Financial Management Flashcards
1
Q
What is the ultimate objective of the financial management function in a profit-oriented entity?
A
The ultimate objective of financial management is to maximize the value of the entity, usually as reflected by the market price for the firm’s stock.
2
Q
Identify some of the responsibilities of the financial management function of an entity.
A
- Managing the capital and financial structure of the entity; 2. Planning, allocating and controlling an entity’s financial resources; 3. Identifying and managing financial risks faced by the entity.
3
Q
Define “unexpired cost.”
A
An asset; it has future value to the entity (e.g., the cost of a 3-year insurance policy would be an asset during the period covered).
4
Q
Define “opportunity cost.”
A
Benefit lost from an opportunity as a result of choosing another opportunity. It is measured as the discounted value of the cash flow or other benefit foregone and is relevant in making current decisions.
5
Q
Define “cost” as used in accounting.
A
Amount paid or obligation incurred for a good or service; may be unexpired or expired. An unexpired cost is an asset. An expired cost is an expense.
6
Q
How is a firm’s cost of capital determined?
A
It is the rate of return that must be earned by prospective investors in order for a firm to attract and retain their investments. Investors’ expected rate of return is determined primarily by the rate of return that could be earned on other opportunities with comparable risk.
7
Q
Define “weighted-average cost of capital.”
A
Cost of each element of capital weighted by the proportion (percentage) of total capital provided by each element, with the resulting products summed to get the weighted average cost for all elements of capital.
8
Q
Define “differential cost.”
A
Costs which are different between two or more alternatives. Differential costs are relevant in making decisions between the alternatives. For example: In deciding whether or not to accept a special order for a product, only the new costs that would be incurred in accepting the order would be relevant. Fixed costs that would not change whether or not the order is accepted would not be relevant.
9
Q
Define “sunk cost.”
A
Costs incurred in the past that cannot be changed by current or future decisions and, therefore, are irrelevant to current decisions.
10
Q
What are the major elements of a firm’s capital (or capital structure)?
A
Long-term debt, Preferred stock and Common stock.
11
Q
Define “expired cost.”
A
The benefit to an entity from the good or service that has been used up and is of no future value to the entity. An expired cost is an expense (.e.g., cost of wages and salaries) or a loss (e.g., cost of goods destroyed by fire).
12
Q
Define the “future value” of an annuity.
A
Value at some future date of a series of equal amounts to be invested at the beginning of equal intervals over some period of time. Amount that will accumulate as a result of the amounts invested at the beginning of each period and the compounding of interest on those amounts.
13
Q
Define the “future value” of $1.
A
Value at some future date of a single amount invested now. Amount that will accumulate as a result of compounding of interest on the single amount invested at the present.
14
Q
Define an “annuity due (also called an annuity in advance)”.
A
Series of equal amounts received or paid at the beginning of each equal period.
15
Q
Define the “present value” of an ordinary annuity.
A
Value now of a series of equal amounts to be received at the end of equal intervals over some future period Equal amounts to be received at the end of a number of equal periods are discounted using an interest rate to get the present value of those amounts.
16
Q
Define the “present value” of $1.
A
Value now (at present) of a single amount to be received in the future. Amount to be received in the future is discounted using an interest rate to get the present value of that amount.
17
Q
Define “future value” of an ordinary annuity.
A
Value at some future date of a series of equal amounts to be invested at the end of equal intervals over some period of time. Amount that will accumulate as a result of the amounts invested at the end of each period and the compounding of interest on those amounts.
18
Q
Define an “ordinary annuity (also called an annuity in arrears)”.
A
Series of equal amounts received or paid at the end of each equal period.
19
Q
Define “compound interest”.
A
Interest computed not only on the principal but also on any accumulated unpaid interest (i.e., interest is paid on interest).
20
Q
Define “effective interest rate”.
A
- The annual interest rate implicit in the relationship between the net proceeds of a borrowing (or other arrangement) and the dollar cost of the borrowing (or other arrangement). 2. Computed as: Dollar cost of borrowing/Net proceeds of borrowing.
21
Q
Define a “fixed interest rate”.
A
The percentage rate of interest does not change over the life of the loan or parts of that life.
22
Q
Define “simple interest”.
A
Interest computed on the principal only; there is no compounding in the interest computation (i.e., no interest paid on interest).
23
Q
Define a “variable interest rate”.
A
The percentage rate of interest can change over the life of the related debt instrument.
24
Q
Define “effective annual percentage rate” (also called the “annual percentage yield”).
A
Annual percentage rate with compounding on loans that are for a fraction of a year.
25
Define "interest".
Cost of the use of money. Expressed as a percentage rate, almost always as an annual percentage rate, applied to the principal to determine dollar amount.
26
Define "annual percentage rate (APR)".
1. The annualized effective interest rate (without compounding) on loans that are for a fraction of a year. In effect, the effective interest rate for a portion of a year is "grossed up" to an annual rate. 2. Computed as the effective interest rate for the fraction of a year multiplied by the number of such fractions in a whole year. 3. Basis of interest rate disclosure in U.S.
27
Define "stated rate (of interest)" (also used interchangeably as "nominal rate" or "quoted rate").
The annual rate of interest specified in a debt instrument or other contract/agreement; it does not take into account the compound effects of payment frequency.
28
How is "fair value" defined and determined for United States Generally Accepted Accounting Principles (GAAP) purposes?
Fair value for United States Generally Accepted Accounting Principles (GAAP) purposes is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants.
29
Identify and briefly describe the three approaches to determining fair value as specified by United States Generally Accepted Accounting Principles (GAAP).
1. Market approach: Information generated by market transactions for identical or similar items. 2. Income approach: Converts future amounts of benefit or sacrifice to determine current value. 3. Cost approach: Determines the amount required to acquire or construct a comparable item.
30
What are some of the factors that must be considered in assigning value?
The following factors must be considered in assigning value: 1. The specific item or items (asset, liability, equity, etc.) being valued; 2. The condition of the item(s); 3. The location of the item(s); 4. The time at which the valuation is occurring; 5. The economic environment in which the valuation is occurring.
31
Identify and briefly describe the three component levels of the United States Generally Accepted Accounting Principles (GAAP) hierarchy of inputs used for determining fair value.
