FM - Concepts and Tools

Question 1

financial management

Answer 1

Financing.
Risk management.
Capital budgeting.

Question 2

Sunk cost

Answer 2

Are the costs of resources incurred in the past; they cannot be changed by current or future decisions. Therefore, sunk costs are irrelevant to current and future decision-making.
-ex, The original cost of the old machine.

Question 3

Differential (or Incremental) costs

Answer 3

Are those costs that are different between two or more alternatives. Cost elements that do not differ between alternatives are not relevant in making economic comparisons, but cost elements that are different between alternatives are relevant in making such comparisons.
-Differential costs are relevant to current and future economic decisions.

Question 4

Cost of debt

Answer 4

The rate of return that must be earned in order to attract and retain lenders’ funds. The required rate would be determined by such factors as the level of interest in the general market, the perceived default risk of the firm, perceived interest-rate and inflationary risks, and similar factors. Historically, debt has been considered less risky than equity and the required rate of return has been less than the rate required on preferred and common stock.

Question 5

Cost of preferred stock

Answer 5

The rate of return that must be earned in order to attract and retain preferred shareholders’ investment. Preferred stock has characteristics of both debt (a dividend rate paid before common stock dividends) and equity (possible claim to additional dividends and claim to assets on liquidation after debt). Therefore, the required rate of return is determined by factors which enter into determining the rates for each of those securities. Normally, preferred stock is considered more risky than debt, but less risky than common stock and, consequently, the rate of return required by investors has been higher than the cost of debt, but lower than the cost of common stock.

Question 6

Cost of common stock

Answer 6

The rate of return that must be earned in order to attract and retain common shareholders’ investment. The required rate would be determined by such factors as the various perceived risks associated with the firm’s common stock, as well as expected dividends and price appreciation. Historically, common stock has been considered more risky than debt or preferred stock and, as a consequence, the required rate of return has been higher than the rate on debt or preferred stock.

Question 7

weighted average cost

Answer 7

The weighted average cost of capital is calculated as the required rate of return on each source of capital weighted by the proportion of total capital provided by each source, and the resulting weighted costs summed to get the total weighted average.
-The weighted average cost of capital generally is more appropriate for economic analysis than the cost of individual capital elements.

Question 8

rate of return

Answer 8

The rate of return investors can earn in the market on securities with comparable risk determines a firm’s cost of capital.

Question 9

Opportunity costs

Answer 9

The opportunity cost for each source of financing is the expected rate of return that investors could earn from the best available alternative investment with perceived comparable risk.
-Opportunity costs are relevant to current and future economic decisions.

Question 10

company‐wide cost of capital to evaluate new capital investments

Answer 10

High‐risk divisions will over‐invest in new projects and low‐risk divisions will under‐invest in new projects.

Question 11

Product cost.

Answer 11

Product cost is the cost assigned to goods that were either purchased or manufactured for resale. Product cost also is often referred to as “inventoriable cost.”

Question 12

future value, an annuity due

Answer 12

• annuity in advance.
• payments occur at the beginning of each period.
• In computing future value, an annuity due will earn one more period of interest than an ordinary annuity.
• An annuity due will result in a higher future value than an ordinary annuity of the same amount.

Question 13

Compounding of interest

Answer 13

Compounding of interest involves earning of interest on interest already earned.

Question 14

discount rate

Answer 14

The interest rate used to determine the present value of a future amount

Question 15

present value

Answer 15

• The present value of an annuity will be less than the sum of the series of payments.
• The present value of an amount is less than the future value of that amount.

Question 16

interest (or discount) rates will give the greater present value of $1.00 and greater future value of $1.00

Answer 16

For present value, the higher the interest or discount rate, the lower the present value of a future amount.

Since the higher the interest or discount rate, the more that is counted as interest, the less there is in present value.

For future value, the higher the interest rate, the greater the future value of a present amount. Since future value is computed as principal plus compounded interest, the higher the interest rate, the greater the amount of interest earned each period and, therefore, the greater the accumulated future amount.

Question 17

stated rate of interest

Answer 17

The stated rate of interest is the rate specified in the loan contract.

Question 18

effective annual percentage rate

Answer 18

The effective annual percentage rate will be higher than the annual percentage rate due to compounding.

Question 19

effective interest rate

Answer 19

The effective interest rate is determined as the full cost of a loan divided by the net cash proceeds.

