Chapter 15

Question 1

The four responsibilities of financial managers

Answer 1

1. Determine a firm’s long term investments
2. Obtain funds to pay for said investments
3. Conduct the firm’s everyday financial activities
4. Manage the risks that the firm takes

Question 2

How are accountants and financial managers different?

Answer 2

Accountants create data to reflect a firm’s financial status

Financial managers make decision to improve that status

Question 3

Cash flow management

Answer 3

The activity of investing extra funds that are not needed immediately to earn more money.

Question 4

Financial control

Answer 4

Process of checking actual performance against plans to ensure desired financial outcomes occur

Question 5

Developing a financial plan

Answer 5

Describes a firm’s strategies for reaching some future financial position
Must answer the following questions:
1. What funds are needed to meet immediate plans?
2. When will the firm need more funds?
3. Where can the firm get the funds to meet both its short and long term needs?

Question 6

Short term (operating) expenditures: Accounts payable

Answer 6

Unpaid bills owed to suppliers plus wages and taxes due within a year.
Largest single category of short-term debt

Question 7

Short term (operating) expenditures: Accounts receivable

Answer 7

Funds due from customers who bought on credit.

Investments in firm’s product that the company has not yet received payment for, thus temporarily tying up their funds.

Question 8

Credit policies (its specific payment terms)

Answer 8

The standards as to which buyers are eligible for what type of credit. (typically, credit is extended to customers with good payment histories)
“2/10, net 30” = 2% discount if the credit is paid within 10 days, and 30 days to pay the regular price.

Question 9

Short term (operating) expenditures: Inventories

Answer 9

Funds that are tied up between the time that a firm buys raw materials and the time it takes to sell the finished products.
Too little = Missing out on potential sales
Too much = The tied up funds cannot be used elsewhere

Question 10

Long term (capital) expenditures (how are they different from short term expenditures)

Answer 10

• Unlike inventories and other short term assets, long term purchases are not normally sold or converted to cash
• Long term acquisitions require a very large investment
• Represents a locked commitment of company funds that last into the future

Question 11

Short term financing: Trade credit (the three forms of trade credit)

Answer 11

Granting of credit by one firm to another, basically a short term loan.

1. Open-book credit: “gentlemen’s agreement”, buyers receive merchandise along with invoices, sellers ship products on trusting the buyers
2. Promissory notes: A legal binding to assure when and how much money will be paid to the seller
3. Trade draft: Document attached to the shipment by the seller. Buyer must sign the draft to take possession of the merchandise, and the document becomes a trade acceptance.

Question 12

Short term financing: Secured short term loans

Answer 12

On top of a promissory note in which the borrower promises to repay the loan plus interest, banks require collateral to be put up in a secured loan - the right to seize certain assets if payments are not made. This allows buyers to get funds they may not normally qualify for. Moreover, this carries lower interest rates than unsecured loans.

Question 13

Secured short term loans: Types of collateral

Answer 13

Inventory as collateral: More attractive as collateral when it can be readily converted into cash
Accounts receivable as collateral: Process is called pledging accounts receivable, usually service firms that do not have inventory uses this as collateral. Also, lenders with the capability of evaluating the quality of the receivables usually accept this type of collateral.

Question 14

Factoring

Answer 14

Firms raising funds by selling its account receivable. Purchaser of the receivables (called a factor) buys for example 50,000 worth of receivables for 80 percent of that sum (40,000) and tries to collect to receivables to earn profit. (usually 2-4%)
Basically means firms are outsourcing the collection process of the receivables.

Question 15

Short term financing: Unsecured short term loans

Answer 15

Borrower does not have to put up collateral. Most cases though, the borrower must keep a portion of the loan amount on deposit.
The amount, duration, interest rate, and payment schedules are all negotiated, and the borrower must usually have a good relationship with the lending bank.

Question 16

Unsecured short term loans: Lines of credit

Answer 16

A standing agreement with a bank to lend a firm a maximum amount of fund on request. Benefits the firm as they know in advance that the bank regards the firm as creditworthy and will lend funds on short notice.

Question 17

Unsecured short term loans: Revolving credit agreements

Answer 17

Like a bank credit card for the firm. Lender agrees to make a certain amount of funds available on demand, in return the bank charges a commitment fee - a charge for holding open a line of credit for the firm even if they do not borrow any funds. (usually 0.5-1 percent of the committed amount)
If a firm agrees to 100,000 under a revolving credit agreement and they borrow 80,000 they still have 20,000 left. If the firm then pays off 50,000 of the debt, then 70,000 becomes available. The firm pays interest on the borrowed funds and pays a fee on the unused funds.

Question 18

Unsecured short term loans: Commercial paper

Answer 18

Backed solely by the firm’s promise to pay, option for only the largest and most creditworthy firm. Firm issues a commercial paper with a certain face value, and other companies buy the paper for less than that value. At the end of the specified period (usually 30-90 days, but legally 270 days), the issuing company pays back with the face value.
i.e., Air Canada issues a commercial paper for 10.2 mil, and insurance company buys for 10 mil and earns a 200,000 profit when they get paid back.