Level 1: Quoted prices in active markets for identical items. Level 2: Quoted prices in inactive markets or for items similar (but not identical) to those being valued; observable inputs other than quoted prices relevant to the item being valued. Level 3: Unobservable inputs relevant to valuing an item (e.g., assumptions, estimates, etc.).
32
Identify ways in which professional judgment must be used in carrying out a valuation.
Professional judgment is used in valuation to develop an understanding of the purpose and context of a valuation, the selection of appropriate quantitative techniques and data, and ultimately, the assignment of a value.
33
Briefly describe the nature of level 1 inputs identified in the United States Generally Accepted Accounting Principles (GAAP) fair-value framework.
Level 1 of the U.S. GAAP fair value framework consists of quoted market prices in active markets for identical assets or liabilities.
34
Briefly describe the nature of level 3 inputs identified in the United States Generally Accepted Accounting Principles (GAAP) fair-value framework.
Level 3 of the U.S. GAAP fair value framework consists of inputs that are not observable but are based on an entity's assumptions and estimates.
35
Briefly describe the nature of level 2 inputs identified in the United States Generally Accepted Accounting Principles (GAAP) fair-value framework.
Level 2 of the U.S. GAAP fair value framework consists of inputs that are either directly or indirectly observable, including: 1. Quoted prices for similar items in active markets and in markets that are inactive; 2. Quoted prices for identical items in inactive markets; 3. Observable inputs other than quoted prices; 4. Inputs not directly observable but which are derived from or corroborated by observable market data.
36
Identify and describe the three (3) possible alternative values of beta.
Beta (B) = 1: The individual asset being valued changes in the same proportion as the entire class of the asset being valued; the asset has average systematic risk for the entire class. Beta (B) \> 1: The individual asset being valued changes greater than the entire class of the asset being valued; the asset is more volatile than the entire class. Beta (B)
37
What are the major assumptions and limitations of the capital asset pricing model (CAPM)?
1. All investors have equal access to all investments and are using a one period time horizon; 2. Asset risk is measured solely by its variance from the asset class benchmark; 3. There are no external cost - commissions, taxes, etc.; 4. There are no restrictions on borrowing or lending at the risk-free rate of return; 5. There is a market and market benchmark for all asset classes; 6. Uses historical data.
38
Give the capital asset pricing model formula and describe its components.
RR = RFR + B(ERR - RFR) Where: RR = Required rate of return. RFR = Risk-free rate of return. B = Beta, a measure of volatility. ERR = Expected rate of return for a benchmark for the entire class of the asset being valued.
39
Define/describe the "capital asset pricing model (CAPM)".
The capital asset pricing model (CAPM) is an economic model that determines the relationship between risk and expected return and uses that measure in assigning value to securities, portfolios, capital projects and other assets.
40
Define "Beta".
Beta is a measure of the systematic risk associated with an investment as reflected by its volatility as compared with the volatility of the entire class of the investment.
41
What are some major limitations of the original Black-Scholes option pricing model?
1. Appropriate only for European call options, which permit exercise only at the expiration date; 2. Assumes options are for stocks that pay no dividends; 3. Assumes options are for stocks whose price increases in small increments; 4. Assumes the risk-free rate of return remains constant during life of the option; 5. Assumes there are no transaction costs or taxes associated with the options.
42
Briefly describe the methodology of the binomial option pricing model.
The binomial option-pricing model is a method that can be generalized for the valuation of options. It uses a tree or network diagram to represent points in time between the present (valuation date) and the expiration of the option and uses probabilities to work backwards in assigning value to each branch in the tree to derive a value at the present (valuation date).
43
What is the Black-Scholes option-pricing model?
The Black-Scholes model is a mathematical formula for valuing stock options, which are derivative instruments (and certain other instruments). The original model was developed to value European-style options, which permit exercise only at the expiration date of the option.
44
What are some major advantages of the original Black-Scholes option pricing model?
1. Assigns probability factor to the likelihood that the price of the stock will pay off within the time to expiration; 2. Assigns probability factor to the likelihood that the option will be exercised; 3. Discounts the exercise price to present value.
45
Describe the Income approach to valuing a business.
The income approach to valuing a business determines the value of a business by calculating the present value of the expected benefit stream to be generated by the business. This approach may use discounted cash flows, capitalization of earnings, multiple of earnings or other similar approaches that develop a fair value based on income/earnings.
46
Describe the Asset approach to valuing a business.
The asset approach to valuing a business determines the value of a business by adding (summing) the values of the individual asset that comprise the business. The sum of those asset values constitutes the value of the entire business. This approach is particularly appropriate when the business being valued has little or no cash flows and/or earnings, or when the business will not continue as a going concern.
47
Identify the three basic approaches to valuing a business.
1. Market approach. 2. Income approach. 3. Asset approach.
48
Describe the Market approach to valuing a business.
The market approach to valuing a business determines the value of a business by comparing it to other entities with highly similar characteristics for which a fair value can be more readily determined.
49
Identify and describe the two major classes of quantitative business forecasting methods.
1. Time-series models: Use patterns from past data to predict a future value or values. These methods are not concerned with causes of patterns, just the patterns in the data. 2. Causal models: Use assumed relationships between the variable being forecasted and other variables to make projections based on those relationships.
50
Identify and describe the two major classes of business forecasting methods.
1. Qualitative: methods that are subjective in nature and based on judgment and opinion. 2. Quantitative: methods that are objective in nature and based on mathematical calculations and determinations.
51
Identify and describe three classes of qualitative business forecasting methods.
1. Executive opinion: The collective judgment and opinion of executives and managers are used to develop a forecast. 2. Market research: Surveys of customers and others are done to determine preferences and other factors as a basis for formulating a forecast. 3. Delphi method: Uses a consensus developed by a group of experts using a multi-stage process for converging on a forecast.
52
Identify and briefly describe major time-series patterns.
1. Level - data are relatively constant or stable over time; 2. Seasonal - data reflect up and down swings over short or intermediated periods of time; each swing of about the same timing and level of change; 3. Cycles - data reflect up and down swings over a long period of time; 4. Trend - data reflect a steady and persistent up or down movement over a long period of time; 5. Random - data reflect unpredictable, erratic variations over time.
