Financial Mgmt

Question 1

How is the weighted average cost of capital calculated?

Answer 1

Taking projects in excess of that WACC% would maximize shareholder return. It is calculated using the weighted average of long term debt, preferred stock, and common stock.

Question 2

What is a stock dividend?

Answer 2

It is a corporation’s ratable distribution of additional shares of stock to its stockholders.
It is paid in stock of the corporation, not cash.
Stockholders will have the same proportionate share of ownership in the corporation.
A stock split alters the par value of stock and a stock dividend does not.

Question 3

How is CAPM calculated?

Answer 3

CAPM = risk free rate + (market rate - risk free rate) X beta
Market rate is the expected return on the equity market.

Question 4

What is a key aspect of supply chain mgmt

Answer 4

The sharing of info about forecasted production needs with suppliers, who share it with their suppliers etc

Question 5

How is the annual cost of carrying inventory calculated? No safety stock is kept.

Answer 5

It is the average inventory level X cost per unit of inventory X cost of capital.
Avg inventory level = order size /2

Question 6

What is the benefit of using long term debt

Answer 6

The relatively low after tax cost due to the interest deduction.
Note appropriate use of debt will increase earnings per share.
Financial risk is a disadvantage of the issuance of debt.
Issuance of debt does not dilute control.
Debt financing is the least costly and using it would tend to maximize EPS.

Question 7

What is the formula for economic order quantity

Answer 7

EOQ = root of (2aD / k)
a = cost of placing one order
D = annual demand in units
k = annual cost of carrying one unit in inventory for 1 year (inventory carrying cost)
This is the amount to be ordered. It minimizes the sum of the ordering and carrying costs.

Question 8

What do investors value for common shares?

Answer 8

Investors value common shares more highly if they have a lower required return because then they apply a lower discount rate to the expected future dividend stream of the company.
Note lower expected dividend growth would reduce, not increase, the market value of the outstanding common shares of the company.
Note expected holding periods of investors are not relevant to market valuation of OS CS.

Question 9

What is the cost of debt before tax

Answer 9

It is the bond yield to maturity, the after flotation cost yield.

Question 10

How is the marginal cost of capital calculated

Answer 10

Take the incremental relevant %s
Cost of equity
New debt financing X (1 - tax rate)

Question 11

What is the arbitrage pricing model

Answer 11

It includes a series of systematic risk factors to estimate systematic risk.
CAPM only includes one.
Note unsystematic risk is assumed to be diversified away.
It is used for pricing common stock.

Question 12

What is economic order quantity

Answer 12

Minimizes the sum of ordering and carrying costs
It orders at the point where carrying costs equate nearest to restocking costs in order to minimize total inventory cost
Assumes periodic demand is known. Carrying costs, costs of placing an order, purchase cost per unit are assumed to be constant.

Question 13

Just in time

Answer 13

attempts to reduce inventory levels to near zero
Company will be receiving less materials at any point in time, increasing the likelihood of stockout; the avg inventory will be less, resulting in less carrying costs.
Ordering costs are likely to decrease with less purchase orders being processed by the manufacturer.
No impact to cost of quality.

Question 14

Materials requirements planning

Answer 14

Is a manufacturing planning system

Question 15

What is the theory underlying cost of capital related to

Answer 15

Existing long term financing and obtaining NEW long term financing.
NOT short term

Question 16

Which ratio is a measure of AR

Answer 16

The days sales outstanding provides a measure of average age of AR. = weighted % X day pmt is made
Note the current ratio is a measure of liquidity
The collection to debt ratio is not commonly used.

Question 17

What is a call provision

Answer 17

A call provision allows the corporation to call the bond even if the bondholder does not want to dispose of the investment.

Question 18

What is the financing in the formation stage

Answer 18

Personal savings, trade credit, and govt agencies are the main sources. Prior to demonstrating initial success, a company is not likely to easily attract venture capital financing.

Question 19

Rapid growth financing?

Answer 19

If a company is reasonably profitable, it will experience financing needs in excess of funds available either internally or from trade or bank credit. Additional debt financing would often result in an unreasonable amount of financial leverage at this stage of development and public equity financing is not yet available to the company. This is the stage most likely to seek venture capital financing.

Question 20

Growth to maturing financing

Answer 20

The company is able to access formal markets for debt and equity because it has a track record of success and a better balance between cash in and outflows than it had in the rapid growth stage. Formal capital markets provide financing at lower cost than venture capitalists.

Question 21

Maturity and industry decline

Answer 21

Characterized by more than adequate cash flows, relative to available investment opportunities.

Question 22

When are common shareholders better off related to financial leverage

Answer 22

When the firm performs poorly, the common stockholders are better off with less financial leverage.

Question 23

What is a floating rate bond

Answer 23

Will generally hold a steady market value because its value will not change due to changes in prevailing interest rates.

