Financial Management

Question 1

Financial Management 5 Functions

Answer 1

1. Financing—Raising capital to fund the business
2. Capital budgeting—Selecting the best long-term projects based on risk and return
3. Financial management—Managing cash flow so that funds are available when needed at
   the lowest cost
4. Corporate governance—Ensuring behavior by managers that is ethical and in the best
   interests of shareholders
5. Risk management—Identifying and managing the firm’s exposure to all types of risk

Question 2

Working Capital Management - Inventory conversion period (ICP)

Answer 2

The average number of days required to convert inventory
to sales
• ICP = Average inventory / Cost of sales per day
• Average inventory = (Beginning inventory + Ending inventory) / 2
• Assume 365 days in a year unless told otherwise

Question 3

Working Capital Management - Receivables collection period (RCP)

Answer 3

The average number of days required to collect accounts
receivable
• RCP = Average receivables / Credit sales per day

Question 4

Working Capital Management - Payables deferral period (PDP)

Answer 4

The average number of days between the purchase of inventory
(including materials and labor for a manufacturing entity) and payment for them
• PDP = Average payables / Purchases per day

Question 5

Working Capital Management - Cash conversion cycle (CCC)

Answer 5

The average number of days between the payment of cash to
suppliers of material and labor and cash inflows from customers
• CCC = ICP + RCP – PDP

Question 6

Cash Balances are maintained for

Answer 6

• Operations—To pay ordinary expenses
• Compensating balances—To receive various bank services, fee waivers, and loans
• Trade discounts—Quick payment of bills for early payment discounts
• Speculative balances—Funds to take advantage of special business opportunities
• Precautionary balances—Amounts that may be needed in emergency situations

Question 7

Float

Answer 7

refers to the time it takes for checks to be mailed, processed, and reflected in accounts.

Question 8

Management techniques try to maximize float on payments and minimize it on receipts.

Answer 8

• Zero-balance accounts—The firm is notified each day of checks presented for payment
and transfers only the funds needed to cover them.
• Lockbox system—Customers send payments directly to bank to speed up deposits.
• Concentration banking—Customers pay to local branches instead of main offices.
• Electronic funds transfers—Customers pay electronically for fastest processing.

Question 9

Private debt

Answer 9

Loans obtained from banks and other financial institutions or from syndicates of
lenders. Virtually all such loans have variable interest rates that are tied to an index:

Question 10

Private Debt - Prime Rate

Answer 10

This is the rate that the lender charges its most creditworthy customers.
Loans to other customers would include a fixed amount above this (e.g., prime plus 2%).

Question 11

Private Debt - LIBOR (London Interbank Offered Rate)

Answer 11

When the borrower and lender are in different

countries, the base used will typically be the LIBOR rather than the prime rate.

Question 12

Public debt

Answer 12

To bypass institutional lenders, a corporation may sell bonds directly to investors
as a means of borrowing, with fixed interest rates and maturity dates for the securities, which can
then trade on the open market.

Question 13

SEC registered bonds

Answer 13

To be sold on U.S. markets, bonds must satisfy the stringent

registration and disclosure requirements of the SEC.

Question 14

Eurobonds

Answer 14

Bonds denominated in U.S. dollars can be sold on the European exchanges,
which have less stringent requirements.

Question 15

Debt Covenants - Positive

Answer 15

• Providing annual audited financial statements to the lender
• Maintaining minimum ratios of current assets to current liabilities or financial measures
• Maintaining life insurance policies on key officers or employees of the company

Question 16

Debt Covenants - Negative

Answer 16

• Not borrowing additional sums during the time period from other lenders
• Not selling certain assets of the business
• Not paying dividends to shareholders
• Not exceeding certain compensation limits for executives

Question 17

Secured and Unsecured Bonds

Answer 17

Debt obligations may be secured by certain collateral or may specifically be placed behind other
forms of debt in the priority of repayment. In roughly declining order of safety (and increasing order
of interest rate), there are:

Question 18

Order of Bond Safety

Answer 18

• Mortgage bonds—Secured by certain real estate owned by the borrower
• Collateral trust bonds—Secured by financial assets of the firm
• Debentures—Unsecured bonds
• Subordinated debentures—Unsecured bonds that will be repaid after all other creditors
in the event of a liquidation of the corporation
• Income bonds—Bonds whose interest payments will be made only out of earnings of the
corporation

Question 19

Term bonds

Answer 19

Principal will be repaid on a single maturity date.

