BAM 313 Unit 1-4 Exam

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Text: Authors: Publisher: Foundations of Finance: The Logic and Practice of Financial Management 6th Edition, 2008 ISBN-0-13-233922-6 Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr. Pearson/Prentice Hall 925 N. Spurgeon Street, Santa Ana, CA 92701 Phone: 714-547-9625 Fax: 714-547-5777 04/10 BAM 313 Introduction to Financial Management Study Guide Attention Students: If you are taking a quantitative course such as finance, you may find it helpful to use a financial calculator. These calculators are inexpensive and may be purchased for about $25 through Amazon or other online sites. The HP 10BII, TI BAII Plus and Sharp EL-733A are among the most popular. The following website provides detailed tutorials on how to use a financial calculator. Go to the website listed below and click on the calculator you have chosen for step-by-step instructions on how to successfully work through various calculations. www.tvmcalcs.com/calculator For assistance, please contact California Coast University’s Student Services Department at (714) 547-9625. Message From the President iv Introduction to Financial Management Welcome to California Coast University. I hope you will find this course interesting and useful throughout your career. This course was designed to meet the unique needs of students like you who are both highly motivated and capable of completing a degree program through distance learning. Our faculty and administration have been involved in distance learning for almost forty years and understand the characteristics common to successful students in this unique educational environment. This course was prepared by CCU faculty members who are not only outstanding educators, but who have real world experience as well. They have prepared these guidelines to help you successfully complete your educational goals and to get the most from your distance learning experience. Again, we hope that you will find this course both helpful and motivating. We send our best wishes as you work toward the completion of your degree. Sincerely, Thomas M. Neal President All rights reserved. No part of this book may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording, or by any information storage and retrieval system without written permission from the publisher, except for the inclusion of brief quotation in review. Copyright © 2009 by California Coast University First Printing 2002 Syllabus viii Introduction to Financial Management Course Number BAM313 Course Title Introduction to Financial Management Catalog Description This course introduces students to the elementary principles and motives of financial management, and covers basic fundamental principles of short-term financing, time value of money, risk and value, and cost. Students will understand the interrelationships underlying the various data and techniques in which financial decisions are based, and will be able to analyze financial data and apply basic concepts to make confident financial decisions in their respective business futures. Units of Credit 3 Units of Credit Course Objectives Upon successful completion of this course, students will be able to: • Understand the scope and environment of financial management. • Comprehend the valuation of financial assets. • Confidently understand investment in long term assets. • Analyze capital structure and dividend policy. Learning Resources Textbook: Foundations of Finance: The Logic and Practice of Financial Management 6th Edition, 2008 Arthur J. Keown, John D. Martin, J. William Petty, David F. Scott, Jr. Pearson ISBN-0-13-233922-3 All course examinations are based on the contents of the textbook required for this course. To successfully complete the examinations, you will need the textbook. You may rent the textbook from our Rental Library or you may purchase the textbook from other sources. The Study Guide The Study Guide was designed to help you further understand the material in the textbook and master the course content. Each Study Guide chapter corresponds to a chapter in the textbook. Additional Readings and Online Resources To help you to further understand this subject material, additional readings and online resources related to this course are listed in this Syllabus. Syllabus ix Introduction to Financial Management The Library Information and Resources Network, Inc. (LIRN) The Library Information and Resources Network (LIRN) is an online library resource that provides access to multiple research databases. CCU doctoral candidates who enrolled in their program after February 1, 2010 receive complimentary access to LIRN. If you are a current student enrolled in another CCU program and wish to request access to LIRN, you may do so for a one-time fee of $25. Please contact the CCU Library to fill out a Request for Online Library Resources form and submit it, with payment, to the University. You will be emailed a confidential identification number to use for the remainder of your studies at CCU. Supplementary Materials Unit Examination Answer Sheets* Final Examination Scheduling Form Master of Education and Doctor of Education students will not receive unit exam answer sheets. Unit Examinations for these programs require written responses. Your Course Grade Your grades on course examinations are determined by the percentage of correct answers. The University uses the following grading system: A = 90% – 100% correct B = 80% – 89% correct C = 70% – 79% correct D = 60% – 69% correct F = 59% and below correct Your grade in this course will be based on the number of points you earn. Grades are based on the percentage of points you earned out of a total of 500 points: Four Unit Examinations 100 points each 400 points total 80% of your grade Final Examination 100 points 100 points total 20% of your grade Syllabus x Introduction to Financial Management Mastering the Course Content In order to successfully complete this course, we recommend that you do the following before beginning: • Be sure that you have the correct edition of the course textbook. Check the ISBN number of your textbook with the ISBN number listed on the cover page of this Study Guide. • Review the Table of Contents at the end of this Syllabus. You will only be responsible for the chapters in the textbook that are listed in the Table of Contents. Each Study Guide contains several components selected and developed by the faculty to help you master the content of the course. Each chapter in the Study Guide corresponds to a chapter in the textbook. Study Guides vary depending on the course, but most will include: Learning Objectives Overviews Self Tests Summaries Key Terms Critical Analysis Questions (Master and Doctoral students only) The most efficient way to complete this course is to read the materials in both the Study Guide and textbook in the sequence in which it appears, generally from beginning to end. Read the Overviews and Summaries Before reading a chapter of your textbook, review the corresponding Learning Objectives, Overview, Key Terms and Summary sections in the Study Guide. These were prepared to give you an overview of the content to be learned. Review the Self Test After you have reviewed the Study Guide summaries, look at the items on the Self Test. As you identify your areas of relative strength and weakness, you will become more aware of the material you will need to learn in greater depth. Review the Critical Analysis (Master and Doctoral students only) The Critical Analysis questions are designed to help you gain a deeper understanding and appreciation for the course subject matter. This section will encourage you to give additional thought to the topics discussed in the chapter by presenting vignettes or cases with real world relevance. Syllabus xi Introduction to Financial Management Read and Review the Chapter Once you have the scope and organization of the chapter in mind, turn to the c
orresponding chapter in the text and read the material carefully. Keep the Learning Objectives, Self Test and/or Critical Analysis questions in mind as you read. Highlight important concepts and information in your Study Guide and write notes in the Study Guide margins as you read. These notes will help you study for the Unit and Final Examinations. Check Your Mastery of Each Chapter When you feel that you have mastered the concepts presented in the chapter, complete the Study Guide Self Test and/or Critical Analysis questions without referring to the textbook or your notes. Correct your Self Test and review each Critical Analysis response using the Answer Key and Solutions Guide provided in the Study Guide. Your results will help you identify any areas you need to review. Unit Examinations Each course contains four Unit Examinations and a Final Examination. Unit Examinations usually consist of 25 objective (multiple choice or true/false) test questions as well as comprehensive writing assignments selected to reflect the Learning Objectives identified in each chapter. For Master of Education and Doctor of Education students, Unit Examinations consist of Written Assignments only. Unit Examinations may be found approximately every four to six chapters throughout your Study Guide. Unit Examinations are open-book, do not require a proctor, and are not timed. This will allow you to proceed at your own pace. It is recommended that you check your answers against the material in your textbook for accuracy. Written Assignments Each Unit Examination includes a written component. This assignment may be in the form of written questions or case study problems. The written assignment affords the student an opportunity to demonstrate a level of subject mastery beyond the objective Unit Examinations, which reflects his/her ability to analyze, synthesize, evaluate and apply his/her knowledge. The written assignment materials are found immediately following each Unit Examination. Syllabus xii Introduction to Financial Management Written Assignment Requirements • Always include your name, student number, course number, course title and unit number on each page of your written assignment (this is for your protection in case your materials become separated). • Begin each written assignment by identifying the question number you are answering followed by the actual question itself (in bold type). • Use a standard essay format for responses to all questions (i.e. an introduction, middle paragraphs and conclusion). • All responses must be typed double-spaced, using a standard font (i.e. Times New Roman) and 12 point type size for ease of reading and grading. • All online responses must be submitted as a MS Word Document file only. Written assignments are judged on the quality of the response in regard to the question. Word count is NOT one of the criteria that is used in assigning points to written assignments. However, students who are successful in earning the maximum number of points tend to submit written assignments that fall in the following ranges: • Undergraduate courses: 350 – 500 words or 1 – 2 pages. • Graduate courses: 500 – 750 words or 2 – 3 pages. • Doctoral courses: 750 – 1000 words or 4 – 5 pages. Plagiarism All work must be free of any form of plagiarism. Put written answers into your own words. Do not simply cut and paste your answers from the Internet and do not copy your answers from the textbook. Plagiarism consists of taking and using the ideas, writings or inventions of another, without giving credit to that person and presenting it as one’s own. This is an offense that the University takes very seriously. An example of a correctly prepared written response may be found by visiting the Coast Connection student portal. Citation Styles The majority of your response should be your own original writing based on what you have learned from the textbook. However, if you choose to use outside material to answer a written assignment question, be sure to provide a reference (or citation) for the material. The following points are designed to help you understand how to provide proper references for your work: Syllabus xiii Introduction to Financial Management • References are listed in two places. • The first reference is briefly listed within your answer. This includes identifying information that directs the reader to your List of References at the end of your Written Assignment. • The second reference is at the end of your work in the List of References section. • All references cited should provide enough identifying information so that the reader can access the original material. For more detailed information on the proper use of citations, please refer to the Student Handbook. Submitting Your Unit Examinations by Mail Send your completed Unit Examination along with any written assignments to the following mailing address: California Coast University Testing Department 925 N. Spurgeon Street Santa Ana, CA 92701 Submitting Your Unit Examinations via the Internet Students may access the online testing features via the Coast Connection student portal. Multiple choice Unit Examinations may be completed and submitted online. After logging in to your online account at www.calcoast-online.com, select the Testing link, then select Complete Unit Exam. It is recommended that you complete the Unit Examinations on the hard copy answer sheet first, then transfer the answers to the online answer sheet. The written assignments for each Unit Examination may be submitted online as well. After accessing the student portal, choose the Writing Assignment link and then select Writing Assignment Submission. If you will be submitting multiple Word documents, please upload and submit them one at a time. Syllabus xiv Introduction to Financial Management Repeating Examinations After a Unit Examination grade has been posted, students have the option of repeating the exam to improve their grade
