B2 - Financial Markets Flashcards
1
Q
When is a bond selling at a premium?
A
The bond sells at a premium when the stated coupon rate on the bond is greater than the market interest rate (effective interest rate) at a given date.
2
Q
When is a bond selling at a discount?
A
The bond sells at a discount when the stated coupon rate on the bond is less than the market interest rate (effective interest rate) at a given date.
3
Q
What is a floating rate loan (bond)?
A
Floating rate or variable rate loans maintain a constant value. If rates change, the value of the debt will simple adjust.
4
Q
What is the formula to compute the market capitalization?
A
Market capitalization = number of common shares outstanding * FMV per share
5
Q
What is the overall cost of capital?
A
It is the hurdle rate or rate of return used by a company to invest in a project financially feasible.
6
Q
What bond interest rate is used to compute the cost of debt?
A
The interest rate used to compute the cost of debt is the effective interest rate of the bond. The coupon rate is not used for this computation.
7
Q
What is the formula to compute the expected rate of return?
A
Expected rate of return = annual dividend/current market price
8
Q
What is the formula to calculate the cost of preferred stock?
A
Cost of preferred stock = Preferred stock dividends (par value)/Net proceeds of preferred stock [selling price - floating cost (i.e., issuance cost)] * Dividend %
9
Q
What is the beta coefficient in the CAPM formula and what is the formula to compute it?
A
Beta Coefficient = % change in stock price/% change in market price
the beta coefficient is a measure of risk (volatility) relative to the overall market and it is calculated for an individual stock.
A beta of 1 -> stock and overall market have equal volatility
A beta greater (less) than 1 -> stock is more (less) volatile than the market.
10
Q
What is the formula to compute the capital asset pricing model (CAPM)?
A
CAPM = Risk-free rate + risk premium
CAPM = Risk-free rate + (beta*market risk premium)
CAPM = Risk-free rate + [Beta * (market return - risk-free rate)]
11
Q
When does a capital investment increase the value of a firm?
A
The value of a firm is increased when the capital investment exceeds the rate of return associated with the firm’s beta factor
12
Q
What is the capital asset pricing model (CAPM)?
A
CAPM is used to estimate the cost of equity capital or cost of common stock for an individual stock.
13
Q
What is the formula to determine the rate of return of a stock using the dividend growth model?
A
Required rate of return (DCF) = forecasted dividend [dividend*(1+expected rate)]/current stock price + expected growth rate. This formula is also used to determine the cost of equity or common stock.
14
Q
When does financial leverage increases?
A
Financial leverage increases when the debt-to-equity ratio increases. Issuing more bonds/debt will increase the debt-to-equity ratio.
15
Q
What is the formula to compute the quick ratio?
A
Quick ratio = Cash and cash equivalents + ST marketable securities + Receivables (net of allowance)/ current liabilities
16
Q
What is the interpretation of the quick ratio?
A
- it is a more rigorous test of liquidity than the current ratio because inventory and prepaids are excluded from current assets.
- The higher the quick ratio (or acid-test ratio), the better.
17
Q
What is the formula to compute inventory turnover ratio?
A
inventory turnover ratio = COGS/(beg inventory + end inventory)/2
18
Q
What is the formula to compute the cash conversion cyle?
A
cash conversion cycle = days in AR - days in AP + days in inventory
19
Q
How can the cash conversion cycle formula be interpreted?
A
it is interpreted as how long it takes for a company to buy inventory on credit from a vendor, sell that inventory on credit, collect cash for the sale, and use the proceeds to pay the vendor for the purchase.
20
Q
What are the inventory carrying costs affecting inventory levels?
A
- storage costs
- insurance costs
- opportunity costs (surplus inventory does not generate any interest income or dividend income)
- Lost inventory due to obsolescense or spoilage.
21
Q
What factors help determine the safety stock?
A
- Reliability of sales forecasts
- Possibility of customer dissatisfaction resulting from back orders.
- Stockout costs, including loss of income, the cost of restoring goodwill with customers, and the cost of expedited shipping to meet customer demand
- Lead time
- Seasonal demands on inventory
The cost to reorder does not impact the safety stock.