Question 20

Inflation risk.

Answer 20

factor explains the difference between real and nominal interest rates
-The inflation risk premium compensates investors for the expected adverse effects of future inflation on the security.

Question 21

short‐term interest rates

Answer 21

There is less risk involved in the short run and investors are willing to accept lower rates on short‐term investments because of their liquidity. Short‐term rates have ordinarily been lower than long‐term rates.

Question 22

real risk-free (inflation-free) rate of interest

Answer 22

the interest rate that would occur if there are no risks associated with the instrument and inflation is expected to be zero.
Because no inflation is expected, the rate is considered a “real” rate (i.e., the rate with - or after - zero inflation).
The rate of return on short-term U.S. Treasury securities assuming no inflation is commonly considered as the risk-free rate.

Question 23

default risk

Answer 23

premium compensates for the possibility that the issuer of debt will not pay interest and/or principal at the contracted time and/or in the contracted amount.
The greater the perceived default risk, the higher the nominal interest rate.
U.S. Treasury securities are assumed to have no default risk and, therefore, have the lowest interest rates for comparable taxable securities in the United States.
The difference between the quoted interest rate on a U.S. T-bond and on a corporate bond with similar amount, maturity, liquidity, tax and other features will be the amount of the default premium.
Example: If T-bonds are quoted at 5.5% and otherwise comparable corporate bonds are quoted at 7.8%, the default risk premium would be 2.3% (i.e., 7.8% − 5.5% = 2.3%).

Question 24

maturity premium

Answer 24

compensates for the risk that longer-term fixed-rate instruments will decline in value as a result of an increase in the market rate of interest.
The value of outstanding fixed-rate instruments changes inversely with changes in the market rate of interest; therefore, if over time the market rate of interest increases, the market value of outstanding comparable instruments will decline.
This risk is commonly called “interest rate risk”—the risk associated with a change in the market interest rate.
All long-term fixed-rate instruments, including U.S. Treasury securities, are subject to the interest rate risk and call for a maturity premium.
The longer the time to maturity, the higher the maturity premium.

Question 25

liquidity premium

Answer 25

(also called the marketability premium) compensates for the fact that some securities cannot be converted to cash on short notice at approximate fair market value.
The greater the perceived illiquidity of a security, the higher the liquidity premium.
Securities of the U.S. Treasury and those of financially strong corporations that are widely traded in active markets carry little or no liquidity premium; less liquid securities of small entities are likely to carry a relatively significant liquidity premium.

Question 26

Stated interest rate

Answer 26

The stated interest rate (also called the nominal or quoted interest rate) is the annual rate specified in the loan agreement or comparable contract; it does not take into account the compounding effects of frequency of payments or the effects of inflation

Question 27

Simple interest

Answer 27

Simple interest is interest computed on the original principal only; there is no compounding in the interest computation. (

Question 28

Compound interest

Answer 28

Compound interest provides that interest be paid not only on the principal, but also on any amount of accumulated unpaid interest. Compound interest pays interest on interest; simple interest does not.

Question 29

APR

Answer 29

The calculation of annual percentage rate (APR) is a function of the basic equation: Interest = Principal x Interest Rate x Time period of loan. Rearranged, the interest rate on an annual basis (APR) is:
Interest (cost)
APR = ________________________ , or
Principal x Time fraction of year

Interest (cost)		1 APR =	\_\_\_\_\_\_\_\_\_\_\_\_	x	\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_
Principal		Time fraction of year

Question 30

real interest rate

Answer 30

The real interest rate is the stated (or nominal) rate of interest for a period less the rate of inflation for that period.

Question 31

Market approach (also called the sales comparison approach)

Answer 31

-most likely to provide the best evidence of fair value
Uses prices and other relevant information generated by market transactions involving assets or liabilities that are identical or comparable to those being valued.
-The market approach to determining value will most likely provide the best evidence of fair value. The market approach is based on using prices or other relevant information generated by actual market transactions for assets or liabilities that are identical or comparable to those being valued.
-This approach is based on the premise that a market participant will not pay more than it costs to purchase a similar item.

Question 32

Income approach

Answer 32

-converts future amounts to current amounts
Uses valuation techniques to convert future amounts of economic benefits or sacrifices of economic benefits to determine what those future amounts are worth as of the valuation date.
Typically converts future cash flows or earnings amounts using models, including:
Discounted cash flows
Option pricing models
Earnings capitalization models
This approach is based on the premise that a market participant is willing to pay the present value of the future economic benefits to acquire an item.

