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BEC - Wiley > Module 44: Financial Management > Flashcards

Module 44: Financial Management Flashcards

1
Q

Arbitrage pricing model

A

Uses a series of systematic risk factors to develop a value that reflects the multiple dimensions of systematic risk

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2
Q

Cash discounts

A

Discounts for early payment of accounts

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3
Q

Compensating balance

A

Required minimum level of deposit based on loan agreement

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4
Q

Concentration banking

A

Payments from customers that are routed to local branch offices rather than firm headquarters. Reduces collection time.

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5
Q

Cost of capital

A

weighted-average cost of a firm;s debt and equity financing components

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6
Q

Debenture

A

A bond that is not secured by the pledge of specific property

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7
Q

Economic order quantity (EOQ)

A

An inventory technique that minimizes the sum of inventory ordering and carrying costs

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8
Q

Electronic funds transfer

A

The movement of funds electronically without use of a check

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9
Q

Factoring

A

The sale of receivables to a finance company

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10
Q

Financial leverage

A

Measures the extent to which the firm uses debt financing

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11
Q

Float

A

The time that elapses relating to mailing, processing, and clearing checks

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12
Q

Inventory conversion period

A

The average length of time required to convert materials into finished goods and sell the goods

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13
Q

Just-in-time production

A

A demand-pull system in which each component of a finished good is produced when needed by next stage of production

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14
Q

Just-in-time purchasing

A

A demand-pull inventory system in which raw materials arrive just as they are needed for production. Minimizes inventory holding costs

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15
Q

Lockbox system

A

A system in which customer payments are sent to a post office box that is maintained by a company’s bank. This reduces collection time and improves controls.

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16
Q

Mortgage bond

A

Bond secured with the pledge of specific property

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17
Q

Operating leverage

A

Measures the degree to which a firm builds fixed costs into its operations

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18
Q

Payables deferral period

A

Average length of time between the purchase of materials and labor and the payment of cash for them

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19
Q

Precautionary balances

A

Cash available for emergencies

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20
Q

Receivables collection period

A

Average length of time required to collection AR

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21
Q

Speculative balances

A

Cash available to take advantage of favorable business opportunities

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22
Q

Subordinated debenture

A

A bond with claims subordinated to other general creditors

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23
Q

Supply chain

A

Describes the processes involved in a good’s production and distribution

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24
Q

Warehousing

A

Inventory financing in which inventory is held in a public warehouse under the lender’s control

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25
Q

What is financial management?

A

Deal with the various types of monetary decisions that must be made by managers in a company, along with the tools and analyses used to make those decisions

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26
Q

Financing function

A

Raising capital to support the firm’s operations and investment programs

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27
Q

Capital budgeting function

A

Selecting the best projects in which to invest firm resources, based on a consideration of risks and return

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28
Q

Financial management function

A

Managing the firm’s internal cash flows and its capital structure (mix of debt and equity financing) to minimize the financing costs and ensure that the firm can pay its obligations when due

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29
Q

Corporate governance function

A

Developing an ownership and corporate governance aystem for the firm that will ensure that managers act ethically and in the best interest of stakeholders

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30
Q

Risk-management function

A

Managing the firm’s exposure to all types of risk

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31
Q

Working capital management

A

Involves managing and financing the current assets and current liabilities of the firm

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32
Q

Cash conversion cycle

A

Length of time between when the firm makes payments and when it receives cash inflows

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33
Q

How is the cash conversion cycle analyzed?

A
  • Inventory conversion period
  • Receivables collection period
  • Payables deferral period
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34
Q

Inventory conversion period

A

Average time required to convert materials into finished goods and sell those goods

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35
Q

Inventory conversion period formula

A

Average inventory / cost of goods sold per day

*Divide by 365 days if given annual amount

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36
Q

Receivables collection period (DSO - days sales outstanding)

A

Average time required to collect accounts receivable

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37
Q

Receivables collection period formula (DSO)

A

Average receivables / credit sales per day

*Divide by 365 days if given annual amount

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38
Q

Payables deferral period

A

Average length of time between purchase of materials and labor and the payment of cash for them

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39
Q

Payables deferral period formula

A

Average payables / purchases per day

Average payables /(Cost of goods sold /365)

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40
Q

Cash conversion cycle formula

A

Inventory conversion period + receivables conversion period - payables deferral period

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41
Q

What is effective working capital management?

