Financial Management - Wiley Q&A 86 Questions Flashcards
Capital Asset Pricing Model explain what is it for and the equation to arrive at this
Formula is: Cost of Equity = RF + (RF-km) x bi
Where RF is risk free rate of return and km is market rate and bi is beta.
CAPM ultimate goal is to calculate the cost of equity.
Formula example above, first you must solve the right side of equation after the + sign and then allow this result to be added to RF preceding the + sign to get your answer.
Formula for Determining EFFECTIVE RATE OF LOAN INTEREST - Compute THE FOLLOWING: Company borrows a One Year Bank Loan of $500,000 at a stated rate of 8% with a requirement to maintain a 20% balance in its checking account. The company would otherwise maintain a zero balance checking without this requirement.
1st: Consider how much the company would maintain in the account if the compensating balance did not exist. If there is a zero-balance maintenance concept, we do not need to figure any required minimum balances into our equation. FIGURE THE EFFECTIVE RATE OF INTEREST:
Compute:
Available Principal: = $500,000 - (20% * $500,000) =
Interest PAID for 360 days: = $500,000 * 8% * (360 days/360 days) = $40,000 note if it were a shorter loan period the numerator would be the loan days, the denominator is the number of days in financial year.
Effective Interest Rate Calc:
INTEREST PAID $40,000
____________________ = 10%
PRINCIPAL AVAIL400,000
Compensating balances—Loan agreements may require the borrower to maintain an average demand deposit balance equal to some percentage of the face amount of the loan. Such requirements increase the effective interest rate of the loan, because the firm does not get use of the full amount of the loan principal. As an example, if a firm gets a $100,000, 90-day loan at 6% with a 10% compensating balance arrangement, the effective interest rate on the loan would be calculated as follows:
Principal available = $100,000 – (10% × $100,000)
Interest for 90 days=$100,000 × 6% × (90 days/360 days)=$1,500
Effective interest rate=Interest paid/Principal available × (360 days/90 days)=
$1,500/$90,000 × (360 days/90 days) = 6.67%
Order of operations, work the first part of equation $1,500/$90,000 and then multiply this by 4 to get 6.67% otherwise the answer will differ.
How does the Arbitrage Pricing Model compare to the Capital Asset Pricing Model?
The arbitrage pricing model uses a series of systematic risk factors.Investors face two different types of risk for an investment.
Arbitrage pricing model. Investors face two different types of risk for an investment.
- Systematic risk—Market risk that cannot be diversified away.
- Unsystematic risk—The risk of the specific investment that can be eliminated through diversification.
CAPM uses only one variable to capture systematic risk, the market rate of return or km. The arbitrage pricing model uses a series of systematic risk factors to develop a value that reflects the multiple dimensions of systematic risk. For example, systematic risk may be affected by future oil prices, exchange rates, interest rates, economic growth, etc. The formulation of the arbitrage pricing model is as follows:
rp = b1(k1–kRF) + b2 (k2–kRF) + b3 (k3–kRF)
Where
rp = The risk premium on the particular investment. This is the amount that should be added to the risk-free rate to get an estimate of the cost of capital.
krf = The risk-free interest rate.
b 1,2,3… = The betas for the individual risk factors (e.g., exchange rate risk, oil price risk, interest rate risk, etc.)
k 1,2,3… = The market interest rate associated with each of the risk factors.
As you can see, the amounts in the parentheses are equal to the risk premium associated with each of the factors, (i.e., the market rate for each factor minus the risk-free rate).
What is the major advantage of a zero-balance account system?
It maximizes the float involved in cash disbursements.
E.g. by using regional banks and not transferring funds until the checks are presented, the float on disbursements is maximized.
A company has an outstanding one-year bank loan of $500,000 at a stated interest rate of 8%. The company is required to maintain a 20% compensating balance in its checking account. The company would maintain a zero balance in this account if the requirement did not exist. What is the effective interest rate of the loan?
Long formula:
Actual Interest paid during the loan period
divided by Available Principal/ (360/# of days of loan)
Short formula example if using interest rates only:
In this example we can use .08/1-.20 or .08/.80 = 10%
or substitute with numbers $40,000/$400,000.
Short examples work great if the loan is a full year. If a partial year loan less then 360 days, use the long formula with $ amounts to be safe in your answer.
Compute best checking account or loan.
Kemple is a newly established janitorial firm, and the owner is deciding what type of checking account to open. Kemple is planning to keep a $500 minimum balance in the account for emergencies and plans to write roughly 80 checks per month. The bank charges $10 per month plus a $0.10 per check charge for a standard business checking account with no minimum balance. Kemple also has the option of a premium business checking account that requires a $2,500 minimum balance but has no monthly fees or per check charges. If Kemple’s cost of funds is 10%, which account should Kemple choose?
Standard Business Checking will cost - As Annualized:
$120 annual bank charges
$ 96 per check chg at 80 checks x .10 per ck. per mo.
$ 50 for $500 planned balance at 10% cost of funds
_____
$266 Total cost of checking account.
