Ch. 3 Financial Management Flashcards
What is market risk, marketability and default risk?
Firms are primarily concerned with the marketability and default risk of the securities they purchase.
market risk- risk that is associated with a security that cannot be eliminated by diversification.
marketability- the ability to sell a security for its face market value quickly and in large amounts
default risk- the probability of receiving principal and interest payments in a timely manner
What are 3 examples of market risk /systematic risk?
- congressional tax reform.
- inflation or recession.
- world energy situation(s).
What is company risk? How does it compare to market risk?
Company risk can be alleviated or avoided through diversification. It is much more specific than market risk.
A ratio that examines the percentage change in earnings available to common stockholders that is associated with a given percentage change in earnings before interest and taxes is a measure of ????
the degree of financial leverage.
What is Treasury stock?
increases a firm’s financial leverage because the debt-to-equity ratio increases
(as a result of the decrease in total stockholders’ equity).
is shares of the firm’s own stock held by the firm.
List short-term debt (not credit)
Bank loans- secured and unsecured
commercial paper.
Spontaneous financing created through A/P and accruals
What is the company’s cost of preferred stock?
A company recently issued 9% preferred stock. The preferred stock sold for $40 a share with a par of $20. The cost of issuing the stock was $5 a share.
The annual dividend per share is 9% multiplied by the par value of $20, or $1.80. The stock sold for $40. Subtracting the $5 issue costs gives net proceeds of $35 a share.
The cost of preferred stock is the $1.80 dividend divided by proceeds of $35 a share, which is 5.1%.
What is the Gordon growth model?
one of the most popular/straightforward dividend discount models.
DDMs are procedures for valuing stock price using
predicted dividends & discounting them back to PV.
It determines the intrinsic (inherent) value of a stock based on a future series of dividends that grow at a constant rate.
When determining fair value measurements on a nonrecurring basis, what 3 items need to be disclosed?
- The valuation method(s)
- The fair value measurement as of the reporting date
- Reconciliation of the beginning and ending balances when using unobservable inputs
According to the hedging approach to financing, seasonal variations in current assets should be financed with ______?
What is long term assets financed with?
short-term debt
** Under the hedging approach, the length of financing term is matched to the life or duration of assets financed. Long-term assets are financed with long-term debt and short-term assets (such as current assets) are financed with short-term debt.
What is the overall cost of capital?
it is the rate of return on what?
rate of return on assets that covers the costs associated with the funds employed
What is the effective cost of the loan?
A corporation obtains a loan of $200,000 at an annual rate of 12%. The corporation must keep a compensating balance of 20% of any amount borrowed on deposit at the bank, but normally does not have a cash balance account with the bank.
Loan $200,000 x 12% interest = $24,000 per year.
Loan $200,000 less 20% of amount borrowed = $40,000
Loan $200,000 less $40,000 comp balance = $160,000
$24,000 per year divided by $160,000 available = 15% effective cost of the loan
The optimal capitalization for an organization usually can be determined by the ????
lowest total weighted-average cost of capital (WACC).
WACC - What is the weighted-average after-tax cost of capital for this company?
tax rate of 30% has the following capital structure:
Weight Instrument Cost of Capital
40% Bonds 10%
50% Common stock 10%
10% Preferred stock 20%
The cost of debt is the before-tax rate. Since interest expense is a tax-deductible item, thus providing a depreciation shield, an after-tax cost must first be determined:
After-tax cost of debt = kd × (1 - T)
After-tax cost of debt = .10 × (1 - 0.30) = 0.07 (7%)
(kd = Pretax cost of debt; T = Tax rate)
Capital Item Weight Cost Weighting Factor
Debt 40% x 7% = 2.8%
Common Stock 50% x 10% = 5.0%
Preferred Stock 10% x 20% = 2.0%
TOTAL 100% WACC = 9.8%
A company uses its company-wide cost of capital to evaluate new capital investments. What is the implication of this policy when the company has multiple operating divisions, each having unique risk attributes and capital costs?
High-risk, low-risk ….invest in new projects
High-risk divisions will OVER-invest in new projects and
low-risk divisions will UNDER-invest in new projects.
