Financial Management Free – Flashcards
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What are the two basic sources of funds for all businesses?
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The two basic sources of funds for all businesses are debt and equity.
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What is working capital management?
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It is the management of current assets, such as inventory, and current liabilities, such as money owed to suppliers.
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Explain the difference between profitable and unprofitable firms.
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A profitable firm is able to generate more than enough cash through its productive assets to cover its operating expenses, taxes, and payments to creditors. Unprofitable firms fail to do this, and therefore they may be forced to declare bankruptcy.
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What are the three major decisions that most concern financial managers?
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Financial managers are most concerned about the capital budgeting decision, the financing decision, and the working capital decision.
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What is the general decision rule for a firm considering undertaking a project? Give a real-life example.
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A firm should undertake a capital project only if the value of its future cash flows exceeds the cost of the project.
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What is capital structure and why is it important to a company?
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Capital structure shows how a company is financed; it is the mix of debt and equity on the liability side of the balance sheet. It is important as it affects the risk and the value of the company. In general, companies with higher debt-to-equity proportions are riskier because debt comes with legal obligations to pay periodic payments to creditors and to repay the principal at the end.
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What is working capital management and what are some of the working capital decisions that a financial manager faces?
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Working capital management is the day-to-day management of a firm's current assets and liabilities to make sure that there is enough cash to cover operating expenses and there is spare cash to earn interest. The financial manager has to make decisions about the inventory levels or terms of collecting payments (receivables) from customers.
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What are the three forms of business organization discussed in this chapter?
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The three forms of business organization we discussed are sole proprietorship, partnership, and corporation.
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What are the advantages and disadvantages of a sole proprietorship?
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Advantages: •It is the easiest business type to start. •It is the least regulated. •Owners keep all the profits and do not have to share the decision-making authority with anyone. •All income is taxed as personal income which is usually in a lower tax bracket than corporate income. Disadvantages: •The proprietor has an unlimited liability for all business debt and financial obligations of the firm. •The amount of capital that can be invested in the firm is limited by the proprietor's wealth. •It is difficult to transfer ownership (requires sale of the business).
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What is a partnership and what is the biggest disadvantage of this business organization? How can it be avoided?
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A partnership consists of two or more owners legally joined together to manage a business. The major disadvantage to partnerships is that all partners have unlimited liability for the organization's debts and legal obligations no matter what stake they have in the business. One way to avoid this is to form a limited partnership in which only general partners have unlimited liability and limited partners are only responsible for business obligations up to the amount of capital they contributed to the partnership.
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Who are the owners in a corporation and how is their ownership represented?
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The owners of a corporation are its stockholders or shareholders, and the evidence of their ownership is represented by shares of common stock. Other types of ownership do exist and include preferred stock.
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Explain what is meant by stockholders' limited liability.
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Limited Liability for a stockholder means that the stockholder's legal liability extends only to the capital contributed or the amount invested.
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What is double taxation?
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The owners of a corporation are subject to double taxation—first at the corporate level and then again at a personal level when they are given dividends.
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What is the business organization form preferred by most physicians lawyers, and accountants, and why?
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Most lawyers, accountants, and doctors form what are known as limited liability partnerships. These formations combine the tax advantages of partnerships with the limited liability of corporations.
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What is the most important governing body within a business organization? What responsibilities does it have?
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The most important governing body within an organization is the board of directors. Its main role is to represent the shareholders. The board also hires (and occasionally fires) the CEO and advises him or her on major decisions.
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Almost all public companies hire a certified public accounting firm to perform an independent audit of the financial statements. What exactly does an audit mean?
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An independent CPA firm that performs an audit of a firm ensures that the financial numbers are reasonably accurate, that accounting principles have been adhered to year after year and not in a manner that distorts the firm's performance, and that the accounting principles used are in accordance with generally accepted accounting principles (GAAP).
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What are some of the drawbacks to setting profit maximization as the main goal of a company?
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•It is difficult to determine what is meant by profits. •It does not address the size and timing of cash flows—it does not account for the time value of money. •It ignores the uncertainty of risk of cash flows.
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What is the appropriate goal of financial managers? Can managers' decisions affect this goal in any way? If so how?
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The appropriate goal of financial managers should be to maximize the current value of the firm's stock price. Managers' decisions affect the stock price in many ways as the value of the stock is determined by the future cash flows the firm can generate. Managers can affect the cash flows by, for example, selecting what products or services to produce, what type of assets to purchase, or what advertising campaign to undertake.
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What are the major factors affecting stock price?
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The following factors affect the stock price: the firm, the economy, economic shocks, the business environment, expected cash flows, and current market conditions.
