B6-4 Flashcards
The Elbow Corporation is computing the annual percentage rate of interest on its most recent borrowing of $10,000. The note carried a nominal interest rate of 10% and provided net proceeds to Elbow Corporation of $9,500 after reduction for documentary stamps and loan origination fees. The annual percentage rate of interest is:
a.
10.5%
b.
10%
c.
11%
d.
9.5%
Choice “a” is correct. The annual percentage rate on debt is equal to the amount of the payments required under the contract divided by the net proceeds of the debt. In this case, the amount of the payments is $1,000 ($10,000 x 10%) while the amount of net proceeds is $9,500. The annual percentage rate is $1,000 / $9,500 or 10.5%.
Which tool would most likely be used to determine the best course of action under conditions of uncertainty?
a.
Cost-volume-profit analysis.
b.
Scattergraph method.
c.
Program evaluation and review technique (PERT).
d.
Expected value (EV).
Choice “d” is correct. Probability and expected value formulate quantitative models to address the issue of appropriate course of action in an environment of uncertainty. The expected value is a weighted average of all values and variables. The course of action with the highest expected monetary value should be selected.
Choice “a” is incorrect. Cost-volume profit analysis is a method used to evaluate operating decisions.
Choice “c” is incorrect. PERT is a technique used in project management that focuses on the time required to complete each step in a project. It allows a project manager to monitor a project’s progress and identify potential bottlenecks or delays that will postpone the completion date.
Choice “b” is incorrect. The scattergraph method is used in statistical analysis to plot relationships between variables to determine a line function that best describes those relationships.
Solway International is owed £10,000 from its U.K. customer. The current exchange rate is $1.30 to the U.K. pound (£1.00). Solway has purchased a put option to sell £10,000 in 60 days time for $1.25, and Solway has paid a premium of $0.005. If 60 days from now the exchange rate is $1.20, what will be the overall result for Solway International?
a.
Solway will exercise the option and it will benefit Solway by $450.
b.
Solway will exercise the option and it will benefit Solway by $500.
c.
Solway will exercise the option and it will benefit Solway by $550.
d.
Solway will allow the option to expire unexercised.
Choice “a” is correct. The option price is $1.25 less the premium of $.005 so the net proceeds are computed at $1.245. Solway will sell the £10,000 at $1.250 and receive $12,450, net of the premium, instead of receiving $12,000 at the spot rate of $1.20, a benefit of $450. Note that the premium is not included in determining whether or not to exercise the option because the premium is a sunk cost.
Choices “d”, “b”, and “c” are incorrect, per the above explanation.
A company has several long-term floating-rate bonds outstanding. The company’s cash flows have stabilized, and the company is considering hedging interest rate risk. Which of the following derivative instruments is recommended for this purpose?
a.
Futures contract on a stock.
b.
Interest rate swap agreement.
c.
Forward contract on a commodity.
d.
Structured short-term note.
Choice “b” is correct. An interest rate swap agreement would be effective in hedging the risk associated with interest rate fluctuations. A swap agreement is a private agreement between two parties, generally assisted by an intermediary, to exchange future cash payments. In this case, the company would most likely enter into an interest rate swap in which it would pay another party a fixed rate of interest in exchange for receipt of payments of a floating rate of interest. The company would then use the floating interest payments received to pay the interest on its floating-rate bonds. In this way, the company would use the swap agreement to convert its interest payments from floating-rate to fixed-rate.
Choice “d” is incorrect. A structured short term note would not be effective in hedging the interest rate risks associated with long term floating rate bonds. Long term rates will fluctuate based on the expectations associated with the long term bond market. Short term rates at a point in time are based on different assumptions by investors and lenders.
Choice “c” is incorrect. Forward contracts on commodities have a lower likelihood of effectively hedging interest rate risk than an interest rate swap. The financial markets that impact interest rates are more directly connected to interest rates than commodities.
Choice “a” is incorrect. Futures contracts on equities have a lower likelihood of effectively hedging interest rate risk than an interest rate swap. The financial markets that impact interest rates are more directly connected to interest rates than equities.