53
Identify and briefly describe the major types of causal models used for forecasting.
Regression - uses an equation to relate a dependent variable to one or more independent variables to forecast the dependent variable. Input-output models - describe the flow from one stage, sector, or other component to another in order to forecast values for either the predecessor or successor stage, sector or other component. Economic models - specify a statistical relationship between various economic quantities to forecast the value of one using the value of another.
54
Identify the major forms of causal models used for forecasting.
1. Regression models (linear or non-linear); 2. Input-Output models; 3. Economic models.
55
Identify the major forms of time-series models (mathematical methods) used for forecasting.
1. Naive; 2. Simple mean (average); 3. Simple moving average; 4. Weighted moving average; 5. Exponential smoothing; 6. Trend-adjusted exponential smoothing; 7. Seasonal indexes; 8. Linear trend line.
56
Define "risk".
The possibility of loss or other unfavorable results that derives from the uncertainty implicit in future outcomes.
57
Describe the risk/reward relationship.
The greater the perceived risk of an undertaking, the higher the expected reward from the undertaking.
58
Describe the relationship between a firm's capital projects and the firm's capital that funds those projects.
The rate of return earned on a firm's capital projects must be equal or greater than the rate of return required to attract and maintain investors' capital.
59
Define "capital budgeting".
The process of measuring, evaluating, and selecting long-term investment opportunities, primarily in the form of projects or programs.
60
Define "risk premium".
The rate of return expected above the risk-free rate based on the perceived level of risk inherent in an investment/undertaking.
61
Define "risk-free rate of return".
The rate of return expected solely for the deferred current consumption that results from making an investment; rate of return expected assuming virtually no risk. In the United States it is measured by the rates paid on United States Treasury obligations.
62
Give examples of risk associated with investments in capital projects.
1. Incomplete or incorrect analysis of a project; 2. Unanticipated actions of customers, suppliers and competitors; 3. Unanticipated changes in laws, regulations, etc.; 4. Unanticipated macroeconomic changes (e.g., interest rates, inflation/deflation, tax rates, currency exchange rates, etc.).
63
Identify the disadvantages of the payback period approach to project evaluation.
1. Ignores the time value of money; 2. Ignores cash flows received after the payback period; 3. Does not measure total project profitability; 4. Maximum payback period may be arbitrary.
64
Identify the advantages of the payback period approach to project evaluation.
1. Easy to use and understand; 2. Useful in evaluating liquidity of a project; 3. Use of a short payback period reduces uncertainty.
65
Under what circumstances would the payback period approach to project evaluation be most appropriate?
1. When used as a preliminary screening technique; 2. When used in conjunction with other evaluation techniques.
66
Identify five different techniques for evaluating capital budgeting projects.
1. Payback period approach; 2. Discounted payback period approach; 3. Accounting rate of return approach; 4. Net present value approach; 5. Internal rate of return approach.
67
Describe the payback period approach to project evaluation.
Determines the number of years (or other periods) needed to recover the initial cash investment in the project and compares the resulting time with a pre-established maximum payback period. Uses undiscounted expected future cash flows.
68
Identify a technique that is intended to rank capital budgeting projects in terms of desirability.
The profitability index (PI).
69
Will the payback period from using the discounted payback period approach be longer or shorter than using undiscounted payback period approach (to capital budgeting)?
The discounted payback period will be longer than the undiscounted payback period because the present value of cash flows will be less than the undiscounted values.
70
Identify the advantages of the discounted payback period approach to capital budgeting evaluation.
1. Easy to use and understand; 2. Uses time value of money approach; 3. Useful in evaluating liquidity of a project; 4. Use of a short payback period reduces uncertainty.
71
Identify the disadvantages of the discounted payback period approach to capital budgeting evaluation.
1. Ignores cash flows received after the payback period; 2. Does not measure total project profitability; 3. Maximum payback period may be arbitrary.
72
Describe the discounted payback period approach to capital budgeting evaluation.
A variation of the payback period approach that takes the time value of money into account by discounting expected future cash flows.
73
Describe the accounting rate-of-return (also called the simple rate of return) approach to capital project evaluation.
Measures the expected average annual incremental accounting income from a project as a percent of the initial (or average) investment and compares that with established minimum rate required.
74
What are the advantages of the accounting rate-of-return approach to project evaluation?
Easy to use and understand; Consistent with financial statement values; Considers entire life and results of project.
75
What are the disadvantages of the accounting rate-of-return approach to project evaluation?
Ignores the time value of money; Uses accrual accounting values, not cash flows.
76
In computing the accounting rate-of-return approach (to capital budgeting), will using the Initial Investment or the Average Investment give the higher rate of return?
Because the average investment gives a smaller denominator, the accounting rate of return will be higher when the average investment is used, rather than when the initial investment is used.
77
What alternative investment bases can be used in the accounting rate-of-return approach (to capital budgeting)?
Two alternative investment bases may be used: 1. Initial investment; 2. Average investment (i.e., the average book value of the asset over its life).
78
How is the Net Present Value determined?
It is the difference (net) between the present value of expected cash flows from a project and the initial cost of the project.
79
Using the net-present-value approach (to capital budgeting), under what conditions would a project be considered economically feasible?
If the Net Present Value is zero or positive, the project is considered economically feasible; otherwise, the project is not considered economically feasible.
80
Describe the net-present-value approach to capital project evaluation.
Compares present value of expected cash flows of project with initial cash investment in project. Derived by discounting future cash flows (or savings) and determining whether or not the resulting present value is more or less than the cost of the investment
81
Identify the disadvantages of the net-present-value approach to capital project evaluation.
Requires estimation of cash flows over entire life of the project, which could be very long. Assumes cash flows are immediately reinvested at the discount rate.
82
Identify the advantages of the net-present-value approach to capital project evaluation.
1. Uses time value of money concept; 2. Relates project rate of return to cost of capital; 3. Considers entire life and results of project; 4. Easier to compute than internal rate of return approach.
83
Compare the internal-rate-of-return (IRR) approach with the net-present-value (NPV) approach (to capital budgeting).