A

Involves shortening the cash conversion cycle as much as possible without harming operations

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42
Q

Why should management maintain a sufficient amount of cash?

A
  • Take advantage of trade discounts
  • Maintain its credit rating
  • Meet unexpected needs
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43
Q

Why do firms hold cash?

A
  • Transactions

- Compensation to financial institution

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44
Q

Compensating balance

A

Financial institutions requiring minimum balances

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45
Q

Why do firms prepare cash budgets?

A
  • Take advantage of cash discounts
  • Take advantage of business opportunities
  • Meet emergencies, such as funds for strikes, natural disasters, and cyclical downturns
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46
Q

Speculative balances

A

Cash available for favorable business opportunities

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47
Q

Cash discounts

A

Usually provided by suppliers for early payment of invoices

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48
Q

Precautionary balances

A

Cash available for emergencies

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49
Q

Cash management: Float

A

The time that elapses relating to mailing, processing, and clearing checks

Float exists for both the firm’s payments to suppliers and the firm’s receipts from customers

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50
Q

What is effective cash management in regards to the float?

A

Effective cash management involves extending the float for disbursements and shortening the float for cash receipts

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51
Q

Zero-balance accounts

A

Maintaining a regional bank account to which just enough funds are transferred daily to pay the checks presented

Regional banks typically receive the checks drawn on their customers’ accounts in the morning from the Federal Reserve

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52
Q

Advantages of zero-balance accounts?

A
  • checks take longer to clear at a regional bank, providing more float for cash disbursements
  • Extra cash foes not have be deposited in the account for contingencies
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53
Q

How is a zero-balance account cost-effective?

A

Firm saves on interest costs from the longer float is adequate to cover any additional fees for account maintenance and cash transfers

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54
Q

Lockbox system

A

Customer payments are sent to a post office box that is maintained by a bank. Bank personnel retrieve the payments and deposit them into the firm’s bank account

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55
Q

Advantages of a lockbox system

A
  • Increases the internal control over cash because firm personnel do not have access to cash receipts
  • Provides for more timely deposit of receipts which reduces the need for cash for contingencies
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56
Q

Cost-effectiveness of a lockbox system

A

If the interest costs saved due to obtaining more timely deposits is sufficient to cover the net increase in costs of cash receipt processing (bank fees less internal costs saved from having the bank process receipts)

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57
Q

Concentration banking

A

Customers in an area make payments to a local branch office rather firm headquarters. The local branch makes deposits in an account at a local bank. Then, surplus funds are periodically transferred to the firm’s primary bank.

Float related to cash receipts is shortened.
Wire transfers can involve a significant fee.

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58
Q

Official bank checks

A

Slower but less expensive way of transferring funds. These are depository transfer checks) which are preprinted checks used to make transfers

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59
Q

Electronic funds transfer

A

Funds are moved electronically between accounts without the use of a check.

Take the float out of both the receipts and disbursements processes

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60
Q

International cash management

A

Can use various systems, including electronic systems to manage the cash accounts they hold in various countries.

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61
Q

Marketable securities management

A

Can be converted to cash very quickly

Advantage over cash in that they provide an investment return

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62
Q

Minimum investment required

A

Some investments, such as high-yield certificates of deposits, require larger investments

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63
Q

Safety

A

The risk to principal

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64
Q

Marketability (liquidity)

A

Relates to the speed with which the investment can be liquidated

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65
Q

Maturity

A

The length of time the funds are committed

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66
Q

Yield

A

The higher the yield the better. Also comes with higher risk or longer maturity

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67
Q

Short-term investments: Treasury bills (T-bills)

A

Short-term obligations of federal government. Any maturity date up to 182 days. The active market ensures liquidity.

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68
Q

Short-term investments: Treasury notes

A

Government obligations with maturities from one to ten years.

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69
Q

Short-term investments: Treasury Inflation Protected Securities (TIPS)

A

Government obligations that pay interest that equates to a real rate of return specified by the US Treasury, plus principal at maturity that is adjusted for inflation. These are useful to a firm that wants to minimize interest rate risk.

