Finance final

.pdf

School

West Virginia University *

*We aren’t endorsed by this school

Course

340

Subject

Finance

Date

May 24, 2024

Type

pdf

Pages

Uploaded by DoctorWater38292

Info Technics Inc. has total assets equal to $1,000,000. Its total current liabilities equal $200,000 and it has no short- term debt. The firm's total equity equals $500,000. What is the firm's total debt to total capital ratio? 0.3750 Total Current Liabilities 200,000 Total Assets 1,000,000 Total Equity - 500,000 Total Current Liabilities 200,000 Long-term debt + 300,000 Total Capital 800,000 Total Liabilities and equity 1,000,000 (D/C) ratio = 300,000 / 800,000 Calculate the times-interest-earned ratio = 5.00 Gross Profit 566 Selling expenses 175 General and administrative expenses 216 Earnings before interests and taxes (EBIT) 175 Interest Expense 35 TIE ratio = EBIT / Interest 175 / 35 Info Technics Inc. has total assets equal to $1,000,000. Its total current liabilities equal $200,000 and it has no short- term debt. The firm's total equity equals $500,000. What is the firm's equity multiplier? 2.00 Equity Multiplier = Total Assets / Equity 1,000,000 / 500,000 Brookman Inc.'s latest EPS was $2.75, its book value per share was $22.75, it had 315,000 shares outstanding, and its debt/total invested capital ratio was 44%. The firm finances using only debt and common equity and its total assets equal total invested capital. How much debt was outstanding? 5,630,625 EPS 2.75 Shares Outstanding 315,000 BVPS 22.75 Debt to total capital ratio 44.0% Total Equity = shares outstanding x BVPS = 7,166,250 Total Assets = Total Equity / (1 - Debt to Capital ratio) = 12,796,875 Total debt = Total Assets - Equity = 5,630,625 A firm has total interest charges of $20,000 per year, sales of $2 million, a tax rate of 25%, and a profit margin of 6%. What is the firm's times-interest-earned ratio? 9 Net Income 2,000,000 (0.06) = 120,000 Earnings before taxes = 120,000 / (1 - 0.25) = 160,000 EBIT = 160,000 + 20,000 = 180,000 TIE = EBIT / Interest = 180,000 / 20,000 A fire has destroyed many of the financial records at Anderson Associates. You are assigned to piece together information to prepare a financial report. Anderson has no preferred stock, its total current liabilities equal $250,000, and its total assets equal $2,500,000. The firm has no short-term debt. What is the firm's total debt to total capital ratio if its ROE is 15%, its ROA is 10%, and its total current liabilities and total assets remain constant? 25.9% Equity Multiplier = ROE / ROA = 0.15 / 0.10 = 1.5 Actual / Expected = 1.5 2,500,000 / E = 1.5 E = 1,666,667 LTD = 2,500,000 - 1,666,667 - 250,000 = 583,333 Total Debt to Capital Ratio = Debt / Debt + Equity = Debt / Capital 583,333 / (583,333 + 1,666,667) Calculate the market value ratios, that is, the price/earnings ratio and the market/book value ratio. Roberts had an average of 10,000 shares outstanding during 2021, and the stock price on December 31, 2021, was $40.00. EPS = Net Income / Number of shares outstanding = 105,000 / 10,000 = 10.5 Price / Earnings = Price per share / Earnings per share = 40 / 10.5 = 3.81 Book Value per share = Common Equity / Shares Outstanding 1,105,000 / 10,000 Market / Book Value = Market Price / Book Value = 40 / 110.5 = 0.36 Chang Corp. has $375,000 of assets, and it uses only common equity capital (zero debt). Its sales for the last year were $595,000, and its net income was $25,000. Stockholders recently voted in a new management team that has promised to lower costs and get the return on equity up to 15.0%. What profit margin would the firm need in order to achieve the 15% ROE, holding everything else constant? Return on equity = Net income / Equity 25,000 / 375,000 = 6.667% 15% = Net Income / 375,000 15%* 375,000 Net Income = 56,250 Profit Margin = Net income / Sales 56,250 / 595,000 = 9.45% A fire has destroyed many of the financial records at Anderson Associates. You are assigned to piece together information to prepare a financial report. You have found that the firm's return on equity is 12% and its equity multiplier is 1.6667. Anderson has no preferred stock. What is its return on assets? Return on equity = 12% Equity Multiplier = 1.6667 ROE = ROA x Equity Multiplier ROA = ROE / Equity Multiplier ROA = 7.198 % ROA = 12% / 1.6667 Calculate the profitability ratios, that is, the operating margin, the profit margin, return on total assets, return on common equity, return on invested capital, and basic earning power of assets. (Numbers are in Millions) Net Income = 105 Sales = 2,400 Total Assets = 2,270 EBIT = 175 Common Equity = 1,105 Taxes = 25% Debt = (Current liabilities + Long term debt) - (Accounts payable + Accruals) 845 = (745 + 420) - (205 + 115) Operating Margin = EBIT / Sales = 175 / 2,400 Profit Margin = Net income / Sales = 105 / 2,400 ROA = Net Income / Total Assets = 105 / 2,270 ROE = Net Income / Common Equity = 105 / 1105 ROIC = EBIT ( 1 - T) / Debt + Equity = (175 ( 1 - 0.25) ) / (845 + 1,105) BEP = EBIT / Total Assets = 175 / 2,270 Cutler Enterprises has current assets equal to $4.5 million. The company's current ratio is 1.25. What is the firm's level of current liabilities (in millions)? Current Assets = 4.5 million Current Ratio = CA / CL = 1.25 4.5 / CL = 1.25 1.25 (CL) = 4.5 CL = 3.6 Calculate the Current Ratio Current Assets = 1,070 Current Liabilities = 745 CA / CL = 1,070 / 745 Lewis Inc. has sales of $2 million per year, all of which are credit sales. Its sales outstanding is 42 days. What is its average accounts receivable balance? Assume a 365-day year. DSO = Accounts Receivables / (Sales / 365) 42 days = AR / (2 million / 365) Jericho Motors has $4 billion in total assets. The other side of its balance sheet consists of $0.4 billion in current liabilities, $1.2 billion in long-term debt, and $2.4 billion in common equity. The company has 500 million shares of common stock outstanding, and its stock price is $25 per share. What is Jericho's market-to-book ratio? TA = 4 billion CL = 400 million LT debt = 1.2 billion CE = 2.4 billion Shares Outstanding= 500 million Price per share = 25 Book Value = 2.4 billion / 500 million = 4.80 M/B = 25 / 4.8 = 5.208 Use the DuPont equation to determine Roberts' return on equity. NI / Sales x Sales / TA x TA / Common Equity ROE = Profit margin × Total assets turnover × Equity multiplier = $105 / $2,400 × 2,400 / $2,270 × $2,270 / $1,105 = 0.04375 × 1.0573 × 2.0543 = 0.0950 Rowe and Company have an equity multiplier equal to 2.0, a total assets turnover of 0.25, and a profit margin of 10%. Rowe has no preferred stock. The president is unhappy with the current return on equity, and he thinks it could be doubled. This could be accomplished (1) by increasing the profit margin to 14% and (2) by increasing debt utilization. Total assets turnover will not change. The firm's total assets equal $10 million, its total current liabilities are $400,000, and the firm has no short-term debt or preferred stock. What is the firm's total debt to total capital ratio if the ROE is doubled under these assumptions? Total Debt to Capital Ratio = Debt / Debt + Equity ROE = PM x TAT x EM Before = 10% x 0.25 x 2.00 = 5.00% After 5.00% x 2 = 10.00% = 14% x 0.25 x EM = EM = 2.8571 = 10 / (14 x .25) Assets / Equity = 2.8571 10 million / Equity = 2.8571 = Equity = 3.5 million Debt = 10 million - 400 k - 3.5 million = 6.1 million Total debt to capital ratio = 6. 1 million / 9.6 = 0.6354 Southeast Jewelers Inc. sells only on credit. Its days sales outstanding is 73 days, and its average accounts receivable balance is $500,000. What are its sales for the year? Assume a 365-day year. DSO = Accounts receivable / (Sales / 365) 73 days = $500,000 / (Sales / 365) 73 (Sales / 365) = $500,000 Sales = (500,000 *73) / 365 Sales = $2,500,000 Calculate the asset management ratios, that is, the inventory turnover ratio, fixed assets turnover, total assets turnover, and days sales outstanding. Assume a 365-day year. COGS = 1,834 Inventory = 625 Sales = 2,400 Net Fixed Assets = 1,200 TA = 2,270 AR = 245 Inventory Turnover = COGS / Inventory = 1,834 / 625 Fixed assets turnover = Sales / Net Fixed Costs = 2,400 / 1,200 Total assets turnover = Sales / Total Assets = 2,400 / 2,270 DSO = AR / (Sales / 365) = 245 / (2,400 / 365) A firm has total interest charges of $20,000 per year, sales of $2 million, a tax rate of 25%, and a profit margin of 6%. What is the firm's TIE, if its profit margin decreases to 3% and its interest charges double to $40,000 per year? Net income = $2,000,000(0.03) = $60,000 Earnings before taxes = $60,000/(1 – 0.25) = $80,000 EBIT = $80,000 + $40,000 = $120,000 TIE = EBIT/Interest = $120,000/$40,000 = 3.0× EBIT (Operating Income) = Sales - Operations costs excluding depreciation - depreciation Net operating working capital = Current assets − (Current liabilities − Notes payable) Scranton Shipyards has $20 million in total invested operating capital, and its WACC is 10%. Scranton has the following income statement: Sales 10 million - Operating Costs 6 million = EBIT 4 million Taxes = 40% EVA = EBIT (1 - T) - (WACC x Total Invested Capital) EVA = 4 million (1 - .40) - (.10 x 20 million) GPD Corporation has operating income (EBIT) of $300,000, total assets of $1,500,000, and its capital structure consists of 40% debt and 60% common equity. Total assets equal total invested capital. The firm's after-tax cost of capital is 10.5% and its tax rate is 40%. The firm has 50,000 shares of common stock currently outstanding and the current price of a share of common stock is $27.00. What is the firm's Economic Value Added (EVA)? EVA = EBIT (1 – T) – (Total invested capital)(After-tax percentage cost of capital) EVA = 300,000(0.6) - (1,500,000) (0.105) GPD Corporation has operating income (EBIT) of $300,000, total assets of $1,500,000, and its capital structure consists of 40% debt and 60% common equity. Total assets equal total invested capital. The firm's after-tax cost of capital is 10.5% and its tax rate is 40%. The firm has 50,000 shares of common stock currently outstanding and the current price of a share of common stock is $27.00. What is the firm's Market Value Added (MVA)? MVA = Shares Outstanding (Price) - (common equity) (total assets) 50,000 (27.00) - (0.6) (1,500,000) You want to quit your job and return to school for an MBA degree 3 years from now, and you plan to save $7,000 per year, beginning immediately. You will make 3 deposits in an account that pays 5.2% interest. Under these assumptions, how much will you have 3 years from today? PV = 7000 i=5.2% FV= PV (1+i) ^ n 7000 (1+0.052) ^ 1 + 7000 (1+0.052) ^ 2 + 7000 (1+0.052) ^ 3 A company is offering bonds that pay $100 per year indefinitely. If you require a 12% return on these bonds — that is, the discount rate is 12% — what is the value of each bond? 100 / 0.12 How much would $5,000 due in 25 years be worth today if the discount rate were 5.5%? PV = FV / (1 + i) ^ n PV = 5,000 / (1.055) ^ 25 Given the following information, determine the net present value, internal rate of return, and the modified internal rate of return if the cost of capital and reinvestment rate is 5. The NPV, IRR, and MIRR, respectively, are: Period Cash flow NPV – 131605.66 0 -200,000 IRR – 29.08% 1 50,000 MIRR – 24.28% 2 75,000 3 250,000 NPV = (interest rate, initial payment (0), Cash flows (L1)) Notes: Cash flows go on stat – edit, all except 0 because is the initial payment. Initial payment is always negative. IRR = (initial payment (0), Cash Flows (L1) MIRR = ((CF1) * (1 + r) ^ x) + (CF2) * (1 + r) ^ x) + CF3 = FV of cash inflows MIRR = ((FV of cash inflows) / (initial payment)) ^ (1/x) – 1 O'Brien Inc. has the following data: rRF = 5.00%; RPM = 6.00%; and b = 1.05. What is the firm's cost of equity from retained earnings based on the CAPM? rRF=5.00% RPM = 6.00% b=1.05 rs= rRF + b(RPM) You inherited $100,000 that was deposited into a trust account on your 15th birthday that earns interest at a fixed rate of return of 3 percent, compounded monthly. The trust agreement specified that you would not have access to the money until you are 40 years old. The amount that will be available for withdrawal from the account on your 40th birthday is closest to: ((Find FV) N and I should be on the same compounding basis / Use TVM solver N= (40-15) 12 = 300 I = 3/12 = .25 PV = -100,000 Solve FV = 211,502 What is the present value of a security that will pay $29,000 in 20 years if securities of equal risk pay 5% annually? (Finding PV) TVM : N=20 I= 5 FV= 29,000 solve for PV = 10,929.80 Your parents will retire in 19 years. They currently have $350,000 saved, and they think they will need $800,000 at retirement. What annual interest rate must they earn to reach their goal, assuming they don’t save any additional funds? (Finding I) TVM: N=19 PV= -350,000 PMT=0 FV= 800,000 Solve for I = 4.45% You have $33,556.25 in a brokerage account, and you plan to deposit an additional $5,000 at the end of every future year until your account totals $220,000. You expect to earn 12% annually on the account. How many years will it take to reach your goal? USE TVM (Finding N) I= 12 PV= -33,556.25 PMT= -5000 FV= 220,000 Solve for N=11 yrs Leo wants to begin saving $1,000 each year, starting three years from now, for five years. The present value of those savings right now if the discount rate is 5 percent is closest to (Finding PV with Discount Rate) Use PV = ⅀ PMT/(1+i)^t PMT=1000 i= .05 t= starting at the end of yr 3 counting forward 5 yrs (1000/ (1.05)^3) + (1000/(1.05)^4) + (1000/(1.05)^5) + (1000/(1.05)^6 )+ (1000/(1.05)^7) = 3,927 What’s the future value of a 5%, 5 -year ordinary annuity that pays $800 each year? If this was an annuity due, what would its future value be? Use TVM: N= 5 I= 5 PV=0 PMT=-800 solve for FV= 4,421 To get annuity due change PMT setting to BEGIN instead of END Solve for FV= 4,642 ( DON'T FORGET TO SWITCH BACK TO END) You want to buy a car, and a local bank will lend you $40,000. The loan will be fully amortized over 5 years (60 months), and the nominal interest rate will be 8% with interest paid monthly. What will be the monthly loan payment? What will be the loan’s EA R? (Finding PMT and EAR) TVM: N= 60 I=8/12 PV= -40,000 FV=0 solve for PMT= $811.06 To find EAR use: EAR=(1+APR/m) ^m- -1 = 1+(.08/12))^12 -1 = 8.30% You can use EFF on calc too since you have APR EFF (8,12) Tresnan Brothers is expected to pay a $1.80 per share dividend at the end of the year (i.e., ). The dividend is expected to grow at a constant rate of 4% a year. The required rate of return on the stock is 10%. What is the stock’s current value per share? Value of a stock = D1/ (rs-g) = 1.80/ (0.10-0.04) = $30 Model Products, Inc. just paid $3.00 to their shareholders as the annual dividend. In the same press release, the company announced that future dividends will be increasing by 4 percent per year. If you require a 12 percent rate of return, the value of a share of Model Products stock is closest to: P0 = D0 * (1 + g) / (R - g) = 3 * (1 + 4%) / (12% - 4%) = 39 Holtzman Clothiers’ stock currently sells for $38.00 a share. It just paid a dividend of $2.00 a share (i.e., ). The dividend is expected to grow at a constant rate of 5% a year. What stock price is expected 1 year from now? What is the required rate of return? P1= P0(1 + g) = $38(1.05) = $39.90 rs=(D1/P0)+g=2(1.05)/38+0.05=10.53% The Yellen Corporation issued a bond with a $1,000 par value and a coupon rate of 5 percent. If the bond has 30 years remaining and the yield to maturity is 8 percent, the bond’s value is closest to:( bond pays semi -annual coupon) N=30*2=60 I=8/2=4 PMT=(.05*1000)/2=25 FV=1000 solve for PV=661 An investor invests $20,000 today for a four-year term and receives 9 percent annual compound interest. The interest-on-interest (i.e. compound interest) the investor earns during the four years is closest to: TVM: N=4 I=9 PV=-20000 Solve for FV=28,232 TIE= FV-PV = 28232-20000= 8232 Simple interest = principal*rate*time = 20000*.09*4=7200 Interest on interest=TIE-simple interest= 8232-7200=1032 ← ANS Taurus bonds have a bond price of $925. These bonds mature in five years, have a coupon rate of 10 percent (paid semi-annually), and have a face value of $1,000. The yield to maturity on these bonds is closest to: N= 10 PV= -925 PMT=(.10*1000)/2=50 FV=1000 solve I=6.02 x 2 = 12.04% Consider an investment of $1,000 whose value grows at 2 percent in the first year, 10 percent in the second year, 15 percent in the third year, and 3 percent in the fourth year. The value of the investment at the end of the fourth year is closest to: Value of investment = Initial value * (1 + Growth rate in year 1) * (1 + Growth rate in year 2) * (1 + Growth rate in year 3) * (1 + Growth rate in year 4) $1,000 * (1 + 4%) * (1 + 7%) * (1 + 9%) * (1 + 4%)= $1,261.47 When evaluating your portfolio at year end, you notice that the mutual fund you bought a year ago for $10 is now trading for $13. The mutual fund has recently paid a $2.00 dividend. Your total return is closest to: Total Return = (Ending Value – Beginning Value + Dividends or Interest) /Beginning Value * 100= ((13- 10+2)/10)*100=50% Nesmith Corporation’s outstanding bonds have a $1,000 par value, an 8% semiannual coupon, 14 years to maturity, and an 11% YTM. What is the bond’s price? N=14*2=28 = 11/2=5.5 PMT=(.08*1000)/2=40 FV =1000 solve for PV=$788.18 Madison Products, Inc. is estimating its weighted average cost of capital. The company has collected the following information: target capital structure :30 percent debt (Wd) and 70 percent common equity. (Wc) The company can issue new long-term debt at par with a yield to maturity of 8 percent ( Rd). The company’s marginal tax rate is 35 percent(t). The risk-free rate is 3 percent. The market risk premium is 6 percent. The stock’s beta is 1.4 Its weighted average cost of capital is closest to: Find Rs = rRF + Bs (rM-rRF) rRF=risk -free rate Bs=Beta rM=market return rM-rRF)=risk premium Rs=.03+1.4(.06)=0.114 WACC=(.30)(.08)(1-.35) + (.70)(0.114)= Torch Industries can issue perpetual preferred stock at a price of $57.00 a share. The stock would pay a constant annual dividend of $6.00 a share. What is the company’s cost of preferred stock, ? Rp=Dp/Pp=6.00/57.00=10.53% Pearson Motors has a target capital structure of 30% debt and 70% common equity, with no preferred stock. The yield to maturity on the company’s outstanding bonds is 9%, and its tax rate is 25%. Pearson’s CFO estimates that the company’s WACC is 10.50%. What is Pearson’s cost of common equity? WACC = (wd )(rd )(1 – T) + (wc )(rs ) 0.1050 = (0.3) (0.09)(1 – 0.25) + (0.7)rs= Rs= 12.11% Hairston Industries has $5 million of debt and $20 million of equity. If Hairston's beta is currently 1.75 and its tax rate is 40%, what is its unlevered beta, bU? bU = bL /[1 + (1 – T)(D/E)] = unlevered beta bU= 1.75/(1+(1-.40)(5/20))=1.52 Consider the following probability distribution of possible returns to a project: Probability Return Expected Return Variance 5% -6% .05 x -.06 ((-0.06-SUM)^2) x 0.05 10% -2% .10 x -.02 ((-0.02-SUM)^2) x 0.10 60% 3% .60 x .03 ((0.03-SUM)^2) x 0.60 25% 8%. .25 x .08 ((0.08-SUM)^2) x 0.25 = SUM =sum The standard deviation of this distribution is closest to: SD=SQRT (sum) Company XYZ is considering investing in a new project that requires an initial outlay of $100,000. The project is expected to generate revenues of $50,000 in the first year, with an annual increase of 10% thereafter. Operating expenses are estimated to be $20,000 in the first year, increasing by 5% annually. Depreciation expense is $10,000 per year. The tax rate is 30%. Calculate the operating cash flows for each year of the project. Calculate Earnings Before Interest and Taxes (EBIT): EBIT = Revenues - Operating Expenses - Depreciation Calculate Taxes: Taxes = EBIT * Tax Rate Calculate Operating Cash Flow (OCF): OCF = EBIT - Taxes + Depreciation Let's calculate the operating cash flows for each year of the project: Year 1: Revenues = $50,000 Operating Expenses = $20,000 Depreciation = $10,000 EBIT = $50,000 - $20,000 - $10,000 = $20,000 Taxes = $20,000 * 0.30 = $6,000 OCF = $20,000 - $6,000 + $10,000 = $24,000 Year 2 and onwards: Revenues increase by 10% annually. Operating Expenses increase by 5% annually. Revenues Year 2 = $50,000 * 1.10 = $55,000 Operating Expenses Year 2 = $20,000 * 1.05 = $21,000 EBIT Year 2 = $55,000 - $21,000 - $10,000 = $24,000 Taxes Year 2 = $24,000 * 0.30 = $7,200 OCF Year 2 = $24,000 - $7,200 + $10,000 = $26,800 You can continue this calculation for subsequent years with the revenue and operating expense increases. So, the operating cash flows for each year of the project are: Year 1: $24,000 Year 2: $26,800 Year 3: (Calculate using the same method) Year 4: (Calculate using the same method) Pluto Manufacturing, Inc., bought equipment costing $100,000 four years ago. The equipment is classified as a 5-year MACRS asset. If the equipment was just sold for $20,000 and the tax rate is 40%, the amount of tax that Pluto must pay on the sale is closest to: Book value= (purchase price) (1 – sum of MACR rates from beginning to current date)= (100000)(1- (.2+.32+.192+.1152))=17280 tax paid = (selling price*tax rate) -(book value*tax rate)= 20000*0.4-17280*0.4=1088 Terms An Analyst is examining a company’s’ financial statements to evaluate whether the company is managing its expenses well. The analyst will most likely focus on which of the following ratios? Net Profit Margin Which of the following is true regarding when the yield to maturity on a bond is greater than its coupon rate? The bond will trade at a discount to face value If the discount rate for both projects is 10 percent, the decision should be to reject both projects In the dividend discount valuation model, which of the following is correct? The growth rate of dividends must be less than the required rate of return Which of the following is not a true statement? A C corporation cannot issue additional shares of equity following its initial public offering. The primary goal of a publicly owned firm is best described as the: A maximization of stock price. The board of directors of a publicly traded company represents the company’s: shareholders In the agency relationship between the company’s management and the owners, the company’s owners are the agents, and the managers are the principals. A corporation is a form of business That is separate and distinct from its owners and management. The intrinsic value of a stock is the: estimate of a stock’s true value, based on risk, and return information about the corporation. The DuPont system includes the breakdown of the return on equity into asset management, profitability, and financial leverage ratios.