Which of the following is the company’s cost of capital?
cost of debt is currently 8% based on the company’s
debt ratio of 40%.
The company complies with this requirement and has determined that a stock issuance would require a 10% return in order to attract investors.
40% cost of debt is given
100% − 40% cost of debt = 60% cost of equity
WACC = (.40 × .08) + (.60 × .10)
= .032 + .06
= .092, or 9.2% company’s cost of capital
Note: Be sure to review the final answer for reasonableness: the result must be between 8% and 10%, and be a bit closer to 10% since equity carries more than half the weighting.
What is the market rate of interest on a 1-year U.S. Treasury bill? Given: Risk-free rate of interest 2% Inflation premium 1% Default risk premium 3% Liquidity premium 2% Maturity risk premium 1%
Risk-free rate of interest 2% + Inflation premium 1% = 3%
Ignore:
Default risk premium 3%
Liquidity premium 2%
Maturity risk premium 1%
what is the net present value?
Given a 10% discount rate with cash inflows of $3,000 at the end of each year for five years and an initial investment of $11,000
The present value of the payment in the first year is $3,000 ÷ 1.1, or $2,727.
The present value of the payment in the second year is $3,000 ÷ (1.1 × 1.1), or $2,479.
The present value of the payment in the third year is $3,000 ÷ (1.1 × 1.1 × 1.1), or $2,254.
The present value of the payment in the fourth year is $3,000 ÷ (1.1 × 1.1 × 1.1 × 1.1), or $2,049.
The present value of the payment in the fifth year is $3,000 ÷ (1.1 × 1.1 × 1.1 × 1.1 × 1.1), or $1,863.
The sum of the present value of the five future payments is $11,372. The cost of the investment is $11,000, so the net present value is $11,372 - $11,000, or $372, rounded to $370.
What is the net present value?
What is the formula?
The net present value is the excess of the discounted present value of future cash returns less the investment cost.
The formula to calculate present value for any single future payment is PV = Payment ÷ (1 + r)n, where r is the interest rate and n is the number of periods.
What are the 3 appropriate value assumptions?
Price, worth, and value
“Price” is the actual observed exchange price
“Worth” defines the advantages of ownership based upon the perceived benefits at a particular point in time and for a particular use.
“Value” is the amount that would be received in exchange for an asset between willing parties in an arm’s-length transaction.
Solvency is the organization’s ability to meet long-term obligations. What is it closely related to?
the use of leverage.
Leverage is created when a portion of the company’s assets are acquired by issuing debt rather than using equity to finance the purchase; therefore, solvency is related to the use of leverage.
What are Solvency ratios?
- Related to long-term viability of firm
- Related to financial risk. A lack of solvency could lead to a greater risk of defaulting on current maturities that could ultimately lead to bankruptcy and liquidation.
When analyzing the capital asset pricing model, which of the following risks can be diversified away?
Stock price is an unsystematic risk and can be diversified away.
Systematic risks cannot be diversified away and include interest rates, recessions, and wars.
In determining cash flows from a proposed investment, the amount of the investment’s depreciation tax savings (shield) in a given year is equal to:
the depreciation times the tax rate.
Many items in capital budgeting have related tax effects. Items that do not affect cash flows such as depreciation must be taken into consideration when income taxes are relevant or the present value of the cash flows related to taxes is relevant.
Noncash items are adjusted for the tax impact by multiplying by the tax rate;
cash items (such as revenues) are adjusted by multiplying by (1 − tax rate).
What does The net present value method determine?
the discounted rate of return.
What does The net present value method predict?
What does NPV adjust for?
What does NPV seek to determine?
- the present value of money in the future
- adjusts for the time value of money.
- whether the present value of the estimated net future cash inflows at a desired (or required) rate of return will be greater or less than the cost of the proposed investment.
