Financial_Management 1

Question 1

For what are Letters of Credit used?

Answer 1

Used for importing goods. Issued by importer’s bank.

A letter of credit is an international financing tool that guarantees payment to an international supplier upon the safe arrival of the goods by issuing a loan to the purchaser. A letter of credit can be irrevocable (not subject to cancellation if the specific conditions are met) or revocable.

Question 2

What is the difference between Treasury Bills- Notes and Bonds?

Answer 2

• Treasury Bills: Short term (less than one year) Think: $1 Bill
• Treasury Notes: Medium term (less than 10 years- more than 1) Treasury
• Bonds: Long term (greater than 10 years) Think: government is in long-term bondage to you; they owe you money

Question 3

What is the Nominal (Face- Coupon- Stated) Rate?

Answer 3

Interest rate stated on the face of a bond.

Question 4

How is Current Yield calculated?

Answer 4

CY = Interest Payment / Bond Price

Question 5

What is the Effective (YTM- Market) Rate?

Answer 5

PV of Principle + Interest

Question 6

What is a Zero Coupon Bond?

Answer 6

These types of bonds do not pay interest. Instead they sell at a deep discount from the face or maturity value. The return to the investor is the difference between the cost and the bond’s maturity
value.

The advantage of these bonds is that there are no interest payment requirements until the bonds mature.
In addition, the amortization of interest is tax-deductible even though the firm is not making any interest payments.

Question 7

What are the characteristics of a Junk Bond?

Answer 7

• High interest rate
• High default risk

These bonds carry very high-risk premiums. Junk bonds often have resulted from leveraged buyouts or are issued by large firms that are in troubled circumstances. They may appeal to investors who feel they can diversify the risk by purchasing a portfolio of the bonds in different industries.

Question 8

What are subordinated debentures?

Answer 8

Debenture Bonds that will be repaid if any assets are left after liquidation of a company

A bond with claims subordinated to other general creditors in the event of bankruptcy of the firm. That is, the bondholders receive distributions only after general creditors and senior debt holders have been paid. As you would expect, subordinated debentures have higher yields than senior unsecured debt.

Question 9

What are Redeemable Bonds?

Answer 9

Provision in Bond contract allows demand of Bond payment under certain circumstances

A bondholder may have the right to redeem the bonds for cash under certain circumstances

Question 10

What are debenture bonds?

Answer 10

Bonds unsecured by collateral

A bond that is not secured by the pledge of specific property. It is a general obligation of the firm. Because of the default risk , such bonds can only be issued by firms with the highest credit rating. Debentures typically have a higher yield than mortgage bonds and other secured debt.

Question 11

What is a Callable Bond?

Answer 11

Borrower can pay off debt early

• To make something callable means there is a provision that at the issuer’s option the preferred stock or bond can be called in for cancellation or payment at a specified price (usually greater than the original issue price) during a specified time period (prior to bond maturity). Called shares are not considered treasury shares.

Also, liabilities can be callable at the option of the creditor (i.e., the creditor has the right to demand repayment of a liability at a given date).

• Callable bonds reduce issuer risk by allowing the bonds to be called in if interest rates decline. The holder of callable bonds, however, is exposed to greater risk (i.e., loss of relatively high interest in a declining interest rate period).

In contrast, a noncallable bond is less risky for a bondholder, so it should sell at a lower yield.

Question 12

What is a Convertible Bond?

Answer 12

Lender can demand payment via company stock instead of money

Question 13

What is the advantage of Preferred Stock?

Answer 13

Hold dividend priority over common stock

Preferred stock is often referred to as a hybrid in that it has some of the characteristics of debt and some of the characteristics of equity. Preferred stock is more risky than debt; however, it is less risky than common stock.

a. Similarities to debt:

(1) There is a fixed dividend similar to the fixed interest charge for debt.
(2) Preferred stockholders have priority over common stockholders in the case of liquidation and dividend payments.
(3) Preferred stockholders have no voting rights.

b. Similarities to equity:

(1) Preferred stock increases equity.
(2) The original investment does not need to be paid back.
(3) There is no maturity date.
(4) Preferred dividends are not a deductible expense.
(5) The preferred dividend is not required to be paid.
(6) The liability for preferred stockholders is limited to their initial investment.

Question 14

What is Weighted Average Cost of Capital?

Answer 14

The weighted-average cost of capital can be computed as follows:
WACC = (wt x k ) + (wt x k ) + (wt x k )
d d pf pf e e

The optimal capital structure is determined by computing the lowest weighted-average cost of capital to raise that amount.

Example: Assume that the firm can issue new debt at 5% and that the marginal tax rate is 40%. The firm has $1,000 par preferred stock that pays a dividend of 4%. Using the CAPM, it is estimated that investors require a 16% return on equity investments. The firm has a target capital structure of 30% debt, 10% preferred stock, and 60% equity. What is the firm’s WACC?