Premium Checking will cost:
$250 for $2,500 minimum balance x cost of funds 10%
Result: Standard Business Checking will cost $16 more per year. Kemple should choose the Premium Checking.
DQZ Telecom is considering a project costing $50,000,000. DQZ plans to use the following combination of debt and equity to finance the investment:
- Issue $15,000,000 of 20-year bonds at a price of 101, with a coupon rate of 8%, and flotation costs of 1.5% of par. The after-flotation cost yield is 8.08%.
- Use $35,000,000 of funds generated from earnings.
- The equity market is expected to earn 12%. US Treasury bonds currently yield is 5%. Beta coefficient for DQZ is est to be .60. DQZ effective corporate income tax rate of 40%.
The before-tax cost of DQZ’s planned debt financing, net of flotation costs, in the first year is?
Debt financing option figured:
First Item relates to debt whereas the second two relate to equity, although the last item of three contains the “effective corporate tax rate” that is necessary for calc.
Question ask “before tax” net of flotation and first year cost
IN this example the answer is given for 8.08% or the after-flotation cost yield.
Normal calculation for cost of debt is:
Interest multiplied by 1-marginal tax rate is the cost of debt before flotation costs. Flotation costs are involved when issuing “new” debt. SEE ANOTHER NOT CARD FOR COMPUTING COST OF DEBT.
ALSO NPV SHOULD BE CALCULATED BUT WILL REQUIRE A TABLE BUT CAN BE ESTIMATED. ESTIMATE WOULD LOOK LIKE
Capital and operating leases differ in that the lessor
Capital leases characteristics:
- lessor is treated as owner even it the asset might revert back to the lessee.
- is a Financing transaction on the books by setting up the asset and corresponding note payable.
- typically payments will include P/I, repair/maint and insurance, or misc.
Operating leases:
NOT CAPITALIZED EXPENSED INSTEAD
NOT a source of financing
Explain the average collection period, how does the firm measure the number of days?
The collection period is the average time it takes from sale to collection (receipt of payment from customer).
Note receipt does not consider bank clearing time, it only considers the time in which the firm receives its payment.
Marginal Cost of Capital compute given the following:
Currently the company has to following structure:
Debt: $650,000 of 10% debt outstanding
Equity Financing: $500,000
RRR of equity holders is 15%
Retained earnings has no money available for investment purposes currently.
Raising New Equity will cost the firm 16%
New Debt would have before-tax-cost of 9%
Corporate Tax Rate is 50%
When calculating MCC the company should assign a cost of LIST A to Equity Capital and LIST B after tax debt financing:
List A List B
15% 4.5%
15% 5%
16% 4.5%
16% 5%
Cost of Marginal Equity is already provided 16%
Cost of Debt: 9% x .50 = 4.5%
The trickier problems will involve using existing retained earnings to finance versus new debt or paying off old debt and replacing with equity if feasible.
A firm must select from among several methods of financing arrangements when meeting its capital requirements. To acquire additional growth capital while attempting to maximize earnings per share, a firm should normally
Select debt over equity initially, even though increased debt is accompanied by interest costs and a degree of risk.
Answer:
Generally Debt financing is the least costly and using it would tend to maximize earnings per share.
Explain ADVANTAGES and DISADVANTAGES of issuing debt (or DEBT FINANCING).
Advantages and Disadvantages of Debt Financing
In deciding whether debt should be used as a form of financing, management must keep in mind the following advantages and disadvantages.
Advantages of debt financing include
- Interest is tax-deductible.
- The obligation is generally fixed in terms of interest and principal payments.
- In periods of inflation, debt is paid back with dollars that are worth less than the ones borrowed.
- The owners (common stockholders) do not give up control of the firm.
- Debtors do not participate in excess earnings of firm.
- Debt is less costly than equity. Therefore, the use of debt, up to some limit, will lower the firm’s cost of capital.
Disadvantages of debt financing include:
- Interest and principal obligations must be paid regardless of the economic position of the firm.
- Interest payments are fixed in amount regardless of how poorly the firm performs.
- Debt agreements contain covenants that place restrictions of the flexibility of the firm.
- Excessive debt increases the risk of equity holders and therefore depresses share prices.
Which of the following inventory management techniques focuses on a set of procedures to determine inventory levels for demand-dependent inventory types such as work-in-process and raw materials?
Materials requirements planning
which is a computerized system that plans manufacturing based on demand estimates.
Inventory Management - What is Cycle Counting?
cycle costing deals with costing of facilities or products
Safety Stock Reorder Point
Is a technique used to balance inventory holding costs against the costs of stockouts.
Economic Order Quantity
Is a technique used to determine the optimum amounts to order
What are the goals of inventory management?
First - effective Forecasting of Sales and coordination with purchasing and production. Two goals are:
- To ensure adequate inventories to sustain operations
- To minimize inventory costs, including carrying costs, ordering and receiving costs, and cost of running out of stock
How and When do you compute “Production Pattern” in inventory management and what items do you compare?
f the firm has seasonal demand for its products, management must decide whether to plan for level or seasonal production.