Question 19

Long term financing: Debt financing (two primary sources of debt financing)

Answer 19

Long term borrowing from outside the company, appealing for companies that have predictable profits and cash flow patterns.

• Long term loans
• Bonds

Question 20

Debt financing: Long term loans

Answer 20

From a chartered bank, usually one with which firms have developed a long standing relationship with.
Interest rates can vary, some paying fixed rates while others have floating rates.
Advantages: Arranged quickly, duration of the loan is easily matched the the firm’s needs, and the clauses of the agreement can be changed.
Disadvantages: Larger borrowers find it hard to find a supplier with enough funds. There may be restrictions to the loan and they may have to pledge long term assets as collateral. They also may have to agree not to take on any more debt until borrowed funds are repaid.

Question 21

Debt financing: Bonds (7 different types)

Answer 21

Major source of long term debt financing for most large corporations. Attractive when companies need large amounts of funds for long periods of time. But they involve expensive administrative and selling costs, with high interest rates for companies with poor credit. ‘Default’ is when the company fails to make a bond payment.
1. Corporate bond: A contract - a promise by the issuing company to pay the bondholder a certain amount of money (called principal) on a specified date, including interest rate. The ‘bond indenture’ lists the terms of the bond.
2. Registered bonds: Bondholders register their names with the company
3. Bearer/coupon bonds: Bondholders clip coupons and send them to the company to receive payments; coupons can be redeemed by anyone regardless of the ownership
Secured bonds: Firms reduce the risk of their bonds by pledging assets to bondholders in the even of default.
4. Unsecured bonds (debentures): No specific property is pledged as security for the bonds. Holders may have claims against other properties but is inferior.
5. Callable bonds: Calling in bondholders before the maturity date to pay them off, usually since the prevailing interest rates are lower than the rate being paid on the bond.
6. Serial Bonds: Firm retires portions of the bond in installments. Instead of paying a large sum of principal all at once, this spreads out the repayment over several periods.
7. Convertible Bonds: Bonds that can be converted in to common stock of the company. Bondholders may choose to exchange the bonds during periods where the company’s stock is higher than the price they paid for the bonds.

Question 22

Long term financing: Equity financing (two types)

Answer 22

Looking within the company for long-term funding.

• Issuing stock
• Retaining the firm’s earnings

Question 23

Equity financing: Issuing stock (three ways to express common stocks)

Answer 23

Company obtain funds by selling shares of common stock, individuals and companies buy a firm’s stock hoping that it will increase in value or provide dividend income.
1. Par value: The face value of a share, set by the company’s board of directors.
2. Book value: Stockholder’s equity divided by the number of shares
3. Market value: The real value, its current price in the market.
Successful companies usually have their market value higher the the book value.
Can be expensive as dividends to stockholders are more expensive than paying bond interest. However total reliance on debt finance can be bad as the firm promises to pay back regardless of the profitability of the company.

Question 24

How can the price of a share of stock be influenced?

Answer 24

Objective factors (company's profits)
Subjective factors (rumors) 
Investor relations (publicizing positive aspects of the company's financial condition to financial analysts and institutions) 
Stockbroker recommendations

Question 25

Equity financing: retained earnings

Answer 25

Instead of paying out dividends, firms can fund projects using their own profits.
Firms with a history of continued success with retained earnings may be attractive to an investor but may also bring stock prices down if not enough dividends are being paid.

Question 26

Long term financing: hybrid financing (preferred stock)

Answer 26

Features characteristic of both bonds and common stock.
Fixed amounts like a bond, but never matures, like a common stock. Dividends do not have to be paid during periods where the firm makes no profit. If dividends are paid, holders of these stocks receive them first.
Some preferred stock is callable, meaning the issuing firm can require the stockholder to surrender their shares in exchange for cash. This cash payment is called the call price, and its amount is specified in the agreement between the preferred stockholders and the firm.

Question 27

Capital structure

Answer 27

The mix of debt and equity financing to meet the firm’s long term needs for funds.
All-equity financing and no debt may be the safest strategy, but also the most expensive.
All-debt financing may be cheaper but very risk heavy.

Question 28

Investment management: how can you manage risks?

Answer 28

Risk management:
Diversification: Buying several kinds of investment from different companies, industries and countries.
Asset Allocation: The proportion of funds invested in each of the investment alternatives. Younger investors may invest more on riskier common stocks while older investors may prefer more conservative investments such as bonds.

Question 29

Securities markets (primary and secondary, private placements)

Answer 29

The market in which stocks and bonds are sold in
Primary securities markets: Buying and selling of new shares of stocks and bonds
Secondary securities markets: Market for existing stocks and bonds; companies do not receive any funding from this
Private placements: Businesses sell to select individuals or groups to keep their plans confidential

Question 30

Investment bankers (what do they do?)

