Financial Markets and Financing

Question 1

money markets trade debt securities with maturities of more than 1 year. True or false?

Answer 1

False

they trade securities with maturities of less than 1 year

Question 2

examples of money market securities

Answer 2

Question 3

what doe capital markets trade?

Answer 3

long-term debt and equity securities

an example is the New York Stock Exchange

Question 4

primary markets vs. secondary markets

Answer 4

Question 5

what does the efficient markets hypothesis state?

Answer 5

that current stock prices immediately and fully reflect all relevant information.

the market is continuously adjusting to new information and acting to correct pricing errors

Question 6

securities ratings

Answer 6

based upon the probability of default and the protection for investors in case of default

a firm must pay to have its debt rated

Question 7

factors involved in the analysis used for rating

Answer 7

• the ability of the issuer to service its debt with its cash flow
• the amount of debt it has already issued
• the type of debt issued
• the firm’s cash flow stability

Question 8

How does a rating effect the cost of capital

Answer 8

-higher ratings reduce interest costs
-lower ratings incur higher rates of return

Question 9

rate of return

Answer 9

(amount received - amount invested) / amount invested

Question 10

investment risk

Answer 10

Question 11

credit risk

Answer 11

the risk that the issuer of a debt security will default

Question 12

foreign exchange risk

Answer 12

the risk that a foreign currency transaction will be affected by fluctuations in exchange rates

Question 13

interest rate risk

Answer 13

the risk that an investment security will fluctuate in value due to changes in interest rates

Question 14

liquidity risk

Answer 14

the risk that a security cannot be sold on short notice for its market value

Question 15

financial risk

Answer 15

the risk of an adverse outcome based on a change in the financial markets, such as changes in interest rates or changes in investors’ desired rates of return.

Question 16

purchasing-power risk

Answer 16

the risk that a general rise in the price level will reduce the quantity of goods that can be purchased with a fixed sum of money

Question 17

usable funds

Answer 17

invoice amount x (1-discount %)

Question 18

annualized cost of not taking a discount can be calculated with the following formula

Answer 18

discount % / (100%-discount percentage) x days in year / (total payment period - discount period)

Question 19

term loan

Answer 19

a loan that must be repaid by a certain date

Question 20

line of credit

Answer 20

an informal borrowing arrangement.

It allows the debtor to reborrow amounts up to a maximum, as long as certain minimum payments are made each month.

Question 21

revolving line of credit

Answer 21

allows the borrower to continuously pay off and reborrow from the line of credit.

There may be a commitment fee on the unused portion

Question 22

effective interest rate

Answer 22

net interest expense / usable funds

Question 23

effective rate on discounted loan

Answer 23

stated rate / (1.0 - stated rate)

Question 24

simple interest loan

Answer 24

a loan in which the interest is paid at the end of the loan term.

Interest expense = loan amount x stated rate

Question 25

discounted loan

Answer 25

requires the interest to be paid at the beginning of the loan term

loan amount = usable funds / (1.0 - stated rate)

Question 26

loans with compensating balances

Answer 26

rather than charge interest, banks sometimes require borrowers to maintain a compensating balance during the term.

loan amount = usable funds / (1.0 - compensating balnce %)

Question 27

effective interest with compensating balance (no dollars)

Answer 27

stated rate / (1.0 - Compensating balance %)

Question 28

a firm has received an invoice for $120,000 with terms of 2/10, net 30. The firm’s bank will lend it the necessary amount for 30 days at a nominal annual rate of 6% with a compensating balance of 10%. What is the loan amount

Answer 28

$130,667

=usable funds / (1.0 - Compensating balance %)
= ($120,000 x 98%) / (100% - 10%)
= $117,600 / 90%

Question 29

effective rate formula for a loan offered on a discounted basis with a compensating balance requirement

Answer 29

stated rate / (1.0 - stated rate - compensating balance %)

Question 30

annualized rate of commercial paper

Answer 30

[(face value - net proceeds) / net proceeds] x number of terms per year

Question 31

Management should select the financing option that results in the lowest present value of ____

Answer 31

after-tax cash outflows

Question 32

Return on investment formula

Answer 32

capital turnover (sales / investment) x profit margin (income/sales)

Question 33

A manufacturer with seasonal sales would be most likely to obtain _________________ from a commercial bank to finance the need for a fixed amount of additional capital during the busy season.

Answer 33

unsecured short-term loan

An unsecured short-term loan is often used to finance a firm’s need for fluctuating (e.g., seasonal) current assets. This practice is consistent with the maturity-matching (self-liquidating) approach to financing current assets.

Question 34

The prime lending rate of commercial banks is an announced rate and is often understated from the viewpoint of even the most credit-worthy firms. Which one of the following requirements always results in a higher effective interest rate?

Answer 34

The imposition of a compensating balance with an absolute minimum that cannot be met by current transaction balances.

When a firm borrows money from the bank, it is often required to keep a certain percentage of the funds in the bank at all times. These compensating balances effectively increase the rate of interest on the money borrowed from the bank.

Question 35

The strong form of the efficient markets hypothesis (EMH) states that current market prices of securities reflect

Answer 35

All information whether it is public or private.

The EMH states that stock prices reflect all relevant information, so the market is continuously adjusting to new information. Stock prices are in equilibrium, so investors cannot earn abnormal returns. The strong form of the EMH states that all public and private information is instantaneously reflected in current market prices of securities. Thus, investors cannot earn abnormal returns.

Question 36

According to COSO, a risk profile is a view of the relationship between

Answer 36

risk and performance

A risk profile is a composite view of (1) the types, severity, and interdependencies of risks related to a specific strategy or business objective and (2) their effect on performance.

Question 37

Systematic risk explains why

Answer 37

stock values tend to move in the same direction

Systematic risk, also called market risk, is the risk faced by all firms

Question 38

Compared with another bond with the same risk and maturity but without a conversion feature, a convertible bond has a

Answer 38

Lower coupon rate because they offer investors a chance for capital gains