The gross margin ratio can be subjected to detailed analysis by a firm’s _______?
management
detailed information on gross margin ratio is only available to management
Formula for gross margin ratio
divide gross margin by net sales revenue
Discount is a ____ bond
Premium is a ____ bond
Discount = bad Premium = good
Net means ____ is involved
subtraction
More fixed cost means a business risk is higher or lower?
higher
List 3 lockbox system examples
- checks collected several times/day by local banks (not sent to corporate headquarters)
- checks deposited in company’s local accounts
- lockbox system reduces the time required to receive funds
Costs to procure inventory are ____ cost for a reseller and ______ _____ costs for a manufacturer
ordering cost for reseller
production setup costs for manufacturer
What is the formula for # of days sales in inventory
Sales - Gross Profit = COGS
COGS / Average Inventory = Inventory turnover
360 / Inventory turnover = # of days sales in inventory
Calculate # of days sales in inventory
Sales $ 2.1M Gross profit 600K Inventories (beginning) 240K Inventories (ending) 300K Days in the year 360
$2.1 M sales - 600K gross profit = $1.5M COGS
$1.5M / (0.5 x ($240K+$300K)) = 5.56 times Inventory Turnover =
360 days / 5.56 times = 64.75 = 65 days
What is the formula for acid-test (quick) ratio?
What are quick assets?
quick assets / current liabilities
cash, marketable securities, and accounts receivable (excludes inventory & prepaid exp)
What term refers to a performance measurement that is calculated as an = after-tax operating income - total assets x WACC?
Economic value added
What is Economic value added (EVA) ?
What does it focus on?
the economic profit of a project
the earnings above the required cost of capital for shareholders
What does Return on Investment (ROI) focus on?
What is it also called?
What is the formula?
the optimal use of invested capital
also called Return on Total Assets
operating income divided by average invested capital
What is the formula for # of days in cash conversion cycle?
Days inventory outstanding + days sales outstanding - days payable outstanding
What is formula for Days inventory outstanding?
DIO = Ave inventory / COGS per day
What is formula for days sales outstanding?
What does the ratio evaluate?
It is the average what?
Ave AR / Revenue per day = DSO
evaluates A/R
average collection period
What is formula for days payable outstanding
DPO = Ave AP / COGS per day
What is the formula for COGS per day?
= COGS / 365 days in year
Can DTC be deposited in any bank?
No, DTC is sent to a concentration bank serving as a clearinghouse
What is the recommended technique to evaluate projects when capital is rationed?
What is the formula?
given: cash inflows & outflows
Profitability index
also called Excess PV index
Total PV of all future net cash inflows / total cash outflow = profitability index
What does the economic order quantity formula assume?
- the periodic demand for the good is known
- TOTAL carrying costs vary with quantity ordered
- Costs of placing an order are UNAFFECTED by quantity ordered
- Purchase costs per unit are NOT affected by quantity discounts
What is the capital structure?
the percentage of debt, preferred stock and common stock used for financing a firm’s assets
The cost of equity is ____ than the cost of debt
Firms must have the _____ to pay dividends to kept stockholders happy
higher since stockholders are subject to more risk than debt holders
cash
What is a business risk in capital structure decisions?
cash flow
Capital structure is defined as the percentage of debt, preferred stock, and common stock used for financing a firm’s assets.
Data file security is intended to prevent ______ changes to data files
unauthorized
The level of safety stock does not depend on the cost to _______ stock.
reorder
When sales forecasts are uncertain, a HIGHER OR LOWER level of safety stock is needed.
higher
How should company improve it’s accounts receivable turnover ratio?
Should enter into Factoring agreement to sell its A/R at a discount, thus immediate receipt of cash.
By reducing the discount to 1/10 or 3/20, the customers are less likely to pay quickly.
Pledging is using the accounts receivable balance to secure a loan. This would have no effect on the accounts receivable turnover ratio.
Name 3 ways to speed up collections
Wire transfers, concentration banks, and lockboxes
The gross margin ratio can be subjected to detailed analysis by a firm’s ________.
What is the gross margin ratio formula?
What is gross margin formula?
management
detailed information below would only be available to management
= gross margin / net sales revenue = gross margin ratio
= (unit price - unit cost) x number of units = gross margin
If the time-adjusted rate of return, or internal rate of return, is higher than the rate of return required by the company, then the net present value of the project is _______.
positive
The acid-test ratio shows the ability of a company to pay its current liabilities without having to ______ its inventory.
liquidate
A bond that is issued at a discount will have a coupon rate that is ______ than the required market rate
less
The cost of capital used in this analysis should be ________ weighted average cost of capital
marginal
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