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70
Q

Short-term investments: Federal agency securities

A

Offerings of government agencies, such as the Federal Home Loan Bank. Offer security, liquidity, and pay slightly higher yields than treasury issues.

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71
Q

Short-term investments: Certificates of deposit (CD)

A

Savings deposits at financial institutions; two-tier market for CDs - small ( $500-10,000) with lower interest rates and large ($100,000) with higher interest rates

CDs are not as liquid or safe; normally insured up to $100,000 by the federal government

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72
Q

Short-term investments: Commercial paper

A

Large unsecured ST promissory notes issued to the public by large creditworthy corporations. Usually had a two-to nine-month maturity period and usually held to maturity by the investor because there is no active secondary market.

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73
Q

Short-term investments: Banker’s acceptance

A

A draft drawn on a bank for payment when presented to the bank.

74
Q

Where do banker’s acceptances usually arise?

A

From payments for goods by corporations in foreign countries.

75
Q

What is the process for a banker’s acceptance?

A

The corporation receiving the banker’s acceptance may have to wait 30-90 days to present the acceptance for payment. These instruments usually sell at a discount.

76
Q

Short-term investments: Eurodollar certificate of deposit

A

US dollars held on deposit by foreign banks and in turn lent by the banks to anyone seeking dollars. To obtain dollars, foreign banks offer Eurodollar certificates of deposit. As an investment, Eurodollar certificates of deposit pay higher yields than T-bills or certificates of deposit at large US banks

77
Q

Short-term investments: Money market funds

A

Shares in a fund that purchases higher-yielding bank CDs, commercial paper, and other large-denomination, higher-yielding securities

78
Q

Short-term investments: Money market accounts

A

Similar to savings accounts, individual or business investors deposit idle funds in the accounts and the funds are used to invest in higher-yielding bank CDs, commercial paper

79
Q

Short-term investments: Equity and debt securities

A

Investment in publicly traded stocks and bonds of other corporations. Greater risk than other ST investments, but also offer higher average LT returns.
Should purchase a balanced portfolio to diversify away the unsystematic risk (e.g. default risk) of the individual investments

80
Q

What does effective inventory management start with?

A

Effective forecasting of sales and coordination of purchasing and production

81
Q

What are the two goals of inventory management?

A
  • To ensure adequate inventories to sustain operations

- Minimize inventory costs, including carrying costs, ordering and receiving costs, and cost of running out of stock

82
Q

Seasonal production

A

Involves increasing production during periods of peak demand and reducing production during slow sales periods. Usually has additional operating costs for such things as overtime wages and maintenance

83
Q

Level production

A

Working at a consistent level of effort to manufacture the annual forecasted amount of inventory. Results in inventory buildups during slow sales period.

84
Q

Inventory and inflation

A

Price instability occurs in a number of markets; can be hedged partially by controlled holding low levels of inventory

85
Q

How to hedge risk of inventory and inflation?

A

Hedge the price movement with a futures contract to sell silver at a specified price in the future

86
Q

Supply chain

A

Describes a good’s production and distribution. 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.

87
Q

What is a key aspect of supply chain management?

A

Sharing of key information from the point of sale to the final consumer back to the manufacturer, to the manufacturer’s suppliers, and to suppliers’ suppliers

88
Q

Economic order quanitity (EOQ)

A

Minimizes the sum of the ordering and carrying costs

89
Q

Carrying costs

A

Increases with order size

90
Q

Ordering costs

A

Decreases with order size

91
Q

EOQ formula

A

Square root 2aD / k

a = cost of placing one order 
D = annual demand in units 
k = cost of carrying one unit of inventory for one year
92
Q

Stockouts

A

Inventory is no longer in stock

93
Q

Safety stock

A

Used to guard against stockouts; maintained by increasing the lead time

94
Q

Lead time

A

The time that elapses from order placement until order arrival

95
Q

Examples of carrying costs of safety stock (and inventory)

A
  • Storage
  • Interest
  • Spoilage
  • Insurance
  • Property taxes
96
Q

Examples of stockout costs

A
  • Profit on lost sales
  • Customer ill will
  • Idle equipment
  • Work stoppages
97
Q

What is the most common approach to setting the optimum safety-stock level?