. Each Unit Examination may only be repeated once. Students may retake one Unit Examination per course, free of charge. The cost for each additional, repeated exam will be $90. Payment must be paid in full to the Accounting Department prior to repeating exams. Requests to retake a Unit Examination will only be honored if the Final Exam has NOT been sent. *Master of Education and Doctor of Education students are not eligible to retake Unit Exams. If you would like to improve your grade, you may pay the current cost of tuition to retake the course. Final Examination Scheduling a Final Examination Final Examination requests can be submitted via U.S. mail, online through the Coast Connection student portal or by calling the Testing Department at (714) 547-9625. A Final Exam Scheduling Form is located on the last page of this Study Guide. Please fill out all required fields and mail it to the University. If you would like to put in a Final Exam request online, log in to your student account at www.calcoast-online.com and choose the Testing link, then select Final Exam Scheduling. Final Exams will only be sent if you have completed all four Unit Examinations and submitted all four Writing Assignments. Submitting Your Final Examination Final Examinations can be submitted by mail, fax or online through the student portal. After you have completed your exam, you or your proctor can fax it to the Grading Department at (714) 547-1451 or mail it to the University. When faxing exams, please do not resize your fax. For online submissions, once you have logged into the student portal, click on the Testing tab and then choose either Proctored Final or Non Proctored Final. If your Final Exam was sent to your proctor, then he or she will have to enter a password that was issued to them on the Proctor Instruction Sheet for the course. Syllabus xv Introduction to Financial Management Proctors The University requires that all Final Examinations except Associate and Bachelors level elective courses be completed under the supervision of a Proctor. At the time you enrolled into your program, you were given the total number of proctored Final Examinations required for your degr
ee program. The purpose of the proctored Final Examination is to verify that you are, in fact, the person who is enrolled in the course of study. It is also to verify that you are completing the Final Examination without the aid of any outside assistance. During the proctored Final Examination, you may use your textbook and any notes you have taken during the completion of your Unit Examinations. Your designated Proctor will verify your identity and that you have completed the Final Examination without any outside assistance. A Proctor can be anyone EXCEPT an immediate family member, someone who resides with you or a current/former CCU student. Receiving Your Examination Grades After your examinations are scored, a grade report will be mailed to you or you may arrange to have your grade e-mailed to you. You may also check your grades on the Coast Connection student portal. Grades are normally posted and available for review within 5 business days. Most students receive their grades by regular mail within two weeks after the University receives their examinations. If you do not receive a grade report within two weeks, please contact the Testing Department and a duplicate grade report will be sent to you. Students from foreign countries: Allow 4–6 weeks to receive your grade report by mail. Your Overall Grade Point Average In addition to receiving a passing grade for each course, all students must maintain a required Overall Grade Point Average in order to graduate. Undergraduate students need an Overall Grade Point Average of 2.0 (C) on a 4.0 scale. Graduate and Doctoral students need an Overall Grade Point Average of 3.0 (B) on a 4.0 scale. Online Final Exam submissions must be completed in one session; you can not save answers and go back to your exam later. We recommend that you complete your Final Exam on paper first, then transfer the answers to your online answer sheet. Syllabus xvi Introduction to Financial Management A = 4 grade points B = 3 grade points C = 2 grade points D = 1 grade point F = 0 grade points Students who do not meet the overall G.P.A. requirement by the end of their program must pay the current cost of tuition to repeat courses until they improve their overall G.P.A. Overall course grades of “F” will be displayed on your Degree Plan and count as 0 units completed. You must pay to retake these courses. Doctor of Education students must repeat any courses in which the overall course grade is a “D” or “F”. Be sure to keep a copy of all work you submit to the University. Syllabus xvii Introduction to Financial Management If you have any questions about how to proceed through the course or regarding any California Coast University policies and procedures, the easiest way to get help is to e-mail or phone the University. University office hours are Monday through Friday from 8:30 a.m. to 4:00 p.m., Pacific Standard Time. California Coast University 925 N. Spurgeon Street, Santa Ana, California 92701 Phone: (714) 547-9625 • Fax: (714) 547-5777 Test Answer Sheet Fax Line: (714) 547-1451 e-mail: testing@calcoast.edu Don’t forget: You are not alone! We are here to help you achieve your dream! BAM 313 Syllabus xviii Introduction to Financial Management Learning Objectives The learning objectives for this course are listed below: Chapter 1 • Identify the goal of the firm. • Compare the various legal forms of business organization and explain why the corpo- rate form of business is the most logical choice for a firm that is large or growing. • Describe the corporate tax features that affect business decisions. • Explain the ten principles that form the foundations of financial management. • Explain what has led to the era of the multinational corporation. Chapter 2 • Describe key components of the U.S. financial market system. • Understand the role of the investment-banking business in the context of raising cor- porate capital. • Distinguish between privately placed securities and publicly offered securities. • Be acquainted with securities flotation costs and securities markets regulations. • Understand the rate-of-return relationships among various classes of financing vehicles that persist in the financial markets. • Be acquainted with recent interest rate levels and the fundamentals of interest rate determination. • Explain the popular theories of the term structure of interest rates. • Understand the relationships among the multinational firm, efficient financial markets, and inter-country risk. Chapter 3 • Compute a company’s profits, as reflected by its income statement. • Determine a firm’s financial position at a point in time based on its balance sheet. • Measure a company’s cash flows. Chapter 4 • Explain the purpose and importance of financial analysis. • Calculate and use a comprehensive set of measurements to evaluate a company’s performance. • Describe the limitations of financial ratio analysis. Chapter 5 • Explain the mechanics of compounding, that is, how money grows over time when it is invested. • Be able to move money through time using time value of money tables, financial cal- culators, and spreadsheets. Syllabus xix Introduction to Financial Management • Discuss the relationship between compounding and bringing the value of money back to the present. • Define an ordinary annuity and calculate its compound or future value. • Differentiate between an ordinary annuity and an annuity due and determine the fu- ture and present value of an annuity due. • Explain loan amortization. • Determine the future or present value of a sum when there are non-annual compound- ing periods. • Determine the present value of an uneven stream of payments. • Determine the present value of a perpetuity. • Explain how the international setting complicates the time value of money. Chapter 6 • Define and measure the expected rate of return of an individual investment. • Define and measure the riskiness of an individual investment. • Compare the historical relationship between risk and rates of return in the capital markets. • Explain how diversifying investments affects the riskiness and expected rate of return of a portfolio or combination of assets. • Explain the relationship between an investor’s required rate of return on an investment and the riskiness of the investment. Chapter 7 • Distinguish between different kinds of bonds. • Explain the more popular features of bonds. • Define the term value as used for several different purposes. • Explain the factors that determine value. • Describe the basic process for valuing assets. • Estimate the value of a bond. • Compute a bondholder’s expected rate of return. • Explain three important relationships that exist in bond valuation. Chapter 8 • Identity the basic characteristics of preferred stock. • Value preferred stock. • Identify the basic characteristics of common stock. • Value common stock. • Calculate a stock’s expected rate of return. Syllabus xx Introduction to Financial Management Chapter 9 • Discuss the difficulty encountered in finding profitable projects in competitive markets and the importance of the search. • Determine whether a new project should be accepted or rejected using the payback period, the net present value, the profitability index, and the internal rate of return. • Explain how the capital-budgeting decision process changes when a dollar limit is placed on the capital budget. • Discuss the problems encountered in project ranking. • Explain the importance of ethical considerations in capital-budgeting decisions. • Discuss the trends in the use of different capital-budgeting criteria. • Explain how foreign markets provide opportunities for finding new capital-budgeting projects. Chapter
10 • Identify guidelines by which we measure cash flows. • Explain how a project’s benefits and costs—that is, its free cash flows—are calculated. • Explain the importance of options, or flexibility, in capital budgeting. • Explain what the appropriate measure of risk is for capital-budgeting purposes. • Determine the acceptability of a new project using the risk-adjusted discount method of adjusting for risk. • Explain the use of simulation for imitating the performance of a project under evalua- tion. • Explain why a multinational firm faces a more difficult time estimating cash flows along with increased risks. Chapter 11 • Describe the concepts underlying the firm’s cost of capital (technically, its weighted average cost of capital) and the purpose for its calculation. • Calculate the after-tax cost of debt, preferred stock, and common equity. • Calculate a firm’s weighted average cost of capital. • Describe the procedure used by PepsiCo to estimate the cost of capital for a multidivi- sional firm. • Use the cost of capital to evaluate new investment opportunities. • Compute the economic profit earned by the firm and use this quantity to calculate incentive-based compensation. • Calculate equivalent interest rates for different countries. Chapter 12 • Understand the difference between business risk and financial risk. • Use the technique of break-even analysis in a variety of analytical settings. Syllabus xxi Introduction to Financial Management • Distinguish among the financial concepts of operating leverage, financial leverage, and combined leverage. • Calculate the firm’s degree of operating leverage, financial leverage, and combined leverage. • Understand the concept of an optimal capital structure. • Explain the main underpinnings of capital structure theory. • Understand and be able to graph the moderate position on capital structure impor- tance. • Incorporate the concepts of agency costs and free cash flow into a discussion on capi- tal structure management. • Use the basic tools of capital structure management. • Understand how business risk and global sales impact the multinational firm. Chapter 13 • Describe the trade-off between paying dividends and retaining the profits within the company. • Explain the relationship between a corporation’s dividend policy and the market price of its common stock. • Describe practical considerations that may be important to the firm’s dividend policy. • Distinguish among the types of dividend policies corporations frequently use. • Specify the procedures a company follows in administering the dividend payment. • Describe why and how a firm might pay non-cash dividends (stock dividends and stock splits) instead of cash dividends. • Explain the purpose and procedures related to stock repurchases. • Understand the relationship between a policy of low dividend payments and interna- tional capital budgeting opportunities that confront the multinational firm. Chapter 14 • Use the percent of sales method to forecast the financing requirements of a firm. • Describe the limitations of the percent of sales forecast method. • Prepare a cash budget and use it to evaluate the amount and timing of a firm’s financ- ing needs. Chapter 15 • Describe the risk–return trade-off involved in managing a firm’s working capital. • Explain the determinants of net working capital. • Calculate a firm’s cash conversion cycle and interpret its determinants. • Calculate the effective cost of short-term credit. • List and describe the basic sources of short-term credit. • Describe the special problems encountered by multinational firms in managing working capital. Syllabus xxii Introduction to Financial Management Robert S. Pindyck, Microeconomics, 6th Ed. Prentice Hall, 2005. Peter N. Ireland, “Long-term Interest Rate and Inflation: A Fisherian Approach,” Federal Reserve Bank of Richmond, Economic Quarterly, 82 (Winter 1996). Richard Roll, The Behavior of Interest Rates: An Application of the Efficient Market Model to U.S. Treasury Bills, New York: Basic Books, 1970. J. R. Hicks, Value and Capital, London: Oxford University Press, 1946. Jack and Suzy Welch, “How Healthy Is Your company?,” Business Week, May 8, 2006. Peter Bernstein, Against the Gods: the Remarkable Story of Risk. John Wiley & Sons, Inc., New York, 1996. Ronald Fink, “Bondholder Backlash,” CFO Magazine, February 01, 2006. John C. Kellecher and Justin J. MacCormack, “Internal Rate of Return: A Cautionary Tale,” McKinsey Quarterly, September 234, 2004. John R. Graham and Campbell r. Harvey, “The theory and Practice of Corporate Finance: Evidence from the Field,” Journal of Financial Economics 60, 1-2 (May/June 2001). Eugene F. Fama and Kenneth R. French, “Industry Costs of Equity,” Journal of Financial Economics 43 (1997). W. Carl Kester and Timothy A. Luehrman, “What Makes You Think U.S. Capital Is So Expensive?” Journal of Applied Corporate Finance (Summer 1992). A. A. Berle, Jr., and G.C. Means, The Modern Corporation and Private Property, New York: Macmillan, 1932. Edward I. Altman and Marti G. Subrahmanyam, eds., Recent Advances in Corporate Finance (Homewood, IL: Irwin, 1985). Joel M. Stern and Donald H. Chew, Jr., eds., The Revolution in corporate Finance (New York: Basil Blackwell, 1986). Suggested Readings Syllabus xxiii Introduction to Financial Management Suggested Online Readings Careers in Business www.careers-in-business.com Financial Scandals www.ex.ac.uk/RDavies/arian/scandals/classic. html Investopedia financial dictionary www.investopedia.com Executive Pay Watch www.aflcio.org Federal Reserve Statistical Releases www.federalreserve.gov Inflation Indices www.stats.bls.gov North American Industry Classification System www.naics.com Financenter www.financenter.com Find Bonds by name http://bond.yahoo.com Investing in preferred stock www.jbv.com Personal and Business finance http://moneycentral.msn.com Personal finance calculators www.dinkytown.net Treasury Management Web site – Current yield information www.tmpages.com Federal Reserve Bank of St. Louis www.stlouisfed.org Table of Contents xxiv Introduction to Financial Management Syllabus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . viii-xxiii Unit One Chapter 1: An Introduction to the Foundations of Financial Management – The Ties That Bind. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1-11 Chapter 2: The Financial Markets and Interest Rates. . . . . . . . . . . . . . . . 12-22 Chapter 3: Understanding Financial Statements and Cash Flows . . . . . . . 23-35 Chapter 4: Evaluating a Firm’s Financial Performance . . . . . . . . . . . . . . 36-45 Unit 1 Examination Instructions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46 Unit 1 Examination. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47-54 Unit 1 Essay Examination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55 Unit Two Chapter 5: The Time Value of Money. . . . . . . . . . . . . . . . . . . . . . . . . . . 58-67 Chapter 6: The Meaning and Measurement of Risk and Return. . . . . . . . . 68-76 Chapter 7: The Valuation and characteristics of Bonds. . . . . . . . . . . . . . 77-86 Chapter 8: The Valuation and Characteristics of Stock . . . . . . . . . . . . . . 87-96 Unit 2 Examination Instructions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96 Unit 2 Examination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97-102 Unit 2 Essay Examination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103 Unit Three Chapter 9: Capital-Budgeting Techniques and Practice . . . . . . . . . . . . . . 105-114 Chapter 10: Cash Flows and Other Topics in Capital Budgeting. . . . . . . . 115-124 Chapter 11: The Cost of Capital. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125-134 Unit 3 Examination Instructions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135 Unit 3 Exa