1. The IRR Approach computes the discount rate that would make the present value of a project's cash inflows and outflows equal to zero; 2. The NPV Approach uses an assumed discount rate to determine whether or not the present value of a project's cash inflows and outflows is positive or not.
84
Describe the internal rate of return (also called time adjusted rate of return) approach to capital project evaluation.
Evaluates a project by determining the discount rate that equates the present value of a project's cash inflows with the present value of the project's cash outflows.
85
Identify the advantages of the internal-rate-of-return approach to capital project evaluation.
1. Recognizes the time value of money; 2. Considers the entire life and results of the project.
86
Under what conditions is the internal-rate-of-return approach (to capital budgeting) not appropriate?
When future cash flows of a project are both positive and negative, the internal rate of return method should not be used because it can result in multiple solutions.
87
Identify the disadvantages of the internal-rate-of-return approach to capital project evaluation.
1. Difficult to compute; 2. Requires estimation of cash flows over entire life of project, which could be very long; 3. Requires all future cash flows be in the same direction, either inflows or outflows; 4. Assumes cash flows resulting from the project are immediately reinvested at the project's internal rate of return.
88
Will the profitability index and the net-present-value approach (to capital budgeting) result in the same ranking of multiple projects?
No. Since the Net Present Value Approach does not explicitly consider the initial cost of each project, it does not give the same ranking as the Profitability Index, which considers both the Net Present Value and the initial cost of the project.
89
Describe the profitability index (also called cost/benefit ratio or present value index).
Ranks projects by taking into account both the net present value of each project and the cost of each project; computed as: PI = NPV/Project Cost.
90
When using the profitability index, how are projects ranked relative to each other?
The projects are ranked according to the computed Profitability Index (i.e., NPV/Project Cost) for each for each project; the higher the PI, the higher the rank of the project.
91
In ranking economically feasible projects, what is the primary shortcoming of the net-present-value approach?
It fails to take into account differences in the initial cost of economically feasible projects. Each project is evaluated independently of each other project, therefore differences in initial cost among projects is not considered.
92
Give three reasons for capital rationing.
1. Insufficient funds to undertake all economically feasible projects; 2. Insufficient management capacity to take on all economically feasible projects; 3. Perceived instability in the market/economy.
93
What is the preferred method of ranking economically feasible projects?
The Profitability Index, which takes into account both the Net Present Value and the initial cost of each project.
94
In what circumstance might the use of the payback period approach be useful in ranking capital projects?
When liquidity issues are a major concern in selecting from a set of projects.
95
Describe the concept of capital rationing.
Limiting the number of economically feasible projects that are undertaken and selecting those that will be undertaken.
96
Describe the components of a firm's capital structure.
All elements of long-term debt and owners' equity.
97
Which is more inclusive, capital structure or financial structure?
Financial Structure, which includes current and non-current liabilities, as well as owners' equity. Capital Structure does not include current liabilities, only long-term debt and owners' equity.
98
What are "Financing Options"?
The alternative ways that funding may be obtained to carry out capital projects and other undertakings of an entity.
99
Describe the components of a firm's financial structure.
All elements of liabilities (current and non-current) and owners' equity of a firm constitute its Financial Structure.
100
Describe the concept of short-term financing.
Short-term financing involves: 1. Obtaining funding through obligations (debt) that must be repaid within one year (current liabilities), or 2. The use of current assets to obtain funding.
101
Identify at least five forms of short-term financing.
1. Trade accounts payable. 2. Accrued accounts payable. 3. Short-term notes. 4. Lines of credit, revolving credit or letter of credit. 5. Commercial paper. 6. Pledging accounts receivable. 7. Factoring accounts receivable. 8. Inventory secured loans.
102
What are the disadvantages of using short-term notes for short-term financing purposes?
1. Poor credit rating = High interest rate; 2. Requires satisfaction in the short term; 3. May require compensating balance or security.
103
List the disadvantages of using short-term payables (for financing purposes).
1. Requires payment in the short-term; 2. Use specific; 3. Lost discounts increase cost.
104
List the advantages of using short-term payables (for financing purposes).
1. Ease of use; 2. Flexible; 3. Usually interest free; 4. Usually no security required; 5. Discounts may be offered for early payment.
105
Why are cash discounts offered on trade accounts?
Cash discounts are offered to encourage early payment of amounts due on trade accounts.
106
Describe trade accounts payable (also called trade credit) as a means of short-term financing.
Deferred payment for goods or services provided by suppliers in the normal course of business. May carry the offer of a cash discount for early payment of obligation.
107
What is the meaning of cash discount terms of "2/10, n/30"?
The term 2/10, n/30 is a typical credit term and means the following: 1. The first digit (2) is the percent discount offered by the seller; 2. The second digit (10) is the number of days within which the discount is available; 3. n/30 indicates that if the buyer does not pay the (full) invoice amount within the 10 days to qualify for the discount, then the net amount is due within 30 days after the sales invoice date.
108
List the advantages of short-term notes (for financing purposes).
1. Commonly available for creditworthy firms; 2. Flexible - amounts and periods (within one year) can be varied; 3. Generally, no collateral required; 4. Provides cash.
109
Define "compensating balance".
An amount that a borrower may be required to maintain in a demand deposit account with a lender as a condition of receiving a loan or other bank services.
110
Identify the advantages of commercial paper for financing purposes.
1. Large amounts can be obtained; 2. Interest rate generally lower than other short-term sources; 3. No collateral required; 4. Provides cash for general use.
111
Define "commercial paper".
Short-term unsecured promissory notes sold by large, highly creditworthy firms as a form of short-term financing (i.e., 270 days or less).
112
Define a "revolving credit agreement".
A revolving line of credit is a legal agreement between a borrower and a financial institution whereby the financial institution agrees to provide an amount of credit to the borrower. The line of credit may be borrowed, repaid, and then reborrowed in a "revolving" or recurring manner.
113
Identify the advantages of stand-by credit for financing purposes.
1. Commonly available for creditworthy firms; 2. Highly flexible (debt incurred only when needed); 3. No collateral required; 4. May provide cash for general use.
114
Identify the disadvantages of stand-by credit for financing purposes.
1. Poor credit rating = high interest rate; 2. Usually involves a fee; 3. Compensating balance may be required; 4. Requires satisfaction in the short-term.
