BEC – Financing Options
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Which one of the following statements concerning the relationship between the concepts and measurement of capital structure and financial structure of a firm is correct? A. Capital structure and financial structure are the same concepts and measurements. B. The concept and measurement of capital structure includes the concept and measurement of financial structure. C. The concept and measurement of financial structure includes the concept and measurement of capital structure. D. The concept and measurement of capital structure are not related to the concept and measurement of financial structure.
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C, correct The financial structure of a firm includes all items of liabilities and equity used to finance the firm's assets. From an accounting perspective, financial structure includes all the accounts shown on the right-hand side of the balance sheet and is measured as the sum of all liabilities and shareholders' equity, which is an amount equal to total assets. *******IMPORTANT********The capital structure of a firm includes only long-term liabilities and shareholders' equity. Capital structure, unlike financial structure, does not include current (or short-term) liabilities, including such items as accounts payable, wages and salaries payable, short-term notes, etc. Thus, financial structure includes capital structure, plus current liabilities.*********
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The term "financial structure" refers to which one of the following? A. All debt. B. All equity. C. All debt and equity. D. All long-term debt and equity.
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C, correct
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Which one of the following most likely would not be considered when computing the weighted average cost of capital? A. Short-term debt. B. Long-term debt. C. Common stock. D. Preferred stock.
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A, correct Short-term debt likely would not be considered when computing the weighted average cost of capital. Short-term debt is not considered part of the capital structure of an entity.
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The term "capital structure" refers to which one of the following? A. All debt. B. All equity. C. All debt and equity. D. All long-term debt and equity.
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D, correct Capital structure includes all long-term debt and all owners' equity. It does not include short-term debt.
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Which of the following statements concerning short-term financing is/are correct? I. Accounts payable can provide short-term financing. II. Accounts receivable can provide short-term financing. III. Inventory can provide short-term financing. A. I only. B. I and II, only. C. I and III, only. D. I, II, and III.
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D, correct All three statements are correct. Accounts payable, accounts receivable, and inventory all can provide short-term financing.
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Which one of the following generally is not an advantage associated with the use of trade accounts payable and accrued accounts payable for short-term financing needs? A. Flexibility. B. Ease of use. C. Available for all short-term needs. D. Absence of collateral required.
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C, correct Trade and accrued accounts payable are not available for financing all short-term needs. They can be used only for financing costs/expenses acquired through trade and accrual accounts. For example, they could not be used to finance short-term cash borrowings. A short-term note (or other source) would be used to meet short-term cash needs.
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Alpha Company borrowed $20,000 from High Bank, giving a one-year note. The terms of the note provided for 6% interest and required a 10% compensating balance. Which one of the following is the effective rate of interest on the loan? A. 4.0% B. 6.0% C. 6.7% D. 10.0%
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C, correct The effective rate of interest on the loan is 6.7% and is computed as the net proceeds from the loan divided into the cost of the loan. The cost of the loan is $1,200 ($20,000 x .06 = $1,200) and the net proceeds is $18,000 ($20,000 - [.10 x $20,000] = $18,000; the remaining $2,000 must be maintained as a compensating balance. Thus, the effective interest is: $1,200/$18,000 = 6.666%.
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On January 23, Inco Company received from one of its suppliers a statement with terms of "2/10, n/30." Because the statement was misfiled, it was not located for payment until February 5. On which one of the following dates should the bill be paid? A. February 5. B. February 6. C. February 22. D. February 28.
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C, correct Since the date for taking the discount has passed, there is no financial benefit from paying the statement until the final due date, February 22. Payment on that date would assure no penalty for late payment.
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Which one of the following provides a source of spontaneous financing for a firm? A. Accounts receivable. B. Accounts payable. C. Bonds. D. Common stock.
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B, correct Accounts payable are a source of spontaneous financing. Spontaneous financing occurs when credit is provided in the course of day-to-day operations; In general, the level of financing goes up concurrent with the purchase of goods or services or the carrying out of other day-to-day activities.
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Which one of the following forms of short-term financing is least likely to be considered a spontaneous source of funding? A. Short-term notes payable. B. Accrued taxes payable. C. Accrued salaries payable. D. Trade accounts payable.
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A, Correct! Spontaneous financing occurs automatically in the carrying out of day-to-day operations. Financing through the use of short-term notes payable does not occur automatically as a result of carrying out day-to-day operations, but rather requires negotiation with a lending institution, usually a commercial bank, and the execution of a promissory note. The other forms of payable occur spontaneously as a result of normal business operations.