Question 20

Serial bonds

Answer 20

Principal repayment will occur in installments

Question 21

Sinking funds

Answer 21

Regular deposits will be made by the borrower into an account from
which repayment of the bonds will be made.

Question 22

Convertible bonds

Answer 22

The bondholder may convert the bonds to the common stock of the company as a form of repayment instead of holding them to maturity for cash.

Question 23

Redeemable bonds

Answer 23

The bondholder may be able to demand repayment of the bonds in advance of the normal maturity date should certain events occur (such as the buyout of
the company by another firm).

Question 24

Callable bonds

Answer 24

The borrowing firm may force the bondholders to redeem the bonds before their normal maturity date (usually there is a set premium above the normal redemption price to compensate them for this forced liquidation).

Question 25

Stated rate

Answer 25

The fixed interest payment calculated from the face value of the bond. It is
also known as the coupon rate, face rate, or nominal rate.

Question 26

Current yield

Answer 26

The fixed interest payment divided by the current selling price of the
bond. When the bond is trading at a discount, this rate will be higher than the stated rate,
and when the bond is trading at a premium, this rate will be lower than the stated rate. This
rate can be somewhat misleading, since it reports the interest payment as a percentage of
the current price but doesn’t take into account the fact that the principal repayment of the
bond will not be the current selling price but the face value.

Question 27

Yield to maturity

Answer 27

The interest rate at which the present value of the cash flows of interest
and principal will equal the current selling price of the bonds. For a bond selling at a
discount, it will be even higher than the current yield, since it accounts for the “bonus”
interest payment reflected in the discount. For a bond selling at a premium, this rate will
be even lower than the current yield, since it reflects the loss of the premium when the
principal is repaid. This rate is also known as the effective rate or market rate.

Question 28

Common Stock - Advantages to firm:

Answer 28

• The firm has no specific obligation to pay investors, increasing financial flexibility.
• Increased equity reduces the risk to lenders and reduces borrowing costs.

Question 29

Common Stock - Disadvantages to firm:

Answer 29

• Issuance costs are greater than for debt.
• Ownership and control must be shared with all the new shareholders.
• Dividends are not tax-deductible.
• Shareholders ultimately receive a much higher return than lenders if the business is successful,
so the long-run cost of capital obtained this way is typically much higher.

Question 30

Operating leverage

Answer 30

The degree to which a firm has built fixed costs into its operations
• Higher fixed costs mean more risk when revenues are below expectations
• Profit grows rapidly relative to revenue increases due to lower variable costs
• % change in operating income / % change in unit volume = Degree of operating leverage

Question 31

Financial leverage

Answer 31

The degree to which a firm uses debt financing in its business
• Higher debt means higher interest and principal obligations for repayment, increasing risk
if performance is not up to expectations
• Debt financing costs less than equity financing and doesn’t increase with greater performance,
so overall profit and asset growth potential is greater
• % change in earnings per share / % change in earnings before interest and taxes = Degree
of financial leverage

Question 32

Debt

Answer 32

The cost of debt financing is the after-tax cost of interest payments, as measured by the
yield to maturity. It can be calculated in two ways:
1. Yield to maturity × (1 – Effective tax rate)
2. (Interest expense – Tax deduction for interest) / Carrying value of debt

Question 33

Preferred stock

Answer 33

The cost of preferred stock financing is the stipulated dividend divided by the
issue price of the stock.

Question 34

Common stock

Answer 34

The cost of common stock financing represents the expected returns of the
common shareholders and is difficult to estimate

Question 35

Capital asset pricing model (CAPM)

Answer 35

Volatility of stock price relative to average stock.
This model assumes the expected return of a particular stock depends on its volatility (beta) relative to the overall stock market.
CAPM = Beta × Excess of normal market return over risk-free investments + Normal return on risk-free investments

Question 36

Arbitrage pricing model

Answer 36

This model is a more sophisticated CAPM with separate excess returns and betas for each component making up the stock characteristics