Level production involves working at a consistent level of effort to manufacture the annual forecasted amount of inventory. Level production results in the most efficient use of labor and facilities throughout the year. However, it also results in inventory buildups during slow sales periods. This results in additional inventory holding costs.
Seasonal production involves increasing production during periods of peak demand and reducing production during slow sales periods. Seasonal production often has additional operating costs for such things as overtime wages and maintenance.
EXAMPLE: A firm has projected the following data for the two alternatives of level production and seasonal production. The firm’s short-term interest cost is 7%.
Level production Seasonal production Average inventory $200,000 $150,000 Production costs $1,000,000 $1,010,000
Which alternative is preferable?
Under the level production alternative, the firm would incur an additional $3,500 (($200,000 – $150,000) × 7%) in inventory holding costs, but it would also save $10,000 ($1,010,000 – $1,000,000) in production costs. Therefore, level production would be the best production alternative. It would save the firm $6,500 ($10,000 – $3,500).
Explain Inflation (deflation) as it relates to Inventory.
Inventory and Inflation. A firm’s inventory policy also might be affected by inflation (deflation). As an example, if a firm uses silver as a raw material, the firm could experience significant gains or losses simply because of price fluctuations that occur in the silver market. Price instability occurs in a number of markets, such as copper, wheat, sugar, etc. The problem may be partially controlled by holding low levels of inventory. Another way would be to hedge the price movement with a futures contract to sell silver at a specified price in the future. In this manner, if the price of the silver falls, reducing the value of the inventory, the value of the future contract would rise to completely or partially offset the inventory loss.
SUPPLY CHAIN - EXPLAIN.
Describes a good’s production and distribution.
It illustrates the flow of goods, services, and information from acquisition of basic raw materials through the manufacturing and distribution process to delivery of the product to the consumer, regardless of whether those activities occur in one or many firms. To manage inventories and their relationships with their suppliers many firms use a process known as supply chain management. A KEY ASPECT of supply chain management IS the SHARING OF KEY INFORMATION from the point of sale to the final consumer back to the manufacturer, to the manufacturer’s suppliers, and to the suppliers’ suppliers. As an example, if a manufacturer/distributor shares its sales forecasts with its suppliers and they in turn share their sales forecasts with their suppliers, the need for inventories for all firms is significantly decreased. The manufacturer/distributor, for example, needs far less raw materials inventory than normally would be the case because its suppliers are aware of the manufacturer’s projected needs and are prepared to have the materials available when needed. Specialized software facilitates the process of information sharing along the supply chain network.
Economic Order Quantity - Explain
computes HOW MUCH to order. The amount to be ordered is known as the economic order quantity (EOQ).
The EOQ “minimizes” the sum of the ordering and carrying costs.
The total inventory cost function includes carrying costs (which increase with order size) and ordering costs (which decrease with order size)
The EOQ formula is derived by setting the annual carrying costs equal to annual ordering cost or by differentiating the cost function with respect to order size.
Formula:
EOQ = Square root of 2aD/k
a is the cost of placing “one order”
D is the annual demand in units
k is cost of carrying one unit of inventory for one year
What are some of the costs of carrying safety stock (and inventory in general)?
- Storage (related utilities and rent costs)
2. Interest to buy and/or carry
3. Spoilage of Obsolesence
4. Insurance to protect value may not be adequate to cover losses fully.
5. Property taxes part of the storage
Explain Safety Stock and Stockouts and costs of Stockouts.
When to reorder? The objective is to order at a point in time so as to avoid stockouts but not so early that an excessive safety stock is maintained. Safety stocks may be used to guard against stockouts; they are maintained by increasing the lead time (the time that elapses from order placement until order arrival).Thus, safety stocks decrease stockout costs but increase carrying costs. Examples of stockout costs include:
1. Profit on lost sales
2. Customer ill will
3. Idle equipment
4. Work stoppages
The most common approach to setting the optimum safety-stock level is to examine previous lead-time periods to determine the probabilities of running out of stock (a stockout) for different assessed levels of safety stock.
Explain Inventory Management and MRP.
Materials requirements planning (MRP) is a * computerized system that manufactures finished goods based on demand forecasts. Demand forecasts are used to develop bills of materials that outline the materials, components, and subassemblies that go into the final products. Finally, a master production schedule is developed that specifies the quantity and timing of production of goods, taking into account the lead time required to purchase materials and to manufacture the various components of finished products. A key weakness of MRP is that it is a “push through” system. Once the master schedule is developed goods are pushed through the production process whether they are needed or not. Therefore, inventories may accumulate at various stages, especially if there are production slowdowns or unreliable demand forecasts. MRP II was developed as an extension of MRP and it features an automated closed loop system. That is, production planning drives the master schedule which drives the materials plans which is input to the capacity plan. It uses technology to integrate the functional areas of a manufacturing company.