A

To examine previous lead time periods to determine the probabilities of running out of stock (stockout)

98
Q

Materials requirements planning (MRP)

A

Computerized system that manufactures finished goods based on demand forecasts

99
Q

What is a key weakness of an MRP system?

A

Push through system - whether they are needed or not.

100
Q

MRP II

A

Extension of MRP and features an automated closed loop system; uses technology to integrate the functional areas of a manufacturing company

101
Q

JIT (Just-in-time) purchasing

A

Demand-pull inventory system which may be applied to purchasing so that raw material arrives just as it is needed for production

102
Q

Primary benefit of JIT purchasing?

A
  • Reduction of inventories ideally to zero

* most important aspect is relationship with suppliers

103
Q

JIT production

A

Demand pull system in which each component of a finished good is produced when needed by the next production stage

104
Q

How to accomplish JIT production?

A
  • Emphasize reducing production cycle time (manufacturing lead time) and setup time
  • Emphasize production flexibility
  • Emphasize solving production problems immediately
  • Focus on simplifying production activities
105
Q

Manufacturing cells

A

Produce a product or type of product with the workers being able to operate a number of the different machines

106
Q

What does JIT reduce?

A

Scrap and rework

107
Q

Advantages of JIT?

A
  • Lower investments in inventories and in space to store inventory
  • Lower inventory carrying and handling costs
  • Reduced risk of defective and obsolete inventory
  • Reduced manufacturing costs
  • Luxury of dealing with a reduced number of reliable, quality-oriented suppliers
108
Q

Backflush costing

A

Simplified costing system. Lack of inventories in a JIT system makes choices about cost-flow unimportant - all manufacturing costs run through COGS

109
Q

How can JIT systems breakdown?

A
  • Suppliers for not provide timely delivery of quality materials
  • Employers are not well trained or supervised
  • Technology and equipment are not reliable
110
Q

Enterprise Resource Planning Systems (ERP)

A

Enterprise-wide computerized information systems that connect all functional areas within an organization

111
Q

What does effective receivables management involve?

A

Involves systems for deciding whether or not to grant credit and for monitoring the receivables.

Management should establish consistent credit evaluation procedures that balance the costs of lost sales with the costs of credit losses (uncollectible accounts)

112
Q

What should a firm’s credit policy consist of?

A
  • Credit period: length of time buyers are given to pay for their purchases
  • Discounts - % provided and period allowed for discount for early payment
  • Credit criteria - required financial strength of acceptable credit customers; use credit scoring to evaluate a potential customer
  • Collection policy: diligence used to collect slow-paying accounts
113
Q

Dun & Bradstreet Information Services

A

Source for credit information; makes available its Business Information Report (BIR)

114
Q

Days sales outstanding (DSO)

A

DSO = Receivables / Sales per day

115
Q

Why do current assets fluctuate from month to month?

A

Because firms have seasonal fluctuations in the demand for products and services

116
Q

How are assets financed?

A

With current liabilities such as AP, commercial bank loans, commercial paper

117
Q

Permanent current assets

A

Required to operate business in even the slowest periods of the year

118
Q

How should permanent current assets be financed?

A

Financed with long-term financing, such as stock or bonds

119
Q

Temporary current assets

A

Inventory, accounts receivable; accumulated during periods of higher production and sales

120
Q

Aggressive financing

A

Using extensive amounts of short-term debt to finance current assets

121
Q

How is interest expense affected by aggressive financing?

A

Amount of interest expense over time will be more volatile because the firm has not locked in an interest rate on a long-term basis

122
Q

Conservative financing

A

Financing some current assets with long-term debt which involves a more stable interest rate

123
Q

Advantage of conservative financing?

A

More stable interest rate

124
Q

Disadvantages of long-term financing?

A

Provisions or covenants generally constrain the firm’s future actions; prepayment penalties may make early repayment of long-term debt an expensive proposition

125
Q

Maturity matching/self-liquidating approach

A

Financing assets involves matching asset and liability maturities; strategy minimizes the risk that the firm will be unable to pay its maturing obligations aka hedging approach

126
Q

Trade credit (AP)

A

Significant source of short-term funding

127
Q

Major advantage of trade credit

A

Arises in the normal course of conducting business and bears no interest cost, providing it is paid on time

128
Q

What does terms of 2/10, net 30 mean?