Question 33

Cost approach

Answer 33

Uses valuation techniques to determine the amount required to acquire or construct a substitute item (replacement cost or reproduction cost).
Use of this approach is more limited than the market approach or the income approach.
Use would be especially appropriate for valuing specialized types of assets.

Question 34

Level 1

Answer 34

The highest level:
Inputs in this level are unadjusted quoted prices in active markets for assets or liabilities identical to those being valued that the entity can obtain at the measurement date; all such inputs are observable in a market.
-Quoted prices in an active market provide the most reliable evidence of fair value and should be used when available.
-Stock prices quoted on NASDAQ used for fair value determination would be level 1 inputs in the U.S. GAAP hierarchy of inputs.
-Level 1 inputs are quoted prices in active markets for identical assets or liabilities. Agricultural commodities of identical nature are widely traded in active commodities markets. The prices from those transactions would be the best measure of the value of identical agricultural commodities.

Question 35

Level 2

Answer 35

The middle level:
Inputs in this level are observable for assets or liabilities, either directly or indirectly, other than quoted prices described in level 1, above, and include:
Quoted prices for similar assets or liabilities in active markets;
Quoted prices for identical or similar assets or liabilities in markets that are not active markets and in which there are few relevant transactions, prices are not current or vary substantially, or for which little information is publicly available;
Inputs, other than quoted prices, that are observable for the assets or liabilities being valued, including, for example, interest rates, yield curves, credit risks, and default rates;
Inputs derived principally from, or corroborated by, observable market data by correlations or other means.
Depending on the circumstances specific to the asset or liability being valued, these inputs when applied may need to be adjusted for factors such as condition, location, and the level of activity in the relevant market.

Question 36

Level 3

Answer 36

The lowest level:
Inputs in this level are unobservable for the assets or liabilities being valued and should be used to determine fair value only to the extent observable inputs are not available;
When unobservable inputs are used, they should reflect the entity’s assumptions about what market participants would assume and should be developed based on the best information and data available in the circumstances.
-Valuing the liability associated with remediation of an open‐pit mine to be carried out in 20 years

Question 37

CAPM

Answer 37

CAPM incorporates both the time value of money and the element of risk:
The time value of money is incorporated as the risk-free rate of return;
The element of risk is incorporated in a risk measure called Beta.

Question 38

CAPM Formula

Answer 38

RR = RFR + B(ERR − RFR)
Where:
RR = Required rate of return
RFR = Risk-free rate of return; a measure of the time value of money which in the U.S. is generally measured by the rate (yield) on U. S. Government bonds
B = Beta of the investment; a measure of volatility, as described below
ERR = Expected rate of return for a benchmark for the asset class (type of asset) being valued

Question 39

Beta

Answer 39

Beta in the capital asset pricing model formula is a measure of systematic risk.
-establishes a relationship between the expected return on an individual asset and the return expected on a group of comparable assets.

B = 1, then an investment price (value) moves in line with the asset class benchmark for that investment; the investment has average systematic risk.

B > 1, then an investment price (value) moves greater than the asset class benchmark for that investment; the investment has higher systematic risk—the investment is more volatile than the benchmark for the asset class.
1)In the example, above, B = 2 says that the assumed asset is more volatile (more risky) than the benchmark for its asset class; therefore, the required rate of return (17%) is significantly more than the benchmark rate (10%).

B < 1, then an investment price (value) moves less than the asset class benchmark for that investment; the investment has lower systematic risk—the investment is less volatile than the benchmark for the asset class.

Question 40

capital asset pricing model

Answer 40

• takes the time value of money into account.
• measures the relationship between risk and reward.
• can be used in analyzing securities investment alternatives.
• assumes that all investors in the asset are considering only a one period time horizon.
• assumes that all parties are able to borrow at the risk‐free rate of return.
• The elements used in the formula include the risk‐free rate of return, beta (a measure of volatility for the asset being valued) and the expected rate of return for the entire class of the asset being valued.

Question 41

A measure that describes the risk of an investment project relative to other investments in general is the

Answer 41

The beta coefficient of an individual stock is the correlation between the stock’s price and the price of the overall market. As an example, if the market goes up 5% and the individual stock’s price, on average, goes up 10%, the stock’s beta coefficient is 2.0.

