycle (consumer durable goods such as appliances are more likely to have large swings within a business cycle than necessities such as basic clothing),
2. competition (the greater the competition, the more likely entities will have to lower sale prices), and the
3. stability of local and foreign economies (the more stable the economy, the fewer the revenue swings).
135
Good Stuff Unlimited wishes to pay a dividend to its stockholders; however, management is concerned about the effect that it might have on the solvency position of the organization. What effect would the payment of a cash versus a stock dividend have on the total debt to total capital ratio?
Cash dividend: Increase; Stock dividend: No effect
136
The EBIT-EPS indifference point is the level of EBIT at which:
the EPS for two financing alternatives is the same.
(Earnings before income taxes—EBIT—would be the horizontal axis and EPS earnings per share the vertical axis.) The point of intersection—the indifference point—is the EBIT level at which the finance alternatives produce the same EPS. The indifference point can also be computed mathematically by solving for EBIT after setting equations for financing options equal to each other.
137
Cash discounts are used to incentivize customers to make early payments. Discounts provide all of the following except:
a way to increase orders.
Discounts primarily exist to entice new customers, provide price reduction for current customers, and reduce the average collection period.
138
Which of the following statements does not describe the discounted payback method?
Discounted payback is the length of time required to recover the initial cash investment using a sum of the future revenue streams.
The discounted payback period is the length of time required to recover the initial cash investment using a sum of the discounted future cash flows
PAYBACK MEANS The investment alternative with the shortest payback period is considered the most desirable. The method is simple to compute, easy to understand and explain, and also takes the time value of money into consideration. The chief limitation is that the discounted payback method also emphasizes liquidity and disregards profitability.
139
Which of the following is not a form of business risk?
The level of the firm's financial leverage
The level of financial leverage is related to a firm's financial risk.
Business Risks:
1. Amount of operating leverage held by the firm
2.
3. Management's decision to vary the price of the product.
140
Why does the cost of capital increase when a company issues new stock?
Flotation costs are associated with new stock.
Flotation costs (costs of issuing the new securities) reduce the proceeds received from the stock issue, which increases the cost of financing.
141
Compared to other firms in the industry, a company that maintains a conservative working capital policy will tend to have a:
higher ratio of current assets to fixed assets.
Net working capital is the excess of current assets over current liabilities. A firm with a conservative working capital policy will tend to maintain a larger portion of its assets in current assets rather than in noncurrent assets (e.g., fixed assets) and a smaller percentage of short-term financing.
142
If Carlisle Company did not have preferred stock, the degree of total leverage would:
The degree of total leverage decreases proportionately to a decrease in financial leverage.
143
What is a bond?
1. A bond is a form of long-term debt.
2. Bonds are publicly offered
3. The borrower agrees to make payments of interest and principal on specific dates.
4. Bonds are held by many different investors.
5. Bonds have a coupon rate that is fixed.
144
The Davis Company has a short-term cash need and plans to take out a 120-day promissory note. What effect will this transaction have on the long-term debt-to-equity ratio and the equity to total debt ratio?
Since a 120-day promissory note would be a current liability, the long-term debt to equity capital ratio would not be affected. The equity to total debt ratio would decrease, since the denominator would increase and the numerator would remain unchanged.
145
For a given level of sales, and holding all other financial statement items constant, a company's return on equity (ROE) will:
decrease as their total assets increase.
146
Harden Hammers holds a large amount of short-term debt and has relatively low liquidity. What will most likely result?
High risk and high return
Liquidity measures a firm’s ability to satisfy short-term obligations. It implies that the company has the ability to turn assets into cash or the ability to obtain cash. It is also related to the speed with which given assets can be converted into cash. Companies with low liquidity do not have the ability to generate cash needed to repay loans, causing higher risk. Short-term debt has a lower cost than long-term debt and it contributes to the high return. Investors must be compensated for assuming higher risk.
147
Norton, Inc., has a 2-to-1 current ratio. This ratio would increase to more than 2 to 1 if:
the company sold merchandise on open account that earned a normal gross margin. A sale of merchandise on account would lower inventory but increase accounts receivable by an amount greater than the decrease in inventory; thus, the current ratio would increase.
The company purchasing inventory on open account would cause a decrease in the current ratio because inventory and accounts payable would increase by the same amount.
148
Describe Marketable Securities
low risk and high liquidity
held as a substitute for cash
held as temporary investment
provide a temporary place for funds received that have yet to be invested
149
When merchandise is purchased on credit, does net working capital change?
No. Total current assets will increase as inventory increases. Total current liab will increase as inventory increases. Net working capital (current assets less current liab) will not change because they are increasing/decreasing by the same amount.
150
Which of the following is the best measure of interest rate risk for a corporate bond?
Stated rate of interest
Interest rate risk occurs due to fluctuating interest rates. This risk depends on how sensitive a bond’s price is compared to interest rate changes in the market. Risk is impacted by the bond's coupon rate (stated rate) and the time to maturity.
151
Firms are primarily concerned with securities they purchase??
marketability and default risk of the securities they purchase.
152
Unsecured loans are not backed by any collateral. Which of the following is not an unsecured bank loan?
Short-term credit is secured by current assets such as inventory or accounts receivable.
Unsecured loans include a line of credit, revolving credit agreement, commercial paper, or a letter of credit. These are used primarily to resolve short-term cash flow issues.
153
What are limitations or weaknesses of ratio analysis?
1. Accounting data is affected by estimates.
2. Seasonal factors may affect some balances.
3. Use of historical data