The quick ratio is a liquidity ratio, and the total asset turnover is an asset management ratio. If the yield to maturity on a bond remains constant, a premium bond’s value will decrease as it approaches maturity. If the risk associated with a stock increase, yet the stock’s current dividend and expected growth rate remain unchanged, the value of the stock will most likely : Decrease In general, as market interest rates decrease, bond prices are most likely to decrease Risk that can be diversified away is best described as: unsystematic risk Diversification is least effective when the returns on assets in a portfolio are perfectly positively correlated with each other. Using the net present value method, the intermediate cash flows are reinvested at the: project’s cost of capital. Sunk costs include any cost that: has previously been incurred and cannot be changed. The internal rate of return for a project will increase if: the initial cost of the project can be reduced. Which of the following statements is incorrect ? The cost of retained earnings is zero. If a company estimates its weighted average cost of capital and then uses that same cost of capital to evaluate all projects, the company will most likely : accept too many high-risk projects and too few low-risk projects. The primary financial goal of financial management is to maximize the market value of owners’ equity. Characteristics of a corporation include limited no operating control Which business form must pay income taxes on earnings at the business level and then owners pay income taxes on the same earnings when the business earnings are distributed? C corporation Dividends are determined by the corporation’s board of directors. Investors’ capital is best characterized as the sum of the market value of debt and the market value of equity= The rate of tax on the next dollar earned is best described as the marginal tax rate. The cash conversion cycle is the days sales outstanding, plus the days in inventory, less the days payable outstanding. Which financial statement reports a company’s capital expenditures during a particular time? Statement of Cash Flows Which of the following will decrease shareholders’ equity on a corporation’s balance sheet? The payment of dividends As a company loosens its credit standards, the investment in accounts receivable is expected to increase. A plastics manufacturing company has decided to decrease inventory turnover from 10 times to 4 times per year. Assuming a constant sales level, which statement is true? The chance for spoilage will increase. Which of the following is a true statement? A bond’s price converges to its face value as it approaches maturity The net present value investment decision criteria typically assumes that cash flows are reinvested at the project’s cost of capital. A decrease in a project’s cost of capital tends to cause which of the following to increase? Net present value When evaluating mutually exclusive projects, the recommended method of evaluation is the: Net present value. The CEO said, “Mr. Sewat, since you have spent $6,000 in the past on research and development for this project, I must say you are making a mistake not to include it as a negative cash flow for the project.” Apparently, the CEO does not understand the concept of sunk costs. Which of the following statements is correct? When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are tax deductible. As a rule, at the optimal capital structure the: weighted average cost of capital is minimized. Which of the following would most likely increase the risk to the bondholder? Inclusion of a call provision Bond ratings reflect which of the following? Default risk Which form of efficient market asserts that asset prices fully reflect all information, which includes both public and private information? Strong-form efficient Joe Analyst believes that he can predict the market by trading based on how announced earnings differ from the expected earnings of a company. Joe is counting on the market not being semi-strong efficient The risk that diminishes as a portfolio of assets becomes more diversified is best described as: unsystematic risk. Annual Report: A document issued by a company each year that outlines the company's financial performance and activities throughout the year. It includes the income statement, balance sheet, and cash flow statement. - Balance Sheet: A financial statement that shows a company's assets, liabilities, and owner's equity at a given point in time. - Income Statement: A financial statement that shows a company's revenues, expenses, and net income over a period of time. Common stockholders' equity or net worth: The net balance of a company's assets minus its liabilities, representing the ownership interest of its common stockholders. It is also referred to as shareholders' equity or net worth. - Retained earnings: Earnings that are not paid out to shareholders as dividends, but are instead reinvested in the company. Statement of stockholders' equity: A financial statement that shows the changes in a company's ownership interest over a specified period of time. - Statement of cash flows: A financial statement that shows the sources and uses of a company's cash over a period of time. Depreciation: An accounting method used to allocate the cost of an asset over its expected lifetime. - Amortization: A method of spreading the cost of an intangible asset, such as a patent, over its expected lifetime. - EBITDA: It stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It is a measure of a company's financial performance that eliminates the effect of financing and accounting decisions. It is often used as a measure of a company's operating profitability and cash flow. Operating current assets: Assets that are used to generate revenue and are expected to be converted into cash within one year. Examples include accounts receivable, inventories, and prepaid expenses. - Operating current liabilities: Liabilities that are related to a company's operations and are expected to be paid off within one year. Examples include accounts payable and accrued expenses. - Net operating working capital: The difference between a company's operating current assets and its operating current liabilities. - Total net operating capital: The sum of a company's operating current assets and its long-term assets, minus its operating current liabilities and its long-term liabilities. Accounting Profit: The amount of income a company earns before taxes and other non-cash expenses, such as depreciation and amortization. - Net cash flow: The amount of cash generated by a company's operations, after accounting for all cash outflows, such as taxes and capital expenditures. - NOPAT: Net operating profit after tax, or the amount of income a company earns after subtracting taxes and non-cash expenses. - Free Cash Flow: The amount of cash available to a company after accounting for all cash outflows, such as capital expenditures and dividends. - Return on Invested Capital: A measure of a company's financial performance, calculated by dividing its net operating profit after tax (NOPAT) by its total investment capital. Market Value Added: The difference between the market value of a company and the total amount of capital invested in the company. - Economic Value Added: The difference between the net operating profit after tax (NOPAT) and the cost of the capital invested in the company. Progressive Tax: A type of tax system where the tax rate increases as the taxpayer's income increases. - Taxable Income: The amount of income subject to taxation. - Marginal and Average Tax Rates: The marginal tax rate is the rate of tax applied to each additional dollar of income; the average tax rate is the total amount of tax paid divided by the total income. Capital Gain or Loss: The gain or loss on the sale of a capital asset, such as stocks or real estate. - Tax Loss Carry-back and Carry-forward: Tax losses that can be carried back to a prior tax year and deducted from taxes due, or