Question 24

How does market value change with different types of bonds - zero coupon, callable, convertible

Answer 24

Zero coupon - increases in value as it approaches maturity
Callable - has a fixed interest rate and its market value fluctuates with changes in prevailing interest rates
Convertible - has a fixed interest rate and is convertible into stock. Market value fluctuates with both changes in prevailing interest rates and changes in the value of the stock.

Question 25

What is the advantage of a zero balance account system

Answer 25

There is no money on deposit in the account.
By using regional banks and not transferring funds until the checks are presented, the float on disbursement is maximized.
Note it does not affect the float on cash receipts.

Question 26

How do you calculate EPS given EBIT and two different options of financing - debt or equity?

Answer 26

Under debt option:
Calculate interest and subtract from EBIT to get EBT.
Calculate taxes which is 40% of EBT.
Subtract taxes to get net earnings.
EPS = net earnings / shares outstanding
Under equity option:
There will not be any interest cost.
The EPS will have higher net earnings but higher shares outstanding with the additional equity financing.

Question 27

How is equivalent annual interest rate calculated? Given terms of 2/10, n/40. If pmt is made on 40th day.

Answer 27

The buyer is receiving 2% of the face for paying the account 30 days before it is due.
Nominal annual cost = 2%/98% X 360 days / (40-10 days)
= 2/98% X 12 = 24.49%

Question 28

When would a firm not increase the debt in its financial structure

Answer 28

Increased economic uncertainty
Decrease in corporate income tax rate
Increase in federal funds rate, increases cost of debt
Increase in price earnings ratio decreases the cost of equity

Question 29

Calculate net annual benefit/loss from having service. Firm has daily cash receipts of 100k and collection time of 4 days. A bank has offered to reduce the collection time to 2 days for a monthly fee of 500$. Money market rates are expected to average 6% for the year.

Answer 29

A reduction of 2 days of collection time on receipts of 100k would increase the firm’s average cash balance by 200$ (2 X 100k).
This would save the firm interest in the amount of 12k (200k X 6%). The net benefit is the interest savings, 12k less the fee of 6k

Question 30

What is the cost assigned to retained earnings?

Answer 30

New common equity has floatation costs that increase its cost above retained earnings.

Question 31

What is a compensating balance

Answer 31

Compensates a financial institution for services rendered by providing it with deposits of funds
NOTE it is NOT for compensating possible losses on a marketable securities portfolio

Question 32

Types of bonds

Answer 32

Serial bonds are bond issues that mature in installments (ie on the same date each year over a period of years).
Term bonds, mature on a single date.
Zero coupon bonds increase in value each year as they approach maturity, providing the owner with the total payoff at maturity.
Deep discount and zero coupon bonds sell for a small fraction of their face value but deep discount bonds pay interest (based on an interest rate that is significantly below the market rate) while zero coupon bonds do not.
Commodity backed or asset linked bonds are redeemable in measures of a commodity such as barrels of oil.
Junk bonds are high interest rate, high risk, unsecured bonds which have been used extensively to finance leveraged buyouts.

Question 33

What is degree of operating leverage DOL

Answer 33

Measures the degree to which a firm builds fixed costs into its operations - the higher fixed costs are, the higher the business risk
DOL = % change in operating income / % change in sales/unit volume

Question 34

Degree of total leverage

Answer 34

It is the multiple of degree of operating leverage X degree of financial leverage.
Other things equal, DOL is higher if DOTL is higher.

Question 35

Degree of financial leverage

Answer 35

Measures the extent to which the firm uses debt financing, which has higher risk.
It is a measure of the change in earnings available to common stockholders associated with a given change in operating earnings.
DFL = % change in EPS/ % change in EBIT

Question 36

Dividends in practice

Answer 36

Firms tend to establish a stable dividend policy and are hesitant to decrease dividends.

Question 37

How is the cash conversion cycle measured

Answer 37

It measures the time period from the time the firm pays for its materials and labor to the time it collects its cash from sales
= inventory conversion period + receivables conversion period - payables deferral period
Does NOT include long term financing period
Inventory conversion period = avg inventory / COGS per day
Receivables conversion period = avg receivables / Credit sales per day
Payable deferral period = Avg payables / purchases per day
Read carefully - who is paying? customer or company to payables?

Question 38

Short term vs long term debt financing

Answer 38

An important financial strategy involves matching maturities of assets and liabilities to reduce risk.
LT rates have traditionally been more stable than short term rates.
Short term debt is more difficult to repay than long term because it is due within one year.
ST financing requirements change more frequently than LT requirements.

