Financial Management & Capital Budgeting Flash Cards
Which of the following is not a strategy through which a financial institution (or any business) could manage the risk that it cannot obtain funding in the short run (or roll over its obligations)?
A.Purchase credit default swaps.
B.Reduce the mismatch between the maturities of their assets and liabilities.
C.Maintain a large cushion of cash and short-term securities.
D.Maintain a variety of long, secure lines of credit.
Choice A (Correct): Credit default swaps protect lenders against default by its borrowers but does not assure the availability of debt in the future.
Bander Co. is determining how to finance some long-term projects. Bander has decided it prefers the benefits of no fixed charges, no fixed maturity date and an increase in the credit-worthiness of the company. Which of the following would best meet Bander’s financing requirements?
A.Bonds.
B.Common stock.
C.Long-term debt.
D.Short-term debt.
Choice B (Correct) and Choices A, C, D (Incorrect): Generally all debt, including bonds, long-term debt, and short-term debt involves fixed charges and fixed maturity dates. In addition, the more debt financing a company has, the lower its credit worthiness. As a result, common stock would be the best alternative to meet the financing objectives.
A lender and a borrower signed a contract for a $1,000 loan for one year. The lender asked the borrower to pay 3% interest. Inflation occurred and prices rose by 2% over the next year. The borrower repaid $1,030. What is the amount worth in real terms, after inflation?
A.$1,060.90
B.$1,050.60
C.$1,019.80
D.$1,009.80
Choice D (Correct) and Choices A, B, C (Incorrect): At a rate of inflation of 2%, $102 dollars at the end of the period are equivalent to $100 at the beginning. As a result, $1,030 at the end of the year would be equivalent to $1,030 x 100/102 or $1009.89.
What would be the primary reason for a company to agree to a debt covenant limiting the percentage of its long-term debt?
A.To cause the price of the company’s stock to rise.
B.To lower the company’s bond rating.
C.To reduce the risk for existing bondholders.
D.To reduce the interest rate on the bonds being sold
Choice D (Correct): A company with a lower debt to equity ratio is generally considered to entail a lower risk and, as a result, will generally enable the company to borrow at lower interest rates. By agreeing to a debt covenant limiting long-term debt, the company is providing assurance to lenders that the ratio will not get too high, keeping the cost of borrowing lower for the company.
The economic order quantity formula assumes that:
A.Periodic demand for the good is known
B.Carrying costs per unit vary with quantity ordered
C.Costs of placing an order vary with quantity ordered
D.Purchase costs per unit differ due to quantity discounts
Choice A (Correct): The economic order quantity is calculated by taking the square root of 2AP/S where A is the periodic demand in units, P is the cost of placing an order and S is the cost of maintaining a unit in inventory for an entire period. The periodic demand must be known or estimable in order to calculate the economic order quantity.
When estimating cash flow for use in capital budgeting, depreciation is
A.Included as a cash or other cost. [
B.Excluded for all purposes in the computation.
C.Utilized to estimate the salvage value of an investment.
D.Utilized in determining the tax costs or benefit.
Choice D (Correct) and Choices A, B, C (Incorrect): Since depreciation does not involve the payment of cash, it is not included as an expense when calculating cash flows associated with an investment alternative. Depreciation is tax deductible, however, and the tax effect is taken into consideration.
A company has several long-term floating-rate bonds outstanding. The company’s cash flows have stabilized, and the company is considering hedging interest rate risk. Which of the following derivative instruments is recommended for this purpose?
A.Structured short-term note.
B.Forward contract on a commodity.
C.Futures contract on a stock.
D.Swap agreement.
Choice D (Correct): A swap agreement is a form of derivative under which one party is entitled to an amount from the counterparty that is calculated by applying a variable rate of interest to a principal balance while being liable to the counterparty for an amount calculated by applying a fixed rate to the same balance. When entered into as a means of hedging interest rate risk, a swap enables an entity to essentially convert a variable rate liability into a fixed rate obligation, making cash flows predictable.
Which of the following assumptions is associated with the economic order quantity formula?
A.The carrying cost per unit will vary with quantity ordered.
B.The cost of placing an order will vary with quantity ordered.
C.Periodic demand is known.
D.The purchase cost per unit will vary based on quantity discounts.