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What is an agency relationship and what is an agency conflict? How can agency conflicts be reduced in a corporation?
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Agency relationships develop when a principal hires an agent to perform some service or represent the firm. An agency conflict arises when the agent's interests and behaviors are at odds with those of the principal. Agency conflicts can be reduced through the following three mechanisms: management compensation, control of the firm, and the board of directors.
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What starts to happen when if a firm is poorly managed and its stock price falls substantially below its maximum?
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If the stock price falls below its maximum potential price, it attracts corporate raiders, who look for fundamentally sound but poorly managed companies they can buy, turn around, and sell for a handsome profit.
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What are some of the regulations pertaining to boards of directors that were put in place to reduce agency conflicts?
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Some of the regulations include: a.The majority of board members must be outsiders. b.A separation of the CEO and chairman of the board positions is recommended. c.The CEO and CFO must certify all financial statements.
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How could business dishonesty and low integrity cause an economic downfall? Give an example.
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Business dishonesty and lack of transparency lead to corruption, which in turn creates inefficiencies in an economy, inhibits the growth of capital markets, and slows the rate of economic growth. For example, until the mid-1990s the Russian market had a difficult time attracting investors as there was no reliable financial information on any of the companies. Only after the Russians made a conscious decision to make their records and motives transparent were they able to draw foreign investments.
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What are some possible ways to resolve a conflict of interest?
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One way to resolve a conflict of interest is by complete disclosure. As long as both parties are aware of the fact that, for example, both parties in a lawsuit are represented by the same firm, disclosure is sufficient. Another way to avoid a conflict of interest is for the company to remove itself from serving the interest of one of the parties. This is, for example, the case with accounting firms not being allowed to serve as consultants to companies for which they perform audits.
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What ethical conflict does insider trading present?
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Insider trading is an example of information asymmetry. The main idea is that investment decisions should be made on an even playing field. Insider trading is morally wrong and has also been made illegal.
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What is the role of the financial system and what are the components of the system?
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The role of the financial system is to gather money from businesses and individuals and to channel funds to those who need them. The financial system consists of financial markets and financial institutions.
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What does a competitive financial system imply about interest rates?
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If the financial system is competitive, one will receive the highest possible rate for money invested with a bank and the lowest possible interest rate when borrowing money. Also, only firms with good credit ratings and projects with high rates of return will be financed.
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What is the difference between saver-lenders and borrower-spenders and who are the major representatives of each?
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Saver-lenders are those who have more money than they need right now. The principal saver-lenders in the economy are households. Borrower-spenders are those who need the money saver-lenders are offering. The main borrower-spenders in the economy are businesses, although households are important mortgage borrowers.
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List the two ways in which a transfer of funds takes place in an economy. What is the main difference between these two?
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Funds can flow directly through financial markets or indirectly through intermediation markets where funds flow through financial institutions first.
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Suppose you own a security that you know can be easily sold in the secondary market but the security will sell at a lower price than you paid for it. What would this mean for the security's marketability and liquidity?
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As the price of the security is lower than that you paid for it, it has a lower degree of liquidity to you, the owner. That is because the security cannot now be sold without a loss in value to the owner. Marketability refers to the ease to which a security can be sold or converted to cash. The information in the problem does mention a drastically lower price and so we must conclude that the security's marketability in not affected.
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Why are the direct financial markets also called wholesale markets?
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The financial markets are also called wholesale markets because the minimum transaction or security denomination is $1 million or more.,Trader, Inc., a $300 million company, and Horst Corp., with an asset size of $35 million, are two privately held corporations. Explain which firm is more likely to go public and register with the SEC, and why. Trader, Inc., is more likely to go public. Going through an IPO is a very expensive process, and given Trader's higher worth, they are more likely to be positioned to go through with it.
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What is a primary market? What does IPO stand for?
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A primary market is where new securities are sold for the first time. IPO stands for initial public offering.
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Identify whether the following transactions are primary market or secondary market transactions. a. Jim Hendry bought 300 shares of IBM through his brokerage account. b. Peggy Jones bought $5,000 of IBM bonds from the firm. c. Hathaway Insurance Company bought 500,000 shares of Trigen Corp. when the company issued stock.
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•secondary •secondary •primary
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Investment Banking: What does it mean to underwrite a new security issue? What compensation does an investment banker get from underwriting a security issue?
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To underwrite a new security issue means that the investment banker buys the entire issue from the firm at a guaranteed price and then resells the security to individual investors or other institutions at a higher price. The difference between the banker's purchase price and the total resale price is called the underwriting spread, and it is the banker's compensation. In addition to underwriting new securities, investment banks also provide other services, such as preparing the prospectus, preparing legal documents to be filed with the SEC, and providing general financial advice to the issuer.