115
Define "letter of credit".
A conditional commitment by a bank to pay a third party in accordance with specified terms and commitments (e.g., bank payments to a supplier upon proof that goods have been shipped to bank client).
116
Define "line of credit".
An informal agreement between a borrower and a financial institution whereby the financial institution agrees to a maximum amount of credit that it will extend to the borrower at any one time, not legally binding on financial institution.
117
Distinguish between factoring accounts receivable "with recourse" and "without recourse".
1. If accounts receivable are factored "without recourse" the factor (buyer) bears the risk associated with collectability (unless fraud is involved). 2. If accounts receivable are factored "with recourse" the factor (buyer) has recourse against the selling firm for some or all of the risk associated with uncollectability.
118
Describe a" floating loan agreement".
The borrower gives a lien against all of its inventory to the lender, but retains control of its inventory, which it continuously sells and replaces.
119
Define "factoring of accounts receivable".
The sale of trade accounts receivable to a commercial bank or other financial institution, called a "factor". Sale may be "With Recourse" or "Without Recourse."
120
Describe the use of an inventory-secured loan for short-term financing.
A firm pledges part or all of its inventory as collateral for a short-term loan.
121
Describe a "terminal warehouse agreement".
The inventory used as collateral is moved to a public warehouse where it is held as security.
122
Define "pledging of accounts receivable".
The use of trade accounts receivable as collateral for a short-term loan, usually from a commercial bank or finance company.
123
Identify the disadvantages of using inventory-secured loans for short-term financing.
1. Not available for all inventory; 2. Pledged inventory may not be available when needed; 3. More costly than certain other forms of short-term financing; 4. Requires repayment in the short-term.
124
Describe the concept of long-term financing.
Long-term financing involves obtaining funding through sources for which repayment is not due within one year, including sources which do not require any "repayment" (e.g., common or preferred stock). These sources of funding constitute the capital structure of a firm.
125
Identity major forms of long-term financing.
1. Long-term notes; 2. Financial (Capital) leases; 3. Bonds; 4. Preferred stock; 5. Common stock.
126
Identify the disadvantages of leasing, for long-term financing purposes.
Not all assets available for leasing; Lease terms may prove different than the period of asset usefulness; Often chosen over buying for noneconomic reasons (e.g., convenience).
127
Define a "net lease".
Lessee (using party) assumes the cost associated with ownership during the life of the lease, including maintenance, taxes, insurance, etc.
128
Describe the use of long-term notes, for long-term financing purposes.
Long-term notes are used for borrowings normally of from one to ten years, but some may be of longer duration. Such borrowings usually require collateral, and may have restrictive covenants, but often permit repayment in installments of some period of time.
129
Define "long-term financing".
Financing provided by those sources of capital funding that do not mature within one year (e.g., long-term notes, financial leases, bonds, preferred stock and common stock).
130
Define a "net-net lease".
Lessee (using party) assumes not only the cost associated with ownership during the life of the lease, including maintenance, taxes, insurance, etc., but also obligation for a residual value at the end of the lease.
131
Identify the disadvantages of long-term notes, for financing purposes.
Poor credit rating results in higher interest rate, greater security requirements, and more restrictive covenants. Violation of restrictive covenants can trigger serious consequences.
132
Identify the advantages of leasing, for long-term financing purposes.
Limited immediate cash outlay; Possible lower cost than purchasing; Possible scheduling of payments to coincide with cash flows; Debt (lease payments) is specific to amount needed.
133
Define "bonds".
Long-term promissory notes wherein the borrower, in return for buyers'/lenders' funds, promises to pay the bondholders a fixed amount of interest each year and to repay the face value of the note at maturity.
134
Define a "bond indenture".
The bond contract, setting forth such terms as face amount of bond, coupon or stated interest rate, maturity date, etc.
135
Define "market rate risk".
The risk of loss in the market value of outstanding bonds and other fixed rate instruments as a result of an increase in the market rate of interest during the life of the outstanding instrument. If the market rate of interest increases after an instrument is issued, the market value of the instrument will decrease.
136
Describe the calculation of the current yield on a bond.
The ratio of annual interest payments to the current market price of the bond. It is computed as: Annual interest payment/Current market price
137
Define "bond maturity".
The time at which the issuer repays the par value to the bondholders.
138
Describe the yield to maturity for bonds (also called the expected rate of return).
The rate of return required by investors as implied by the current market price of the bonds; determined as the discount rate that equates present value of cash flows from the bonds with the current price of the bonds.
139
How is the selling price of a bond determined?
As the sum of the present value of future cash flows from: 1. Periodic interest - PV of an annuity. 2. Maturity face value - PV of $1. Both discounted using market rate of return.
140
How is the currently expected rate of return on Preferred Stock (PSER) determined?
PSER = Annual Preferred Dividend/Market Price of preferred stock. Note: This expected rate of return is the current cost of Preferred Stock capital.
141
List the advantages of using preferred stock (for long-term financing).
1. No legally required periodic payments (i.e., dividends); 2. Lower cost of capital than Common Stock; 3. Does not dilute Common Stock voting strength; 4. No maturity date; 5. No security required.
142
Distinguish between Convertible Preferred Stock and Nonconvertible Preferred Stock.
1. Convertible Preferred Stock = Preferred shareholders can exchange (convert) preferred stock for common stock according to a specified exchange plan. 2. Nonconvertible Preferred Stock = Preferred shareholders cannot exchange (convert) their preferred stock to common stock.
143
Define "preferred stock".
Ownership interest in a corporation which has certain preferences over common stock; often described as have characteristics of both bonds and common stock.
144
Define "callable preferred stock".
The issuing firm has the right to buy back the preferred stock, normally at a premium.
145
Distinguish between Participating Preferred Stock and Nonparticipating Preferred Stock
1. Participating Preferred Stock = Preferred shareholders can "participate" with common shareholders in receiving dividends in excess of the preferred preference rate. 2. Nonparticipating Preferred Stock = Preferred shareholders cannot "participate" with common shareholders in receiving dividends in excess of the preferred preference rate; each period they receive only their preference rate of dividends.
