Chapter 5

Question 1

What are the 6 types of risk ?

Answer 1

Financial flexibility 
Short term liquidity risk 
Long term liquidity risk 
Credit risk 
Bankruptcy risk 
Market equity risk

Question 2

Financial flexibility

Answer 2

The ability of a firm to obtain debt financing conditional on its current leverage and profitability of its operating assets.

Question 3

Short-term liquidity

Answer 3

Near term ability to generate cash to meet working capital needs and debt service requirements.

Question 4

Long term solvency risk

Answer 4

The longer term ability to generate cash internally or externally to satisfy plant capacity and debt repayment needs.

Question 5

Bankruptcy risk

Answer 5

Insufficient profitability and cash flows and high debt service costs

Question 6

Severity of events to a firms investors

Answer 6

Not severe=stretching out trade payables

Less severe=
failing to make a required interest payment on time
Restructuring debt

More severe=
Defaulting on a principal payment on debt
Filing for bankruptcy

Very severe= liquidating the firm

Question 7

Market equity beta

Answer 7

Measures the covariability of a firm’s returns with an index of returns of all securities in the equity capital market.

Market equity betas increase with financial leverage

Question 8

Firm specific risk

Answer 8

Ability to attract, retain, motivate employees

Dependence on one or few customers

Dependence on one or few suppliers

Environmental or political scrutiny

Litigation

Question 9

Industry risk

Answer 9

Availability and price of raw materials or other production inputs

Competition

Technology

Regulation

Labor wages and supply

Question 10

Domestic risk

Answer 10

Political environment
Recessions
Inflation or deflation 
Interest rate volatility 
Demographic shifts

Question 11

International risk

Answer 11

Exchange rate volatility
Host government regulations and posturing
Political unrest or asset expropriation

Question 12

Disaggregation of ROCE suggest that common equity shareholders benefit from increasing leverage

Answer 12

Increasing leverage has both benefits and risk.

Question 13

Alternative disaggregation of ROCE

Answer 13

ROCE= operating ROA + (leverage x spread)

Question 14

Spread

Answer 14

Spread is the difference between operating ROA and the net borrowing rate.

Greater the spread between operating ROA and net borrowing rate, more beneficial incremental borrowing will be for common shareholders. (More financial flexibility)

Question 15

Leverage

Answer 15

Total financing obligations divided by common equity

Question 16

Operating cash flow to current liabilities ratio

Answer 16

Cash flow from operations

/ average current liabilities

Question 17

Working capital turn over ratio

Answer 17

Accounts receivable turn over=sales/ avg accounts receivable

Inventory= cogs/avg inventories

Accounts payable= purchases/avg AP