mination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136-141 Unit 3 Essay Examination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142 Unit Four Chapter 12: Determining the Financing Mix. . . . . . . . . . . . . . . . . . . . . . 144-153 Chapter 13: Dividend Policy and Internal Financing . . . . . . . . . . . . . . . . 154-164 Chapter 14: Short-Term Financial Planning . . . . . . . . . . . . . . . . . . . . . . 166-174 Chapter 15: Working-Capital Management . . . . . . . . . . . . . . . . . . . . . . . 175-184 Table of Contents xxv Introduction to Financial Management Unit 4 Examination Instructions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 185 Unit 4 Examination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 186-191 Unit 4 Essay Examination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 192-193 Final Examination Instructions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 194 Final Examination Scheduling Form . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 195 Objectives 1 Introduction to Financial Management Chapter Number One An Introduction to the Foundations of Financial Management – The Ties That Bind Learning Objectives Upon successful completion of this chapter, you should be able to: 1. Identify the goal of the firm. 2. Compare the various legal forms of business organization and explain why the corporate form of business is the most logical choice for a firm that is large or growing. 3. Describe the corporate tax features that affect business decisions. 4. Explain the ten principles that form the foundations of financial management. 5. Explain what has led to the era of the multinational corporation. Instructions to Students • Read pages 4-29 of your textbook • Reference: Foundations of Finance: The Logic and Practice of Financial Management, by Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr., 6th Edition 2008 Overview 2 Introduction to Financial Management This chapter lays a foundation for what will follow. First, it focuses on the goal of the firm, followed by a review of the legal forms of business organization, and a discussion of the tax implications relating to financial decisions. Ten Principles that form the foundations of financial management then follow. Key Terms 3 Introduction to Financial Management The key terms listed below are terms you should be familiar with. Write your definition below each item. Check your answers at the end of this chapter. Sole proprietorship: Partnership: General partnership: Limited partnership: Corporation: S-type corporation: Limited liability company (LLC): Taxable income: Gross income: Marginal tax rate: Depreciation: Capital gain (or loss): Incremental cash flow: Efficient market: Agency problem: Summary 4 Introduction to Financial Management This chapter outlines the framework for the maintenance and creation of shareholder wealth, which should be the goal of the firm and its managers. The commonly accepted goal of profit maximization is contrasted with the more complete goal of the maximization of shareholder wealth. Because it deals well with uncertainty and time in a real-world environment, the maximization of shareholder wealth is found to be the proper goal for the firm. The legal forms of business are examined. The sole proprietorship is a business operation owned and managed by an individual. Initiating this form of business is simple and generally does not involve any substantial organizational costs. The proprietor has complete control of the firm but must be willing to assume full responsibility for its outcomes. The general partnership, which is simply a coming together or two or more individuals, is similar to the sole proprietorship. The limited partnership is another form of partnership sanctioned by states to permit all but one of the partners to have limited liability if this is agreeable to all partners. The corporation increases the flow of capital from public investors to the business community. Although larger organizational costs and regulations are imposed on this legal entity, the corporation is more conducive to raising large amounts of capital. Limited liability, continuity of life, and ease of transfer in ownership, which increase the marketability of the investment, have contributed greatly in attracting large numbers of investors to the corporate environment. The formal control of the corporation is vested in the parties who own the greatest number of shares. However, dayto-day operations are managed by the corporate officers, who theoretically serve on behalf of the firm’s stockholders. The tax environment is presented insomuch as taxes affect our business decisions. Three taxable entities exist: the individual, including partnerships; the corporation; and the fiduciary. Only information on the corporate tax environment is given here. For the most part, taxable income for the corporation is equal to the firm’s operating income plus capital gains less any interest expense. The corporation is allowed an income exclusion of 70 percent of the dividends received from another corporation. Tax consequences, particularly marginal tax rates, have a direct bearing on the decisions of the financial manager. An examination of the 10 principles on which finance is built is presented. The techniques and tools introduced in this text are all motivated by these 10 principles. They are: 1. The-Risk-Return Trade-Off – We won’t take on additional risk unless we expect to be compen- sated with additional return. 2. The Time Value of Money – A dollar received today is worth more than a dollar received in the future. 3. Cash – Not Profits – Is King. 4. Incremental Cash Flows – It’s only what changes that counts. Summary 5 Introduction to Financial Management 5. The Curse of Competitive Markets – Why it’s hard to find exceptionally profitable projects. 6. Efficient capital markets – The markets are quick and the prices are right. 7. The Agency Problem – Managers won’t work for the firm’s owners unless it’s in their best interest. 8. Taxes Bias Business Decisions 9. All Risk is not Equal – Some risk can be diversified away, and some can not. 10. Ethical behavior means doing the right thing, but ethical dilemmas are everywhere in finance. With the collapse of communism and the acceptance of the free market system in third world countries, U.S. firms have been spurred on to look beyond their own boundaries for new business. The end result has been that it is not uncommon for major U.S. companies to earn over half their income from sales abroad. Foreign firms are also increasingly investing in the United States. Self Test 6 Introduction to Financial Management Multiple Choice Questions (Circle the correct answer) 1) Joe is deciding whether or not to invest $10,000 in a business that has pending law- suits against it. If Joe invests and the business loses the lawsuits, the most Joe can lose is a. $10,000 plus his share of the lawsuits if Joe is a limited partner. b. $10,000 if Joe is a limited partner. c. $10,000 if Joe is a general partner. d. $10,000 is Joe is a sole proprietor. 2) Which of the following statements about the corporate form of business organization is true? a. The corporate form has the disadvantage of double taxation relative to a sole propri- etorship. b. The corporate form is preferred over the sole proprietorship because a corporation is easier to form and faces less regulation. c. The corporate form has the advantage of unlimited liability. d. Sole proprietorships are the most common form of business organization because li- ability is limited to the amount invested in the business by the sol
e proprietor. 3) Which of the following categories of owners have unlimited liability? a. general partners in a limited partnership b. sole proprietors c. shareholders of a corporation d. both A and B 4) A corporation has an average tax rate of 25% and a marginal tax rate of 39%. The corporation can invest in a tax-free project with an expected before-tax return of 6.8% or in a taxable project with an expected before-tax return of 10%. The corpora- tion should a. Invest in the taxable project because the return is greater. b. Be indifferent between the two investments because the after-tax returns are the same. c. Invest in the tax-free project because the after-tax return is greater. d. Invest in the taxable project because the after-tax return is greater. 5) When evaluating an investment project, which of the following best describes the financial information needed by the decision maker? a. After-tax accounting profits b. Pre-tax accounting profits adjusted for any accounting method changes c. After-tax incremental cash flows to the company as a whole d. Incremental cash flows before taxes so the decision will not be biased by a tax code that may change in the future Self Test 7 Introduction to Financial Management 6) A corporation may normally exclude what percentage of dividend income received from another corporation? a. 70% b. 30% c. 35% d. 50% 7) Company A reports sales of $100,000 and net income of $15,000. Company B re- ports sales of $100,000 and net income of $10,000. Therefore: a. Company A’s cash flow is $5,000 more than Company B’s cash flow. b. Company B is creating less value for its shareholders than Company A. c. Company A’s cash flow may be higher or lower than Company B’s cash flow even though A’s net income is higher. d. Company B’s accounts receivable must be higher than Company A’s accounts receiv- able. 8) Profits are down so the controller decides to change the corporation’s accounting policy relating to inventory costing. The change will allow the corporation to report higher income and higher assets, although the physical inventory has not changed. Which of the following statements is most correct? a. If the stock price increases, the stock market is efficient. b. The stock price is likely to decrease because reported inventory is higher. c. The stock price is likely to increase because income is higher. d. The stock price is likely to be unaffected because the stock market is efficient. 9) John invested $1,000 in a risky investment and Bill invested $1,000 in a less risky investment. One year later, Bill’s investment is worth $1,030. Which of the following statements is most correct? a. If John’s investment is worth more than $1,030, then Bill was irrational to invest in the less risky investment. b. If John’s investment is worth less than $1,030, then John was irrational to invest in the risky project. c. John’s investment must be worth more than $1,030 because of the risk-return tradeoff, given that John’s investment was more risky. d. The worth of John’s investment cannot be determined with the information given. 10) High Tech Corp. cut its research and development budget in 2008 by $4,000,000 in order to improve its cash flow for the year. Which of the following statements is most correct? a. The change will have no impact on stock price because the company’s profits will not change in 2008. Self Test 8 Introduction to Financial Management b. The stock price will increase only if reported profits in 2009 are also higher than profits reported in 2007. c. The stock price will likely increase because the value of stock is based on reported cash flow. d. The stock price may decrease because investors may predict that future cash flows will decrease due to the lack of innovation and new products. Answer Keys 9 Introduction to Financial Management Key Term Definitions Sole proprietorship: A business owned by a single individual. Partnership: An association of two or more individuals joining together as co-owners to operate a business for profit. General partnership: A partnership in which all partners are fully liable for the indebtedness incurred by the partnership. Limited partnership: A partnership in which one or more of the partners has limited liability, restricted to the amount of capital he or she invests in the partnership. Corporation: An entity that legally functions separate and apart from its owners. S-type corporation: A corporation that, because of specific qualifications, is taxed as though it were a partnership. Limited liability company (LLC): A cross between a partnership and a corporation under which the owners retain limited liability but the company is run and is taxed like a partnership. Taxable income: Gross income from all sources, except for allowable exclusions, less any taxdeductible expenses. Gross income: A firm’s dollar sales from its product or services less the cost of producing or acquiring them. Marginal tax rate: The tax rate that would be applied to the next dollar of income. Depreciation: The means by which an asset’s value is expensed over its useful life for federal income tax purposes. Capital gain (or loss): As defined by the revenue code, a gain or loss resulting from the sale or exchange of a capital asset. Incremental cash flow: The cash flows that result from the acceptance of a project the firm takes on. Efficient market: A market in which the prices of securities at any instant in time fully reflect all publicly available information about the securities and their actual public values. Agency problem: Problems and conflicts resulting from the separation of the management and ownership of the firm. Answer Keys 10 Introduction to Financial Management Answers to Self Test 1) b 2) a 3) d 4) c 5) c 6) a 7) c 8) d 9) d 10) d Notes 11 Introduction to Financial Management Objectives 12 Introduction to Financial Management Chapter Number Two The Financial Markets and Interest Rates Learning Objectives Upon successful completion of this chapter, you should be able to: 1. Describe key components of the U.S. financial market system. 