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Cranjet Inc., is issuing 10,000 bonds, and its investment banker has guaranteed a price of $985 per bond. The investment banker sells the entire issue to investors for $10,150,000. a.What is the underwriting spread for this issue? b.What is the percentage underwriting cost? c.How much did Cranjet raise?
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a. $300,000 ($10,150,000 - $985 x 10,000) b. 3.05 percent ($30/$985) c. $9,850,000 ($985 x 10,000)
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Financial Institutions: What are some of the ways in which a financial institution or intermediary can raise money?
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A financial intermediary can raise money through the sale of financial products that individuals or businesses will purchase, such as checking and savings accounts, life insurance policies, or pension or retirement funds.
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How do financial institutions act as "intermediaries" to provide services to small businesses?
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Financial intermediation is the process whereby borrowing occurs indirectly from a financial institution that has converted financial securities with one set of characteristics into securities with another set of characteristics for the borrower's specific need.
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Which financial institution is usually the most important to businesses?
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The primary financial intermediaries are commercial banks, life insurance companies, casualty insurance companies, pension funds, investment funds, and business finance companies. Commercial banks are the largest and most prominent financial intermediaries in the economy and offer the widest range of financial services to businesses.
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What is the main difference between money markets and capital markets?
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Money markets are markets in which short-term debt instruments with maturities of less than one year are bought and sold. Capital markets are markets in which equity securities and debt instruments with maturities of more than one year are sold.
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What is a stock market index? List three stock market indexes.
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A stock market index is a tool used to measure the performance of the stock market—whether the prices are on average going up or down. Some of the better known indexes are the Dow Jones Industrial Average, the NYSE Index, and the S&P 500 Index.
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What is the Dow Jones Industrial Average?
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The Dow Jones Industrial Average consists of the 30 largest public companies in the United States, and it was established to gauge the performance of the U.S. economy, specifically the industrial component of the stock market.
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What does NASDAQ represent?
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NASDAQ is an acronym for National Association for Securities Dealers Automated Quotations, and it is the largest electronic stock exchange in the United States.
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What are U.S. Treasury bills?
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Treasury Bills are one of the most common money market instruments. Money market instruments are lower in risk than other securities because of their high liquidity and low default risk.
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Besides U.S. Treasury bills what are other money market instruments?
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Other common money market instruments include commercial paper, bank negotiable CDs, and other marketable short-term securities.
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What is the primary role of money markets? Explain how money markets work.
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Money markets provide an option for large corporations to adjust their liquidity positions. Since only seldom are cash receipts and cash expenditures perfectly synchronized, money markets allow companies to temporarily invest idle cash in Treasury bills or negotiable CDs. If a company is short on cash, it can borrow the money from money markets by selling commercial paper at lower interest rates than through commercial banks.
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How do capital market instruments differ from money market instruments?
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Capital market instruments are less liquid or marketable, they have longer maturities, usually between 1 and 30 years, and they carry more financial risk.
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What are the major differences between public and private markets?
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Public markets are organized financial markets where the public buys and sells securities through their stock brokers. The SEC regulates public securities markets in the United States. In contrast, private markets involve direct transactions between two parties. These transactions lack SEC regulation.
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What are the two risk-hedging instruments discussed in the chapter?
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The two risk-hedging instruments discussed are futures and options markets.
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What is the real rate of interest and how is it determined?
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The real rate of interest measures the return earned on savings, and it represents the cost of borrowing to finance capital goods. The real rate of interest is determined by the interaction between firms that invest in capital projects and the rate of return businesses can expect to earn on investments in capital goods, and individuals' time preference for consumption. Graphically, it is that point when the desired saving level equals the desired level of investment in the economy.
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How does the nominal rate of interest vary over time?
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The nominal rate is the rate that we observe in the marketplace. it is determined by both the real rate as well expected inflation. Therefore, the nominal rate will fluctuate according the changes in the real rate as well as changes in expected inflation.
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What is the Fisher equation and how is it used?
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The Fisher equation is the expected, not the reported or actual, annualized change in commodity prices (∆Pe). It is used to protect the buying power from changes in inflation, and it is incorporated into a loan contract by adding it to the real interest rate that would exist in the absence of inflation.
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Imagine you borrow $500 from your roommate agreeing to pay her back the $500 plus 7 percent interest in one year. Assume inflation over the life of the contract is expected to be 4.25 percent. What is the total amount you will have to pay her back in a year? How much of the interest payment is the result of the real rate of interest?
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You will pay her back $556.25 ($500 x 1.1125) in one year, of which $35 will be a result of the real interest rate ($500 x 1.07).
