Finance and the Firm

  • Three fields of finance (corporate finance, investment and portfolio management, financial institutions and financial markets)
  • Major decisions faced by financial managers (capital budgeting, capital structure, working capital management)
  • Three forms of business organization
  • The goal of financial management in corporation (maximizing the current price of the existing stock)
  • How investors monitor managers to ensure that managerial decisions are in the best interests of the owners

 

Sample questions

 

1.1. The person generally directly responsible for overseeing the cash and credit functions, financial planning, and capital expenditures is the:

  1. treasurer.
  2. director.
  3. controller.
  4. chairman of the board.

 

1.2.  The management of a firm’s short-term assets and liabilities is called:

  1. working capital management.
  2. debt management.
  3. equity management.
  4. capital budgeting.

 

1.3.  The primary goal of the financial manager is

  1. minimizing risk
  2. maximizing profit
  3. Maximizing value per share of existing stocks
  4. minimizing return

 

1.4.  Capital structure decisions include consideration of the:

  1. amount of long-term debt to assume.
  2. cost of acquiring funds.

III.  current assets and liabilities.

  1. net working capital.

 

  1. I and II only
  2. II and III only
  3. III and IV only
  4. I, II, and IV only

 

  1. Financial Markets and Interest Rates

 

Financial markets

    • Primary market vs. secondary market
    • Money market vs. capital market
      • Money market securities: Treasury bills, commercial paper, negotiable certificates of deposits (NCDs)
      • Capital market securities: Treasury bonds, municipal bonds, corporate bonds, common stocks, preferred stocks
    • Public offering vs. private placement
    • Major stock exchanges
      • Organized security exchange (e.g., NYSE)
      • Over-the-counter exchange (OTC, e.g., NASDAQ)

 

Interest Rates

  • The risk-free rate of interest (RF) reflects the real rate of interest (k*) plus a premium (IP) to compensate investors for inflation (rising prices). RF = k* +IP
  • The nominal rate of interest (kN) contain an inflation premium (IP) to compensate investors for inflation and a risk premium (RP) to compensate investors for issuer risk characteristics such as the risk of default.
  • The risk-free interest rate changes over time in response to changes in the supply of funds available and in the demand for funds.
  • Understand the term structure of interest rates (yield curve).
  • Risk premiums on debt securities should reflect the following: default risk, maturity risk (interest rate risk), liquidity risk, contractual provisions, and tax provisions
  • The returns required on risky assets (stocks and bonds) change over time in response to changes in the risk-free rate and/or in the risk premium required by investors

 

Sample questions

 

2.1.  By definition, the money market involves the buying and selling of

  1. funds that mature in more than one year
  2. flows of funds
  3. stocks and bonds
  4. short-term funds

 

2.2. The largest and best known security exchange is the

  1. American Stock Exchange (ASE).
  2. Chicago Board of Trade (CBOT).
  3. Pacific Stock Exchange (PSE).
  4. New York Stock Exchange (NYSE).

 

2.3.      Your uncle would like to restrict his interest rate risk and his default risk, but he would still like to invest in corporate bonds. He would most likely invest in

  1. AAA bonds with 10 years to maturity
  2. BBB bonds with 10 years to maturity
  3. AAA bonds with 5 years to maturity
  4. BBB bonds with 5 years to maturity

 

2.4.      The                                 is/are a graphic depiction of the term structure of interest rates.

  1. risk-return profile
  2. aggregate demand curve
  3. yield curve
  4. supply and demand functions

 

2.5.      The rate on 1-year Treasury notes is 5.50%, the rate on 10-year treasury bonds is 5.85%, and the rate on 10-year AAA rated corporate bonds is 6.60%.  The approximate risk premium on the corporate bonds is

  1. 0.35%.                                                 c. 0.75%.
  2. 1.10%                                                  d. 1.45%.

 

Use the following information to answer questions 2.6. and 2.7.

 

Security                                                          Yield

Risk-free long-term capital                             6.7%

Grade AA long-term corporate bonds                        8.0%

Grade BB long-term corporate bonds            9.4%

The S & P 500 stock index                             13.5%

 

  • If inflation were to unexpectedly increase by 1%, then the rate on newly  issued        AA and BB corporate bonds would
  1. be approximately 8.0% and 9.4%.
  2. also increase by approximately 1% each.
  3. decrease since the risk-free rate no longer covers expected inflation.
  4. none of the above.