An American importer expects to pay a British supplier 500,000 British pounds in three months. Which of the following hedges is best for the importer to fix the price in dollars?
a.
Buying British pound call options.
b.
Selling British pound put options.
c.
Buying British pound put options.
d.
Selling British pound call options.
Choice “a” is correct. To fix a price in dollars to buy British pounds, British pound call options should be purchased. Call options would allow, but not require, the purchaser of the call to acquire the currency (British pounds) for a specified price at or before a specified time in the future. If the price goes up, the purchaser (the importer) would exercise the options; if not, the purchaser (importer) would buy the British pounds in the market and let the options expire. British pound futures could also be used, but that was not one of the choices listed.
Choice “c” is incorrect. Buying British pound put options would allow, but not require, the purchaser of the put to sell the currency for a specified price at a specified time in the future. Since the importer needs British pounds, buying put options would not work. The importer needs to end up with British pounds.
Choice “b” is incorrect. Selling British pound put options would not work. The importer needs to end up with British pounds. Selling put options could work, but the option would be exercised, or not, by the purchaser and not by the importer. If the options were not exercised, the importer could end up with nothing (other than the option premium).
Choice “d” is incorrect. Selling British pound call options would not work. The importer needs to end up with British pounds; if call options are sold, the other party can exercise the options or let them expire, and if the options were exercised, the importer would have to supply the British pounds. This answer is backwards.
Investment managers develop portfolios of different investments to combine, offset, and thereby reduce overall risk. Not all risks can be eliminated by development of a portfolio. Risks that cannot be eliminated through a portfolio are called:
a.
Systematic risks.
b.
Unsystematic risks.
c.
Non-market risks.
d.
Firm-specific risks.
Rule: Portfolio theory is concerned with construction of an investment portfolio that efficiently balances its risk with its rate of return. Risk is often reduced by diversification, the process of mixing investments of different or offsetting risks. The broad categories of risk are summarized in the following mnemonic to get us DUNS.
Diversifiable
Unsystematic (non-market/firm-specific)
Non-diversifiable
Systematic (market)
Choice “a” is correct. Non-diversifiable risk cannot be eliminated by the application of portfolio theory. Non-diversifiable risk is also referred to as market or systematic risk.
Choice “c” is incorrect. Diversifiable risk can be eliminated through effective application of portfolio theory. Diversifiable risks are also termed non-market risk.
Choice “b” is incorrect. Diversifiable risk can be eliminated through effective application of portfolio theory. Diversifiable risks are also termed unsystematic risk.
Choice “d” is incorrect. Diversifiable risk can be eliminated through effective application of portfolio theory. Diversifiable risks are also termed firm-specific risk.
The required rate of return is generally computed as the risk-free rate of return plus a number of risk premium adjustments. All of the following risk adjustments are used to compute the required rate of return, except:
a.
Credit risk premium.
b.
Default risk premium.
c.
Maturity risk premium.
d.
Purchasing power risk premium.
Choice “a” is correct. Credit risk relates to the ability of a firm to obtain, not grant, credit. Require rate of return adjustments do not include a credit risk adjustment.
Choice “b” is incorrect. Default risk premium (DRP) is an appropriate risk adjustment to the risk-free rate of return and is the additional compensation demanded by lenders for bearing the risk that the issuer of the security will fail to pay interest or fail to repay the principal.
Choice “d” is incorrect. Purchasing power risk premium, or inflation premium (IP), is an appropriate risk adjustment to the risk free-rate of return and is the compensation investors require to bear the risk that price levels may change and affect asset values or the purchasing power of invested dollars (e.g., real estate).
Choice “c” is incorrect. Maturity risk premium (MRP), or interest rate risk, is an appropriate risk adjustment to the risk-free rate of return and is the compensation investors demand for bearing risk. This risk increases with the term to maturity.
Hagar Company’s bank requires a compensating balance of 20 percent on a $100,000 loan. If the stated interest on the loan is 7 percent, what is the effective cost of the loan?
a.
8.75 percent.
b.
8.18 percent.
c.