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Your parents have given you $1000 a year before your graduation so that you can take a trip when you graduate. You wisely decide to invest the money in a bank CD that pays 6.75 percent interest. You know that the trip costs $1,025 right now and that the inflation for the year is predicted to be 4 percent. Will you have enough money in a year to purchase the trip?
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Yes. The CD will be worth $1,067.50 at the end of the year ($1,000 x 6.75% + $1,000), and the price of the trip will be $1,066 ($1,025 x 4% + $1,025). The CD will be able to cover the trip.
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When are the nominal and real interest rates equal?
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The only time the nominal and real interest rates are equal is when the expected rate of inflation over the contract period is zero.
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How are brokers different from dealers?
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Brokers execute transactions for their clients, but they bear no risk of ownership of the securities in the transaction; in contrast, dealers "make markets" for securities and do bear risk.
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What is the S&P 500 Index?
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The S&P 500 Index represents the largest 500 companies in the publicly traded U.S. stock issues, and it incorporates about 80 percent of the total market capitalization of all stocks on the New York Stock Exchange.
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Identify the type of transactions (direct or indirect) the following are: a. You buy 200 shares of Fidelity Growth Mutual Fund. b.Roger opens a bank CD for $5000 c.Bank of America makes a $25,000 loan to Leila Coffee Shop. d.Nora buys $3,000 of Xerox bonds from a new issue.
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a. indirect, since Fidelity is an investment fund b. indirect, since the bank will then loan the funds to a deficit spending unit c. direct, since Bank of America is a money center bank, which is making a direct loan d. direct, since Nora is buying the new issue through an investment bank
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If the nominal rate of interest is 7.5 percent and the real rate is 4 percent what is the expected inflation premium?
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If we follow the Fisher equation, i = r + ∆Pe and note that i = 0.075 while r =0.04 then it is easy to see that = ∆Pe= 0.035 or 3.5%.
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What is the relationship between business cycles and the general level of interest rates?
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As Exhibit 2.5 shows, we can see that interest rates tend to follow the business cycle.
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Explain how the choice of FIFO versus LIFO can affect a firm's balance sheet and income statement.
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FIFO makes sense during times of rising prices because it allows the firm to eliminate the lower priced inventory first, resulting in higher profit margin. This allows the firm to leave higher valued inventory on the balance sheet. During inflationary times, a firm using LIFO would see a lower profit margin and lower values of inventory on the balance sheet. It is important that anyone who is analyzing firms using different accounting methods on inventory recognize the impact on the bottom line (profit margin and net income) and on current assets.
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How does the use of market-value accounting help managers?
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Market-value accounting of both assets and liabilities allows managers to have a truer picture of their company's financial condition and to do a better job of estimating cash flows that the assets would generate. However, marking-to-market is not as easy as it sounds because of the difficulties involved in coming up with the correct market value of current assets and liabilities.
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What is a major reason for the accounting scandals in recent years? How do firms attempt to meet Wall Street analysts' projection of earnings?
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Most people believe that managers' short-term focus is driven by Wall Street's demand that companies meet or beat the earnings forecasted by stock analysts. Rather than report the actual earnings of the firm, managers try to meet the market's expectations by starting with the bottom-line number and backing into a sales figure. Thus, the sales may be consistent with the reported earnings figure, but do not represent the true revenue generated by the firm.
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Why are taxes and the tax code important for managerial decision making?
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Understanding the tax code is critical to finance managers, since most decisions are made on an after-tax basis. Furthermore, taxes affect any valuation analysis and also determine the bottom-line figure that is of concern to shareholders and managers.
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Identify the five fundamental principles of GAAP and explain briefly their importance.
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The assumption of arm's length transaction assumes that all business transactions between two parties are made rationally from an economic perspective and both parties will make the deal that provides them the best value. The cost principle calls for the recognition of all accounting transactions at historic cost, or the amount paid or received when the transaction was concluded at arm's length. The realization principle implies that revenue should be recognized only at the time of the sale. The matching principle dictates that revenue is first recognized and then is matched with the costs incurred in producing the revenue. Finally, the going concern assumption implies that the firm will continue to operate and that all assets should be recorded at their cost rather than at their liquidation value.
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Explain why firms prefer to use accelerated depreciation methods over the straight-line method for tax purposes.
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When a firm uses accelerated depreciation, the depreciation expense is higher than with the straight-line method. This reduces the taxable income and the amount of tax paid by the firm. As a result of this higher noncash expense, the firm's cash flow is higher.
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What is treasury stock? Why do firms have treasury stock?
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Any shares repurchased by the company in the open market are recorded as treasury stock in the shareholders' equity account in the balance sheet. The most common reason for firms doing this is to reduce the number of shares outstanding in the market when the management believes that its firm's stock is undervalued. This reduction in the number of shares outstanding is expected to boost the share price.