carried forward to a future tax year and deducted from taxes due. Improper Accumulation: The accumulation of income or assets beyond the level required to cover reasonable expenses. - S Corporation: A type of corporation that is exempt from federal income tax, but must pay out all profits to its shareholders. a). Liquidity ratios: As the name suggests, liquidity ratios are the metrics that is used to know whether a firm will be able to meet its debt obligations from its current assets or not, as and when it will become due. (i). Current ratio: It is one of the measure of liquidity of the firm, which is used to measure a firms short-term obligations. Formula to calculate current ratio = Current assets / current liabilities (ii). Quick ratio or Acid test ratio: It is also one of the meausre to liquidity, which is used to measure a firms ability to meet its current obligations from its most liquid assets( the asset which can be quickly converted into cash). Formula : (Cash & cash equivalent + marketable securities + Accounts receivables) / current liabilities (b). Asset management ratios: Asset management ratio is a measure of how efficiently and effectively a management is using its assets to generate ravenues for the firm. It is also known as asset efficiency ratio. (i). Inventory turnover ratio: It a measure to know how many times a firm has sold or replaced the inventory for a given period. This ratio is used to see whether a company has excessive inventory in comparison with its sales. Formula: COGS(cost of goods sold) / Average inventory (ii). Days sales outstanding: It is a measure a firm uses to know the average number of days it is taking to collect payment after a sale has been made. It is also used to know the size of the outstanding account receivable in average number of days. Formula: Total accounts receivables / net credit sales (iii). Fixed asset turnover ratios: It is a measure which tells how a company is using its fixed assets to generate sales. Formula: Net sales for the given period / Net fixed assets (iv). Total asset turnover ratio: it is a ratio used to measure how efficiently a firm is using its total assets to generate sales. Formula: Net sales / Total assets (c). Financial leverage ratio: It is a ratio which measures an overall debt burden of a company and compare it with the assets or equity. (i). Debt ratio: It is a ratio which meausres the extent of a companmy's assets that are financed by debts. Formula: Total Debt / Total Assets (ii). Times interest earned : It is a ratio which measures the ability of a company to meet its obligations based on its current income. Formula: EBIT (Earnings before interest & taxes) / Total interest payable on debts. (iii). EBITDA coverage ratio: It is a ratio to measure a firms ability to pay off its debt obligations using its EBITDA. Formula: EBITDA + Lease payments(if any) / Debt payments (d). Profitability ratios: It ia ratio which measure a firms ability to generate earnings with relative to its revenue. (i). Profit margin on sales: It is a ratio which measures the amount of net income earned from each dollar of sales. It is also known as return on sales ratio. Formula: Gross profit / Revenue (ii). Basic earning power (BEP): It is a measure which calculates basic earnings of the company before the effect of income taxes and leverage. Formula: EBIT / Total assets (iii). Return on Total assets ( ROA) : It is one of the profitability ratio which measures how efficiently a firm uses its total assets to generate earnings for the company. Formula: Operating profit (EBIT) / Total assets (iv). Return on common equity : It is a profitability ratio which measures the amount of profit or net income a investors are getting from their investment in equity. Formula: Net income / Average common equity PV (Present Value): The current worth of a sum of money to be received or paid in the future, discounted back to its value at present. I (Interest Rate): The percentage rate used to determine the interest earned or paid on an investment or loan. INT (Interest): The amount of money earned or paid for the use of funds, calculated as a percentage of the principal amount. FVN (Future Value): The projected value of a sum of money invested or saved, taking into account interest or other potential earnings. PVAN (Present Value of an Annuity): The present value of a series of equal payments to be made or received at regular intervals, discounted to their current value. FVAN (Future Value of an Annuity): The future value of a series of equal payments to be made or received at regular intervals, taking into account interest or other potential earnings. PMT (Payment): The regular, equal cash flow made or received at fixed intervals in an annuity or loan. N (Number of Periods): The total number of periods, usually expressed in years, months, or other units, over which an investment or loan is calculated. INom (Nominal Interest Rate): The stated annual interest rate, typically not adjusted for compounding. b. Opportunity Cost Rate: The rate of return that could have been earned on an investment's next best alternative use. It represents the cost of forgoing an alternative investment when a decision is made to allocate resources elsewhere. Definitions related to Cash Flows: Annuity: A series of equal payments made or received at regular intervals over time. Lump-sum Payment: A single, one-time payment of a sum of money. Cash Flow: The movement of money into or out of a business, investment, or individual's finances. Uneven Cash Flow Stream: A series of cash flows that vary in amount and timing. Types of Annuities: Ordinary (or Deferred) Annuity: Payments occur at the end of each period. Annuity Due: Payments occur at the beginning of each period. Perpetuity: Explanation: An infinite series of cash flows that continue indefinitely, with no end date. It is often used in the context of investments or financial instruments that promise perpetual payments. f. Definitions related to Time Value of Money: Outflow: A cash flow representing an expense or payment. Inflow: A cash flow representing income or money received. Time Line: A visual representation of cash flows over time. Terminal Value: The value of an investment or project at the end of its forecasted period. g. Compounding and Discounting: Compounding: The process of calculating the future value of an investment by adding earned interest to the principal, allowing it to earn more interest over time. Discounting: The process of calculating the present value of a future sum of money by reducing it to its current value. Compounding Frequencies: Different intervals at which interest is added to the principal, including annual, semiannual, quarterly, monthly, and daily compounding. Interest Rate Terminology: Effective Annual Rate (EAR or EFF%) : The annual interest rate that takes into account compounding and reflects the true cost or return on an investment. Nominal (Quoted) Interest Rate: The stated interest rate before considering compounding. APR (Annual Percentage Rate): The annualized cost of borrowing or the annual return on investment, including fees and other costs. Periodic Rate: The interest rate applied for each compounding period. Amortization Related Terms: Amortization Schedule: A table or plan that outlines the periodic payments of an amortizing loan, showing the breakdown of principal and interest for each payment. Principal versus Interest Component: In an amortizing loan payment, the principal component reduces the outstanding loan balance, while the interest component is the cost of borrowing. Amortized Loan: A loan that is repaid in equal installments, typically including both principal and interest, over a specified period. Bond : A bond is a fixed-income security that represents a loan made by an investor to a borrower, typically a corporation or government. The bond obligates the issuer to repay the principal amount at a specified future date and make periodic interest payments to the bondholder. Treasury Bond : A Treasury bond is a