Business 2 - Financial Management

Question 1

Commercial Paper

Answer 1

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

Question 2

Commercial Paper Market

Answer 2

1. Avoids the expense of maintaining a compensating balance with a commercial bank
2. Provides a broad distribution for borrowing
3. Accrues a Benedict to the borrower because it’s name becomes more widely known

Question 3

Default Risk

Answer 3

Risk that the security will not be repaid because the issuing entity is insolvent or illiquid.

Question 4

Floating Rate Bonds

Answer 4

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

Question 5

Market Capitalization

Answer 5

Equal to the number of common shares outstanding multiplied by the fair market value per share

Question 6

Optimal Capitalization

Answer 6

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.

Question 7

Overall Cost of Capital

Answer 7

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.

Question 8

Common Stock

Answer 8

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.

Question 9

Leases have two as two types….

Answer 9

Operating & Finance Lease

Question 10

Operating Lease (lease expense)

Answer 10

Interest expense and the amortization of ROU asset recorded on IS for every payment made

Question 11

Finance Lease

Answer 11

Interest expense and amortization are separately recorded on IS

Question 12

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

Answer 12

1. Ownership - transfer at end of lease
2. Written - purchase option that’s reasonably certain to exercise
3. Net - PV of all lease payment & Residual Val >= underlying assets FV
4. Economic - life of underlying asset is encompassed within term of lease
5. Specialized - asset such that it is not expected to have alternative use to lessor when lease ends

Question 13

Weighted Average Cost of Capital (WACC)

Answer 13

Average cost of debt and equity financing associated with a firm’s existing assets and operations. It covers the cost of funds employed.

Question 14

3 Common Methods of Computing the Cost of Retained Earnings

Answer 14

1. Capital Asset pricing model (CAPM)
2. Discounted Cash Flows (DCF)
3. Bond Yield plus Risk Premium (CAPM)

Question 15

Cost of Retained Earnings (formula)

Answer 15

= Risk free rate + Risk Premium
= Risk free rate + (Beta x Market Risk Premium)
= Risk free rate + [ Beta x ( Market Return - Risk free rate) ]

Question 16

Net Cost of Debt

Answer 16

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.

Question 17

(Blank) might cause a firm to increase the debt in its financial structure.

Answer 17

An increase in the corporate income tax rate because interest is tax deductible, while dividends are not tax deductible.

Question 18

Benefits of debt financing over equity financing

Answer 18

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)

Question 19

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

Answer 19

1. Exceeds
2. Increase

Question 20

Which of the following quantitative factors, when compared to its industry average, could be an indicator of potential corporate failure?

Answer 20

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.

Question 21

If Carlisle Company did not have preferred stock, the degree of total leverage would….

Answer 21

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.

Question 22

Gross Profit Method

Answer 22

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.