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Define book-value accounting and market- value accounting.
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Book-value accounting implies that all assets and liabilities are recorded and reported at the historical cost when they were acquired. Market-value accounting requires that all assets and liabilities are reported at their current market value.
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Compare and contrast depreciation expense and amortization expense.
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Depreciation expense is the amount by which a firm's fixed assets are written down in a period during which the assets are utilized for generating cash flows. Amortization is the amount by which intangible assets like goodwill, patents, license, copyrights, and trademarks are written down in any period that they are utilized by the firm to generate benefits. Both depreciation and amortization are noncash expenses that will serve to boost the firm's after-tax cash flows.
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Why are retained earnings not considered an asset of the firm?
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Retained earnings are part of shareholders' equity that has already been utilized by the company. It is a liability of the company and corresponds to a claim by the firm's shareholders. The retained earnings reported on the balance sheet have already been allocated by the company among various assets and hence are not available for current or future uses. New retained earnings have to be generated to provide for new uses!
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How does net cash flow differ from net income and why?
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Net income or profit after taxes is an accounting figure that includes both cash and noncash expenses. In addition, revenues are recognized before they are collected and expenses are recognized before they are paid. Net cash flow, on the other hand, only recognizes cash inflows and cash outflows that have occurred. Accrual-based accounting causes a time lag between the point when revenues and expenses are recorded and the point when the cash flows actually occur.
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What is the statement of cash flows and what is its role?
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This financial statement records both the cash inflows and cash outflows for a period of time. Thus, it reports the changes in the cash position of a firm between successive accounting periods.
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What does it mean when a company's return on assets (ROA) is equal to its return on equity (ROE)?
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When ROA equals ROE, it means that the firm does not use any leverage. For firms that do use leverage, ROE will be higher than ROA.
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Why is too much liquidity not a good thing?
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Too much liquidity could mean that a firm is not putting its money to work as the shareholders would want it to. It could mean that the firm's managers are being too conservative and investing in low-yield assets, or it could mean that the firm does not have enough investment opportunities and is therefore hanging onto its cash. Recently, several firms including Microsoft had several billions of dollars in cash on their books, and, ultimately, Microsoft paid a special dividend to its shareholders. Too much liquidity can also make it a takeover target for firms looking to utilize the debt capacity of the liquid firm.
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Inventory is excluded when the quick ratio or acid-test ratio is calculated because inventory is the most difficult current asset to convert to cash without loss of value. What types of inventory are likely to be most easily converted to cash?
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For the quick ratio, one uses only the most liquid of all assets—that is, all current assets less inventory, which is not very liquid relative to cash or receivables. While the current ratio assumes that inventory could be sold at book value, the quick ratio assumes that inventory has no value. Hence, this gives a more conservative estimate of a firm's liquidity than the current ratio, and gives a better estimate of the firm's ability to meet its short-term obligations.
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What does a very high inventory turnover ratio signify?
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This could mean a number of things, including that the firm is using up its inventory too fast and is unable to meet the demand for its products, or it has priced its products too low relative to its competitors, or worse, the firm is selling defective products that would eventually be returned.
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How would one explain a low receivables turnover ratio?
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A low receivables turnover implies a high DSO. This could mean that the firm's customers are not paying on time, either because of an inefficient collection system or because of a slowdown in their customers' business or even in the entire economy.
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What additional information does the fixed assets turnover ratio provide over the total assets turnover ratio? For which industries does it carry greater significance?
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The total assets turnover ratio measures the level of sales per dollar invested in total assets. The higher the number, the more efficiently the management is using the firm's assets. Too high a number relative to its peers could imply that the firm is reaching its full capacity and may require an additional investment in plant and equipment to generate additional sales. The fixed asset turnover ratio can be utilized to break down the performance of individual manufacturing facilities or a division. This ratio provides significant information for manufacturing firms that are capital-intensive, while it will be of much less significance for the service industry, where there is less reliance on plant and equipment.
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How does financial leverage help shareholders?
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Financial leverage implies the use of debt capital in addition to the owners' capital to finance the firm. With the addition of debt, the owners' capital can go a long way in acquiring assets for the firm. Given that creditors only get the fixed-interest payments and do not get any share of the gains from the company, the shareholders gain from the usage of debt. This is called the leverage multiplier effect. As the company's revenues grow, shareholders get all the gain and the debt holders merely receive their interest payments.
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Why do banks have a low ROA (relative to other industries) but a high ROE?
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Banks have a very small equity base relative to firms in most other industries. Thus, they are highly leveraged with borrowed funds. Since their equity base is small, this magnifies the return on equity, but the return on assets is relatively small for the large asset base.