22
Q
What is the formula to compute the total annual cost of safety stock?
A
Total annual cost of safety stock = carrying cost + expected stockout cost
23
Q
How to compute the expected stockout cost?
A
Expected stockout cost = stockout units * stockout cost/unit * probability at units of safety stock levels (probability %) * orders per year
24
Q
How to compute the carrying cost?
A
Carrying cost = (inventory investment/unit * carrying cost % = carrying cost per unit) * safety stock units
25
What is the economic order quantity (EOQ) assumption?
EOQ assumes that demand is known and constant throughout the year. EOQ assumes that carrying costs and ordering costs are fixed. Annual sales volume is a crucial variable.
26
What is the purpose of the economic order quantity (EOQ) model?
EOQ is an inventory model that attempts to minimize both ordering cost (shipping) and minimize carrying costs.
27
What is the formula to compute the EOQ?
EOQ = √2SO/C
S = sales in units
O = cost per purchase order (primary production set-up costs)
C = carrying cost per unit
28
What is the formula to compute the reorder point?
Reorder point = Safety stock + [lead time * sales during the lead time (e.g., avg sales/50 weeks)]
29
What is the reorder point?
It is the point at which a company should order or manufacture additional inventory in order to meet demand and avoid incurring stockout costs.
30
When does stockout costs occur?
Stockout costs occur when customer orders cannot be filled. it includes lost income from orders that cannot be filled, the cost of restoring goodwill, and cost of expedited shipping.
31
What are the 4 key management processes or core activities of the Supply Chain Operations Reference (SCORE) Model?
1. Plan
2. Source
3. Make
4. Deliver
32
What is Material requirement planning (MRP)?
Inventory technique that projects and plans inventory levels to control the usage of raw materials in the production process. MRP is primarily applied to work in process and raw materials.
33
What is a spontanous source of financing for a firm?
Accounts payable is considered spontanous financing because no formal agreement is needed with the lender (vendor). Borrower gets the goods without immediate payment, this spontanous financing, 30 days.
34
What is the formula to compute the APR or quick payment discount?
APR or quick payment discount = 360/Pay period - Discount period * Discount %/100% - Discount%
35
What is the cost of not taking a credit discount?
The cost of not taking a credit discount might be higher than the cost of a bank loan
36
What is a method of delaying cash disbursement?
Paying by means of a draft (or check) allows the firm to take advantage of the float period.
37
How to compute the company's float?
Checks drawn but not cleared * #days
Less: checks received but not cleared * #days
= Float
38
What is the formula to calculate avg. gross receivables?
Avg. gross receivables = Avg. daily sales ($ amount) * Avg. collection period (days' sales in AR)
39
How to compute days' sales in AR (or avg. collection period)?
Days' sales in AR = Ending AR, net/(credit sales, net/365)
40
How does the lockbox system works?
Lockboxes are system mailboxes, usually in many locations, where customers send payments. The company's bank checks these mailboxes frequently and immediately deposits checks received. This accelerates the collection of AR.
41
What is the primary reason for a company to agree to a debt covenant?
a company agrees to a debt covenant to limit the percentage of its long-term debt to reduce the coupon rate on new bonds being sold.
42
What is the function of the P/E ratio?
It measures the amount that investors are willing to pay for each dollar of earnings per share. Higher P/E ratios generally indicate that investors are anticipating more growth and are bidding up the price of the shares in advance of performance.
43
What is the formula to compute free cash flow?
Free cash flow = Net income + noncash expenses (depreciation and amortization) - increase in working capital - capital expenditures.
44
What are the inputs used in the computation of the Black-Scholes model?
1. Current price of the underlying stock (higher price -> higher option value)
2. Option exercise price
3. Risk-free interest rate (higher rate -> higher option value)
4. Current time until expiration (longer time -> higher call option value)
5. Some measure of risk for the underlying stock (volatility) (higher risk -> higher option value)
45
What is the Black-Scholes model used for?
The Black-scholes model is used to determine the fair values for call and put options.