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An amount that a bank requires a firm to maintain in a demand deposit account with the bank in return for a line of credit or loan is called: A. Commercial paper. B. Compensating balance. C. Bankers' acceptance. D. Secured loan.
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B, correct. Banks sometimes require (or expect) that a firm maintain a balance in a demand deposit account with the bank, in return for a line of credit or a loan (or for other services) provided by the bank. These balances are called compensating balances -- they serve as part of the compensation received by the bank for its services. The balance required (or expected) is often expressed as a percentage of the line of credit or loan balance, but also may be expressed as an absolute minimum amount. The cost associated with maintaining the balance increases the cost of related bank services to the extent that the required compensating balance exceeds an amount that otherwise would be maintained.
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Which one of the following would an importer of goods from a new foreign supplier most likely use to assure the supplier of payment? A. Line of credit. B. Letter of credit. C. Trade account application. D. Commercial paper.
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B, correct A letter of credit would be used to assure a foreign supplier of payment. A letter of credit is a conditional commitment to pay a third party in accordance with specified terms.
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Which one of the following typically is not a characteristic of commercial paper? A. Matures in the short-term. B. Loans are secured. C. Users have high credit ratings. D. Provide cash for operating use.
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B, correct Commercial paper is short-term unsecured promissory notes. Typically, use of commercial paper does not involve security from the borrower.
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Nexco, Inc. is considering factoring its accounts receivable. Factorco, Inc. has offered the following terms for accounts receivable due in 30 days: Value of receivables to be held in reserve for contingencies 10% Following costs are deducted at time accounts are factored: Interest rate on amounts provided (annual rate) 12% Factor fee on total receivables factored 2% If Nexco plans to factor $200,000 of accounts receivable due in 30 days, which one of the following is the amount it will receive from Factorco at the time the accounts are factored? A. $154,880 B. $174,240 C. $176,000 D. $196,000
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B, correct The amount provided would be $200,000 accounts receivable - $20,000 reserve - $4,000 factor fee = $176,000, for which interest would be charged for 30 days, or 1% (i.e., 1/12 of 12%). Therefore, the correct amount received would be $176,000 - ($176,000 x .01) = $176,000 - $1,760 = $174,240.
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Po Co. plans to use its inventory as collateral for a short-term loan. Which one of the following types of loan agreements with its lender would provide Po Co. the most flexibility in the use of the inventory it pledges as collateral? A. Field warehouse agreement. B. Floating lien agreement. C. Chattel mortgage agreement. D. Terminal warehouse agreement.
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B, correct Under a floating lien agreement the borrower gives the lender a lien against its inventory, but retains control of the inventory and can continuously sell and replace the inventory.
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Nexco, Inc. is considering factoring its accounts receivable. Factorco, Inc. has offered the following terms for accounts receivable due in 30 days: Value of receivables to be held in reserve for contingencies 10% Following costs are deducted at time accounts are factored: Interest rate on amounts provided 12% Factor fee on total receivables factored 2% If Nexco factors $200,000 of its accounts receivable due in 30 days with Factorco and, during that 30 days, $10,000 of those accounts receivable are reversed because the related goods were return or allowances were granted, which one of the following is the amount that Nexco will receive from Factorco at the end of the 30 day period? A. $ -0- (no amount) B. $ 9,800 C. $10,000 D. $19,600
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C, correct The amount held in reserve was .10 x $200,000, or $20,000. During the 30-day period of the factor agreement, $10,000 of the accounts receivable factored had to be reversed because of sales returns and allowances. Therefore, at the end of the 30-day period, Factorco would pay Nexco the remaining $10,000 ($20,000 reserve - $10,000 reversed = $10,000).
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Which one of the following forms of collateral is most commonly used as security for short-term loans? A. Inventory. B. Property, plant, and equipment. C. Real estate. D. Investments.
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A, correct
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Factoring accounts receivable without recourse transfers risk of uncollectibility to the buyer. True False
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True
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Which of the following statements concerning long-term financing is/are correct? I. Long-term financing consists of sources that constitute capital structure. II. Long-term financing consists of sources on which the weighted-average cost of capital is based. III. Long-term financing consists only of equity sources of capital. A. I only. B. I and II, only. C. I and III, only. D. I, II, and III.
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B, correct Statements I and II are correct; Statement III is not correct. Long-term financing consists of sources that constitute capital structure (as opposed to financial structure). These are the sources of financing that are used to calculate the weighted-average cost of capital (Statements I and II, respectively). Statement III is not correct because long-term financing includes long-term debt, as well as equity.