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Why is the ROE a more appropriate proxy of wealth maximization for smaller firms rather than for larger ones?
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The basis on which any business or investment decisions are evaluated must include the size, timing, and uncertainty in the future cash flows. ROE considers neither the risk of the cash flows nor the size of the initial investment or future cash flows from that investment. While the ROE and shareholder wealth are correlated, this is still a problem in large, well-diversified companies with resources from multiple sources. Smaller firms have fewer resources and sources and can better correlate their ROE to shareholder wealth.
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Why is it not enough for an analyst to look at just the short-term and long-term debt on a firm's balance sheet?
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The amount of liabilities shown on a firm's balance sheet is not the total obligation of a firm in any given period. To get a true picture, one needs to look at the financial footnotes that follow the financial statements. This is where you will be able to find the amount of debt repayment that the firm is responsible for in the coming years. In addition, off-balance sheet items could reflect certain future liabilities of the firm that do not have to be reported on the balance sheet. One also should look for lease obligations of the firm that are reported off the balance sheet but nevertheless remain a fixed obligation that the firm has to meet with its cash flows. Thus, it is important for the analyst to look beyond the short-term and long-term debt on the balance sheet to get a true measure of the firm's true financial commitments in any given period.
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Explain the phrase "a dollar today is worth more than a dollar tomorrow."
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The implication is that if one was to receive a dollar today instead of in the future the dollar could be invested and will be worth more than a dollar tomorrow because of the interest earned during that one day. This makes it more valuable than receiving a dollar tomorrow.
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Explain the importance of a time line.
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Time lines are important tools used to analyze investments that involve cash flow streams over a period of time. They are horizontal lines that start at time zero (today) and show cash flows as they occur over time. Because of time value of money it is crucial to keep track of not only the size, but also the timing of the cash flows.
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Differentiate future value from present value.
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Future value measures what one or more cash flows are worth at the end of a specified period while present value measures what one or more cash flows that are to be received in the future will be worth today (at t = 0).
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What are the two factors to be considered in time value of money?
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The factors that are critical in time value of money are the size of the cash flows and the timing of the cash flows.
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Differentiate between compounding and discounting.
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The process of converting an amount given at the present time into a future value is called compounding. It is the process of earning interest over time. Discounting is the process of converting future cash flows to what its present value is. In other words present value is the current value of the future cash flows that are discounted at an appropriate interest rate.
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Explain how compound interest differs from simple interest.
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Suppose I invest $100 for three years at a rate of 10 percent. Simple interest would imply that I will earn $10 for each of the three years for a total of $30 interest. At the end of three years I would have $130. Compound interest recognizes that the interest earned in years 1 and 2 will also earn interest over the remaining period. Thus the $10 earned in the first year would earn interest at 10 percent for the next two years, and the $10 earned in the second year would earn interest for the third year. Thus the total amount that I would have at the end of three years would be: . By compounding, I have earned an additional interest of $3.10. The total interest or compound interest is the $33.10 earned on the $100 invested, while the simple interest earned is equal to $30.
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If you were given a choice of investing in an account that paid quarterly interest and one that paid monthly interest which one should you choose and why?
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The impact of compounding really dictates that one should pick the account that pays interest more frequently (as long as the interest rates are the same). This allows for the interest earned in the earlier periods to earn interest and the investment to grow more.
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Growth rates are exponential over time. Explain.
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Growth rates, as well as interest rates, are not linear, but rather exponential over time. In other words, the growth rate of the invested funds is accelerated by the compounding of interest. Over time, the principal amount you receive interest on will get larger with compounding, thus generating higher interest payments.
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What is the Rule of 72?
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This is a rule of thumb to determine how fast an investment can double. It is a rule that allows you to closely approximate the time that it would take to double your money. It works well with interest rates between 5 and 20 percent but varies more with higher rates. The Rule of 72 says that the time to double your money (TDM) approximately equals 72/i, where i is expressed as a percentage.
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You are planning to take a spring break trip to Cancun your senior year. The trip is exactly two years away but you want to be prepared and have enough money when the time comes. Explain how you would determine the amount of money you will have to save in order to pay for the trip.
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First, determine how much money you will need for the trip. Second, check how much you already have and how it translates into future value cash—how much it will be worth in two years. Next, determine how much you will have to deposit today, given the bank's offered interest rate, to ensure that you will have saved up the difference when the time for your senior spring break comes.
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Identify the steps involved in computing the future value when you have multiple cash flows.
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First, prepare a time line to identify the size and timing of the cash flows. Second, calculate the present value of each individual cash flow using an appropriate discount rate. Finally, add up the present values of the individual cash flows to obtain the present value of a cash flow stream. This approach is especially useful in the real world where the cash flows for each period are not the same.