146
Distinguish between Cumulative Preferred Stock and Noncumulative Preferred Stock
1. Cumulative Preferred Stock = Dividend preference amount not paid in any year accumulates and must be paid before common dividends are paid. 2. Noncumulative Preferred Stock = Dividend preference amount not paid in any year does not accumulate; it is "lost" to the Preferred Shareholder for that period.
147
How is the theoretical value of a share of Preferred Stock (PSV) determined?
PSV = Annual Preferred Dividend/Investors' Required Rate of Return. Note: 1. The annual dividend is assumed to exist in perpetuity. 2. The investors' required rate of return is a "discount rate."
148
Identify the advantages of using common stock for long-term financing.
1. No legally required periodic payments (i.e., dividends); 2. No maturity date; 3. No security required.
149
How is the theoretical value determined for a share of Common Stock (CSV) that is to be held for multiple periods?
CSV = Dividend in 1st Year/(Investors' Required Rate of Return - Dividend Growth Rate) Note: Dividends are assumed to grow at a constant rate indefinitely.
150
Describe the preemptive right of common stock.
The right of first refusal to acquire a proportionate share of any new common stock issued by a corporation.
151
Identify the disadvantages of using common stock for long-term financing.
1. Higher cost of capital that other sources; 2. Dividends paid are not tax deductible; 3. Additional shares issued dilute ownership and earnings per share.
152
Describe the limited liability of common stock.
Common shareholders' liability is limited to their investment in a corporation.
153
Define "business risk".
The risk of loss or other unfavorable outcome that results as variability in operating results increases; the higher the variability in a firm's expected operating earnings, the greater the business risk (i.e., the increased chance that it may not be able to meet its debt obligations).
154
Define the "hedging principle" of financing (also called the "principle of self-liquidating debt").
Principle that focuses on matching cash flows from assets with the cash requirements needed to satisfy the related financing. Thus, long-term assets should be financed with long-term sources of capital and short-term assets should be financed with short-term sources of financing.
155
Generally, how do the costs compare of financing using long-term debt, Preferred Stock and Common Stock?
Generally, the cost of Long-term Debt is lower than either Preferred Stock or Common Stock and the cost of Preferred Stock is lower than the cost of Common Stock. However, as the level of Long-term Debt increases relative to equity, the cost of marginal debt increases due to the increased risk of default.
156
What macroeconomic conditions affect the cost of capital?
Market conditions and expectations concerning economic factors such as interest rates, tax rates, and inflation/deflation rates.
157
What are some factors that influence the cost of capital to a firm?
1. Macroeconomic conditions (e.g., interest rates, tax rates and inflation/deflation rates, etc.); 2. Past performance of the firm; 3. Amount of total financing used; 4. Relative level of debt financing; 5. Length of debt maturity; 6. Relative level of collateral provided.
158
What is the objective of Optimum Capital Structure?
To minimize a firm's aggregate cost of capital financing by using an optimum mix of debt and equity components; to achieve the lowest possible weighted average cost of capital.
159
Give examples of over-investing in working capital.
1. Maintaining excess cash in low-return accounts; 2. Having excessive (large/old) accounts receivable which don't earn interest; 3. Maintaining more inventory than needed and thus incurring storage costs and increasing the risk of obsolete inventory.
160
Define "current liabilities".
Obligations due to be settled within one year or which will require the use of current assets to satisfy (e.g., Accounts payable, other short-term Payables, some Unearned revenue, etc.).
161
Define "current assets".
Cash and other resources expected to be converted to cash, sold, or consumed within one year (e.g., Accounts receivable, Inventory, some Prepaid items, etc.).
162
Define "working capital" (also called "net working capital").
The difference between a firm's current assets and its current liabilities; expressed as: Current assets - Current liabilities = Working capital.
163
What is the objective of Working Capital Management?
To maintain adequate working capital so as to: 1. Meet on-going operating and financial needs of the firm; 2. Not over invest in net working capital which provide low returns or increase costs.
164
Describe a payment through draft.
Payment is made with a legal instrument, called a "draft," that is drawn on a demand deposit account of the paying firm and paid by the firm's bank only after being approved by the firm.
165
Describe the operation of a lock-box system.
Customers remit payments to firm's post office box where they are collected and then processed and deposited by firm's bank; may reduce the float by several days.
166
Describe concentration banking.
Funds collected in multiple local banks are transferred regularly and (usually) automatically to firm's primary bank; used to accelerate the flow of cash to a firm's principal bank.
167
Describe the uses of zero-balance accounts.
A bank account with no real balance. Two variations exist: 1. Checks written on account overdraw the account, but by agreement with the bank the overdrawn amount is paid automatically from another account. 2. Only the known amount of payments from an account is deposited into the account (e.g., payroll account).
168
Identify the advantages of using a lock-box system.
1. Cash is available for use sooner than it would be if receipts were routed through the firm; 2. Firm's handling of collections is greatly reduced; 3. Reduced likelihood of dishonored checks and earlier identification of those that are.
169
Define "float".
The time between when a payment is initiated and when the related cash is available for use by the recipient.
170
Describe the use of preauthorized checks.
Payment/collection of an amount due through the use of checks that are authorized in advance.
171
Define "commercial paper".
Short-term unsecured promissory notes issued by large, established firms with high credit ratings as a form of short-term financing (i.e., 270 days or less).
172
Define "banker's acceptance".
A draft (or order to pay) drawn on a specific bank by a firm which has an account with the bank. If bank "accepts" the draft, it becomes a negotiable debt instrument of the bank.
173
Define "repurchase agreement" (also calleda "Repo").
A debt investment instrument with a commitment by the buyer to resell the instrument to the seller at a specified price, which includes the original principal plus an interest or fee factor, at a specified time.
174
What are the major considerations in selecting short-term securities as investments?
1. Safety of principal; 2. Price stability of the investment; 3. Marketability or Liquidity of the investment.
175
What are United States Treasury Bills (also called T-Bills)?
Debt investment instruments that are the direct obligation of the U.S. Government; considered to be virtually risk-free and commonly used as the basis for the risk-free rate of return in many financial analysis.
176
Define "default risk".
A measure of the likelihood that the issuer will not be able to make future interest and/or principal payments to a security holder.
177
Identify two major approaches to determining a customer's creditworthiness.