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Which one of the following would not be considered a means of long-term financing? A. Financial lease. B. Common stock. C. Trade accounts payable. D. Bonds payable.
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C, correct Note: Common Stock IS long-term The use of trade accounts payable (a current liability) is a means of short-term financing, not long-term financing.
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Operating leases are a form of long-term financing. True False
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False
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Under which of the following described lease terms would the lessee be responsible during the term of the lease for executory costs associated with the leased asset? Net Lease Net-Net Lease Yes Yes ----correct Yes No No Yes No No
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Under a net lease, the lessee assumes the executory costs associated with the asset during the lease, including such elements as maintenance, taxes and insurance. In a net-net lease, the lessee assumes responsibility for the executory costs during the life of the lease, as well as for a residual value at the end of the lease.
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Financial leverage derives from the use of debt with a fixed or determinable cost (rate of interest) for capital financing. Therefore, financial leverage would be possible with either fixed rate or variable rate debt (notes); however, fixed rate debt would better facilitate financial leverage because the cost of the use of debt-financed capital would not change over the life of the financing. The cost of variable rate debt can change, thereby making the degree of leverage more uncertain over the life of the debt.What would be the primary reason for a company to agree to a debt covenant limiting the percentage of its long-term debt? A. To cause the price of the company's stock to rise. B. To lower the company's credit rating. C. To reduce the risk of existing debt holders. D. To reduce the interest rate on the debt being issued.
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D, correct The primary reason for a company to agree to a debt covenant limiting the percentage of its long-term debt would be to reduce the risk, and therefore the interest rate, on debt being issued. Debt covenants place contractual limitations on activities of the borrower to help protect the lender. As such, they reduce the default risk associated with a debt issue and, therefore, reduce the interest rate on that debt.
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*******The market price of a bond issued at a premium is equal to the present value of its principal amount A. Only, at the stated interest rate. B. And the present value of all future interest payments, at the stated interest rate. C. Only, at the market (effective) interest rate. D. And the present value of all future interest payments, at the market (effective) interest rate.
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D, correct-----YOU MUST KNOW THIS!!!! SO FUNDAMENTAL!!! The market price of a bond, whether issued at par, at a premium, or at a discount, will be the present value of the principal amount plus the present value of future interest payments, all at the (***IMPORTANT***)))market (effective) rate of interest.
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Which one of the following bond issues, with different terms and stated rates of interest, would have the highest interest rate risk, all other things being equal? A. 10-year, 4% bonds. B. 10-year, 6% bonds. C. 30-year, 4% bonds. D. 20-year, 4% bonds.
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C, correct This issue has the longest maturity (with the lowest stated interest rate). Therefore, it will have the highest interest rate risk.
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Allen issues $100 par value preferred stock that is selling for $101 per share, on which the firm has to pay an underwriting fee of $5 per share sold. The stock is paying an annual dividend of $10 per share. Allen's tax rate is 40%. Which one of the following is the cost of preferred stock financing to Allen? A. 4.2% B. 6.2% C. 9.9% D. 10.4%
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D, correct The correct calculation is the annual dividend divided by the net proceeds of the stock issuance. Therefore, the calculation would be $10 annual dividend/$101 selling price - $5 underwriter's fee = $96 proceeds, or $10/$96 = 10.4%
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A company recently issued 9% preferred stock. The preferred stock sold for $40 a share, with a par of $20. The cost of issuing the stock was $5 a share. What is the company's cost of preferred stock? A. 4.5% B. 5.1% C. 9.0% D.10.3%
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B, correct The current cost of capital for newly issued preferred stock is computed as the net proceeds per share divided into the annual cost (dividends) of the newly issued shares. In this question, the net proceeds per share is given as $40 sales price less $5 per share issue cost, or $35 per share net proceeds. The annual cost of the newly issued shares is the par value, $20, multiplied by the preferred dividend rate, 9%, or $20 x .09 = $1.80 annual dividend per share. Therefore, the cost of capital for the newly issued preferred stock is $1.80/$35.00 = 5.1%.
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Which of the following statements concerning preferred stock is/are generally correct? I. Requires dividends be paid. II. Grants ownership interest. III. Grants voting rights. A. I only. B. II only. C. I and II only. D. I, II and III
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B, correct Preferred stock, like common stock, conveys an ownership interest in the entity. Preferred stock does not require the payment of dividends nor does it normally convey voting rights.