46
What are the assumptions underlying the Black-Scholes model?
1. Stock price behave randomly
2. The risk-free rate and volatility of the stock price are constant over the option's life.
3. There are no taxes or transaction costs.
4. The stock pays no dividends, although the model can be adapted to dividend-paying stock.
5. The options are European-style (exercisable only at maturity). American -style options can be exercised any time before maturity.
47
What is the difference between the binomial (Cox-Ross-Rubestain) model and the Black-Scholes model?
Different to the Black-Scholes model, the binomial model considers the following:
1. The consideration of the option over a period of time
2. It can be used for stocks that pay dividends without model modification.
48
What is the effect of a lockbox for receivable management?
the lockbox minimizes collection float by having a bank receive payments from company's customers directly, via mailboxes to which the bank has access.
49
What is opportunity cost?
Opportunity cost is the potential benefit lost by selecting a particular course of action (e.g., the revenue that will not occur if an asset is not sold)
50
What is a relevant cost?
Relevant costs are the cost that will differ among many alternatives
51
When making capital budgeting decision, how is MACRS depreciation compared to straight line depreciation?
MACRS and straight line depreciation will equal in total (only the timing differs)
52
What is the formula to compute after-tax cash flows?
1. Compute the after-tax cash inflows (if tax is given):
Sales
less: cash operating expenses
= Gross income
or Annual cash inflows
* Tax (1-tax rate)
= Income, net of tax or after-tax cash inflows
2. Compute the tax shield if depreciation involved;
Depreciation expense
* tax rate
= Depreciation shield
3. Compute the after tax salvage value (if salvage value given):
Salvage value
* (1-tax rate)
= after-tax salvage value
4. Compute the total cash inflows (discount if required):
After-tax cash inflows (Income, net of tax)
+ Depreciation shield
+ After-tax salvage value
= Total after-tax cash inflows
5. Subtract the after-tax cash inflow from the initial cash outflow to obtain the net cash flows.
Accept -> NPV > 0 (positive #)
Reject -> NPV < 0 (negative #)
53
How is the net present value normally affected?
Net present value is normally affected by the proceeds from the sale of the asset to be replaced.
54
What is the accounting rate of return?
accounting rate of return is a capital budgeting technique, not a rate.
55
How is the discount rate interpreted when the NPV is negative?
If the NPV of a proposed investment is negative, the discount rate used must be greater than the project's internal rate of return (IRR).
56
What is the Internal Rate of Return (IRR)?
Determines the present value factor (and related interest) that yields an NPV equal to zero (the PV of the after-tax cash flows equals the initial investment on the project).
57
What is the formula to calculate the profitability index?
profitability index = Net present value (NPV)/Today's outflow (cost)
Select the project with the highest profitability index.
58
What is a limitation of the profitability index?
The profitability index requires detailed long-term forecasts of project's cash flows. For longer term projects, cash flow projections might be either unavailable or unreliable.
59
What is the formula to compute times interest earned ratio?
times interest earned ratio = Earnings before interest expense and taxes (EBIT)/interest expense
after-tax income = pretax income * (1-Tax rate)
60
What is the purpose of the times interest earned ratio?
It measures the ability of the company to pay its interest charges as they come due. It is the measure of long-term solvency.
61
What is the formula to compute the factor of the Internal Rate of Return (IRR)?
Factor of the IRR = Net incremental investment (investment required)/Net annual cash flows
62
What is the payback method?
The payback method measures the time required to recover the initial investment
63
What is the formula to compute the payback period?
payback period = initial investment/after-tax cash flows
64
What is true about the payback period?
It ignores all cash flows after the end of the payback period
65
How to calculate the total cost of equity using the discounted model or dividend growth model (DDM)?
Cost of equity = [current dividends * (1 + growth rate)]/(cost of equity (CAPM) + Growth rate)
66
how to calculate the total market value of bonds?
Total market value of bond = Par value * Current market value per bond/1,000
67
How is the market rate of interest on a US T-bill computed?
Risk free rate of interest
+ Inflation premium
= Market rate of interest
68
What is the formula to calculate the price-to-book ratio?