Question 39

When would mgmt increase the average inventory

Answer 39

• increase cost in placing an order
• decrease cost of carrying inventory
• increase in annual demand for product
• increase lead time needed to acquire inventory

Question 40

Company has 1.5m in debt and 1m in equity and wants to maintain same proportions. Expected 60k in retained earnings. What amount of new investments can be undertaken without issuing new equity?

Answer 40

The proportion is 40% equity and 60% debt.
Since it maintains same weight, each dollar invested is 40% equity and 60% debt. The first 60k from RE is equity meaning the total investment would be 60/.4 = 150k
When the level of investment exceeds this amount, equity financing must be raised EXTERNALLY.

Question 41

What is impact on AR balance if 40% of customers pay in 70 days but company wants to make it 60 days?

Answer 41

.4 X daily unit sales X unit price X reduction in days outstanding = 40k$ decrease in AR

Question 42

How is financing some current assets with long term debt considered as a financing policy?

Answer 42

It is conservative financing permanent working capital with long term debt.

Question 43

Materials requirements planning MRP

Answer 43

Computerized system that manufactures finished goods based on demand forecasts. This includes bill of materials, master production schedule with lead times and timing to manufacture. A key weakness is that it is a push through system, goods are pushed through whether they are needed or not.

Question 44

Taking the discount calculation

Given 2/10, n/30

Answer 44

The approximated cost of not taking the discount is calculated as:
discount % / (100% - discount %) X 365 days / (total pay period - discount period)
Nominal annual cost = 2%/98% X 365 days / 30-10 days = 37.2%
Note nominal does not consider effects of compounding so effective annual rate will be higher.

Question 45

How is yield to maturity and current yield calculated? GIven bond of $1k paying 12% interest per year for 10 years selling for $900

Answer 45

YM = [Annual interest pmt + (Principal pmt - bond price)/years to maturity ] / 0.6(bond price) + .4(principal pmt) = 13.83%
The current yield = stated interest pmt / current price of bond = 120/900 = 13.33%
Coupon/nominal yield is 12% stated rate.

Question 46

What functions does financial mgmt include

Answer 46

Financing
Capital
Budgeting
Financial mgmt
Corporate governance
Risk mgmt

Question 47

How to find the appropriate level of working capital?

Answer 47

Main reason to retain working capital is to meet the firms financial obligations. Amount is determined by offsetting the benefit of current assets and current liabilities against the probability of technical insolvency.

Question 48

How to calculate when to use wire (cost of $25 each) or not? when collections would be saved by 2 days and bank interest rate is 0.02% per day

Answer 48

25 fee / interest rate for 2 days = 62500

Mgmt should make the change to wire if average transfer is expected to be greater than 62500

Question 49

When is it beneficial to reduce float

Answer 49

Float is the time relating to mailing, processing and clearing checks.
To reduce.minimize float on cash receipts but to maximize on cash disbursements for use of funds

Question 50

What is the benefits of debt over equity financing

Answer 50

When marginal tax rate is high and the company has few noninterest tax benefits, the deduction for interest on debt is maximized.
Many noninterest tax benefits reduces the potential benefit of debt financing.
Debt financing means the company has greater fixed financing charges (interest pmts) while dividends are not. This makes a company with debt have a more volatile income stream.

Question 51

Just in time

Answer 51

Reduction of inventories, ideally to 0
Simplification of production activities
Elimination of the need for sales forecasts.
Note that vendors will inspect their own goods and guarantee that they are free of defects, thus eliminating the need for incoming inspection by the purchaser.

Question 52

Assume that nominal interest rates increase but expected future dividend is not affected over the long run. What happens to stock price?

Answer 52

It will decrease as investors will expect a higher yield from all investments, as the nominal rate of interest has increased. This will make the stock price decline.

Question 53

Calculate the effective interest rate. Given 500k loan with stated rate of 8% and requirement for 20% compensating balance which company would have at 0 if not for that.

Answer 53

=Interest amount / (outstanding balance - compensating balance requirement)
= 40k / 400k = 10%

Question 54

What does the purchase of treasury stock with a firm’s surplus cash do?

Answer 54

It will decrease the firms assets and equity. Therefore it will increase the firm’s financial leverage.

Question 55

Commercial paper market

Answer 55

This market provides more funds at lower rates than other methods provide
The borrower avoids the expense of maintaining a compensating balance with a commercial bank
This market provides a broad distribution for borrowing.
Only very creditworthy firms can issue commercial paper. - restrictions on who can enter the market

Question 56

Capital and operating lease

Answer 56

In a capital lease, the lessee is using the lease as a financing source and the lessor is financing the transaction (providing the investment capital) through the leaser asset.

Question 57

Eurobonds instead of domestic bonds

Answer 57

Eurobonds are not denominated in local currency
They are subject to less stringent registration requirements making them less costly to issue
They carry FX risk to the investor.
Foreign buyers do no necessarily more readily accept eurobonds.