2. Understand the role of the investment-banking business in the context of raising corporate capital. 3. Distinguish between privately placed securities and publicly offered securities. 4. Be acquainted with securities flotation costs and securities markets regulations. 5. Understand the rate-of-return relationships among various classes of financing vehicles that persist in the financial markets. 6. Be acquainted with recent interest rate levels and the fundamentals of interest rate determination. 7. Explain the popular theories of the term structure of interest rates. 8. Understand the relationships among the multinational firm, efficient financial markets, and inter-country risk. Instructions to Students • Read pages 30-59 of your textbook • Reference: Foundations of Finance: The Logic and Practice of Financial Management, by Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr., 6th Edition 2008 Overview 13 Introduction to Financial Management As you read this chapter you will learn how funds are raised in the financial markets. Key components of the U.S. financial market system will be explored, as well as will the differences between privately placed securities and publicly offered securities. The rate of return relationships among various classes of financing vehicles that persist in the financial markets will also be presented. By the end of the chapter you should understand the basics of acquiring financial capital in the funds marketplace. Key Terms 14 Introduction to Financial Management Public offering: Private placement: Venture capital: Primary markets: Initial public offering, IPO: Seasoned equity offering, SEO: Secondary market: Money market: Capital market: Organized security exchanges: Over-the-counter markets: Investment banker: Underwriting: Underwriter’s spread: Syndicate: Privileged subscription: Du
tch auction: Direct sale: Flotation costs: Opportunity cost of funds: Maturity premium: Liquidity premium: Nominal rate of interest: Real rate of interest: Term structure of interest rates: Yield to maturity: Unbiased expectations theory: Liquidity preference theory: Market segmentation theory: The key terms listed below are terms you should be familiar with. Write your definition below each item. Check your answers at the end of this chapter. Summary 15 Introduction to Financial Management This chapter centers on the market environment in which corporations raise long-term funds, including the structure of the U.S. financial markets, the institution of investment banking, and the various methods for distributing securities. It also discusses the role interest rates play in allocating savings to ultimate investment. Corporations can raise funds through public offerings or private placements. The public market is impersonal in that the security issuer does not meet the ultimate investors in the financial instruments. In a private placement, the securities are sold directly to a limited number of institutional investors. The primary market is the market for new issues. The secondary market represents transactions in currently outstanding securities. Both the money and capital markets have primary and secondary sides. The money market refers to transactions in short-term debt instruments. The capital market, on the other hand, refers to transactions in long-term financial instruments. Trading in the capital markets can occur in either the organized security exchanges or the over-the-counter market. The money market is exclusively an over-the-counter market. The investment banker is a financial specialist involved as an intermediary in the merchandising of securities. He or she performs the functions of (1) underwriting, (2) distributing, and (3) advising. Major methods for public distribution of securities include the negotiated purchase, the competitive bid purchase, the commission or best-efforts basis, privileged subscriptions, and direct sales. The direct sale bypasses the use of an investment banker. The negotiated purchase is the most profitable distribution method to the investment banker. It also provides the greatest amount of investment-banking services to the corporate client. Privately placed debt provides an important market outlet for corporate bonds. Major investors in this market are life insurance firms, state and local retirement funds, and private pension funds. Several advantages and disadvantages are associated with private placements. The financial officer must weight these attributes and decide if a private placement is preferable to a public offering. Flotation costs consist of the underwriter’s spread and issuing costs. The flotation costs of common stock exceed those of preferred stock, which, in turn, exceed those of debt. Moreover, flotation costs as a percent of gross proceeds are inversely related to the size of the security issue. On July 30, 2002, President Bush signed into law the Public Company Accounting Reform and Investor Protection Act. This act is commonly known as the Sarbanes-Oxley Act of 2002. Its intended purpose as stated in the act is “to protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws, and for other purposes.” The financial markets give managers an informed indication of investors’ opportunity costs. The more efficient the market, the more informed the indication. This information is a useful input about the rates of return that investors require on financial claims. In turn, this becomes useful to financial mangers as they estimate the overall cost of capital the firm will have to pay for its financing needs. From Principle 1: The risk-Return Trade-Off, you know that the rates of return on various securities are based on the risks that investors face when they invest in those securities. In addition to a risk-free return, investors will want to be compensated for the potential loss of purchasing power resulting from inflation. Moreover, investors require a greater return the greater the default risk, maturity premium, and liquidity premium are on the securities being analyzed. Summary 16 Introduction to Financial Management A system of robust and credible financial markets allows great ideas to be financed and increases the overall wealth of a given economy. The multinational firm with cash to invest in foreign markets will weigh heavily the integrity of both the financial system and the political system of the prospective foreign country where the proposed investment project will be domiciled. A lack of integrity on either the financial side or the political stability side retards direct investment in a less-developed nation. Self Test 17 Introduction to Financial Management Multiple Choice Questions (Circle the correct answer) 1) U.S. corporations finance their activities a. mainly with equity because the U.S. tax system favors equity over debt. b. equally with debt and equity. c. mainly with corporate debt, partially because the U.S. tax system favors debt over equity. d. mainly with equity because equity does not expire or need to be paid back. 2) Which of the following is an advantage of organized stock exchanges? a. screening companies to ensure only low risk stocks are sold b. providing a continuous market c. increased stock price volatility d. Only profitable companies may issue new securities on an organized exchange. 3) An example of a primary market transaction involving a money market security is: a. A new issue of a security with a very short maturity. b. The transfer of a previously-issued security with a very long maturity. c. The transfer of a previously-issued security with a very short maturity. d. A new issue of a security with a very long maturity. 4) Capital market transactions include which of the following? a. Common stock of a public corporation b. All securities that are purchased in the open market c. Any security that is purchased from a brokerage firm that is well capitalized d. U.S. Treasury bills 5) Which of the following statements concerning private placements is most correct? a. Private placements are limited to stocks, not bonds. b. More than half of all private placements are sold to federal, state, or local govern- ments or government agencies. c. Private placements do not involve investment bankers. d. Although not selling the securities to the public, investment bankers may provide ad- vice on the evaluation of prospective buyers and the terms of sale for private place- ments. 6) All of the following are typically advantages of private placements except a. financial flexibility. b. speed. c. the possibility of future SEC registration. d. reduced flotation costs. Self Test 18 Introduction to Financial Management 7) Which of the following would not normally be considered a “flotation cost?” a. Dividends b. Legal fees c. Underwriter’s spread d. Printing and engraving expenses 8) Over the period 1926 to 2005 the standard deviation of returns has been the greatest for which of the following: a. Corporate bonds b. Common stocks c. Common stocks of small firms d. Treasury bills 9) The real rate of return is the return earned above the a. inflation risk premium. b. variability of returns measured by standard deviation. c. risk-adjusted return. d. default risk premium. 10) The risk premium would be greater for an investment in an oil and gas exploration in unproven fields than an investment in preferred stock because a. oil and gas exploration investments have a greater variability in possible returns. b. the preferred stock is more liquid. c. the inflation rate would vary more with oil and gas exploration investments. d. both A and B Answer Keys 19 Introduction to Financial Management Key Term Definitions Public offering: A security offering where all investors have the opportunity to acquire a portion of the financial claims being sold. Private placement: A security offering limited to a small number of potential investors. Venture capital: Funds made available to start-up co
mpanies or companies in the early stages of business, as well as firms in “turnaround” situations. These are risky investments, generally in innovative enterprises and many times in high-technology areas. Primary markets: A market in which securities are offered for the first time for sale to potential investors. Initial public offering, IPO: The first time a company issues its stock to the public. Seasoned equity offering, SEO: The sale of additional stock by a company whose shares are already publicly traded. Secondary market: A market in which currently outstanding securities are traded. Money market: All institutions and procedures that facilitate transactions for short-term instruments issued by borrowers with very high credit ratings. Capital market: All institutions and procedures that facilitate transactions in long-term financial instruments. Organized security exchanges: Formal organizations that facilitate the trading of securities. Over-the-counter markets: All security markets except organized exchanges. The money market is an over-the-counter market. Most corporate bonds also are traded in this market. Investment banker: A financial specialist who underwrites and distributes new securities and advises corporate clients about raising new funds. Underwriting: The purchase and subsequent resale of a new security issue. The risk of selling the new issue at a satisfactory (profitable) price is assumed (underwritten) by the investment banker. Underwriter’s spread: The difference between the price the corporation raising money gets and the public offering price of a security. Syndicate: A group of investment bankers who contractually assist in the buying and selling of a new security issue. Privileged subscription: The process of marketing a new security issue to a select group of investors. Dutch auction: A method of issuing securities (common stock) where investors place bids indicating how many shares they are willing to buy and at what price. Answer Keys 20 Introduction to Financial Management Direct sale: The sale of securities by a corporation to the investing public without the services of an investment-banking firm. Flotation costs: The transaction cost incurred when a firm raises funds by issuing a particular type of security. Opportunity cost of funds: The next-best rate of return available to the investor for a given level of risk. Maturity premium: The additional return required by investors in longer-term securities to compensate them for the greater risk of price fluctuations on those securities caused by interest rate changes. Liquidity premium: The additional return required by investors for securities that cannot be quickly converted into cash at a reasonably predictable price. Nominal rate of interest: The interest rate paid on debt securities without an adjustment for any loss in purchasing power. Real rate of interest: The nominal (quoted) rate of interest less any loss in purchasing power of the dollar during the time of the investment. Term structure of interest rates: The relationship between interest rates and the term to maturity, where the risk of default is held constant. Yield to maturity: The rate of return a bondholder will receive if the bond is held to maturity. Unbiased expectations theory: The theory that the shape of the term structure of interest rates is determined by an investor’s expectations about future interest rates. Liquidity preference theory: The theory that the shape of the term structure of interest rates is determined by an investor’s additional required interest rate in compensation of additional risks. Market segmentation theory: The theory that the shape of the term structure of interest rates implies that the rate of interest for a particular maturity is determined solely by demand and supply for a given maturity. This rate is independent of the demand and supply for securities having different maturities. Answer Keys 21 Introduction to Financial Management Answers to Self Test 1) c 2) b 3) a 4) a 5) d 6) c 7) a 8) c 9) a 10) d Notes 22 Introduction to Financial Management Objectives 23 Introduction to Financial Management Chapter Number Three Understanding Financial Statements and Cash Flows Learning Objectives Upon successful completion of this chapter, you should be able to: 1. Compute a company’s profits, as reflected by its income statement. 