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What is the key economic principle involved in calculating the present value and future value of multiple cash flows?
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Regardless of whether you are calculating the present value or the future value of a cash flow stream, the key idea is to discount or compound the cash flows to the same point in time.
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What is the difference between a perpetuity and an annuity?
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A cash flow stream that consists of the same amount being received or paid on a periodic basis is called an annuity. If the same payments are made periodically forever, the contract is called a perpetuity.
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Define annuity due. Would an investment be worth more if it was an ordinary annuity or an annuity due? Explain.
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When annuity cash flows occur at the beginning of each period, it is called an annuity due. Annuity due will result in a bigger investment than an ordinary annuity because each cash flow will accrue an extra interest payment.
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Raymond Bartz is trying to choose between two equally risky annuities each paying $5,000 per year for five years. One is an ordinary annuity, and the other is an annuity due. Which of the following statements is most correct? a. The present value of the ordinary annuity must exceed the present value of the annuity due, but the future value of an ordinary annuity may be less than the future value of the annuity due. b. The present value of the annuity due exceeds the present value of the ordinary annuity, while the future value of the annuity due is less than the future value of the ordinary annuity. c. The present value of the annuity due exceeds the present value of the ordinary annuity, and the future value of the annuity due also exceeds the future value of the ordinary annuity. d. If interest rates increase, the difference between the present value of the ordinary annuity and the present value of the annuity due remains the same.
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c. The present value of the annuity due exceeds the present value of the ordinary annuity, and the future value of the annuity due also exceeds the future value of the ordinary annuity.
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Which of the following investments will have the highest future value at the end of three years? Assume that the effective annual rate for all investments is the same. a.You earn $3000 at the end of three years (a total of one payment). b.You earn $1,000 at the end of every year for the next three years (a total of three payments). c.You earn $1,000 at the beginning of every year for the next three years (a total of three payments).
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c.Earning $1,000 at the beginning of each year for the next three years will have the highest future value as it is an annuity due.
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Explain whether or not each of the following statements is correct. a.A 15-year mortgage will have larger monthly payments than a 30-year mortgage of the same amount and same interest rate. b.If an investment pays 10 percent interest compounded annually its effective rate will also be 10 percent.
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a.This is a true statement. The 15-year mortgage will have higher monthly payments since more of the principal will have to be paid each month than in the case of a 30-year mortgage. b. This is true since the frequency of compounding is annual and hence the rate for a single period is the same as the rate for a year.
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When will the annual percentage rate (APR) be the same as the effective annual rate (EAR)?
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The annual percentage rate (APR) will be the same as the effective annual rate only if the compounding period is annual, not otherwise.
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Why is the EAR superior to the APR in measuring the true economic cost or return?
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Unlike the APR, which reflects annual compounding, the EAR takes into account the actual number of compounding periods. For example, suppose there are two investment alternatives that both pay an APR of 10 percent. Assume that the first pays interest annually and that the second pays interest quarterly. It would be a mistake to assume that both investments will provide the same return. The real return on the first one is 10 percent, but the second investment actually provides a return of 10.38 percent because of the quarterly compounding. Thus, this is the superior investment!
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Suppose two investments have equal lives and multiple cash flows. A high discount rate tends to favor: a. the investment with large cash flow early. b. the investment with large cash flow late. c. the investment with even cash flow. d. neither investment since they have equal lives.
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a. The investment with large cash flows early will be worth more compared to the one with the large cash flows late. The cash flows that come in later will have a heavier penalty when using a higher discount rate. Thus the investment with large cash flows early will be favored.
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What factors must a financial manager consider when making decisions about account receivables?
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When dealing with accounts receivables, important decisions for the financial manager include the amount of credit offered to various customers and the term of the credit. The financial manager should keep close track of both the aging schedule and the effective DSO. If either or both show consistent deterioration, it may be time to reconsider the firm's credit policy or the characteristics of its customers. In addition, in some industries, sales vary by season. A firm must be aware of seasonal patterns and make the necessary adjustments before drawing any conclusions about its accounts receivable.
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List some of the working capital management characteristics you would expect a computer manufacturing company following just-in-time delivery system such as Dell.
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Firms like Dell are likely to do an exceptional job of managing their inventory and collecting on their receivables. Dell employs a strategy similar to just-in-time management where they maintain just sufficient inventory to meet the needs for a very short time. This saves the firm a huge investment in inventory. Thus their days sales in inventory (DSI) will be very low compared to other industries. Similar to Dell, firms will have a short collection period, and their operating cycle will be much lower than firms in other industries. If other computer manufacturing firms follow the Dell operating philosophy, they will extend their days payables (DPO) to the point that tier cash conversion cycle is negative. In other words, instead of having to invest in its working capital, these firms will end up taking more time to pay their suppliers than the time taken to produce, sell, and collect on the receivables.