A

Means that payment is due in thirty days and a 2% discount is allowed for payment within 10 days

129
Q

What is the approximate cost of not taking the discount?

A

Discount % / 100% - Discount % times 365 days / Total Pay Period - Discount Period

130
Q

What does the nominal rate not take into consideration?

A

The effects of compounding

131
Q

What is the second most important source of short-term funds?

A

Notes payable to commercial banks

132
Q

Maturity

A

Majority of lending has maturity date of one year or less; typically 90 days

133
Q

Promissory note

A

Notes are executed using a signed promissory note; specifies terms of agreement

134
Q

Interest

A

Rate for short-term bank loans; can fluctuate with changes in short-term interest rates

135
Q

Prime rate

A

Rate a bank charges its most creditworthy customers; rate increases for customers with more credit risk

136
Q

What is one basis point equal to?

A

Equal to one hundredth of one percent (0.01%)

137
Q

London Interbank Offered Rate (LIBOR)

A

Availability of dollars for loan on the international market

138
Q

Compensating balances

A

Loan agreements may require the borrower to maintain an average demand deposit balance equal to some percentage of the face amount of the loan; this increases the effective interest rate of the loan because full amount of loan does not get to be used

139
Q

How to calculate the effective interest rate on a loan

A

Principal available = Principal Amount - (Comp. balance % * Principal)

Interest for # of days = Principal * Interest rate * (# days/360 days)

Effective interest rate = Interest paid/Principal available * (360 days/90 days)

140
Q

Informal line of credit

A

An informal specification of the maximum amount that the bank will lend the borrower

141
Q

Revolving credit agreements

A

A line of credit in which the bank is formally committed to lend the firm a specified maximum amount. The bank typically receives a commitment fee as part of the agreement (usually used for intermediate-term financing)

142
Q

Letter of credit

A

Instrument that facilitates international trade; usually issued by importer’s bank, that promises the bank will pay for the imported merchandise when delivered; designed to reduce the risk of nonpayment by the importer

143
Q

Commercial paper

A

Form of unsecured promissory note issued by large, creditworthy firms; maturity dates from 1-9 months; favorable for corporations with the financial strength to issue it; rate is often 2 to 3% less than the prime rate and no compensating balances

144
Q

Disadvantage to commercial paper

A

Market is less predictable than bank financing

145
Q

Pledging of receivables

A

Committing the receivables as collateral for a loan from a financial institution; interest rate will depend on the financial strength of the firm and the quality of the receivables; financial institution will typically lend 60-80% of the receivables

146
Q

Disadvantage of pledging of receivables

A

Interest is computed based on the outstanding loan balance and tends to be quite hight

147
Q

Advantage for small companies for pledging receivables

A

Interest rate will be less than for unsecured loans

148
Q

Factoring

A

Accounts receivable are sold outright to a finance company, who is directly involved in credit decisions

Finance company generally paid a fee of 1 to 3% of the invoices accepted; finance company also receives the interest rate for advancing the funds

149
Q

Example of factoring:

Finance company charges a 2% fee and a 12% interest rate for factoring firm’s receivables which are payable in 30 days. Calculate effective interest rate.

A

2% fee; 1% interest for 1 month (12% annual/12); 3% monthly x 12 = 36% annual rate

150
Q

Asset-backed public offerings

A

e.g. bonds

Collateralized by the firm’s AR. Securities generally have high credit ratings even though issuing firm may have a lower credit rating

aka securitization of assets

151
Q

Inventory financing

A

Firm may borrow funds using inventory as collateral; extent of feasibility depends on the marketability of the inventory

e.g. lumber, metals and grains are easily used as collateral

152
Q

Blanket inventory lien

A

Legal document that establishes the inventory as collateral for the loan; no physical control over inventory is involved

153
Q

Trust receipt

A

Instrument that acknowledges that the borrower holds the inventory and that proceeds from sale will be put in a trust for lender; each item tagged and controlled by serial number; when inventory is sold, funds are transferred to the lender and trust receipt is cancelled

aka floor planning

154
Q

Warehousing

A

Most secure form of inventory financing; inventory is stored in public warehouse or under control of public warehouse personnel