2. Determine a firm’s financial position at a point in time based on its balance sheet. 3. Measure a company’s cash flows. Instructions to Students • Read pages 61-93 of your textbook • Reference: Foundations of Finance: The Logic and Practice of Financial Management, by Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr., 6th Edition 2008 Overview 24 Introduction to Financial Management In this chapter, we review the contents and meaning of a firm’s income statement and balance sheet. We also look very carefully at how to compute a firm’s cash flows from a finance perspective, rather than from an accountant’s view, which in finance speak is called free cash flows. Key Terms 25 Introduction to Financial Management The key terms listed below are terms you should be familiar with. Write your definition below each item. Check your answers at the end of this chapter. Income statement (profit and loss statement): Cost of goods sold: Gross profit: Operating expense: Operating income (earnings before interest and taxes): Earnings before taxes (taxable income): Financing cost: Net income (earnings available to common stockholders): Earnings per share: Dividends per share: Common-sized income statement: Profit margins: Gross profit margin: Operating profit margin: Net profit margin: Balance sheet: Accounting book value: Current assets (gross working capital): Cash: Accounts receivable: Inventories: Fixed assets: Depreciation expense: Accumulated depreciation: Gross fixed assets: Net fixed assets: Debt: Equity: Accounts payable (trade credit): Trade credit: Accrued expenses: Key Terms 26 Introduction to Financial Management Mortgage: Preferred stockholders: Common stockholders: Common stock: Par value: Treasury stock: Retained earnings: Net working capital: Operating working capital: Non-interest-bearing current liabilities (NIBCL): Debt ratio: Common-sized balance sheet: Accrual basis accounting: Free cash flows: Financing cash flows: Summary 27 Introduction to Financial Management A firm’s profits may be viewed as follows: Gross profit = sales – cost of goods sold. Earnings before interest and tax (operating profit) = sales – cost of goods sold – operating expenses. Net profit (net income) = sales – cost of goods sold – operating expenses – interest expenses – taxes. The following five activities determine a company’s net income: 1. The revenue derived from selling the company’s product or service. 2. The cost of producing or acquiring the goods or services to be sold. 3. The operating expenses related to (1) marketing and distributing the product or service to the customer and (2) administering the business. 4. The financing costs of doing business – namely the interest paid to the firm’s creditors. 5. The payment of taxes. The balance sheet presents a company’s assets, liabilities, and equity on a specific date. Its total assets represent all the investments that the firm has made in the business. The total assets must equal the firm’s total debt and equity because every dollar of assets has been financed by the firm’s lenders or stockholders. The firm’s assets include its current assets, fixed assets, and other assets. Its debt includes both its short-term and long-term debt. The firm’s equity includes (1) common stock, which may be shown as par value plus additional paid-in-capital, and (2) retained earnings. All the numbers in a balance sheet are based on historical costs, rather than current market values. In measuring a firm’s cash flows we can take one of two perspectives: the cash flows produced by the firm’s assets (free cash flows) or the cash flows received from or distributed to lenders and investors (financing cash flows). Self Test 28 Introdu
ction to Financial Management Multiple Choice Questions (Circle the correct answer) 1) Wheeler Corporation had retained earnings as of 12/31/08 of $12 million. During 2009, Wheeler’s net income was $4 million. The retained earnings balance at the end of 2009 was equal to $13 million. Therefore, a. Wheeler paid a dividend in 2008 of $5 million. b. Wheeler paid a dividend in 2008 of $3 million. c. Wheeler purchased treasury stock in 2008 for $3 million. d. Wheeler sold common stock during 2008 for $3 million. 2) All of the following are equity accounts on a balance sheet except: a. paid-in capital b. retained earnings c. common stock d. cash 3) Given the following financial statements for ACME Corporation, what amount did the company pay in dividends for 2007? Year Ended 12/31/07 12/31/07 12/31/06 Sales $1,200,000 Current Assets $50,000 $45,000 Cost of Goods Sold 750,000 Gross Fixed Assets 880,000 650,000 Operating Expenses 200,000 Less Acc. Dep. 450,000 350,000 Depreciation Expense 100,000 Fixed Assets 430,000 350,000 EBIT 150,000 Total Assets $480,000 $395,000 Interest Expense 50,000 EBT 100,000 Current Liabilities $35,000 $50,000 Taxes 40,000 Long-term Debt 330,000 270,000 Net Income $ 60,000 Common Stock 5,000 5,000 Retained Earnings 110,000 70,000 Total Liab & Equity $480,000 $395,000 a. $100,000 b. $20,000 c. $45,000 d. $60,000 4) PDQ Corp. has sales of $3,000,000; the firm’s cost of goods sold is $1,425,000; and its total operating expenses are $700,000. The firm’s interest expense is $230,000, and the corporate tax rate is 40%. The firm paid dividends to preferred stockholders of $30,000, and the firm distributed $60,000 in dividend payments to common stockholders. What is PDQ’s “Addition to Retained Earnings”? a. $477,000 Self Test 29 Introduction to Financial Management b. $327,000 c. $297,000 d. $387,000 5) Which of the following accounts does NOT belong on the asset side of a balance sheet? a. Cash b. Inventory c. Depreciation expense d. Accounts receivable 6) Baron, Inc. has total current assets of $1,000,000; total current liabilities of $600,000; and long-term assets of $800,000. How much is the firm’s Total Liabili- ties & Equity? a. $400,000 b. $1,800,000 c. $1,200,000 d. $1,600,000 7) Baron, Inc. has total current assets of $1,000,000; total current liabilities of $600,000; long-term assets of $800,000; and long-term debt of $400,000. How much is the firm’s total equity? a. $800,000 b. $400,000 c. $2,000,000 d. $1,200,000 8) Examples of uses of cash are a. repaying a loan. b. purchasing machinery. c. giving cash dividends to stockholders. d. all of the above. 9) The free cash flow for Synco, Inc. equals $100,000. The firm made fixed asset in- vestments of $50,000, and operating working capital increased by $50,000. What was the after-tax cash flow from operations? a. $0 b. $150,000 c. $200,000 d. $100,000 Self Test 30 Introduction to Financial Management 10) A firm has after-tax cash flow from operations equal to $100,000. Operating working capital increased by $20,000, and the firm purchased $30,000 of fixed assets. The firm’s free cash flow was: a. $90,000 b. $50,000 c. $110,000 d. $150,000 Answer Keys 31 Introduction to Financial Management Key Term Definitions Income statement (profit and loss statement): A basic accounting statement that measures the results of a firm’s operations over a specified period, commonly one year. Cost of goods sold: The cost of producing or acquiring a product or service to be sold in the ordinary course of business. Gross profit: Sales or revenue minus the cost of goods sold. Operating expense: Marketing and selling expenses, general and administrative expenses, and depreciation expense. Operating income (earnings before interest and taxes): Sales less the cost of goods sold less operating expenses. Earnings before taxes (taxable income): Operating income minus interest expense. Financing cost: Cost incurred by a company that often includes interest expenses and preferred dividends. Net income (earnings available to common stockholders): A figure representing a firm’s profit or loss for the period. It also represents the earnings available to the firm’s common and preferred stockholders. Earnings per share: Net income on a per share basis. Dividends per share: The amount of dividends a firm pays for each share outstanding. Common-sized income statement: An income statement in which a firm’s expenses and profits are expressed as a percentage of its sales. Profit margins: Financial ratios (sometimes simply referred to as margins) that reflect the level of the firm’s profits relative to its sales. Gross profit margin: Gross profit divided by net sales. It is a ratio denoting the gross profit earned by the firm as a percentage of its net sales. Operating profit margin: Operating income divided by sales. This ratio serves as an overall measure of the company’s operating effectiveness. Net profit margin: Net income divided by sales. A ratio that measures the net income of the firm as a percent of sales. Balance sheet: A statement that shows a firm’s assets, liabilities, and shareholder equity at a given point in time. It is a snapshot of the firm’s financial position on a particular date. Accounting book value: The value of an asset as shown on a firm’s balance sheet. It represents the historical cost of the asset rather than its current market value or replacement cost. Current assets (gross working capital): Current assets consist primarily of cash, marketable securities, accounts receivable, inventories, and prepaid expenses. Answer Keys 32 Introduction to Financial Management Cash: Cash on hand, demand deposits, and short-term marketable securities that can quickly be converted into cash. Accounts receivable: Money owed by customers who purchased goods or services from the firm on credit. Inventories: Raw materials, work in progress, and finished goods held by the firm for eventual sale. Fixed assets: Assets such as equipment, buildings and land. Depreciation expense: A non-cash expense to allocate the cost of depreciable assets, such as plant equipment, over the life of the asset. Accumulated depreciation: The sum of all depreciation taken over the entire life of a depreciable asset. Gross fixed assets: The original cost of a firm’s fixed assets. Net fixed assets: Gross fixed assets minus the accumulated depreciation taken over the life of the assets. Debt: Liabilities consisting of such sources as credit extended by suppliers or a loan from a bank. Equity: Stockholders’ investment in the firm and the cumulative profits retained in the business up to the date of the balance sheet. Accounts payable (trade credit): Money owed to suppliers for goods or services purchased in the ordinary course of business. Trade credit: Credit made available by a firm’s suppliers in conjunction with the acquisition of materials. Accrued expenses: Expenses that have been incurred but not yet paid in cash. Mortgage: A loan to finance real estate where the lender has first claim on the property in the event the borrower is unable to repay the loan. Preferred stockholders: Stockholders who have claims on the firm’s income and assets after creditors, but before common stockholders. Common stockholders: Investors who own the firm’s common stock. Common stockholders are the residual owners of the firm. Common stock: Shares that represent ownership in a corporation. Par value: On the face of a bond, the stated amount that the firm is to repay upon the maturity date. Treasury stock: The firm’s stock that has been issued and then repurchased by the firm. Answer Keys 33 Introduction to Financial Management Retained earnings: Cumulative profits retained in a business up to the date of the balance sheet. Net working capital: The difference between a firm’s current assets and its current liabilities. Operating working capital: The firm’s current assets less its non-interest-bearing current liabilities. Non-interest-bearing current liabilities (NIBCL): Current liabilities that incur no interest expense, such as accounts payable and accrued expenses. Debt ratio: A
firm’s total liabilities divided by its total assets. It is a ratio that measures the extent to which a firm has been financed with debt. Common-sized balance sheet: A balance sheet in which a firm’s assets and sources of debt and equity are expressed as a percentage of its total assets. Accrual basis accounting: A method of accounting whereby revenue is recorded when it is earned, whether or not the revenue has been received in cash. Likewise, expenses are recorded when they are incurred, even if the money has not actually been paid out. Free cash flows: The amount of cash available from operations after the firm pays for the investments it has made in operating working capital and fixed assets. This cash is available to distribute to the firm’s creditors and owners. Financing cash flows: Cash flows paid to or received from investors and lenders. Answer Keys 34 Introduction to Financial Management Answers to Self Test 1) b 2) d 3) b 4) c 5) c 6) b 7) a 8) d 9) c 10) b Notes 35 Introduction to Financial Management Objectives 36 Introduction to Financial Management Chapter Number Four Evaluating a Firm’s Financial Performance Learning Objectives Upon successful completion of this chapter, you should be able to: 1. Explain the purpose and importance of financial analysis. 2. Calculate and use a comprehensive set of measurements to evaluate a company’s performance. 