debt security issued by the U.S. Department of the Treasury. These are considered among the safest investments because they are backed by the full faith and credit of the U.S. government. Corporate Bond : A corporate bond is a debt security issued by a corporation to raise capital. Investors who buy corporate bonds are essentially lending money to the corporation and receive interest payments in return. Municipal Bond : A municipal bond is a debt security issued by a state, municipality, or county government to finance public infrastructure projects. Interest income from municipal bonds is often exempt from federal income tax. Foreign Bond : A foreign bond is a bond issued by a foreign entity, such as a foreign government or corporation, in a currency other than the investor's home currency. These bonds can carry currency exchange rate risk. Par Value : The par value, also known as face value, is the nominal or principal amount of a bond that is paid to the bondholder at maturity. Maturity Date : The maturity date is the date on which a bond becomes due and the issuer is required to repay the par value to the bondholder. It marks the end of the bond's term. Coupon Payment : A coupon payment is the periodic interest payment made by the issuer to the bondholder. The coupon rate determines the amount of interest paid. Coupon Interest Rate : The coupon interest rate is the fixed annual interest rate expressed as a percentage of the bond's par value. It is also known as the nominal yield or stated yield. Floating-Rate Bond : A floating-rate bond is a bond with an interest rate that is periodically adjusted based on a reference interest rate, often a benchmark like the LIBOR or a government bond rate. Zero Coupon Bond : A zero coupon bond is a bond that does not make periodic interest payments. Instead, it is issued at a discount to its face value and matures at par value, with the difference representing the interest income. Original Issue Discount Bond (OID) : An OID bond is issued at a discount to its face value and matures at par. The difference between the purchase price and par value is considered interest income. Call Provision : A call provision allows the issuer to redeem or call the bond before its maturity date, typically at a specified call price. This feature gives the issuer the option to retire the debt early. Redeemable Bond : A redeemable bond is a bond that can be redeemed by the issuer at maturity or through a call provision. Sinking Fund : A sinking fund is a mechanism that requires the issuer to set aside money periodically to retire a portion of the bond issue. It helps ensure that the issuer has funds available to repay the bondholders at maturity. Convertible Bond : A convertible bond is a hybrid security that allows the bondholder to convert the bond into a predetermined number of the issuer's common stock shares. Warrant : A warrant is a financial instrument that gives the holder the right, but not the obligation, to buy shares of a company's stock at a specified price for a predetermined period. Income Bond : An income bond is a type of bond that pays interest only when the issuer has sufficient earnings. It does not guarantee regular interest payments. Indexed Bond (Purchasing Power Bond) : An indexed bond is designed to protect bondholders from the eroding effects of inflation by adjusting the bond's principal or interest payments based on an inflation index. Premium Bond : A premium bond is a bond that is trading in the secondary market at a price higher than its par value. Discount Bond : A discount bond is a bond trading at a price below its par value in the secondary market. Current Yield (on a Bond) : The current yield is the annual interest income a bond provides relative to its current market price. It is calculated by dividing the bond's annual interest payment by its market price. Yield to Maturity (YTM) : YTM is the total return anticipated on a bond if it is held until it matures. It takes into account the bond's current market price, par value, time to maturity, and coupon interest rate. Yield to Call (YTC) : YTC is the total return expected if a callable bond is held until it can be called by the issuer. It considers the bond's current market price, call price, time to call, and coupon interest rate. Indentures : Indentures are legal documents that outline the terms and conditions of a bond issue. They specify details such as interest rate, maturity date, call provisions, and covenants. Mortgage Bond : A mortgage bond is a bond secured by a specific property or asset, such as real estate. If the issuer defaults, bondholders have a claim on the underlying collateral. Debenture : A debenture is an unsecured bond, meaning it is not backed by specific collateral. Debentures rely on the general creditworthiness of the issuer. Subordinated Debenture : A subordinated debenture is a type of bond that has a lower claim on assets in case of issuer bankruptcy compared to other debt obligations. Development Bond : A development bond is typically issued by a government to fund specific development projects or initiatives. Municipal Bond Insurance : Municipal bond insurance is a form of credit enhancement provided by insurers to guarantee the repayment of principal and interest on municipal bonds. Junk Bond : Junk bonds, also known as high- yield bonds, are bonds with lower credit ratings and higher risk of default. They offer higher yields to compensate for the increased risk. Investment-Grade Bond : An investment-grade bond is a bond with a higher credit rating and lower risk of default. These bonds are considered safer investments. Real Risk-Free Rate of Interest (r) : The real risk-free rate of interest is the theoretical interest rate that would exist in an economy with no inflation and no risk. It serves as a baseline for determining nominal interest rates. Nominal Risk-Free Rate of Interest (rRF) : The nominal risk-free rate of interest is the actual risk-free rate of interest observed in the market, which includes inflation and various risk factors. Inflation Premium (IP) : The inflation premium is the component of a nominal interest rate that compensates investors for the expected loss of purchasing power due to inflation. Default Risk Premium (DRP) : The default risk premium is an additional yield required by investors to compensate for the risk of default by the bond issuer. Liquidity : Liquidity refers to the ease with which an asset, in this case, a bond, can be bought or sold in the market without significantly affecting its price. Liquidity Premium : The liquidity premium is an additional return demanded by investors for investing in less liquid bonds that may be harder to sell in the market. production opportunities - The investment opportunities in productive (cash-generating) assets. time preferences for consumption - the preferences of consumers for current consumption as opposed to saving for future consumption risk - the chance that an investment will provide a low or negative return inflation - amount by which prices increase over time r - nominal rate r* - real, risk-free rate: rate of interest that would exist on default free US Treasury securities if no inflation were expected nominal/quoted risk-free rate - rate of interest on a security that is free of all risk; r RF is proxied by the T-bill or the T-bond rate; r RF includes an inflation premium IP - inflation premium: premium equal to expected inflation that investors add to the real risk-free rate of return DRP - default risk premium: difference between the interest rate on a US Treasury bond and a corporate bond of equal maturity and marketability LP - liquidity premium: a premium added to the equilibrium interest rate on a security cannot be converted to cash on short notice and at close to its "fair market value" interest rate risk - risk of capital losses to which investors are exposed because of changing interest rates MRP - maturity risk premium: premium that reflects interest rate risk reinvestment rate risk - risk that a decline