8.40 percent.
d.
7.00 percent.
Choice “a” is correct. Total interest for the loan is $100,000 × 7% or $7,000. The effective amount received is $80,000 after the 20% compensating balance. The effective interest is $7,000 / $80,000 = 8.75%.
Choices “d”, “b”, and “c” are incorrect, per the above calculation.
Each of the following financial instruments is a derivative, except:
a.
An agreement to buy a piece of equipment in six months at a price determined today.
b.
Interest rate futures.
c.
A contract to purchase a commodity in six months at a price determined today.
d.
A fixed interest, five-year note payable.
Choice “d” is correct. A derivative is a financial contract which derives its value from the performance of another asset or financial contract (interest rate, stock, asset, etc.). A fixed interest, five-year note payable is a debt instrument whose changes in value drive its own performance.
Choice “b” is incorrect. An interest rate future is a derivative whose performance is driven by movement in interest rates.
Choice “a” is incorrect. Buying equipment in six months at a price defined today is an example of a derivative hedging transaction. The value of this contract will be equal to the difference between the actual price in six months and the preset price determined today, with a higher actual price benefiting the buyer (who would have locked in a lower purchase price) and a lower actual price benefiting the seller (who would have locked in a higher sale price).
Choice “c” is incorrect. Buying a commodity in six months at a price defined today is an example of a derivative hedging transaction. The value of this contract will be equal to the difference between the actual price in six months and the preset price determined today, with a higher actual price benefiting the buyer (who would have locked in a lower purchase price) and a lower actual price benefiting the seller (who would have locked in a higher sale price).
Hedgehog International has numerous foreign exchange transactions. Management has elected to hedge transactions as a means of mitigating transaction exposure to exchange rate risk. What is the most effective means that Hedgehog International can use to avoid overhedging?
a.
Hedgehog should acquire the minimum amount required to hedge known transactions.
b.
Hedgehog should enter into a cross hedging agreement.
c.
Hedgehog should acquire the maximum amount required to hedge known and projected transactions.
d.
Hedgehog should acquire parallel loans to provide a means for liquidating unneeded hedge securities.
Choice “a” is correct. Hedgehog should only acquire the minimum amount of hedge contracts needed to offset the effect of known transactions.
Choice “d” is incorrect. Parallel loans represent a swap contract for hedging long-term transaction exposure and are not specifically designed to mitigate the risk of overhedging.
Choice “c” is incorrect. Acquisition of the maximum number of hedge contracts for known and projected transactions exposes the organization to greater risk of overhedging since projected transactions might not materialize.
Choice “b” is incorrect. Cross hedging involves techniques related to currencies that do have hedge instruments available to mitigate risk and are not specifically designed to avoid overhedging.
In evaluating the impact of relative inflation rates on the demand for a foreign currency, which of the following is true?
a.
As inflation associated with a foreign economy increases in relation to a domestic economy, demand for the foreign currency falls.
b.
As inflation associated with a foreign economy decreases in relation to a domestic economy, demand for the foreign currency falls.
c.
Inflation is irrelevant to currency demand.
d.
As inflation associated with a foreign economy increases in relation to a domestic economy, demand for the foreign currency increases.
Choice “a” is correct. As inflation associated with a foreign currency increases in relation to a domestic economy, demand for the foreign currency falls. Inflation weakens the foreign currency in relation to the domestic currency and makes foreign products more expensive and reduces demand. Reduced demand for a foreign import will reduce the demand for its currency.
Choice “c” is incorrect. Inflation, along with interest rates and trade restrictions are significant determinants of exchange rates.
Choice “d” is incorrect. As inflation associated with a foreign currency increases in relation to a domestic economy, demand for the foreign currency falls. Inflation weakens the foreign currency in relation to the domestic currency and makes foreign products more expensive and reduces demand. Reduced demand for a foreign import will reduce the demand for its currency, not increase demand.
Choice “b” is incorrect. As inflation associated with a foreign currency decreases in relation to a domestic economy, demand for the foreign currency rises. Inflation weakens the domestic currency in relation to the foreign currency and makes foreign products less expensive and increases demand. Increased demand for a foreign import will increase the demand for its currency, not decrease demand.