3. Describe the limitations of financial ratio analysis. Instructions to Students • Read pages 94-127 of your textbook • Reference: Foundations of Finance: The Logic and Practice of Financial Management, by Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr., 6th Edition 2008 Overview 37 Introduction to Financial Management Financial analysis can be defined as the process of assessing the financial condition of a firm. The principal analytical tool of the financial analyst is the financial ratio. In this chapter, we provide a set of key financial ratios and a discussion of their effective use. Key Terms 38 Introduction to Financial Management The key terms listed below are terms you should be familiar with. Write your definition below each item. Check your answers at the end of this chapter. Financial ratios: Liquidity: Current ratio: Acid-test (quick) ratio: Average collection period: Accounts receivable turnover ratio: Inventory turnover: Operating return on assets (OROA): Operating profit margin: Total asset turnover: Asset efficiency: Fixed asset turnover: Debt ratio: Times interest earned: Return on equity: Price/earnings ratio: Price/book ratio: Summary 39 Introduction to Financial Management A variety of groups find financial ratios useful. For instance, both managers and shareholders use them to measure and track a company’s performance over time. Financial analysts outside of the firm who have an interest in its economic well-being also use financial ratios. An example of this group would be a loan officer of a commercial bank who wishes to determine the creditworthiness of a loan applicant and its ability to pay the interest and principal associated with the loan request. Financial ratios are the principal tool of financial analysis. Sometimes referred to simply as benchmarks, ratios standardize the financial information of firms so comparisons can be made between firms of varying sizes. Financial ratios can be used to answer at least five questions: (1) How liquid is the company? (2) Are the company’s managers effectively generating profits on the firm’s assets? (3) How is the firm financed? (4) Are the firm’s managers providing a good return on the capital provided by the shareholders? (5) Are the firm’s managers creating or destroying shareholder value? Two methods can be used to analyze a firm’s financial ratios. (1) We can examine the firm’s ratios across time to compare its current and past performance and (2) we can compare the firm’s ratios with those of other firms. Financial ratios provide a popular way to evaluate a firm’s financial performance. However, when evaluating a company’s use of its assets (capital) to create firm value, a financial ratio analysis based entirely on the firm’s financial statements may not be enough. If we want to understand how the shareholders assess the performance of a company’s managers, we can use the market price of the firm’s stock relative to its accounting earnings and equity book value. Economic Value Added (EVA) provides another approach to evaluate a firm’s performance in terms of shareholder value creation. EVA is equal to the return on a company’s invested capital less the investors’ opportunity cost of the funds times the total amount of the capital invested. The following are some of the limitations that you will encounter as you compute and interpret financial ratios: 1. It is sometimes difficult to determine an appropriate industry within which to place the firm. 2. Published industry averages are only approximations rather than scientifically determined averages. 3. Accounting practices differ widely among firms and can lead to differences in computed ratios. 4. Some financial ratios can be too high or too low, which makes the results more difficult to interpret. 5. An industry average may not be a desirable target ratio or norm. 6. Many firms experience seasonal business conditions. As a result, the ratios calculated for them will vary with the time of year the statements are prepared. In spite of their limitations, financial ratios provide us with a very useful tool for assessing a firm’s financial condition. Self Test 40 Introduction to Financial Management Multiple Choice Questions (Circle the correct answer) 1) Financial analysis a. relies on generally accepted accounting principles to make comparisons between companies valid. b. uses historical financial statements to measure a company’s performance and in mak- ing financial projections of future performance. c. uses historical financial statements and is thus useful only to assess past perfor- mance. d. is accounting record-keeping using generally accepted accounting principles. Table 4-1 Garland Company Balance Sheet Assets: Cash and marketable securities $500,000 Accounts receivable 800,000 Inventories 1,350,000 Prepaid expenses 50,000 Total current assets $2,700,000 Fixed assets 5,000,000 Less: accum. depr. (2,000,000) Net fixed assets $3,000,000 Total assets $5,700,000 Liabilities: Accounts payable $400,000 Notes payable 900,000 Accrued taxes 75,000 Total current liabilities $1,375,000 Long-term debt 1,200,000 Owner’s equity 3,125,000 Total liabilities and owner’s equity $5,700,000 Net sales (all credit) $8,000,000 Less: Cost of goods sold (3,500,000) Selling and administrative expense (2,000,000) Depreciation expense (250,000) Interest expense (150,000) Earnings before taxes 2,100,000 Income taxes (700,000) Net income $1,400,000 Common stock dividends $500,000 Common Shares Outstanding 1,000,000 2) Based on the information in Table 4-1, the accounts receivable turnover is: a. 8 b. 100 c. 10 d. 9.5 Self Test 41 Introduction to Financial Management 3) Based on the information in Table 4-1, the inventory turnover ratio is: a. 1.29 times b. 1.99 times c. 2.98 times d. 2.59 times 4) Based on the information in Table 4-1, the operating profit margin is: a. 44.8% b. 32.4% c. 28.1% d. 17.5% Table 4-2 Johnson Company Balance Sheet Assets: Cash and marketable securities $300,000 Accounts receivable 1,215,000 Inventories 1,747,500 Prepaid expenses 24,000 Total current assets 3,286,500 Fixed assets 2,700,000 Less: accum. depr. (1,087,500) Net fixed assets 1,612,500 Total assets $4,899,000 Liabilities: Accounts payable $240,000 Notes payable 825,000 Accrued taxes 42,000 Total current liabilities $1,107,000 Long-term debt 975,000 Common Stock (100,000 shares) 100,000 Retained Earnings 2,717,000 Total liabilities and owner’s equity $4,899,000 Net sales (all credit) $6,375,000 Less: Cost of goods sold (4,312,500) Selling and administrative expense (1,387,500) Depreciation expense (135,000) Interest expense (127,000) Earnings before taxes $412,500 Income taxes (225,000) Net income $187,500
Common stock dividends $97,500 Change in retained earnings $90,000 Self Test 42 Introduction to Financial Management 5) Based on the information in Table 4-2, the debt ratio is: a. 0.20 b. 0.74 c. 0.42 d. 0.70 6) Which of the following ratios would be the poorest indicator of how rapidly the firm’s credit accounts are being collected? a. inventory turnover b. average collection period c. accounts receivable turnover ratio d. cash conversion cycle 7) Which of the following does not provide an indication of liquidity: a. quick ratio b. average collection period c. times-interest-earned d. current ratio 8) KPR, Inc. has current assets of $10,000,000, current liabilities of $4,500,000, inventory of $1,000,000, and sales of $12,000,000. What is the acid test ratio? a. 0.22 b. 2.0 c. 0.1 d. 1.67 9) Roxbury has sales of $2,250,000; a gross profit of $825,000; total operating costs of $620,000; income taxes of $74,800; total assets of $995,000; and interest expense of $18,000. What is Roxbury’s times interest earned ratio? a. 45.8 b. 8.1 c. 1.3 d. 11.4 10) All of the following will improve a firm’s liquidity position except a. increase accounts receivable turnover. b. increase long-term debt and invest the money in marketable securities. c. increase the average collection period. d. increase inventory turnover. Answer Keys 43 Introduction to Financial Management Key Term Definitions Financial ratios: Accounting data restated in relative terms in order to help people identify some of the financial strengths and weaknesses of a company. Liquidity: A firm’s ability to pay its bills on time. Liquidity is related to the ease and quickness with which a firm can convert its non-cash assets into cash, as well as the size of the firm’s investment in non-cash assets relative to its short-term liabilities. Current ratio: A firm’s current assets divided by its current liabilities. Acid-test (quick) ratio: A firm’s current assets and accounts receivable divided by its current liabilities. Average collection period: A firm’s accounts receivable divided by the company’s average daily credit sales (annual credit sales divided by 365). This ratio expresses how rapidly the firm is collecting its credit accounts. Accounts receivable turnover ratio: A firm’s credit sales divided by its accounts receivable. Inventory turnover: A firm’s cost of goods sold divided by its inventory. Operating return on assets (OROA): The ratio of a firm’s operating income divided by its total assets. Operating profit margin: A firm’s operating income (earnings before interest and taxes) divided by sales. Total asset turnover: A firm’s sales divided by its total assets. Asset efficiency: How well a firm is managing its assets. Fixed asset turnover: A firm’s sales divided by its net fixed assets. Debt ratio: A firm’s total liabilities divided by its total assets. Times interest earned: A firm’s earnings before interest and taxes (EBIT) divided by interest expense. This ratio measures a firm’s ability to meet its interest payments from its annual operating earnings. Return on equity: A firm’s net income divided by its common book equity. Price/earnings ratio: The price the market places on $1 of a firm’s earnings. Price/book ratio: The market value of a share of the firm’s stock divided by the book value per share of the firm’s reported equity in the balance sheet. Answer Keys 44 Introduction to Financial Management Answers to Self Test 1) b 2) c 3) d 4) c 5) c 6) a 7) c 8) b 9) d 10) c Notes 45 Introduction to Financial Management Unit 1 Examination Instructions 46 Introduction to Financial Management The Unit Examination The Unit Examination contains 25 questions, either multiple choice or true/false as well as a writing assignment. Your grade on the examination will be determined by the percentage of correct answers. There is no penalty for guessing. The University utilizes the following grading system: A = 90% – 100% correct B = 80% – 89% correct C = 70% – 79% correct D = 60% – 69% correct F = 59% and below correct 4 grade points 3 grade points 2 grade points 1 grade point 0 grade points Completing Unit One Examination Before beginning your examination, we recommend that you thoroughly review the textbook chapters and other materials covered in each Unit and following the suggestions in the “Mastering the Course Content” section of the course Syllabus. This Unit Examination consists of objective test questions as well as a comprehensive writing assignment selected to reflect the Learning Objectives identified in each chapter covered so far in your textbook. Additional detailed information on completing the examination, writing standards, how to challenge test items and how to submit your completed examination may be found in the Syllabus for this course. If you have additional questions feel free to contact Student Services at (714) 547-9625. Unit 1 Examination 47 Introduction to Financial Management Multiple Choice Questions (Enter your answers on the enclosed answer sheet) 1) Maximization of shareholder wealth as a goal is superior to profit maximization be- cause a. it considers the time value of the money. b. following the goal of shareholder wealth maximization will ensure high stock prices. c. it considers uncertainty. d. A and C 2) In terms of the costs to organize each, which of the following sequences is correct, moving from highest to lowest cost? a. sole proprietorship, general partnership, limited partnership, corporation b. corporation, limited partnership, general partnership, sole proprietorship c. sole proprietorship, general partnership, corporation, limited partnership d. general partnership, sole proprietorship, limited partnership, corporation 3) Which of the following are characteristics of a limited partnership? a. General partners have unlimited liability. b. There must be one or more general partners. c. Limited partners may not participate in the management of the limited partnership. d. all of the above 4) Advantages of the corporate form of business organization include a. minimal legal requirements. b. easier transfer of ownership. c. double taxation. d. none of the above. 5) Which of the following forms of business organization has the greatest ability to at- tract new capital? a. Corporation b. General partnership c. Sole proprietorship d. Limited partnership 6) Which of the following is an advantage of the general partnership form of business organization? a. Double taxation b. Easy ability to raise capital c. Limited liability of business owners d. Low cost of formation Unit 1 Examination 48 Introduction to Financial Management 7) Money market instruments include: a. common stock b. preferred stock c. T-bonds d. T-bills 8) The principle of risk-return trade off means that a. higher risk investments must earn higher returns. b. an investor who bought stock in a small corporation five years ago has more money than an investor who bought U.S. Treasury bonds five years ago. c. a rational investor will only take on higher risk if he expects a higher return. d. an investor who takes more risk will earn a higher return. 9) Profits are down so the controller decides to change the corporation’s accounting policy relating to inventory costing. The change will allow the corporation to report higher income and higher assets, although the physical inventory has not changed. Which of the following statements is most correct? a. The stock price is likely to increase because income is higher. b. If the stock price increases, the stock market is efficient. c. The stock price is likely to decrease because reported inventory is higher. d. The stock price is likely to be unaffected because the stock market is efficient. 10) General Electric (GE) has been a public company for many years with its common stock traded on the New York Stock Exchange. If GE decides to sell 500,000 shares of new common stock, the transaction will be described as a. a money market transaction because GE raises new money to fund its business. b. a secondary market transaction because GE common stock has been trading for years. c. an initi
