Financial Management Flashcards
What is the ultimate objective of the financial management function in a profit-oriented entity?
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.
Identify some of the responsibilities of the financial management function of an entity.
- 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.
Define “unexpired cost.”
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).
Define “opportunity cost.”
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.
Define “cost” as used in accounting.
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.
How is a firm’s cost of capital determined?
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.
Define “weighted-average cost of capital.”
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.
Define “differential cost.”
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.
Define “sunk cost.”
Costs incurred in the past that cannot be changed by current or future decisions and, therefore, are irrelevant to current decisions.
What are the major elements of a firm’s capital (or capital structure)?
Long-term debt, Preferred stock and Common stock.
Define “expired cost.”
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).
Define the “future value” of an annuity.
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.
Define the “future value” of $1.
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.
Define an “annuity due (also called an annuity in advance)”.
Series of equal amounts received or paid at the beginning of each equal period.
Define the “present value” of an ordinary annuity.
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.
Define the “present value” of $1.
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.
Define “future value” of an ordinary annuity.
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.
Define an “ordinary annuity (also called an annuity in arrears)”.
Series of equal amounts received or paid at the end of each equal period.
Define “compound interest”.
Interest computed not only on the principal but also on any accumulated unpaid interest (i.e., interest is paid on interest).
Define “effective interest rate”.
- 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.
Define a “fixed interest rate”.
The percentage rate of interest does not change over the life of the loan or parts of that life.
Define “simple interest”.
Interest computed on the principal only; there is no compounding in the interest computation (i.e., no interest paid on interest).
Define a “variable interest rate”.
The percentage rate of interest can change over the life of the related debt instrument.
Define “effective annual percentage rate” (also called the “annual percentage yield”).
Annual percentage rate with compounding on loans that are for a fraction of a year.
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.
Define “annual percentage rate (APR)”.
- 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.
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.
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.
Identify and briefly describe the three approaches to determining fair value as specified by United States Generally Accepted Accounting Principles (GAAP).
- 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.
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.
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.).
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.
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.
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.
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.
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)
What are the major assumptions and limitations of the capital asset pricing model (CAPM)?
- 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.
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.
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.
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.
What are some major limitations of the original Black-Scholes option pricing model?
- 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.
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).
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.
What are some major advantages of the original Black-Scholes option pricing model?
- 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.
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.
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.
Identify the three basic approaches to valuing a business.
- Market approach. 2. Income approach. 3. Asset approach.
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.
Identify and describe the two major classes of quantitative business forecasting methods.
- 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.
Identify and describe the two major classes of business forecasting methods.
- 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.
Identify and describe three classes of qualitative business forecasting methods.
- 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.
Identify and briefly describe major time-series patterns.
- 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.
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.
Identify the major forms of causal models used for forecasting.
- Regression models (linear or non-linear); 2. Input-Output models; 3. Economic models.
Identify the major forms of time-series models (mathematical methods) used for forecasting.
- 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.
Define “risk”.
The possibility of loss or other unfavorable results that derives from the uncertainty implicit in future outcomes.
Describe the risk/reward relationship.
The greater the perceived risk of an undertaking, the higher the expected reward from the undertaking.
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.
Define “capital budgeting”.
The process of measuring, evaluating, and selecting long-term investment opportunities, primarily in the form of projects or programs.
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.
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.
Give examples of risk associated with investments in capital projects.
- 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.).
Identify the disadvantages of the payback period approach to project evaluation.
- 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.
Identify the advantages of the payback period approach to project evaluation.
- Easy to use and understand; 2. Useful in evaluating liquidity of a project; 3. Use of a short payback period reduces uncertainty.
Under what circumstances would the payback period approach to project evaluation be most appropriate?
- When used as a preliminary screening technique; 2. When used in conjunction with other evaluation techniques.
Identify five different techniques for evaluating capital budgeting projects.
- 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.
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.
Identify a technique that is intended to rank capital budgeting projects in terms of desirability.
The profitability index (PI).
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.
Identify the advantages of the discounted payback period approach to capital budgeting evaluation.
- 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.
Identify the disadvantages of the discounted payback period approach to capital budgeting evaluation.
- Ignores cash flows received after the payback period; 2. Does not measure total project profitability; 3. Maximum payback period may be arbitrary.
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.
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.
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.
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.
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.
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).
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.
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.
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
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.
Identify the advantages of the net-present-value approach to capital project evaluation.
- 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.
Compare the internal-rate-of-return (IRR) approach with the net-present-value (NPV) approach (to capital budgeting).
- 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.
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.
Identify the advantages of the internal-rate-of-return approach to capital project evaluation.
- Recognizes the time value of money; 2. Considers the entire life and results of the project.
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.
Identify the disadvantages of the internal-rate-of-return approach to capital project evaluation.
- 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.
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.
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.
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.
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.
Give three reasons for capital rationing.
- 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.