 

  • Among firms, who experiences the lowest average cost of long-term financing?
  1. corporations with AA-rated debt
  2. corporations with only equity financing
  3. corporations with BB-rated debt
  4. corporations that issue high-yield bonds

 

  1. Financial Institutions

 

  • Financial institutions (serving as intermediaries by channeling the savings of individuals, business, and governments into loans and investments.)
  • The role of the investment banker in securities offerings

 

  • Types of Financial Intermediaries
Financial Institutions Categories Primary Sources of Funds
Depository Institutions
Commercial banks Individual savings
Savings and loan associations Individual savings
Savings banks Individual savings
Credit unions Individual savings
Contractual Savings Organizations
Insurance companies Premium paid on policies
Pension funds Employee/employer contributions
Securities Firms
Investment companies & mutual funds Individual savings (investments)
Investment banking firms Other financial institutions
Brokerage firms Other financial institutions
Finance Firms
Finance companies Other financial institutions
Mortgage banking firms Other financial institutions

 

3.1.  A __________________ allows firms access to a specified amount of bank funds over a specified period of time.

  1. line of credit
  2. term loan
  3. debt security
  4. savings account

 

3.2.    In November 1999 President Clinton signed legislation repealing the      Glass-Steagall Act.  The Glass-Steagall Act was Depression Era legislation designed to

  1. require the integration of investment banking and insurance activities.
  2. encourage the chartering of state banks.
  3. severely limit the amount of funds held by a single mutual fund.
  4. separate commercial banking from investment banking activities.

 

  1. Stocks and Bonds

 

  • Legal aspect of bond financing
  • The general features, ratings, popular types, and international issues of corporate bonds (risk and return tradeoff)
  • The rights and features of common stock
  • The rights and features of preferred stock
  • Compare debt and equity capital (ownership interest, voting rights, claims on income and assets, tax deductibility, etc.)

 

Sample questions

 

4.1. A                              is a complex and lengthy legal document stating the conditions under which a bond has been issued.

  1. sinking fund
  2. bond indenture
  3. bond debenture
  4. warrant

 

4.2. Corporate bonds which feature stock purchase warrants have

  1. lower coupon interest rates because bondholders have the option to purchase more bonds at a specified price for a specified time.
  2. higher coupon interest rates because bondholders have the option to purchase more bonds at a specified price for a specified time.
  3. lower coupon interest rates because bondholders have the option to purchase shares of stock at a specified price for a specified time.
  4. higher coupon interest rates because bondholders have the option to purchase shares of stock at a specified price for a specified time.

 

4.3. Which of the following best describes a junk bond?

  1. The stated interest rate is adjusted periodically and they tend to sell at or close to par value.
  2. Short maturities, usually 1 to 5 years, they can be renewed for similar periods at the option of the holder.
  3. Debt rated BB or lower, they are high-risk bonds with high yields.
  4. Bonds that can be redeemed for par at the option of their holder at specific dates after issue.

 

4.4. Preferred stockholders

  1. are senior to bondholders.
  2. are senior to common stockholders.
  3. receive interest payments.
  4. generally have “super” voting rights.

 

  1. Time Value of Money
  • How to determine the future value of an investment made today.
  • How to determine the present value of cash to be received at a future date.
  • How to find the return on an investment.
  • How to determine the number of time periods.
  • How to determine the future and present value of investments with multiple cash flows.
  • Annuity and perpetuity

·         Future Value and Compounding A future value (FV) is the amount of money an investment today (present value, or PV) will grow to over some period of time (n) at some given interest rate (k). The fundamental future value equation for multiple time periods is: FV = PV(1 + k)n, where n represents the number of time periods.

·         Present Value and Discounting. The fundamental present value equation for multiple time periods is: PV = FV[1/(1 + k)n].

·         Determining the Discount Rate. The basic PV equation contains four variables: present value (PV), future value (FV), discount rate (k), and the number of time periods (n). Given any three of these, we can always solve for the fourth. The implied interest rate in an investment is k= (FV / PV)1/n – 1, or

·         Finding the Number of Periods. Finding the number of periods is simply solving the basic PV or FV equation for n.

·         Future and Present Values of Multiple Cash Flows

    • Future Value with Multiple Cash Flows The future value of a set of cash flows is equal to the sum of the future values of the individual flows.
    • Present Value with Multiple Cash Flows Similarly, the present value of a set of cash flows is equal to the sum of the present values of the individual flows.
    • A Note on Cash Flow Timing In solving time value problems, it is important to specify when each cash flow occurs: at the beginning each period, or at the end. Unless told otherwise, we generally assume cash flows occur at the end of each period.
  • Valuing Level Cash Flows: Annuities and Perpetuities

o   Present Value for Annuity Cash Flows. The fundamental present value equation for an ordinary annuity is: Annuity Present Value = C (1 – 1/(1 + k)n)/k

o   Future Value for Annuities. The fundamental future value equation for an ordinary annuity is: Annuity Future Value = C [(1 + k)n – 1]/k.

o   A Note on Annuities Due. When payments occur at the beginning of each time period, we have an annuity due.

o   Perpetuities. A perpetuity is an annuity where t is equal to infinity. Thepresent value of a perpetuity is C/k.