Managers that anticipate greater return for greater risk are referred to as having what attitude toward risk?
a.
Risk averse.
b.
Risk indifferent.
c.
Cautious.
d.
Risk seeking.
Choice “a” is correct. Risk averse behavior describes managers who demand more return on an investment as risk increases. These managers expect to be compensated for increased risk.
Choice “b” is incorrect. Risk indifferent behavior describes a manager who is neutral with regard to the return associated with a particular investment. Typically, the amount of a risk free rate of return associated with an investment of a given amount compared to a higher return associated with higher risk is viewed as having equal value.
Choice “d” is incorrect. Risk seeking behavior describes managers who seek reduced return for higher risk.
Choice “c” is incorrect. The term “cautious” is a distracter. Although caution is an attitude, it is not a technical term.
Corbin Inc. can issue three-month commercial paper with a face value of $1,000,000 for $980,000. Transaction costs would be $1,200. The effective annualized percentage cost of the financing, based on a 360-day year, would be:
a.
8.65%
b.
2.16%
c.
8.00%
d.
8.48%
Choice “a” is correct. The cost to issue the commercial paper is the $20,000 original issue discount ($1 million − $980,000), plus transaction costs of $1,200 for a total of $21,200. Therefore, it costs $21,200 to borrow $980,000 for 3 months. The 3-month effective periodic percentage cost is 2.16% ($21,200 / $980,000).
The effective annualized percentage cost is approximately 8.65% (2.16% × 4).
Choices “b”, “d”, and “c” are incorrect, per the above calculation.
Platinum Co. has a receivable due in 30 days for 30,000 euros. The treasurer is concerned that the value of the euro relative to the dollar will drop before the payment is received. What should Platinum do to reduce this risk?
a.
Enter into an interest rate swap contract for 30 days.
b.
Enter into a forward contract to sell 30,000 euros in 30 days.
c.
Platinum cannot effectively reduce this risk.
d.
Buy 30,000 euros now.
Choice “b” is correct. Since Platinum is going to receive euros in 30 days, it will want to lock in the price of euros now. The way to do that is to enter into a forward contract (referred to in the text as a forward hedge) to sell euros in 30 days. The price will be fixed now, but the transaction will not occur until the end of the 30 day period. A futures contract might be able to be used also. Note that, with the fixed price, Platinum will not be hurt if the price of euros in terms of dollars falls, but it will also not benefit if the price of euros in terms of dollars rises. In this question, the treasurer was concerned about the price of euros dropping.
Choice “d” is incorrect. Buying 30,000 euros now will not reduce the risk of a drop in the value of the euro. In fact, the risk will double since the company will have 60,000 euros in 30 days.
Choice “a” is incorrect. Buying an interest rate swap will do nothing to reduce the risk of a drop in the value of the euro. Interest rate swaps might reduce the risk of changes in interest rates.
Choice “c” is incorrect. Platinum can reduce the risk of a drop in the value of the euro by using the appropriate hedge. Hedges are often used to reduce currency risk.
Which of the following factors is inherent in a firm’s operations if it utilizes only equity financing?
a.
Business risk.
b.
Interest rate risk.
c.
Marginal risk.
d.
Financial risk.
Explanation
Choice “a” is correct. Business risk represents the risk associated with the unique circumstances of a particular company, as they might affect the shareholder value of that company. If an entity purely uses its own cumulative earnings in capitalizing its operations, it is exposed to the risks of its own unique circumstances.
Choice “d” is incorrect. Financial risk, also called default risk, relates to the exposure of lenders to the failure of borrowers to repay principal and interest on debt. An entity using its own cumulative earnings in capitalizing its operations is not exposed to default risk.
Choice “b” is incorrect. A business that exclusively uses equity capitalization would not be exposed to the risk that the value of its financial instruments will change as a result of changes in interest rates.
Choice “c” is incorrect. Incremental changes in risk would be limited if a firm exclusively used its own equity financing to capitalize its operations.