al public offering. d. a seasoned equity offering because GE has sold common stock before. 11) John calls his stockbroker and instructs him to purchase 100 shares of Microsoft Corporation common stock. This transaction occurs in the ________. a. secondary market b. primary market c. credit market d. futures market Unit 1 Examination 49 Introduction to Financial Management 12) The costs associated with issuing securities to the public can be high. Some types of securities have lower expenses associated with them than others. Which of the follow- ing is the least costly security to issue? a. Corporate bonds b. Common stock c. Preferred stock d. All of the above are about equal in cost to issue. 13) The risk premium would be greater for an investment in an oil and gas exploration in unproven fields than an investment in preferred stock because a. oil and gas exploration investments have a greater variability in possible returns. b. the preferred stock is more liquid. c. the inflation rate would vary more with oil and gas exploration investments. d. both A and B 14) Which of the following represents the correct ordering of standard deviation of returns over the period 1926 to 2005 (from highest to lowest standard deviation of returns)? a. Treasury bills, Common stocks, Long-term corporate bonds, Small firm common stocks b. Small firm common stocks, Common stocks, Long-term corporate bonds, Treasury bills c. Treasury bills, Long-term corporate bonds, Common stocks, Small firm common stocks d. Treasury bills, Common stocks, Long-term corporate bonds, Small firm common stocks 15) What is the term for a graphical representation of the relationship between interest rates and the maturities of debt securities? a. Maturity chart b. Term curve c. Inflationary expectations d. Yield curve Table 3-1 Jones Company Financial Information December 2007 December 2008 Net income $2,000 $5,000 Accounts receivable 750 750 Accumulated depreciation 1,000 1,500 Common stock 4,500 5,000 Paid-in capital 7,500 8,000 Retained earnings 1,500 2,500 Accounts payable 750 750 Unit 1 Examination 50 Introduction to Financial Management 16) Based on the information in Table 3-1, assuming that no assets were disposed of dur- ing 2008, the amount of depreciation expense was a. $375. b. $3,500. c. $2,500. d. $500. 17) What financial statement explains the changes that took place in the firm’s cash bal- ance over a period? a. reconciliation of free cash flow b. balance sheet c. income statement d. statement of cash flow Table 3-1 Jones Company Financial Information December 2007 December 2008 Net income $2,000 $5,000 Accounts receivable 750 750 Accumulated depreciation 1,000 1,500 Common stock 4,500 5,000 Paid-in capital 7,500 8,000 Retained earnings 1,500 2,500 Accounts payable 750 750 18) Based on the information in Table 3-1, calculate the after tax cash flow from opera- tions for 2008 (no assets were disposed of during the year, and there was no change in interest payable or taxes payable). a. $3,375 b. $3,750 c. $6,500 d. $5,500 19) Which of the following has the most significant influence on return on equity? a. Common dividends b. Principal payments c. Accruals d. Operating income Unit 1 Examination 51 Introduction to Financial Management 20) Common-sized balance sheets ________. a. show data for companies in the same industry b. show data for companies with approximately the same amount of assets c. show each balance sheet account as a percentage of total sales d. show each balance sheet account as a percentage of total assets Table 4-1 Garland Company Balance Sheet Assets: Cash and marketable securities $500,000 Accounts receivable 800,000 Inventories 1,350,000 Prepaid expenses 50,000 Total current assets $2,700,000 Fixed assets 5,000,000 Less: accum. depr. (2,000,000) Net fixed assets $3,000,000 Total assets $5,700,000 Liabilities: Accounts payable $400,000 Notes payable 900,000 Accrued taxes 75,000 Total current liabilities $1,375,000 Long-term debt 1,200,000 Owner’s equity 3,125,000 Total liabilities and owner’s equity $5,700,000 Net sales (all credit) $8,000,000 Less: Cost of goods sold (3,500,000) Selling and administrative expense (2,000,000) Depreciation expense (250,000) Interest expense (150,000) Earnings before taxes 2,100,000 Income taxes (700,000) Net income $1,400,000 Common stock dividends $500,000 Common Shares Outstanding 1,000,000 21) Based on the information in Table 4-1, the current ratio is a. 2.89. b. 1.21. c. 1.96. d. 1.05. Unit 1 Examination 52 Introduction to Financial Management Table 4-2 Johnson Company Balance Sheet Assets: Cash and marketable securities $300,000 Accounts receivable 1,215,000 Inventories 1,747,500 Prepaid expenses 24,000 Total current assets 3,286,500 Fixed assets 2,700,000 Less: accum. depr. (1,087,500) Net fixed assets 1,612,500 Total assets $4,899,000 Liabilities: Accounts payable $240,000 Notes payable 825,000 Accrued taxes 42,000 Total current liabilities $1,107,000 Long-term debt 975,000 Common Stock (100,000 shares) 100,000 Retained Earnings 2,717,000 Total liabilities and owner’s equity $4,899,000 Net sales (all credit) $6,375,000 Less: Cost of goods sold (4,312,500) Selling and administrative expense (1,387,500) Depreciation expense (135,000) Interest expense (127,000) Earnings before taxes $412,500 Income taxes (225,000) Net income $ 187,500 Common stock dividends $97,500 Change in retained earnings $90,000 22) Based on the information in Table 4-2, the return on equity is a. 6.90%. b. 5.47%. c. 6.66%. d. 3.46%. Unit 1 Examination 53 Introduction to Financial Management 23) Based on the information in Table 4-2, and assuming the company’s stock price is $40 per share, the P/E ratio is a. 2437.5. b. 21.33. c. 2.13. d. 44.44. 24) The two principal sources of financing for corporations are: a. debt and accounts payable b. cash and common equity c. common equity and preferred equity d. debt and equity 25) Which of the following ratios would be the best way to determine how customers are paying for their purchases? a. Total asset turnover b. Inventory turnover c. Average collection period d. Current ratio Unit 1 Examination 54 Introduction to Financial Management Written Assignment for Unit One Be sure to refer to the course syllabus for instructions on format, length, and other information on how to complete this assignment. Please answer ONE of the following: 1. Identify and explain the primary characteristics of each form of legal organization. 2. Distinguish between the money and capital markets. 3. Describe the nature of the balance sheet and the income statement. Why did the authors of the text not use the conventional statement of cash flows in their presenta- tion, computing instead what they call free cash flows? Unit 1 Examination 55 Introduction to Financial Management You Can Do It 56 Introduction to Financial Management You have just completed Unit 1 of this course. You are off to a great start! Keep up the good work! Objectives 57 Introduction to Financial Management Instructions to Students Chapter Number Five The Time Value of Money Learning Objectives Upon successful completion of this chapter, you should be able to: 1. Explain the mechanics of compounding, that is, how money grows over time when it is invested. 2. Be able to move money through time using time value of money tables, financial calculators, and spreadsheets. 3. Discuss the relationship between compounding and bringing the value of money back to the present. 4. Define an ordinary annuity and calculate its compound or future value. 5. Differentiate between an ordinary annuity and an annuity due and determine the future and present value of an annuity due. 6. Explain loan amortization. 7. Determine the future or present value of a sum when there are non-annual compounding periods. 8. Determine the present value of an uneven stream of payments. 9. Determine the present value of a perpetuity. 10. Explain how the international setting complicates the time value of money. • Read pages 130-169 of your textbook • Reference: Foundations of Finance: The Logic and Practice of Financial Management, by Arthur J. Keown, John D. Martin, J.
William Petty, and David F. Scott, Jr., 6th Edition 2008 Overview 58 Introduction to Financial Management In this chapter, the concept of a time value of money is introduced; that is, a dollar today is worth more than a dollar received a year from now. Thus, if we are to compare projects and financial strategies logically, we must either move all dollar flows back to the present or out to some common future date. Key Terms 59 Introduction to Financial Management The key terms listed below are terms you should be familiar with. Write your definition below each item. Check your answers at the end of this chapter. Compound interest: Present value: Annuity: Ordinary annuity: Compound annuity: Future-value interest factor for an annuity: Annuity due: Amortized loan: Annual percentage yield (APY) or effective annual rate (EAR): Perpetuity: Summary 60 Introduction to Financial Management Compound interest occurs when interest paid on an investment during the first period is added to the principal; then, during the second period, interest is earned on this new sum. Although there are several ways to move money through time, they all give you the same result. In the business world, the primary method is through the use of a financial spreadsheet, with Excel being the most popular. Actually, we have only one formula with which to calculate both present value and future value – we simply solve for different variables – FV and PV. This single compounding formula is FV = PV (1 + i). An annuity is a series of equal payments made for a specified number of years. In effect, it is calculated as the sum of the present or future value of the individual cash flows over the life of the annuity. If the cash flows from an annuity occur at the end of each period, the annuity is referred to as an ordinary annuity. If the cash flows occur at the beginning of each period, the annuity is referred to as an annuity due. The procedure for solving for PMT, the annuity payment value when I, n, and PV are known, is also used to determine what payments are associated with paying off a loan in equal installments over time. Loans that are paid off this way, in equal periodic payments, are called amortized loans. Although the payments are fixed, different amounts of each payment are applied toward the principal and interest. With each payment you make, you owe a bit less on the principal. As a result, the amount that goes toward the interest payment declines with each payment made, whereas the portion of each payment that goes toward the principal increases. With non-annual compounding, interest is earned on interest more frequently because the length of the compounding period is shorter. As a result, there is an inverse relationship between the length of the compounding period and the effective annual interest rate. Although some projects will involve a single cash flow, and some will involve annuities, many projects will involve uneven cash flows over several years. However, finding the present or future value of these flows is not difficult because the present value of any cash flow measured in today’s dollars can be compared, by adding the inflows and subtracting the outflows, to the present value of any other cash flow also measured in today’s dollars. A perpetuity is an annuity that continues forever, that is, every year following its establishment the investment pays the same dollar amount. An example of a perpetuity is preferred stock which pays a constant dollar dividend infinitely. Determining the present value of a perpetuity is delightfully simple. We merely need to divide the constant flow by the discount rate. For companies doing business internationally, dramatic fluctuations in inflation rates from country to country can make choosing the appropriate discount rate to move money through time an extremely difficult process. Self Test 61 Introduction to Financial Management Multiple Choice Questions (Circle the correct answer) 1) Your daughter is born today and you want her to be a millionaire by the time she is 40 years old. You open an investment account that promises to pay 10% per year. How much money must you deposit today so your daughter will have $1,000,000 by her 40th birthday? a. $17,689 b. $25,000 c. $20,045 d. $22,095 2) Which of the following conclusions would be true if you earn a higher rate of return on your investments? a. The lower the present value would be for any lump sum you would receive in the future. b. The greater the present value would be for any lump sum you would receive in the future. c. The greater the present value would be for any annuity you would receive in the fu- ture. d. Your rate of return would not have any effect on the present value of any sum to be received in the future. 3) You are going to pay $800 into an account at the beginning of each of 20 years. The account will then be left to compound for an additional 20 years until the end of year 40, when it will turn into a perpetuity. You will receive the first payment from the per- petuity at the end of the 41st year. If the account pays 14%, how much will you re- ceive from the perpetuity each year (round to nearest $1,000)? a. $170,000 b. $160,000 c. $140,000 d. $150,000 4) Your company has received a $50,000 loan from an industrial finance company. The annual payments are $6,202.70. If the company is paying 9 percent interest per year, how many loan payments must the company make? a. 12 b. 13 c. 19 d. 15 5) A financial analyst tells you that investing in stocks will allow you to triple your money in 15 years. What annual rate of return is the analyst assuming you can earn? a. 7.60% b. 9.45% Self Test 62 Introduction to Financial Management c. 7.18% d. 8.14% 6) Today is your 21st birthday and your bank account balance is $15,000. Your account is earning 4.5% interest compounded monthly. How much will be in the account on your 50th birthday? a. $54,914 b. $54,521 c. $55,180 d. $53,761 7) Your son is born today and you want to make him a millionaire by the time he is 50 years old. You deposit $50,000 in an investment account and want to know what an- nual interest rate must you earn in order to have the account value equal to $1,000,000 on your son’s 50th birthday. a. 12.4% b. 6.2% c. 17.8% d. 9.5% 8) You want $20,000 in 5 years to take your spouse on a second honeymoon. Your investment account earns 7% compounded semiannually. How much money must you put in the investment account today? (round to the nearest $1). a. $12,367 b. $14,178 c. $15,985 d. $13,349 9) An investment is expected to yield $300 in three years, $500 in five years, and $300 in seven years. What is the present value of this investment if our opportunity rate is 5%? a. $885 b. $864 c. $735 d. $900 10) You invest $1,000 at a variable rate of interest. Initially the rate is 4% compounded annually for the first year, and the rate increases one-half of one percent annually for five years (year two’s rate is 4.5%, year three’s rate is 5.0%, etc.). How much will you have in the account after five years? Self Test 63 Introduction to Financial Management a. $1,276 b. $1,359 c. $1,338 d. $1,462 Answer Keys 64 Introduction to Financial Management Key Term Definitions Compound interest: The situation in which interest paid on an investment during the first period is added to the principal. Present value: The value in today’s dollars of a future payment discounted back to present at the required rate of return. Annuity: A series of equal dollar payments made for a specified number of years. Ordinary annuity: An annuity where the cash flows occur at the end of each period. Compound annuity: Depositing an equal sum of money at the end of each year for a certain number of years and allowing it to grow. Future-value interest factor for an annuity: the value used as a multiplier to calculate the future value of an annuity. Annuity due: An annuity in which the payments occur at the beginning of each period. Amortized loan: A loan that is paid off in equal periodic payments. Annual percentage yield (APY) or effective annual rate (EAR): The annual compound rate that produces the same return as the nomina