  • APR vs. EAR
    • APR refers to Annual Percentage Rate
    • EAR stands for Effective Annual Rate
    • EAR=(1+APR/m)^m-1
  • Loan Amortization
    • Pure Discount Loan:  repay a single lump sum in the future
    • Interest Only Loan: pay interest each period and repay the entire principal in the future
    • Amortized Loan: repay parts of the loan amount over time

Valuation of Stocks and Bonds

  1. Bonds and Bond Valuation
    1. Bond Features and Prices A bond is a form of interest-only loan; the loan principal is called the face or par value, and the periodic interest payments are called coupons. The coupon rate is the coupon amount divided by the par value. The number of years until the face value is paid is the bond’s maturity.
    2. Bond Values and Yields The market value of a bond is equal to the present value of all of the promised payments discounted at the bond’s yield to maturity (YTM). The YTM, in turn is the market’s required rate of return on the bond.
    3. Bond prices and market interest rates move in opposite directions.
    • When coupon rate = YTM, price = par value.(“selling at par”)
    • When coupon rate > YTM, price > par value (premium bond, or “selling at a premium”)
    • When coupon rate < YTM, price < par value (discount bond, or “selling at a discount”)

 

  1. Common Stock Valuation
    1. Cash Flows The market value of a share of common stock is equal to the present value of all of its future dividend cash flows, D, discounted at the appropriate discount rate, R.
    2. Some Special Cases
      1. Zero Growth If the future cash flows, D, are not expected to change, then the present value, P0 equals D/ks.
      2. Constant Growth If the future cash flows are expected to change at a constant rate, g, then P0 equals D1/( ks – g).

Sample questions

 

  • The future value technique uses ___________ to find the future value, and the present value technique uses ______________ to find the present value.
  1. a) compounding; discounting
  2. b) compounding; compounding
  3. c) discounting; discounting
  4. d) discounting; compounding

 

  • How much money will Elian have in three years if he places $1500 into a CD earning an annual interest rate of 6.5% compounded annually?
  1. $1597.50
  2. $1695.00
  3. $1792.50
  4. $1811.92

 

  • William has a choice of investing $2,500 for 5 years in CD #1 that pays 6% compounded annually or a CD #2 that pays 6.5% simple interest annually (meaning it does not pay interest on the interest). What will be the value of each investment at the end of five years?
  1. #1, $3,250.00; #2, $3,312.50
  2. #1, $3,250.00; #2, $3,425.22
  3. #1, $3,345.56; #2, $3,312.50
  4. #1, $3,345.56; #2, $3,425.22

 

5.4. An annuity stream of cash flow payments is a set of:

a)      level cash flows occurring each time period for a fixed length of time.

b)      level cash flows occurring each time period forever.

c)      increasing cash flows occurring each time period for a fixed length of time.

d)     increasing cash flows occurring each time period forever.

5.5. A 9 percent preferred stock pays an annual dividend of $4.50. What is one share of this stock worth today?

  1. a) $4.50
  2. b) $5.00
  3. c) $45.00
  4. d) $50.00

 

  1. Risk and Return

I.                   Fundamental Concepts about Return and Risk

 

  1. Return is defined as:

 

B.     Risk is the chance that the actual return will differ from what is expected.

 

  1. Measuring the Risk of a Single Asset

  1. Probability distribution
  2. Standard Deviation and Coefficient of Variation

 

 

Expected rate of return:

 

 

Coefficient of variation:

 

 

III.             Return and Risk of a Portfolio

 

  1. Portfolio return is the weighted average of the returns of each asset in the portfolio.
  2. Portfolio risk depends not only on the risk of each asset in the portfolio but also on the correlation between each asset.
  • Positively correlated, meaning they each move in the same direction
  • Negatively correlated, meaning them move in opposite directions
  • Uncorrelated, meaning there is no relationship between them

 

  1. The risk of a portfolio may be reduced through diversification.

 

  1. Risk and return: Beta and the Capital Asset Pricing Model (CAPM)
  • Overall risk of a security consists:
    • Nondiversifiable risk (systematic risk or market risk) is measured by the beta coefficient, which is a relative measure of the relationship between an asset’s return and the market return
    • Diversifiable risk (unystematic risk)
  • CAPM: Kj=RF+bj*(km-RF)
  • Security Market Line (SML): The required returns on all stocks are graphed against their corresponding betas.