Question 42

nominal risk‐free rate of return in the U.S.

Answer 42

In the U.S., the rate paid on U.S. Treasury Bonds (2%) is considered the risk‐free rate of return; that is, the rate of return that is paid for delayed use of funds by investing them, without any risk premium attached to or paid for default risk.

Question 43

A graph that plots beta would show the relationship between

Answer 43

Asset return and benchmark return.

Question 44

option contract

Answer 44

An option contract entitles the holder to buy or sell, but does not require the holder to buy or sell.

Question 45

binomial option pricing model

Answer 45

The binomial option pricing model can be used to value options at multiple points in time.

• The BOPM uses a “tree” to estimate value at a number of time points between the valuation date and the expiration of the option.
• can be used for American-style options, which permit exercise any time up to the expiration date, and when the underlying stock pays dividends, which the original Black Scholes model does not accommodate.

Question 46

The Black‐Scholes model

Answer 46

The Black‐Scholes model can be used for estimating the price of certain derivative financial instruments.

• European call options, which permit exercise only at the expiration date
• Options for stocks that pay no dividends
• Options for stocks whose price increases in small increments
• Discounting the exercise price using the risk-free rate which is assumed to remain constant
• The Black‐Scholes option pricing model does not accommodate options when the price of the underlying stock changes significantly and rapidly. The Black‐Scholes model assumes that the stock for which the option is being valued increases in small increments.

Question 47

Call option

Answer 47

(a contract that gives the right to buy)—a current price above the exercise price increases the option value; the greater the excess, the greater the option value

Question 48

Put option

Answer 48

( a contract that give the right to sell)—a current price below the exercise price increases the option value; the lower the current price relative to the exercise price, the greater the option value

Question 49

Business Valuation Process

Answer 49

Establishing standards and premise of the valuation
Assessment of the economic environment of the business
Analysis of financial statements
Formulation of valuation

Question 50

Business Valuation Approaches

Answer 50

Market approach (for business valuation)
This approach determines the value of an entity by comparing it to other entities with similar characteristics in the same industry, in the same market(s), of the same size, with highly similar product lines, similar risks, and other factors.

Income approach (for business valuation)
This approach determines the fair value of an entity by calculating the net present value of the benefit stream generated by the entity; the resulting net present value is the value of the entity.

Asset approach (for business valuation)
This approach determines the fair value of an entity by adding the values of the individual assets that comprise the business.

Question 51

income approach

Answer 51

The income approach to valuing a business typically uses a discount rate or a capitalization rate.

Question 52

market approach

Answer 52

The market approach to business valuation is based on using the established value of comparable businesses.
-Using the recent sales price of a comparable asset as a basis for valuing another asset is an example of the market approach to business valuation

Question 53

common‐size balance sheet

Answer 53

A common‐size balance sheet would show each asset as a percent of total assets.
A common‐size balance sheet would show each liability as a percent of total assets.
It would not show each liability as a percent of total liabilities.

Question 54

The asset approach

Answer 54

The asset approach is a major approach to assigning value to an entire going business. The asset approach determines the value of an entity by adding together (summing) the values of the individual assets that comprise the entity.

Question 55

common‐size income statement

Answer 55

In a common‐size income statement, each item is measures as a percentage of total revenues

Question 56

The P/E ratio for a share of common stock is computed as:

Answer 56

Market price/EPS.

The price/earnings (P/E) ratio is computed as the market price of the stock divided by the earnings per share (EPS). Note that both values are on a per share basis and the resulting calculation shows the relationship between the price of a share of stock in the market and the earnings for each share of stock.

Question 57

Qualitative methods

Answer 57

1. Are based on judgment or opinion
2. Are subjective in nature (do not use mathematical analysis)
3. Often involve development of consensus
4. Are appropriate when there is an absence of relevant historical data to use for quantitative analysis
5. Are especially useful in making long-term forecasts

A. Executive opinion
A jury of executive opinion in which a group of executives or managers collectively use judgment and opinion to develop a forecast
B. Market research
Surveys of customers or others to determine preferences and other factors
C. Delphi method
Consensus developed by a group of experts using a multi-stage process to converge on a forecast (long-term)

Question 58

Quantitative methods

Answer 58

1. Are based on quantitative models
2. Are objective in nature
3. Rely on mathematical determinations or calculations

A. Time series models
Use patterns in past data to predict a future value or values based on underlying patterns contained in the past data.
-Also called “extrapolation methods,” because they extrapolate future values or patterns from past values or patterns
-These methods (or models) are not concerned with causes, just patterns in data
-These methods are especially useful in making short-term forecasts
B. Causal models
Assume that the variable being forecasted is related to other variables and makes projections based on those associations.