Price-to-book ratio = Price per share today (0) or market capitalization/Equity (C/S + APIC + R/E)
69
What is the formula to calculate the price-to-CF ratio?
Price-to-CF ratio =Price per share today (0) or market capitalization/Operating CF0 (today) * (1 + Growth)/# shares outstanding
70
What is the formula to calculate the price-to-sale ratio?
Price-to-sales ratio =Price per share today (0) or market capitalization/Sales0 (today) * (1 + Growth)/# shares outstanding
71
How to calculate the intrinsic price using the price for forecasted CFs?
current intrinsic price = Po/CF1 * price for forecasted CF
72
What are considered ordering costs in the economic order quantity (EOQ) formula?
Ordering cost typically represent cost of labor associated with the order placement. Examples:
1. cost of entering the purchase order
2. cost of processing the receipt of the inventory
3. cost of inspecting the inventory to ensure goods received are acceptable
4. costs of processing of the vendor invoice and payment consequences
5. costs associated with product set-up
73
What does it mean when net working capital is positive?
This implies that current assets exceed current liabilities and represent a net current asset.
74
When does a line of credit represent a loan from the bank?
A line of credit that are drawn represent a loan from the bank
75
What is a line of credit?
A line of credit represents a revolving loan with a bank, or group of banks, that is up to a specific dollar maximum amount for a defined term and is renewable upon the maturity date.
76
What is a letter of credit?
It represents a third-party guarantee, generally by a bank, of financial obligations incurred by the company.
77
What are the advantages to a corporation to issue commercial paper?
1. Avoids the expense of maintaining a compensating balance with a commercial bank.
2. Provides a broad distribution for borrowing.
3. Accrues a benefit to the borrower because its name becomes more widely known.
78
What is a disadvantage to a corporation to issue commercial paper?
Although commercial paper has a secondary market available, it is generally not an active secondary market. These are sold to highly creditworthy companies.
79
What is a commercial paper?
it is an unsecured, short-term debt instrument issued by a corporation. Commercial paper matures in 270 days or less and typically matures in 30 days.
80
When are fixed rates more favorably used for working capital purposes?
Fixed rates are more favorable if interest rate rises.
81
When are floating rates more favorably used for working capital purposes?
Floating rates are more favorable if interest rates fall.
82
What are the items that impact the optimal level of inventory?
1. The time required to achieve inventory
2. The cost per unit of inventory, which will have a direct impact on inventory carrying costs.
3. The cost of placing an order impacts order frequency, which affects order size and optimal inventory levels.
The current level of inventory does not affect the optimal level.
83
What are the advantages of short-term financing?
1. Current liability, with terms no longer than 1 year.
2. short term rates tend to have a lower cost of borrowing as you save the cost of locking in the interest rate, increased profitability
3. Greater liquidity as you have to turn in inventory into cash faster to pay the short term debt
4. Factoring or pledging AR can be used as collateral to obtains ST financing.
84
What are the disadvantages of short-term financing?
1. interest are variable. if interest rate goes up, interest rate risk.
2. credit risk - we cannot get a loan next time we borrow because we don't have profits or good B/S to request loan.
85
What are the advantages of long-term financing?
1. non-current liability, with maturity longer than 1 year.
2. locked in rate and long term financing
3. If less credit available. we don't need to worry since we locked in the long term borrowing.
86
what are the disadvantages of long-term financing?
1. Long term rates tend to have a higher cost of borrowing (higher interest rates) which decreases profitability.
2. Decreased liquidity for the borrower
87
What is the liquid asset management technique that delays cash disbursements?
Trade credits
88
What is trade credits?
Trade credits or accounts payable represents the purchases of goods and services as part of usual and customary transactions for which payments is made 30 to 45 days after acquisition. Largest form of short term credit for small firms. Deferral of payments to creditors.
89
What is trade acceptance?
It is a formal agreement that allows the supplier (seller) to convert amounts owed by the buyer into a negotiable instrument.
90
When is working capital considered an outflow (reduction to initial cash flow) when determining how to apply it in the initial cash outflow?