 

Sample Questions

 

6.1. Last year Mike bought 100 shares of Dallas Corporation common stock for $53 per share. During the year, he received dividends of $1.45 per share. The stock is currently selling for $60 per share. What rate of return did Mike earn over the year?

  1. 11.7 percent
  2. 13.2 percent
  3. 14.1 percent
  4. 15.9 percent

 

6.2. Which of the following is true regarding the beta coefficient?

  1. It is a measure of unsystematic risk
  2. A beta greater than one represents lower systematic risk than the market.
  3. Generally speaking, the higher the beta the higher the expected return.
  4. A beta of one indicates an asset is totally risk-free.

7. Accounting Basics; Financial Statement Analysis

       I.            The Balance Sheet

    1. Assets: The Left-Hand Side
      • The balance sheet is a snapshot of a firm’s accounting value as of a particular date. Assets are listed on the left-hand side, and liabilities and owners’ equity on the right-hand side.
      • Assets are things the firm owns – cash, marketable securities, machinery, etc. Assets can be tangible (e.g., machinery) or intangible (e.g., prepaid rent).
    2. Liabilities and Owners’ Equity
      • Liabilities are amounts owed by the firm to others – notes payable, long-term debt, etc.
      • Owners’ equity (sometimes called “shareholders’ equity”) is the difference between total assets and total liabilities.
      • The Balance Sheet Equation: Total Assets = Total Liabilities + Owners’ Equity
    3. Net Working Capital
      • Net working capital is the difference between the firm’s current assets and current liabilities.
      • Net working capital can be positive or negative, but is usually positive in a healthy firm, since a positive value indicates that more liquid assets are available than short-term liabilities are due over the next year.
    4. Liquidity
      • The liquidity of an asset is measured by the speed with which it can be converted into cash without significant loss in value. There is a tradeoff between liquidity and foregone potential returns.
    5. Market Value versus Book Value
      • The balance sheet values of a firm’s assets (book values) generally do reflect the historical cost of an asset.
      • The current worth of an asset is its market value. Market value is the relevant value for financial decisions, because it is the market value of the firm that is reflected in share prices.
  1. The Income Statement
    1. The income statement measures the firm’s performance over a specified period of time.
      • The income statement equation is: Revenues – expenses = net income.
      • Net income divided by the number of shares outstanding is earnings per share (EPS).
    2. GAAP and the Income Statement
      • Generally Accepted Accounting Principles (GAAP) require that revenue be recorded on the income statement when earned, or accrued, even if the actual cash inflow from payment has not occurred.
      • Costs on the income statement are determined according to the matching principle; that is, costs are matched with the revenues they produce.
    3. Noncash items such as depreciation are reflected in expenses that are booked but for which no cash is actually paid out. This generally causes accounting income and cash flow to differ.
    4. Taxes

Average vs. Marginal Tax Rates (An average tax rate is equal to total taxes paid divided by total taxable income; A marginal tax rate is the tax rate applied to the next dollar earned. The firm’s marginal tax rate is generally the relevant rate for financial decision-making.)

