Business 2 - Financial Management Flashcards
Commercial Paper
Unsecured, ST debt instrument (matures in 260 days or less) issued by a Corp. Generally does not have an active secondary market & must be used to finance current assets
Commercial Paper Market
- Avoids the expense of maintaining a compensating balance with a commercial bank
- Provides a broad distribution for borrowing
- Accrues a Benedict to the borrower because it’s name becomes more widely known
Default Risk
Risk that the security will not be repaid because the issuing entity is insolvent or illiquid.
Floating Rate Bonds
Automatically adjust the return in a financial instrument to produce a constant market value for that instrument. No P or D would be required since market changes would be accounted for through interest rate
Market Capitalization
Equal to the number of common shares outstanding multiplied by the fair market value per share
Optimal Capitalization
For an organization, it can be determined by the lowest total weighted average cost of capital (WACC). Capitalization at WACC serves to maximize shareholder’s equity.
Overall Cost of Capital
Minimum return a company must achieve in order to make an investment financially feasible. The WACC can be used to measure of the overall cost of capital, because it factors the company’s proportion of its cost of debt and it’s cost of equity.
Common Stock
Equity security that conveys ownership. It does not require any payment, it does not mature, and since it increases equity without having an effect on debt, it decreases the debt equity ratio and increase the credit worthiness of the firm.
Leases have two as two types….
Operating & Finance Lease
Operating Lease (lease expense)
Interest expense and the amortization of ROU asset recorded on IS for every payment made
Finance Lease
Interest expense and amortization are separately recorded on IS
To classify a lease as a finance lease, a lesser must meet one of the following (or be less than 12 mo or less):
If not, it’s an operating lease
- Ownership - transfer at end of lease
- Written - purchase option that’s reasonably certain to exercise
- Net - PV of all lease payment & Residual Val >= underlying assets FV
- Economic - life of underlying asset is encompassed within term of lease
- Specialized - asset such that it is not expected to have alternative use to lessor when lease ends
Weighted Average Cost of Capital (WACC)
Average cost of debt and equity financing associated with a firm’s existing assets and operations. It covers the cost of funds employed.
3 Common Methods of Computing the Cost of Retained Earnings
- Capital Asset pricing model (CAPM)
- Discounted Cash Flows (DCF)
- Bond Yield plus Risk Premium (CAPM)
Cost of Retained Earnings (formula)
= Risk free rate + Risk Premium
= Risk free rate + (Beta x Market Risk Premium)
= Risk free rate + [ Beta x ( Market Return - Risk free rate) ]
Net Cost of Debt
Computed as Effective Interest Rate (net of tax, or 1 - tax rate). If they try to throw a coupon rate at you, you only use that if it is the same as the effective interest rate and no flotation costs involved.
(Blank) might cause a firm to increase the debt in its financial structure.
An increase in the corporate income tax rate because interest is tax deductible, while dividends are not tax deductible.
Benefits of debt financing over equity financing
Likely to be highest if marginal tax rates are high (b/c internet on debt is deductible for tax purposes) and if there are a few non interest tax benefits (b/c there is little or no reason to depart from debt financing)
A capital investment whose rate or return “R” (blank) the rate of return “R” associated with the firms beta factor will (blank) the value of the firm
- Exceeds
- Increase
Which of the following quantitative factors, when compared to its industry average, could be an indicator of potential corporate failure?
When fixed costs are high in relation to variable cost and total cost, the company’s operating leverage is going to be high. The company must generate enough in sales in order to meet its fixed obligations. This would lead to higher risk and could cause the company to fail if sales are not high enough.
If Carlisle Company did not have preferred stock, the degree of total leverage would….
Without preferred stock, the denominator in the total leverage calculation would be larger (b/c preferred stock is subtracted to arrive at the denominator). The same holds true for financial leverage. Therefore, both financial and total leverage would decrease in proportion.
Gross Profit Method
Used for interim financial statements as part of a periodic inventory system. Inventory is valued at retail cost and the avg gross profit % is used to determine the inventory cost.
If we overstate the gross profit rate, this will cause cost of goods sold to be understated & ending inventory to be overstated. When you overstate inventory, the bank could believe that the company has more inventory collateral on hand than it actually has.