Question 59

Mean Absolute Deviation (MAD)

Answer 59

Assesses accuracy using the average of the absolute values of all forecast errors. It measures the absolute value of the average distance (positive or negative) of the actual values from the forecasted values for a number of prior time periods; the desired outcome is a small MAD (near 0).

Question 60

Mean Squared Errors (MSE)

Answer 60

Assesses accuracy using the average of the sum of the forecast errors squared.

Question 61

Mean Average Percentage Error (MAPE)

Answer 61

Assesses accuracy using the forecast error and dividing it by the actual value.

Question 62

Times Series Models

Answer 62

1. Naive
   Uses the immediate prior period’s actual value as a forecast for the next period.
2. Simple mean (average)
   Uses an average of past values as a forecast for a future period (or periods).
3. Simple moving average
   Uses an average of a specific number of the most recent values (with each past value receiving the same emphasis or weight) as a forecast for a future period (or periods). For example, a 12-month moving average would use the value of the most recent 12 months divided by 12.
4. Weighted moving average
   Uses an average of a specific number of the most recent values with each past value receiving a different emphasis or weight which are assigned subjectively. For example:
   Average the last three months with the last month weight being .5, two months ago weight being .3, and three months ago weighted .2 E.g.: Forecasted value = (1 month ago × .5) + (2 months ago × .3) + (3 months ago × .2)/3
   Weights must equal 1.0
5. Exponential smoothing
   A weighted average procedure with weights declining exponentially as data becomes older. Only the weight given to the most recent period is assigned subjectively; it is called the “smoothing factor.” All of the other weights for prior periods are computed based on that smoothing factor.
   Smoothing techniques are used to reduce random fluctuations in time series data.
6. Trend-adjusted exponential smoothing
   An exponential smoothing model which makes adjustments to past date when strong trend patterns are inherent in the data.
   -is a variation of the weighted average model.
7. Seasonal indexes
   Adjust past data to accommodate seasonal patterns in the data.
8. Linear trend line
   Uses least squares method to fit a straight line to past data and extends the trend line to establish a forecast.

Question 63

Time series patterns

Answer 63

1. Level (or horizontal)
   Data are relatively constant or stable over time with little increase or decrease in value.
2. Seasonal
   Data reflect upward and downward swings over short or intermediate periods of time, most commonly one year, with each swing of about the same timing and level of change.
   -can be used to adjust past data to isolate seasonal patterns in using the data for forecasting purposes.
3. Cycles
   Data reflects upward and downward swings over a long period of time.
4. Trend
   Data reflects a steady and persistent upward or downward movement over some long period of time.
5. Random
   Data reflects unpredictable, erratic variations over time.

Question 64

Causal model types

Answer 64

Causal models used for forecasting are based on the assumption that the variable being forecasted is related to one or more other determinable variables.
1. Regression (linear or non-linear)
Uses a mathematical equation that relates a dependent variable to one or more independent variables that influence the dependent variable. Regression fits a curve to the data points to minimize forecasting error.
Trend analysis - Uses linear or nonlinear regression with time as the explanatory (independent) variable.
2. Input-output models
Describes the flow from one stage of a process or sector of an economy to another and enables the forecasting of the inputs required to result in outputs in a subsequent stage.
3. Economic models
Specify the statistical relationship believed to exist between various economic quantities (e.g., the Black-Scholes model for estimating the value of a stock option).

Question 65

comparable sales approach

Answer 65

Under the comparable sales approach, the value of a business is determined by comparing it to other entities with comparable characteristics for which the value is more readily determinable.

Question 66

valuation of business enterprises

Answer 66

I. Nonpublic entities are likely to be more difficult to value than publicly traded entities.
II. The conditions in the macroeconomic environment should be considered in valuing an entity.
III. The status of the industry in which a business operates should be considered in valuing the entity.

Question 67

present value of 1 factor

Answer 67

A present value of 1 factor is used because only one payment is to be made. Present value (which also is cost) = (present value of 1 factor) x (future payment). The future payment is being discounted to its present value.