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Whipco has determined that its pre-tax cost of preferred stock is 12%. If its tax rate is 30%, which one of the following is its after-tax cost of preferred stock? A. 15.6% B. 12.0% C. 8.4% D. 3.6%
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B, correct Since dividends on preferred stock are not tax deductible, no adjustment to the pre-tax cost needs to be made. Therefore, the after-tax cost of preferred stock is the same as the pre-tax cost, 12%.
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Which of the following formulas should be used to calculate the historic economic rate of return on common stock? A. (Dividends + change in price) divided by beginning price. B. (Net income - preferred dividend) divided by common shares outstanding. C. Market price per share divided by earnings per share. D. Dividends per share divided by market price per share.
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A, correct For common stock, expected returns are from dividends and stock price appreciation. Thus, the rate of return on the common stock would be (dividends paid during the period + change in the stock price)/price of the stock at beginning of the period.
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The stock of Fargo Co. is selling for $85. The next annual dividend is expected to be $4.25 and is expected to grow at a rate of 7%. The corporate tax rate is 30%. What percentage represents the firm's cost of common equity? A. 12.0% B. 8.4% C. 7.0% D. 5.0%
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A, correct The firm's cost of common equity is the rate of return currently expected by potential investors in the firm's common stock. When it is assumed that the dividends are expected to grow at a constant rate, that rate of return is calculated as: Common Stock Expected Return (CSER) = (Dividend in 1st Year/Market Price) + Growth Rate Using the values given: CSER = ($4.25/$85.00) + .07 CSER = .05 + .07 = .12 (or 12%) The CSER of 12% is the cost of capital through common stock financing.
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Why would a firm generally choose to finance temporary assets with short-term debt? A. Matching the maturities of assets and liabilities reduces risk. B. Short-term interest rates have traditionally been more stable than long-term interest rates. C. A firm that borrows heavily long-term is more apt to be unable to repay the debt than a firm that borrows heavily short-term. D. Financing requirements remain constant.
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A, correct The hedging principle of financing (also called the principle of self-liquidating debt) holds that long-term or permanent investments in assets should be financed with long-term or permanent sources of capital and short-term needs should be financed with short-term sources of financing. Thus, long-term assets (e.g., property, plant, and equipment, among others) and permanent amounts of current assets (e.g., level of accounts receivable and inventory generally on-hand) should be financed with long-term debt or equity. Conversely, temporary investments in assets (e.g., a temporary increase in inventory to meet seasonal demand) should be financed with temporary sources of financing. The objective of this principle is to match cash flows from assets with the cash requirements need to satisfy the related financing.
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The optimal capitalization for an organization usually can be determined by the A. Maximum degree of financial leverage. B. Maximum degree of total leverage. C. Lowest total weighted-average cost of capital. D. Intersection of the marginal cost of capital and the marginal efficiency of investment.
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C, correct The optimal capitalization for an organization would be determined by the lowest total weighted-average cost of capital. The weighted-average cost of capital determines the average cost of a corporation's capital by weighting each component, both debt and equity. The lowest total weighted-average cost of capital usually would be the optimal capitalization and would maximize the value of the firm's stock.
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Which one of the following sources of new capital usually has the lowest after-tax cost? A. Bonds. B. Preferred stock. C. Common stock. D. Retained earnings.
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A, correct Bonds usually have the lowest after-tax cost of new capital because investors have less risk when investing in bonds than in equity, and because the interest payments to bondholders is deductible for tax purposes.
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The cost of debt most frequently is measured as A. Actual interest rate. B. Actual interest rate adjusted for inflation. C. Actual interest rate plus a risk premium. D. Actual interest rate minus tax savings.
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D, Correct! The cost of debt most frequently is measured as the actual interest rate minus the tax savings. The tax savings result because the interest expense is deductible for tax purposes and the resulting tax savings reduce the effective cost (and rate) of debt financing. For example, if the stated (actual) interest rate is 10% and the tax rate is 40%, the effective interest rate (actual interest rate minus tax savings) will be 10% x (1.00 - .40), or 10% x .60 = 6% effective cost of debt.
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Larson Corp. issued $20 million of long-term debt in the current year. What is a major advantage to Larson with the debt issuance? A. The reduced earnings per share possible through financial leverage. B. The relatively low after-tax cost due to the interest deduction. C. The increased financial risk resulting from the use of the debt. D. The reduction of Larson's control over the company.
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B, correct The issuance of debt results in interest expense, which is deductible for tax purposes. Therefore, the effective cost of debt is less than its stated interest rate by the amount of taxes saved by that interest deduction. The effective cost of debt is its interest cost x (1 - tax rate).