1. Use of credit-rating service; 2. Financial analysis of prospective credit customer.
178
Identify the general credit-related factors that must be determined by an entity if it sells on account.
1. Total period for which credit will be extended for sales on account; 2. Discount terms, if any, granted for early payment of credit sales; 3. Penalty for failure to pay according to credit terms; 4. Nature and extent of documentation required for sales on account.
179
Describe the accounts-receivable management function.
Management functions concerned with the conditions leading to the recognition and collection of accounts receivables.
180
Describe an aging of accounts receivable schedule.
A schedule which shows for each credit customer how long each amount due from the customer has been owed. For example, amounts may be classified as being: not due, 1 - 30 days overdue, 31 - 60 days overdue, 61 - 90 days over due, over 90 days overdue.
181
Identify some measures (averages and ratios) useful in assessing accounts-receivable management.
1. Average collection period; 2. Day's sales in accounts receivable; 3. Accounts receivable turnover; 4. Accounts receivable to current or total assets; 5. Bad debt to sales.
182
Describe the economic order quantity (EOQ).
A model (formula) for determining the size of an inventory order that will minimize total inventory cost, both cost of ordering and cost of carrying inventory; formula uses: 1. Total demand for the inventory item; 2. Cost of each order; 3. Cost of carrying each unit of inventory.
183
Identify the benefits of a just-in-time inventory system (when compared with a traditional materials-requirement-planning inventory system).
1. Reduced investment in inventory; 2. Lower cost of inventory transportation, warehousing, insurance, taxes and related costs; 3. Reduced lead time in acquiring inputs; 4. Lower cost of defects; 5. Less complex and more relevant accounting and performance measurement.
184
Describe the reorder point.
The level of an inventory item on-hand at which that inventory item should be reordered; takes into account: 1. Inventory needed while ordered items are delivered. 2. Inventory need as "safety stock"-- to cover unexpected demand.
185
Identify the characteristics of a just-in-time inventory system.
1. Demand pull - Goods are produced only when there is an end user demand; 2. Excess inventory is minimized; 3. Production in work centers that carry out a full set of production processes; 4. Relationships with suppliers are close and coordinated; 5. Quality standards = Total control of input quality and production process quality; 6. Simplified cost accounting is used.
186
Identify the central objective of inventory management.
To determine and maintain an optimum investment in all inventories. Under investing in inventory can result in shortages and lost sales; over investing in inventory can result in incurring excessive cost for inventory.
187
Identify the characteristics of a traditional materials-requirement-planning inventory system.
1. Supply push - Goods are produced in anticipation of there being a demand for the goods; 2. Inventory buffers maintained; 3. Long set-up times and long production runs; 4. Relationships with suppliers are impersonal; suppliers selected through bidding process; 5. Quality standards = Acceptable levels; allows for some defects; 6. Traditional cost accounting is used.
188
Identify some measures (averages and ratios) useful in assessing inventory management.
1. Inventory turnover; 2. Number of days' sales in inventory.
189
What assumptions are inherent in using the economic order quantity (EOQ) model?
1. Demand is constant during the period; 2. Unit cost and carrying cost are constant during the period; 3. Delivery is instantaneous.
190
Under what circumstances is the use of short-term financing most appropriate?
The use of short-term liabilities for financing purposes is most appropriate when the related assets financed will generate cash in the short-run to be able to repay the liabilities.
191
Describe the characteristics of short-term borrowing.
Financing (borrowing or deferred payment) with payment due within one year or less; generally does not require collateral and does not impose restrictive covenants.
192
Give examples of short-term financing that is available only as needed.
1. Line of credit; 2. Revolving credit; 3. Letter of credit.
193
What is the impact of being required to maintain a compensating balance on the cost of short-term borrowing?
Required compensating balances result in: 1. Less funds available than the amount borrowed and, therefore 2. Effective cost of borrowing is greater than the stated cost.
194
Describe the benefits provided by ratio analysis.
Provides measures and enables comparisons of a firms operating and financial activities and position: 1. For a single firm over time; 2. Across firms. Facilitates identifying operating and financial strengths and weaknesses of a firm.
195
Define "ratio analysis" (for financial management).
The development of quantitative relationships between various elements of a firm's financial, operating and other information.
196
When a ratio requires using a Balance Sheet value together with an Income Statement value, how should the Balance Sheet value be determined?
When a Balance Sheet value is used together with an Income Statement value in a ratio, the Balance Sheet value must be an average balance for the period covered by the Income Statement, not the year-end (or other point-in-time) balance.
197
What does the "defensive-interval ratio" measure? How is it expressed as a formula?
Measures the relationship between highly liquid assets and the average daily use of cash; expressed as: Defensive-Interval Ratio = (Cash [Cash Equivalents] + Net Accounts Receivable + Marketable Securities)/Average Daily Cash Expenditures.
198
What does the "times-interest-earned ratio" measure? How is it expressed as a formula?
Measures the ability of current earnings to cover interest payments for a period; expressed as: (Net Income + Interest Expense + Income Tax Expense)/Interest Expense.
199
Define "liquidity measures".
Measurements of the ability of a firm to pay its obligations as they become due; useful in working capital management.
200
What does "working capital" measure? How is it expressed as a formula?
Measures the extent to which current assets exceed current liabilities and, thus, are uncommitted in the short term; expressed as: Working Capital = Current Assets - Current Liabilities.
201
What does the "working-capital ratio" (also called the "current ratio") measure? How is it expressed as a formula?
Measures the quantitative relationship between current assets and current liabilities in terms of the "number of times" current assets can cover current liabilities; expressed as: Working Capital Ratio = Current Assets/Current Liabilities.
202
What does the "acid test ratio" (also called the "quick ratio") measure? How is it expressed as a formula?
Measures the relationship between highly liquid assets and current liabilities; expressed as: Acid Test Ratio = (Cash [Cash Equivalents] + Net Accounts Receivable + Marketable Securities)/Current Liabilities Note: Inventory is excluded from the numerator.
203
What does the "operating cycle length" measure? How is it expressed as a formula?
Measures the average length of time to invest cash in inventory, convert the inventory to receivables, and collect the receivables; it measures the time to go from cash back to cash and is expressed as: Operating Cycle Length = Number of Days' Sales in Average Receivables + Number of Days' Supply in Inventory.