When an asset is purchased, additional suppliers must be purchased to service the new asset working capital requirements. The additional working capital requirements represent an outflow.
91
When is working capital considered an inflow when determining how to apply it in the initial cash outflow?
When the new asset reduces the working capital requirements because it's so much more efficient than the old asset, that would be treated as an inflow (an addition to the initial purchase price). General rule is increase in working capital.
92
What is the purpose of Planning within the Supply chain Operations Reference (SCOR) Model?
The process of planning consists in developing a way to properly balance demand and supply with goals and objectives of the firm and prepare for necessary infrastructure.
93
What activities under planning associated with the SCOR model?
1. Determining the demand requirements
2. Assessing the ability of suppliers to supply resources
3. Planning the inventory levels.
4. Planning the distribution of inventory
5. Planning for the purchase of raw materials
6. Assessing capacity concerns and capabilities
7. Identifying viable distribution channels
8. Configuring the supply chain
9. Managing the product's life cycle
10. Making make/buy decisions.
94
What is the purpose of concentration banking?
Characterized by the designation of single bank as central depository.
95
What are the advantages of concentration banking?
1. improves controls over inflows and outflows of cash
2. Reduces idle balances
3. Improve effectiveness for investment.
96
What are the advantages of implementing a lockbox system?
1. Cash is more readily available
2. larger cash balances might be invested to maximize interest income
97
When does the safety stock tend to increase?
If lead time became more variable, the amount of safety stock needed to reduce risk of stock out will increase.
98
How does increased volatility impact the price of the call/put option in a Black-Scholes Model?
It increases the value of the call/put option because it increases the chance that the underlying asset price will move such that the option is in-the-money.
99
When is a call/put option in-the-money?
A call/put option is in-the-money when the underlying asset price is higher than the option exercise price.
100
What is the formula to compute price-earnings ratio?
P/E ratio = Price per share today/Expected earnings per share (current earnings * (1 + growth rate)
101
What is the formula to compute PEG ratio?
PEG ratio = P/E ratio/ Growth rate (100 * expected growth rate)
102
What is a working capital financing policy that represents a greater risk of being unable to meet the firm's maturing obligations?
Working capital financing policy that finances permanent current assets with short-term debt.
103
What is an advantage of the net present value method?
It is considered to be superior over the IRR method because different hurdle rates can be used for each of the project to reflect the level of risk associated with each cash flow.
104
If the NPV in an investment is positive, how should the company consider the investment?
- If the result of the investment is positive (greater than zero), make the investment
- If rate of return of the project > than hurdle rate (discount% used in the NPV calculation), then do the investment
- All projects with positive NPV should be accepted, and the order of acceptance starts with the largest NPV.
105
If the NPV in an investment is negative, how should the company consider the investment?
- If the result of the investment is negative (less than zero), do not make the investment
- if the rate of return on the project is < than hurdle rate, the investment should not be made because it does not meet management's minimum rate of return.
106
What is the interest rate determined by management to perform NPV analysis?
Management can use different hurdle rates such as:
1. cost of capital (avg. rate of return demanded by investors)
2. interest rate of the opportunity cost
3. some other minimum required rate of return
107
What is a disadvantage of the NPV?
The NPV is limited by not providing the true rate of return on the investment
108
How is the IRR treated when the discount rate is greater or lower than zero?
- If a discount rate (targeted/hurdle rate) > IRR or IRR < discount rate -> the present value of future cash inflows will be lower resulting in a negative net present value.
- If a discount rate < IRR or IRR > discount rate -> the present value of future cash inflows will be higher resulting in a net present value.
- If IRR = discount rate - indifferent
109
How is the IRR method used by decision makers?
The IRR method focuses decision makers on the discount rate at which the present value of the cash inflows equals the present value of the cash outflows (usually the initial investment). The IRR focuses on percentages.
110
What are the limitations of the IRR?
1. Cash flows generated by the investment are assumed in the IRR analysis to be invested at the internal rate of return. if IRR is unrealistically high or low, it could lead to inappropriate conclusions.