Answer 30

Financial specialists that services companies in issuing new securities (stocks and bonds).
They provide the following services:
1. Advise companies on the timing and financial terms for a new issue
2. Bear some of the risk of issuing a new security
3. Create distribution network that moves the new issues through groups of banks and brokers into the hands of individual investors

Question 31

Stock exchange

Answer 31

Individuals and organizations that provide a setting in which shares of stock can be bought and sold.
The exchange enforces rules to govern its members’ trading activities.
To trade in the exchange, you must buy a membership. These memberships can be bought and sold like other assets.

Question 32

Stockbrokers (full-service and discount)

Answer 32

Receives buy & sell orders from those who aren’t a member of the exchange. Earns commission from the client.
Full-service: Offer services to those who are not informed or are simply not interested. Discount: Offer well-informed individual investors a fast, low cost way to participate in the market. Cost less because they receive fees or salaries instead of commissions.

Question 33

Over-the-counter (OTC) market

Answer 33

Traders act like retailers. Keep supplies of shares on hand and sells them to interested buyers when the opportunity rises.

Question 34

Bull and Bear markets

Answer 34

Bull: Periods of upward-moving stock prices
Bear: Periods of falling stock prices

Question 35

Buying and selling stocks (types and sizes of orders)

Answer 35

Market order: Requests the broker to buy or sell a certain security at the prevailing market price at the time
Limit order: Authorizes the purchase of a stock only if its price is less than or equal to a given limit
Stop order: Instructs the broker to sell a stock if its price falls to a certain level

Round lot: 100 shares or multiples of 100 (200,500,1600, etc)
Odd lot: Number of shares less than 100 (1-99)

Question 36

Stock options

Answer 36

The right to buy or sell a stock

Call option: Gives the owner the right to buy a particular stock at a certain price, with that right lasting until a particular date
Put option: Gives the owner the right to sell a particular stock at a specified price, with that right lasting until a particular date.

Example: You see a stock at 18 and believe it will go up, purchasing a call option; giving you the right to buy 1000 shares any time in the next two months when the stock reaches the price of 23 (strike price). If the stock does rise to 23 you exercise your call option and make a profit of 5 per share. If the stock falls, you will not exercise and your stock option will be “under-water” = worthless.

Question 37

Margin trading

Answer 37

Purchasing stocks by putting down only a portion of the stock’s price. Borrow rest from your broker who in turn borrows from the bank.

When you profit, you can profit more. However when you lose money, you are covering not only for your own losses but the bank’s losses as well.

Question 38

Short sales

Answer 38

Borrowing a security from your broker and selling it. You must restore an equal number of shares of that issue along with a fee.

Question 39

Mutual funds (no-load and load funds)

Answer 39

Pool of investments that consist of a portfolio of stocks, bonds, and short term securities. Gives small investors the access to professional financial management.

no-load: shares are sold without a commission or sales charge
load: carries a fee of between 2-8% of the invested funds.

Question 40

Exchange-traded fund (ETF) How is it different from mutual funds?

Answer 40

Bundle of stocks (or bonds) that tracks the overall movement of the market and trades during the day.

Able to buy and sell ETFs at any time during the day, unlike mutual funds that can only be purchased at the end of the day. ETFs also do not require active management.

Question 41

Hedge funds

Answer 41

Private pools of money that try to give investors a positive return regardless of stock market performance.

Traditionally has been limited for the wealthy, but something called ‘principal-protected notes’ came up for the average investors.

Guarantees investors will get their original investment back at a certain time but does no guarantee any additional returns.

Question 42

Futures contracts

Answer 42

Agreements to purchase or sell a specified amount of a commodity at a given price on a set date in the future.

Question 43

Two basic types of financial risks

Answer 43

Speculative risks: Involves the possibility of profit and loss (investing in stocks)

Pure risks: Involves only the possibility of loss or no loss (car insurance; if an accident occurs there is loss, even if there is no accident there is no real gain)

Question 44

The risk management process

Answer 44

1: Identify risks and potential losses (company with many delivery trucks may need to expect car accidents)
2: Measure the frequency and severity of losses and their impact (if the delivery trucks company had two accidents last year, adding on more will likely add to this number)

3: Evaluate alternatives and choose techniques that will best handle losses
- risk avoidance: Declining to enter or ceasing to participate in a risky activity (company closes its delivery service)
- risk control: Use of loss-prevention techniques to minimize the frequency of losses. (train drivers, map out safer routes, etc)
- risk retention: Predicting certain consequences and coping them with available company funds
- risk transfer: Transfer the risk to another firm, mainly, insurance companies

4: Implement the risk management program (1-3)
5: Monitor results

Question 45

Investment management: how can you evaluate your investments? (ROI analysis)

Answer 45

Look at the following things:

Return from dividends (interest): Calculate the current dividend yield (or interest), by this formula: annual dividend yield/current share price×100% and compare the result with other investments.

Price appreciation: Increase in dollar value of an investment. The profit you gain from selling the share with an appreciation is called ‘capital gain’.

Total return: Calculate: Total return(%)=(Current dividend payment+Capital gain)/Original investment×100