155
Q

Private Debt

A

Two principal types

  1. loans from financial institutions; almost have universal floating interest rate that is tied to a base rate, usually LIBOR or prime rate
  2. Private placement of unregistered bonds sold directly to accredited investors (often pension funds or insurance companies); less expensive to issue than public debt
156
Q

Public long-term debt

A

Selling SEC registered bonds directly to investors; bond agreement specifies the par value, coupon rate, and maturity date of debt

157
Q

Par value

A

face amount of bond; most corporate bonds have $1,000 face amount

158
Q

Coupon rate

A

Interest rate paid on face amount of bond; market value of the bond fluctuates with changes in the market interest rate

159
Q

Maturity date

A

Final date on which repayment of the bond principal is due

160
Q

Public LT debt example:

Issued $500,000 in 6% bonds, maturing in 20 years; interest paid semi-annually

A

Coupon rate is paid in installments of $30 (3% x $1,000) every 6 month for each $1,000 bond

Annual interest is $30,000 ($500,000 x 6%)

What happens if market rate of interest increases to 7% after the bonds are issued?
-Mrkt value of bonds will decline to an amount that will allow a new purchaser to realize a 7% yield to maturity

What happens if market rate of interest decreases to 5%?
-Market price of bons will increase to an amount that will allow the new purchaser to earn only a 5% YTM

161
Q

Eurobond

A

Bond payable in the borrower’s currency but sold outside the borrower’s country

E.g. bond of US firm, payable in US dollars, might be sold in Germany, London and Japan through an international syndicate of investment bankers

162
Q

Advantages of Eurobonds

A

Registration and disclosure requirements for Eurobonds are less stringent than those of the SEC for US issued bonds; cost of issuance is less

163
Q

Debt covenants

A

Restrictions to private and public debt agreements; allow investors (lenders) to monitor and control the activities of the firm

164
Q

Examples of negative debt covenants

A
  • Sale of certain assets
  • Incurrence of additional debt
  • Payment of dividends
  • Compensation of top management
165
Q

Examples of positive debt covenants

A
  • Provide audited financial statements each year
  • Maintain certain minimum financial ratios
  • Maintain life insurance on key employees
166
Q

Secured debt

A

One in which specific assets of the firm are pledged to the bondholders in the event of default

167
Q

Mortgage bond

A

Bond secured with pledge of specific property

168
Q

Collateral trust bond

A

Bond secured by financial assets of the firm

169
Q

Debenture

A

Bond that is not secured by the pledge of specific property; general obligation of firm; can only be issued by firms with highest credit rating; higher yield than mortgage bonds and other secured debt

170
Q

Subordinated debenture

A

Bond with claims subordinated to other general creditors in the event of bankruptcy of the firm; bondholders receive distributions only after general creditors and senior debt holders have been paid

171
Q

Income bond

A

Bond with interest payments that are contingent on the firm’s earnings; higher degree of risk and carry even higher yields; associated with firms undergoing restructuring

172
Q

Serial payments (serial bonds)

A

Paid off in installments over the life of issue; desirable to bondholders because they can choose their maturity date

173
Q

Sinking fund provisions

A

Firm makes payment sinto a sinking fund which is used to retire bonds by purchase

174
Q

Conversion

A

Bonds may be convertible into common stock and this may provide the method of payment

175
Q

Redeemable

A

Bondholder may have right to redeem the bonds for cash under certain circumstances (e.g. if firm is acquired by another firm)

176
Q

A call feature

A

Bonds may have call provision allowing firm to force bondholders to redeem bonds before maturity; these typically call for payment of a 5 to 10% premium over par value to redeem the bonds

177
Q

Why don’t investors like call features?

A

They may be used to force them to liquidate their investment

178
Q

What are the three different yields relevant to bonds?

A
  1. Coupon rate
  2. Current yield
  3. Yield to maturity (YTM)
179
Q

What is the price of a bond dependent upon?

A

Current risk-free interest rate and the credit risk of the particular bond

E.g. Moody’s Investor Service

180
Q

Current yield formula

A

Interest payment / Current price of the bond

181
Q

YTM formula

A

NUMERATOR

Annual interest payment + (principal payment - bond price)/# years to maturity

Denominator
0.6 (price of bond) + 0.4(principal payment)

BEC - Wiley (5 decks)

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