in interest rates will lead to lower income when bonds mature and funds are reinvested term structure of interest rates - relationship between bond yields and maturities yield curve - graph showing the relationship between bond yields and maturities "normal" yield curve - upward-sloping yield curve inverted or "abnormal" yield curve - downward-sloping yield curve humped yield curve - A yield curve where interest rates on intermediate-term maturities are higher than rates on both short- and long-term maturities. corporate bond yield spread - Cbond yield - Tbond yield pure expectations theory - the shape of the yield curve depends on investors' expectations about future interest rates foreign trade deficit - situation that exists when a country imports more than it exports Stand alone risk - security held in isolation and not with other securities Portfolio risk - combining risks in a portfolio; hopefully reduce total risk Tbills will return the promised ____ regardless of economy; still have a little risk - 3% High tech - moves with the economy, and has a positive correlation (typical) Collections - is countercyclical with the economy, and has a negative correlation (unusual) Diversifiable risk - can be diversified away and it this of little concern to diversified investors Market risk - reflects the risk of a general stock market decline and cannot be eliminated by diversification (does not concern investors); measured by beta Stand alone risk = - market risk + diversifiable risk Investors are generally _______, so they will not buy risky assets unless are compensated with high expected returns - averse to risk Risk - The chance that some unfavorable event will occur. Probability distributions - Listings of possible outcomes or events with a probability (chance of occurrence) assigned to each outcome. Expected rate of return (r^ "r hat")- The rate of return expected to be realized from an investment; the weighted average of the probability distribution of possible results. Expected rate of return = - (expected ending value - cost) / cost The tighter (or more peaked) the probability distributions, the more likely the actual outcome will .... - be close to the expected value and, consequently, the less likely the actual return will end up far below the expected return Standard deviation (o "sigma") - A statistical measure of the variability of a set of observations; used to quantify the tightness of the probability distribution; Measures total or stand-alone risk; Average of 35% for an average stock The smaller the standard deviation, the tighter... - the probability distribution and, accordingly, the lower the risk Coefficient of variation (CV) - The standardized measure of the risk per unit of return; calculated as the standard deviation divided by the expected return. Sharpe ratio - A measure of standalone risk that compares the asset's realized excess return to its standard deviation over a specified period. An investment with a higher ratio has performed better than one with a lower ratio. Risk aversion - dislike risk and require higher rates of return as an inducement to buy riskier securities Other things held constant, the higher a security's risk... - the higher its required return, and if this situation does not hold, prices will change to bring about the required condition. Risk premium (RP) - The difference between the expected rate of return on a given risky asset and that on a less risky asset. Serves as compensation for investors to hold riskier securities Capital asset pricing model (CAPM) - A model based on the proposition that any stock's required rate of return is equal to the risk-free rate of return plus a risk premium that reflects only the risk remaining after diversification. Security Market Line (SML) - states that a stock's required return equals the risk-free return plus a risk premium that reflects the stock's risk after diversification Expected return on a portfolio (r^p) - The weighted average of the expected returns on the assets held in the portfolio. Realized rates of return (r- "r bar")- Returns that were actually earned during some past period. Actual returns r- usually turn out to be different from expected returns r^ except for riskless assets. The portfolio's risk is generally _____ than the average of the stocks' σ because diversification lowers the portfolio's risk - smaller Correlation - The tendency of two variables to move together Correlation coefficient (p "rho") - A measure of the degree of relationship between two variables. As a rule, on average, portfolio risk --- as the number of stocks in a portfolio increases.- declines Diversifiable risk - That part of a security's risk associated with random events; it can be eliminated by proper diversification. This risk is also known as company specific, or unsystematic, risk. Market risk - The risk that remains in a portfolio after diversification has eliminated all company-specific risk. This risk is also known as no diversifiable or systematic or beta risk. Market portfolio - A portfolio consisting of all stocks. Relevant risk - The risk that remains once a stock is in a diversified portfolio is its contribution to the portfolio's market risk. It is measured by the extent to which the stock moves up or down with the market. Beta coefficient (b) - A metric that shows the extent to which a given stock's returns move up and down with the stock market. Beta measures market risk. If beta = 1, the security is - just as risky as the average stock If beta > 1, the security is - riskier than average If beta < 1, the security is - less risky than average Average stock's beta - By definition, bA=1 because an average-risk stock is one that tends to move up and down in step with the general market. Market risk premium (RPM) - The additional return over the risk-free rate needed to compensate investors for assuming an average amount of risk. Security market line (SML) equation - An equation that shows the relationship between risk as measured by beta and the required rates of return on individual securities; SML shows the required returns for a given level of risk If inflation increases, SML will... - shift upward but remain parallel If MRP increases, slope... - gets steeper for SML but not for RF 2 perfectly negatively correlated stocks - zero risk 2 perfectly positively correlated stocks - no risk reduction; do not want this Partial correlation (typical)- by combining, risk will be less than risk of either security held separately Standard deviation- as stocks are added- decreases if a firms is borrowing money then it is using financial leverage - Capital budgeting analysis should only include those cash flows that will be affected by the decision. Sunk costs are unrecoverable and cannot be changed, so they have no bearing on the capital budgeting decision. Opportunity costs represent the cash flows the firm gives up by investing in this project rather than its next best alternative, and externalities are the cash flows (both positive and negative) to other projects that result from the firm undertaking this project. These cash flows occur only because the firm took on the capital budgeting project; therefore, they must be included in the analysis. - Increase in the dividend rate of new preferred shares will have no effect on the firms cost of common equity -The greater the current dividend yield , holding the growth rate constant, the greater the cost of equity -The cost of internal equity is lower than the cost of external equity because there are no issue costs involved with the use of retained earnings as there are with the issue of new common stock -Companies tax rate increases then all else equal its WACC will decline -Cost of preferred stock = (percent * value of preferred stock) / price of preferred stock -Dividend = % of preferred stock outstanding * 100

Your preview ends here

Eager to read complete document? Join bartleby learn and gain access to the full version

Access to all documents
Unlimited textbook solutions
24/7 expert homework help