Solution:
WACC = (.30 x (.05 x (1 - .40))) + (.10 x .04) + (.60 x .16)
= .009 + .004 + .096
= .109 or 10.9%

The cost of capital is the weighted-average cost, in percentage form, that a firm will incur in raising new funds to finance future investment. The weighted-average cost of capital (WACC) is calculated using estimates of the future costs of different sources of funds that will be used to finance future investments in (usually) fixed assets or other long-term investments. The WACC is usually calculated on an after-tax basis, reflecting the tax benefits of using debt as part of the capital structure.

Question 15

Formula Cost of common equity

Answer 15

Cost of common equity = (Dividend ÷ Price) + Growth percentage

Dividends paid on stock are not deductible in computing taxable income, so there is no income tax savings when dividends are paid. Debt is different. Interest expense is deductible from income to find taxable income, so interest cost incurred reduces income tax.

Reduced from Price

• u = Dollar amount of underpricing per share from the market price needed to sell the new issue
• f = Flotation cost per share paid to the investment banking firm for selling the new issue

Question 16

How is Cost of Debt calculated?

Answer 16

Cost of Debt = (Interest Expense - Tax Benefit) / Carrying Value of Debt

• Due to the tax shield associated with interest-bearing debt, the effective cost of the debt is lower than the interest rate paid due to the reduction in the taxes paid.
• Interest expense is deductible from income to find taxable income, so interest cost incurred reduces income tax.

Question 17

Bond Price and interest rate

Answer 17

In general, bond prices increase when interest rates decline because the stated rate of interest on the bond is more attractive relative to the market interest rate.

Question 18

bond is issued at a discount / at a premium/ at par

Answer 18

• Bonds are issued at par when both rates ( effective rate of interest and stated rate of interest) are equal and
• at a premium when the stated rate of interest is more than the effective rate.
• at a discount when the stated rate of interest is less than the effective rate

Question 19

What is the primary focus of working capital management?

Answer 19

Managing inventory & receivables (current assets & liabilities)

Question 20

Advantages & Disadvantages of Short & Long -Term Debt Financing

Answer 20

Advantages of short-term credit:

• Funds can be obtained quickly.
• Financing with this credit usually results in lower interest costs.
• There are some spontaneous sources of funds such as trade credit.
• Some of this debt is “interest free,” such as wages payable.

Disadvantages of short-term credit:

• Interest rates tend to vary quickly.
• This type of debt is more risky.

Advantages of long-term credit:

• Interest rates tend to be more stable.

Disadvantages of long-term credit:

• Retirement will probably contain a prepayment penalty.

Question 21

What is the calculation for the interest payment on a bond?

Answer 21

The calculation for the interest payment on a bond is the Stated rate of interest × Par value. This is the calculation used by the corporation to establish the interest to be paid.

Question 22

Cost of preferred stock

Answer 22

Preferred Dividend (Dp)
k = ———————————————
p Price of preferred stock (Pp)

Where:

• kp = Cost of preferred stock
• Dp = Preferred dividend
• Pp = Price of preferred stock

The annual dividend per share is 9% multiplied by the par value of $20, or $1.80

The cost of preferred stock is the annual dividend payment divided by the net issuance price for the preferred stock.

Since preferred dividends are not tax deductible, there is no tax adjustment for the cost of preferred stock as there is for debt.

A preferred stock is sold for $101 per share, has a face value of $100 per share, underwriting fees of $5 per share, and annual dividends of $10 per share. If the tax rate is 40%, the cost of funds (capital) for the preferred stock is:

ks = 10 / (101 - 0 - 5) = 10 / 96 = 0.104, or 10.4%.

Question 23

Residual income

Answer 23

Residual income is the amount of net income in excess of a minimum desired rate of return on invested capital. The minimum desired net income is first computed by multiplying the desired rate of return by invested capital. This amount is then subtracted from reported net income. A positive residual income is viewed favorably because it indicates earnings in excess of the required minimum.

Example:

Net income $150
Return on Investment at minimum Rate of Return
($1,000 at 0.12) 120
—–
Residual income $ 30
=====

Question 24

Relevant costs

Answer 24

Relevant data includes:

• initial investment required,
• future net cash inflows or net savings in cash outflows, and
• disposal cost or salvage value of old equipment and the new equipment.

Relevant costs are

• They are usually used in reference to long-run, nonrecurring decisions, such as capital budgeting decisions.
• Relevant data for capital budgeting is cash-flow (future) oriented.

Historical or past (sunk) costs are irrelevant to the actual decision because the past costs will not be changed (recovered) by future action. However, historical costs are usually the best (sometimes the only) basis for predicting future costs. Accrual accounting (i.e., depreciation) is not relevant;

Question 25

Default Risk

Answer 25

• Default Risk is the risk that the borrower will be unable to make interest and/or principal payments as scheduled on the obligation.
• The higher the possibility of default, the greater the return required by the lender.
• U.S. Treasury securities are considered to be the financial instrument with the least default risk, followed by securities of federal government agencies.