2. The timing or the amount of cash flows used to determine the IRR can be misleading as the cash inflows and outflows can differ significantly when there are several alternating periods.
3. It is based entirely on interest rate, not dollar amount.
111
What is operating leverage?
It is defined as the degree to which a firm uses fixed operating costs, as opposed to variable operating costs. It measures fixed costs relative to total costs.
112
What does a firm with high operating leverage needs to do?
Company with high operating leverage, means that has high fixed costs (as a percentage of total costs) relative to total costs (VC+FC). The company must produce enough revenue to cover all those fixed costs (e.g., depreciation and interest expense). The remaining revenue go straight to operating income since variable costs are so low
113
How to compute operating leverage?
Operating leverage = % change in EBIT/% change in unit sales volume
or
Operating leverage = Fixed expenses/total expenses (VC + FC)
114
What is financial leverage?
Financial leverage is a decision made by management regarding capital structure. Only two ways to raise capital, borrow money or take on partners or stockholders.
115
What are implications of financial leverage?
A company that issues debt must produce sufficient operating income (earnings before interest and taxes) to cover its fixed interest costs. Once covered, additional EBIT will go straight to net income and earnings per share.
116
What is the formula to compute financial leverage?
Financial leverage = % change in EPS/% change in EBIT
It is also computed as Avg. total assets/equity
117
What is combined leverage?
Results from the use of both fixed operating costs and fixed financing costs to magnify returns to the firm's owners.
118
What is the formula to compute combined leverage?
Combine leverage = Degree of operating leverage * degree of financial leverage
119
How is the P/E ratio interpreted?
P/E ratio demonstrates the amount of investment that investors are willing to make for each dollar of earnings per share (EPS). Lower P/E ratio indicates investors are not expecting much growth from the company's stock. higher P/E ratio compared to other companies means that the stock price is overpriced or expectation is that earnings will be higher.
120
How to calculate the market value of equity used to calculate WACC?
Market Value of equity = (total common stock/par value share = # shares outstanding) * market value per share
121
How to calculate the market value of debt used to calculate WACC?
Market Value of debt = (bond payable/par value bonds = # bonds outstanding) * market value per bond
122
How to calculate the weights of equity and debt in capital structure to calculate WACC?
1) calculate the total market value of equity + debt capital structure.
Market value of equity
+ market value of bonds
= Total market value of capital
2) calculate the weight of equity in capital structure.
weight of equity in capital structure = market value equity/total market value of capital
3) calculate the weight of debt in capital structure
weight of debt in capital structure = market value debt/total market value of capital
123
How to calculate WACC?
WACC = (weight of debt in capital structure * after-tax cost of debt) + (weight of equity in capital structure * cost of equity)
WACC is the overall hurdle rate used by the company to determine if it should invest in the project or not. The company will use the lowest hurdle rate.
124
What is the purpose of the equity multiplier?
The equity multiplier measures the portion of assets that are funded by equity rather than debt. No obligations to repay. Its a long-term solvency ratio.
125
What is the formula to compute the equity multiplier?
equity multiplier = Total assets/total equity.
126
How to calculate the cost of debt?
cost of debt = (interest expense/total debt)*(1-tax rate)
127
What is the market approach to value intangible assets?
Requires that actual arm's-length (sales, transfer, licenses) in similar markets be used as a reference for the asset to be valued.
128
How is the market approach of intangible assets calculated?
There are several patent market values, the median values are selected (exclude the outliers), add them up, and then divide them by 2 to determine the patent market value.
129
What are considered multiple price ratios?
1. P/E ratio
2. Forward P/E ratio
3. Price to book ratio
4. Price to cash flow ratio
5. Price to sales ratio
130
What is materials requirement planning?
It's an inventory technique that projects and plans inventory levels to control the usage of raw materials in the production process. It is primarily applicable to to both work in process and raw materials.
131
What is working capital management?
Matches the maturity life of each asset with the length of the financial instrument used to finance that asset.
132
What is the purpose of the profitability index?
the profitability index is used as a way to easily rank and choose a projects based on the future cash flows relative to the upfront or initial investment in a project. Companies select the project with the highest profitability index.