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What costs would a firm following a flexible current asset investment strategy worry about and why?
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The strategy's downside is the high carrying cost associated with owning a high level of inventory and providing liberal credit terms for customers. By investing in current assets, management foregoes the higher rate of return it could have earned by investing in long-term assets. Therefore, there is an opportunity cost involved when investing in current assets. Second, large investments in some types of inventory can require significant warehousing and storage costs, which can be expensive.
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How are customers and suppliers affected by a firm's working capital management decisions?
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Customers like firms to maintain large finished goods inventories because when they go to make a purchase, the item they want will likely be in stock. In general, large inventory helps stimulate sales and increase customer satisfaction, but they can be a costly item on a firm's balance sheet. Management's decisions on the firm's receivables policy is driven by the industry type. Companies selling perishable products, such as food companies, might ask for payment in full in less than 10 days. On the other hand, if the firm is selling durable goods, the terms of credit are likely to be more generous. The terms of sale are also affected by the creditworthiness of the customer. If the firm is confident that it will be paid, it is far more likely to extend credit than if there was some doubt about payment. If the customer is a particularly large firm or if there is a likelihood of repeat business, then extending credit may be part of the marketing effect to secure the order. Thus, when the financial manager makes a decision to increase working capital, good things are likely to happen to the firm—sales should increase, relationships with vendors and suppliers should improve, and work or manufacturing stoppages should be less likely.
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A beverage bottling company in Vermont has days' sales outstanding of 23.7 days. Is this good? Explain.
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In general, a lower DSO reflects the fact that the firm is managing its receivables very well. However, it is not possible to decide whether a DSO of 23.7 days is good or bad unless you have a basis for comparison. That basis of comparison could be a peer group, historical data for the firm itself, or targets set by the management.
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How do the following circumstances affect the cash conversion cycle: (a) favorable credit terms allow the firm to pay its accounts payable more slowly
answer
(b) inventory turnover increases, and (c) accounts receivable turnover decreases?, (a) Favorable credit terms from suppliers allow the firm to use the suppliers' funds to finance their working capital. It also reduces the firm's cash conversion cycle. (b) An increase in the inventory turnover, that is, the DSI decreases, reduces both the firm's operating cycle and the cash conversion cycle. (c) As the accounts receivables turnover (DSO) decreases, the firm improves its receivables management and reduces its operating cycle and hence, its cash conversion cycle.
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What are some industries in which the use of lockboxes would especially benefit companies? Explain.
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Lockboxes are a useful tool to speed up collection of receivables when the customer base is dispersed across a large geographical area. Normally, this would mean customer payments would have to be mailed in, consolidated, and then deposited at the firm's bank. The alternative of setting up a lockbox system allows the firm to redirect customer payments to regional locations for quicker consolidation and cashing of payments. This is typical in the retail industry where each store of a chain is located in a different city or state.
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Suppose you are a financial manager at a big firm and you expect the interest rates to decline in the near future. What current asset investment strategy would you recommend the company pursue?
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At a large firm, management would have access to the commercial paper market, which can provide cheaper funding than short-term bank financing. To borrow in the commercial paper market, a firm has to be financially strong. If interest rates are expected to decline, such firms can plan on raising working capital by issuing commercial paper. Thus, all or a portion of the working capital needs can be funded through short-term funds that can be rolled over as long as interest rates are declining.
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Why is commercial paper only available to the most creditworthy customers?
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Commercial paper is available only to firms that are financially strong for two reasons. First, there is no secondary market for investors to liquidate prior to maturity. Consequently, investors must hold it to maturity and have the confidence that the issuer would pay them back at that time. Second, this type of debt is not secured by any real assets of the issuing firm. Thus, firms that are the most creditworthy are able to raise funds in this market at costs that are lower than bank loans.
question
Explain what a negative cash conversion cycle means.
answer
Recognize the cash conversion cycle is a function a firm's receivables turnover, inventory turnover, and payables turnover. Firms that are highly efficient in managing their inventory and receivables will have a short operating cycle and not need a large investment in working capital. A large payables turnover implies that the firm is making use of their suppliers' funds to fund their working capital needs. The difference between the operating cycle and the payables turnover is the cash conversion cycle. A negative cash conversion cycle means that the time taken by the firm to meet its payables exceeds its operating cycle. In other words, the amount of time to manage their inventory and the time taken to collect its receivables is less than the time taken to pay its suppliers.