204
What does the "number of days' sales in average receivables ratio" measure? How is it expressed as a formula?
Measures the average number of days required to collect receivables; measures the average age of receivables. Number of Days Sales in Average Receivables = 365 (or other days)/Accounts Receivable Turnover.
205
What does the "accounts receivable turnover ratio" measure? How is it expressed as a formula?
Measures the number of times that accounts receivable turnover (are incurred and collected) during a period; expressed as: Accounts Receivable Turnover = Credit Sales/Average Net Accounts Receivable. Useful in assessing credit policies and collection efficiency.
206
What does the "number of days' supply in inventory ratio" measure? How is it expressed as a formula?
Measures the number of days inventory is held before it is sold or used; indicates the efficiency of inventory management. Number of Days Supply in Inventory = 365 (or other days)/Inventory Turnover.
207
Describe operational activity measures.
Ratios (and other measures) that measure the efficiency with which a firm carries out its operating activities.
208
What does the "inventory turnover ratio" measure? How is it expressed as a formula?
Measures the number of times that inventory is acquired and sold or used during a period; expressed as: Inventory Turnover = Cost of Goods Sold/Average Inventory. Useful in assessing overstocking/understocking of inventory and obsolete inventory.
209
What does the "gross profit margin ratio" measure? How is it expressed as a formula?
Measures how much (percentage) of each sales dollar that is available to cover operating expenses and provide a profit; expressed as: Gross Profit Margin = Gross Profit/Net Sales
210
What does the "return on total assets" (also called the "return on investment") measure? How is it expressed as a formula?
Measures the rate of return on total assets and indicates the efficiency with which invested resources (assets or total equity) are used; expressed as: Net Income + Interest Expense + Income Taxes/Average Total Assets. (NOTE: Some versions may not add back Interest Expense and/or Income Taxes.)
211
What does the "price-earnings ratio" ("P/E ratio"; also called the "multiple") measure? How is it expressed as a formula?
Measures the price of a share of common stock relative to its latest earnings per share; expressed as: P/E Ratio = Market price per common share/Earnings per common share. Notice, it measures the number of times ("multiples") earnings per share is reflected in the market price.
212
What does the "return on owners' (all stockholders') equity ratio" measure? How is it expressed as a formula?
Measures the rate of return (earnings) on all stockholders' investment; expressed as: ROE = Net Income/Average Stockholders' Equity.
213
Describe the "Common Stock dividend payout rate" measure.
Measures the extent (percent) of earnings distributed to common shareholders; expressed as: C/S Dividend Payout Rate = C/S Cash Dividends/Net Income Available for Common Shareholders. Also, can be computed on a per share basis.
214
Describe profitability measures.
Ratios (and other measures) that measure aspects of a firm's operating (profit/loss) results on a relative basis.
215
What does the "net profit margin on sales" measure? How is it expressed as a formula?
Measures how much (percentage) of each sales dollar that ends up as net income; expressed as: Profit Margin = Net Income/Net Sales.
216
What does the "economic value added (EVA)" measure? How is it expressed as a formula?
Measures an entity's economic profit (not its accounting profit) as accounting earnings before deducting interest less the dollar value of opportunity cost associated with long-term debt and shareholders' equity; expressed as: EVA = Earnings before interest - [Opportunity cost rate x (L-T debt + SE)].
217
What does the "residual income" measure? How is it expressed as a formula?
Measures the excess of an entity's dollar amount of income over the dollar amount of its required return on average investment (based on its hurdle rate of return); expressed as: Residual Income = Net Income - (Average Invested Capital x Hurdle Rate).
218
What does the "debt ratio" measure? How is it expressed as a formula?
Measures the proportion of assets provided by creditors and indicates the extend of leverage used in funding the entity; expressed as: Debt Ratio = Total Liabilities/Total Assets.
219
What does the "debt to equity ratio" measure? How is it expressed as a formula?
Measures the relative amounts of assets provided by creditors (debt) and shareholders; expressed as: Debt to Equity = Total Liabilities/Total Shareholders' Equity.
220
What does the "owners' equity ratio" measure? How is it expressed as a formula?
Measures the proportion of assets provided by shareholders; expressed as: Owners' Equity Ratio = Shareholders' Equity/Total Assets.
221
Describe equity or investment-leverage measures.
Measures of relative sources of equity and equity value.
222
What does the "book value per common share" measure? How is it expressed as a formula?
Measures the per share amount of common shareholders' claim to assets; expressed as: BV per CS = Common Shareholders' Equity/Number of Common Shares Outstanding. (Can be similarly computed for Preferred Stock.)
223
Describe financial risk.
Risk to common shareholders that derives from a firm's use of debt financing which requires interest payment regardless of the firm's operating results and its use of preferred stock which requires payment of dividends before common shareholders receive dividends.
224
Describe liquidation risk (also called marketability risk).
The risk associated with the possibility that an asset cannot be readily sold for cash equal to its fair value.
225
Describe interest rate risk.
Risk to investors associated with the effects of changes in the market rate of interest on outstanding fixed-rate debt instruments. If the market rate of interest increases, the market value of already outstanding fixed-rate debt instruments will decrease.
226
Describe diversifiable risk (also called unsystematic risk, firm-specific risk, or company-unique risk).
Elements of business risk that can be eliminated through diversification of investments; for example diversification of projects or securities investments.
227
Describe nondiversifiable risk (also called systematic risk or market-related risk).
Elements of risk that cannot be eliminated through diversification of investments; usually derive from general economic and political factors (e.g., general level of interest rate, new taxes, inflation/deflation, etc.).
228
Describe default risk.
The risk associated with the possibility that the issuer of a security will not be able to make future interest payments and/or principal repayment.
229
Describe currency exchange risk.
Risk that derives from changes in exchange rates between currencies; may affect foreign currency transactions, foreign currency investments and/or future foreign currency economic activity.
230
Define "risk".
The possibility of loss or other unfavorable outcome that results from the uncertainty in future events.
231
Describe inflation risk (also called purchasing power risk).
The risk that a rise in the general price level (inflation) will result in reduced purchasing power of a fixed sum of money.