  1. Standardized Financial Statements The values in common-size statements are standardized in order to facilitate comparison to common benchmarks.
    1. Common-Size Balance Sheets are prepared by presenting all statement values as a percentage of total assets .
    2. Common-Size Income Statements are prepared by presenting all statement values as a percentage of sales.
  2. Ratio Analysis
    1. Short-Term Solvency, or Liquidity, Ratios measure the firm’s ability to meet short-term obligations.
      • Current Ratio = Current Assets/Current Liabilities
      • Quick Ratio = (Current Assets – Inventory)/Current Liabilities
      • Cash Ratio = Cash/Current Liabilities
    2. Long-Term Solvency Measures gauge the extent to which a firm uses debt financing rather than equity financing.
      • Total Debt Ratio = (Total Assets – Total Equity)/Total Assets
      • Times Interest Earned = EBIT/Interest
      • Cash Coverage = (EBIT + Depreciation)/Interest
    3. Asset Management, or activity, Measures indicate how effectively the firm’s managers use the assets under their control. Generally, higher turnover measures suggest greater efficiency.
      • Inventory Turnover = Cost of Goods Sold/Inventory
      • Days’ Sales in Inventory = 365/Inventory Turnover
      • Receivables Turnover = Sales/Accounts Receivable
      • Days’ Sales in Receivables (Average Collection Period) = 365/Receivables Turnover
      • Total Asset Turnover = Sales/Total Assets
    4. Profitability Ratios measure management’s ability to control expenses and, as a result, generate income from sales, from the firm’s asset base, or from the funds supplied by equityholders.
      • Net Profit Margin = Net Income/Sales
      • Return on Assets = Net Income/Total Assets
      • Return on Equity = Net Income/Total Equity
    5. Market Value Measures integrate market-based values with accounting values and, as a result, bring us closer to the measurement of the effects of managerial decisions on shareholder wealth.
      • Price-Earnings Ratio = Price per Share/Earnings per Share
      • Market-to-Book Ratio = Market Value per Share/Book Value per Share
  3. The Du Pont Identity is a means of decomposing ROE into its component parts. It suggests that ROE is a function of those decisions which impact profitability, asset utilization, and financial leverage. The Du Pont identity is computed as follows: (Net Income/Sales) (Sales/Assets) (Assets/Total Equity).
  4. Using Financial Statement Information
    1. Why Evaluate Financial Statements? Financial statement analysis is crucial to an understanding of firm performance, both in terms of what the firm has done in the past, and what the firm is likely to do in the future.
      • Internal Uses of financial statement analysis include: evaluation of managerial performance via the evaluation of the effects of management decisions on firm variables (e.g., profitability, sales growth), and planning for the future.
      • External Uses of financial statement analysis include analyses performed by creditors and potential investors, evaluation of competitor firms, and performance assessment for the purpose of acquiring another firm.
    2. Choosing a Benchmark
      • Time-Trend Analysis is the comparison of current data with historical data. That is, past performance is the relevant benchmark.
      • Peer Group Analysis involves comparison to firms that are similar to the firm being evaluated. In other words, the benchmark is the subject firm’s peer group.
    3. Problems with Financial Statement Analysis arise because there are no clear or universally accepted guidelines regarding the determination of optimal values for the ratios discussed above. Other potential difficulties that may arise in financial statement analysis include: (1) identification of comparable peer groups; (2) differences in accounting procedures; (3) differences in fiscal years for financial statements; and, (4) unusual events which have an impact on reported financial results. These problems, as well as differences in interpretation of the date, frequently result in differing opinions about a firm’s future performance.

Sample Questions

7.1. Cash and equivalents are $1,561; short-term investments are $1,052; accounts receivables are $3,616; accounts payable are $5,173; short-term debt is $288; inventories are $1,816; other current liabilities are $1,401; and other current assets are $707. What is the amount of total current liabilities?

  1. $8,752
  2. $6,974
  3. $6,862
  4. $6,574
7.2. CatchaTan Co. had net sales of $750,000 over the past year. During that time, average receivables were $150,000. Assuming a 365-day year, what was the average collection period?
       a. 5 days
       b. 36 days
       c. 48 days

       d. 73 days

 

  1. Capital Budgeting Basics

 

Decision Rules

 

  • Calculate, interpret, and evaluate the payback period.
  • Apply net present value (NPV) and internal rate of return (IRR) to relevant cash flows to choose acceptable capital expenditures.
  • Use net present value profiles to compare NPV and IRR techniques in light of conflicting rankings.

 

Estimating Incremental Cash Flows

 

  • Understand basic capital budgeting terminology.
    • Independent vs. Mutually Exclusive Projects
    • Unlimited Funds vs. Capital Rationing
    • Conventional vs. Nonconventional Cash Flow Patterns
    • Incremental cash flow
  • Determine relevant cash inflows using the income statement format (Free Cash Flow=EBIT(1-tax rate)+depreciation-change in net working capital-net capital spending

 

Sample Questions

8.1. Consider the following four-year project. The initial after-tax outlay or after-tax cost is $1,000,000. The future after-tax cash inflows for years one, two, three, and four are $400,000, $300,000, $200,000, and $200,000, respectively. What is the payback period without discounting cash flows?

 

a.       2.5 years

b.      3.0 years

c.       3.5 years

d.      4.0 years

 

8.2. Dweller Inc. is considering a four-year project that has an initial after-tax outlay or after-tax cost of $80,000. The future after-tax cash inflows from its project are $40,000, $40,000, $30,000, and $30,000 for years one, two, three, and four, respectively. Dweller uses the NPV method and has a discount rate of 12%. Will Dweller accept the project?

 

a.                                                                                                                               Dweller accepts the project because the NPV is greater than $30,000

b.                                                                                                                              Dweller rejects the project because the NPV is less than -$4,000

c.                                                                                                                               Dweller rejects he project because the NPV is -$3,021

d.                                                                                                                              Dweller accepts the project because the NPV is greater than $28,000