Choice C (Correct) and Choices A, B, D (Incorrect): Economic order quantity, the formula used to determine the optimum amount of inventory to purchase with each order to minimize the total of carrying and ordering costs, assumes that the cost of carrying a unit in inventory for one period and the cost of placing an order will remain constant. It also assumes that demand for the period can be estimated. The cost of inventory is not a consideration.
Roger’s Appliance Warehouse has an inventory conversion period of 60 days, an accounts receivable collection period of 25 days and an accounts payable deferral period of 29 days. How long is Roger’s cash conversion cycle?
A.54 days
B.56 days
C.64 days
D.85 days
Choice B (Correct) and Choices A, C, D (Incorrect): The cash conversion cycle measures the number of days from when a business pays for its inputs, to when the business collects cash from the resulting sales of finished goods. It is the calculation of the inventory conversion period + the accounts receivable collection period – the accounts payable deferral period. In this situation the calculation is 60 + 25 – 29 = 56 days.
Roger’s Appliance Warehouse has an inventory conversion period of 60 days, an accounts receivable collection period of 25 days and an accounts payable deferral period of 29 days. How long is Roger’s cash conversion cycle?
A.54 days
B.56 days
C.64 days
D.85 days
Choice B (Correct) and Choices A, C, D (Incorrect): The cash conversion cycle measures the number of days from when a business pays for its inputs, to when the business collects cash from the resulting sales of finished goods. It is the calculation of the inventory conversion period + the accounts receivable collection period – the accounts payable deferral period. In this situation the calculation is 60 + 25 – 29 = 56 days.
Which of the following rates is most commonly compared to the internal rate of return to evaluate whether to make an investment?
A.Short-term rate on U.S. Treasury bonds.
B.Prime rate of interest.
C.Weighted-average cost of capital.
D.Long-term rate on U.S. Treasury bonds.
Choice C (Correct): When determining whether or not to make an investment, the internal rate of return will be compared to a benchmark that is meaningful for the company. This will frequently be the company’s weighted average cost of capital since it will indicate whether the investment will provide a greater return to its shareholders, when the return is greater, or will reduce it, when the return is lower. The short-term rate on US Treasury bonds, the prime rate of interest, or the long-term rate on U.S. Treasury bonds would only be appropriate if the company could borrow at one of those rates.
In capital budgeting, which of the following items is included in the payback model calculation?
A.The total amount of the initial outlay for the project.
B.The present value of the future cash flows of the project.
C.The present value of the estimated salvage value of the project.
D.The amount of depreciation over the life of the project.
Choice A (Correct) and Choices B, C, D (Incorrect): The payback model calculation divides the total initial outlay for a project by its undiscounted after-tax annual net cash inflows. Neither depreciation nor the time value of money are included in the calculation.
A company is considering acquiring a derivative to hedge a risk associated with an investment it is currently holding. Which of the following coefficients of variation would indicate that the hedge will be effective?
A.+0.91
B.+0.19
C.-0.19
D.-0.91
Choice D (Correct) and Choices A, B, C (Incorrect): In order for a hedge to be effective in offsetting a risk associated with an investment, it should respond to market conditions in the opposite way that the hedged investment acts. The closer a coefficient of variation is to 0, the less of a relationship there is between the two items. A coefficient of +1 indicates the two act in pretty much precisely the same manner and a coefficient of -1 indicates that they act in an opposite manner. A coefficient of -0.91 would indicate a strong inverse relationship and a potentially effective hedge.
Which of the following is a risk taken by a lender that the value of the loan will decline as a result of a general economic decline?
A.Market risk.
B.Credit risk.
C.Concentration of credit risk.
D.Economy risk.
Choice A (Correct): Market risk is the risk that the value of a bond or loan will decline due to a decline in the aggregate value of all the assets in the economy.
Which of the following methods should be used if capital rationing needs to be considered when comparing capital projects?
A.Net present value.
B.Internal rate of return.
C.Return on investment.
D.Profitability index.
Choice D (Correct): The profitability index divides net present value of an investment by the initial net investment and can be used to compare the relative profitability of investments. When resources are scarce, those with the highest profitability index will be selected since they represent the highest rate of return relative to the amount invested. Although the net present value method allows a comparison of which investments are most profitable, in terms of the present value of dollars, it does not take into account that a slightly larger net present value may require a substantially greater initial investment, an important factor when resources are scarce. Although both the internal rate of return approach and the return on investment approach allow for the determination of which investments will provide the highest return, neither takes into account the size of investment that may be required to earn the higher investment.