l, or quoted, rate when something is compounded on a non-annual basis. In effect, the APY, or EAR, provides the true rate of return. Perpetuity: An annuity with an infinite life. Answer Keys 65 Introduction to Financial Management Answers to Self Test 1) d 2) a 3) b 4) d 5) a 6) c 7) b 8) b 9) b 10) a Notes 66 Introduction to Financial Management Objectives 67 Introduction to Financial Management Chapter Number Six The Meaning and Measurement of Risk and Return Learning Objectives Upon successful completion of this chapter, you should be able to: 1. Define and measure the expected rate of return of an individual investment. 2. Define and measure the riskiness of an individual investment. 3. Compare the historical relationship between risk and rates of return in the capital markets. 4. Explain how diversifying investments affects the riskiness and expected rate of return of a portfolio or combination of assets. 5. Explain the relationship between an investor’s required rate of return on an investment and the riskiness of the investment. Instructions to Students • Read pages 170-201 of your textbook • Reference: Foundations of Finance: The Logic and Practice of Financial Management, by Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr., 6th Edition 2008 Overview 68 Introduction to Financial Management In this chapter, we examine the factors that determine rates of return (discount rates) in the capital markets. We are particularly interested in the relationship between risk and rates of return. We look at risk both in terms of the riskiness of an individual security and that of a portfolio of securities. Key Terms 69 Introduction to Financial Management The key terms listed below are terms you should be familiar with. Write your definition below each item. Check your answers at the end of this chapter. Expected rate of return: Risk: Standard deviation: Unsystematic risk: Systematic risk: Holding-period return: Characteristic line: Beta: Portfolio beta: Asset allocation: Required rate of return: Risk-free rate of return: Risk premium: Capital asset pricing model (CAPM): Security market line: Summary 70 Introduction to Financial Management In this chapter, we have returned to our study of rates of return and looked ever so carefully at the relationship between risk and rates of return. In a world of uncertainty, we cannot make forecasts with certitude. Thus, we must speak in terms of expected events. The expected return on an investment may therefore be stated as a weighted average of all possible returns, weighted by the probability that each will occur. Risk for our purposes is the variability of returns and can be measured by the standard deviation. Ibbotson and Sinquefield have provided us with annual rates of return earned on different types of security investments as far back as 1926. Ibbotson Associates summarizes, among other things, the annual returns for six portfolios of securities made up of: 1. Common stocks of large companies 2. Common stocks of small firms 3. Long-term corporate bonds 4. Long-term U.S. government bonds 5. Intermediate-term U.S. government bonds 6. U.S. Treasury bills. A comparison of the annual rates of return for these respective portfolios for the years 1926 to 2005 shows a positive relationship between risk and return, with Treasury bills being least risky and common stocks of small firms being most risky. From the data, we are able to see the benefit of diversification in terms of improving the return-risk relationship. Also, the data clearly demonstrate that only common stock has in the long run served as an inflation hedge, and that the risk associated with common stock can be reduced if investors are patient in receiving their returns. We made an important distinction between non-diversifiable risk and diversifiable risk. We concluded that the only relevant risk, given the opportunity to diversify our portfolio, is a security’s non-diversifiable risk, which we called by two other names: systematic risk and market-related risk. The capital asset pricing model provides an intuitive framework for understanding the risk-return relationship. The CAPM suggests that investors determine an appropriate required rate of return, depending upon the amount of systematic risk inherent in a security. This minimum acceptable rate of return is equal to the risk-free rate plus a risk premium for assuming risk. Self Test 71 Introduction to Financial Management Multiple Choice Questions (Circle the correct answer) 1) Investment A has an expected return of 14% with a standard deviation of 4%, while investment B has an expected return of 20% with a standard deviation of 9%. There- fore, a. rational investors could pick either A or B, depending on their level of risk aversion. b. a risk averse investor will definitely select investment A because the standard devia- tion is lower. c. it is irrational for a risk-averse investor to select investment B because its standard deviation is more than twice as big as investment A’s, but the return is not twice as big. d. a rational investor will pick investment B because the return adjusted for risk (20% – 9%) is higher than the return adjusted for risk for investment A ($14% – 4%). 2) The category of securities with the highest historical risk premium is a. small company corporate bonds. b. small company stocks. c. large company stocks. d. government bonds. 3) Joe purchased 500 shares of Robotics Stock at $4 per share on 1/1/07. Bill sold the shares on 12/31/07 for $5.45. Robotics stock has a beta of 1.4, the risk-free rate of return is 5%, and the market risk premium is 9%. Joe’s holding period return is a. 14.90%. b. 17.60%. c. 18.65%. d. 36.25%. 4) Assume that you expect to hold a $20,000 investment for one year. It is forecasted to have a yearend value of $22,000 with a 25% probability; a yearend value of $25,000 with a 50% probability; and a yearend value of $30,000 with a 25% prob- ability. What is the standard deviation of the holding period return for this invest- ment? a. 14.36% b. 32.5% c. 27.5% d. 2.06% 5) The capital asset pricing model a. measures risk as the coefficient of variation between security and market rates of return. b. depicts the total risk of a security. c. provides a risk-return trade off in which risk is measured in terms of the market vola- tility. d. provides a risk-return trade off in which risk is measured in terms of beta. Self Test 72 Introduction to Financial Management 6) Stock A has a beta of 1.2 and a standard deviation of returns of 18%. Stock B has a beta of 1.8 and a standard deviation of returns of 18%. If the market risk premium increases, then a. the required return on stock B will increase more than the required return on stock A b. the required return on stock A will increase more than the required return on stock B c. the required returns on stocks A and B will remain the same d. the required returns on stocks A and B will both increase by the same amount 7) Joe purchased 500 shares of Robotics Stock at $4 per share on 1/1/07. Bill sold the shares on 12/31/07 for $5.45. Robotics stock has a beta of 1.4, the risk-free rate of return is 5%, and the market risk premium is 9%. The required return on Robotics Stock is: a. 19.60% b. 17.60% c. 18.65% d. 36.25% 8) Emery Inc. has a beta equal to 1.5 and a required return of 14% based on the CAPM. If the risk free rate of return is 2%, the expected return on the market portfolio is: a. 9% b. 10% c. 6% d. 8% 9) SeeBreeze Incorporated has a beta of 1.0. If the expected return on the market is 15%, what is the expected return on SeeBreeze Incorporated’s stock? a. 18% b. 14% c. 15% d. cannot be determined without the risk free rate 10) Collectibles Corp. has a beta of 3.25 and a standard deviation of returns of 27%. The return on the market portfolio is 13% and the risk free rate is 5%. What is the risk premium on the market? a. 8.00% b. 10.75% c. 9.00% d. 16.25% Answer Keys 73 Introduction to Financial Management Key Term Definitions Expected rate of return: (1) The discount rate that equates the present value of the future cash flows of a bond with the current
market price of the bond. (2) the rate of return the investor expects to receive on an investment by paying the market price of the security. (3) The arithmetic mean or average of all possible outcomes where those outcomes are weighted by the probability that each will occur. Risk: Potential variability in future cash flows. Standard deviation: A statistical measure of the spread of a probability distribution calculated by squaring the difference between each outcome and its expected value, weighting each value by its probability, summing over all possible outcomes, and taking the square root of this sum. Unsystematic risk: the risk related to an investment return that can be eliminated through diversification. Systematic risk: (1) The risk related to an investment return that cannot be eliminated through diversification. (2) The risk of a project from the viewpoint of a well-diversified shareholder. Holding-period return: The return an investor would receive from holding a security for a designated period of time. Characteristic line: The line of “best fit” through a series of returns for a firm’s stock relative to the market’s returns. Beta: The relationship between an investment’s returns and the market’s returns. This is a measure of the investment’s non-diversifiable risk. Portfolio beta: The relationship between a portfolio’s returns and the market returns. It is a measure of the portfolio’s non-diversifiable risk. Asset allocation: Identifying and selecting the asset classes appropriate for a specific investment portfolio and determining the proportions of those assets within the portfolio. Required rate of return: Minimum rate of return necessary to attract an investor to purchase or hold a security. Risk-free rate of return: The rate of return on risk-free investments. The interest rates on shortterm U.S. Government securities are commonly used to measure this rate. Risk premium: The additional return expected for assuming risk. Capital asset pricing model (CAPM): An equation stating that the expected rate of return on a project is a function of (1) the risk-free rate, (2) the investment’s systematic risk, and (3) the expected risk premium for the market portfolio of all risky securities. Security market line: The return line that reflects the attitudes of investors regarding the minimum acceptable return for a given level of systematic risk associated with a security. Answer Keys 74 Introduction to Financial Management Answers to Self Test 1) a 2) b 3) d 4) a 5) d 6) a 7) b 8) b 9) c 10) a Notes 75 Introduction to Financial Management Objectives 76 Introduction to Financial Management Chapter Number Seven The Valuation and Characteristics of Bonds Learning Objectives Upon successful completion of this chapter, you should be able to: 1. Distinguish between different kinds of bonds. 2. Explain the more popular features of bonds. 3. Define the term value as used for several different purposes. 4. Explain the factors that determine value. 5. Describe the basic process for valuing assets. 6. Estimate the value of a bond. 7. Compute a bondholder’s expected rate of return. 8. Explain three important relationships that exist in bond valuation. Instructions to Students • Read pages 202-227 of your textbook • Reference: Foundations of Finance: The Logic and Practice of Financial Management, by Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr., 6th Edition 2008 Overview 77 Introduction to Financial Management Understanding how to value financial securities is essential if managers are to meet the objective of maximizing the value of the firm. If they are to maximize the investors’ value, they must know what drives the value of an asset. Specifically, they need to understand how bonds and stocks are valued in the marketplace; otherwise, they cannot act in the best interest of the firm’s investors. A bond is one form of a company’s long-term debt. In this chapter, we begin by identifying the different kinds of bonds. We next look at the features or characteristics of most bonds. We then examine the concepts of and procedures for valuing an asset and apply these ideas to valuing bonds. Key Terms 78 Introduction to Financial Management The key terms listed below are terms you should be familiar with. Write your definition below each item. Check your answers at the end of this chapter. Bond: Debenture: Subordinated debenture: Mortgage bond: Eurobond: Zero and very low coupon bond: Junk bond: High-yield bond: Convertible bond: Par value: Coupon interest rate: Maturity: Callable bond (redeemable bond): Call protection period: Indenture: Book value: Liquidation value: Market value: Intrinsic, or economic, value: Fair value: Expected rate of return: Yield to maturity: Current yield: Interest rate risk: Discount bond: Premium bond: Summary 79 Introduction to Financial Management Value is defined differently depending on the context. But for us, value is the present value of future cash flows expected to be received from an investment, discounted at the investor’s required rate of return. Three basic factors determine an asset’s value: (1) The amount and timing of future cash flows, (2) the riskiness of the cash flows, and (3) the investor’s attitude about the risk. The valuation process can be described as follows: It is assigning value to an asset by calculating the present value of its expected future cash flows using the investor’s required rate of return as the discount rate. The investor’s required rate of return equals the risk-free rate of interest plus a risk premium to compensate the investor for assuming risk. The value of a bond is the present value of both future interest to be received and the par or maturity value of the bond. To measure the bondholder’s expected rate of return, we find the discount rate that equates the present value of the future cash flows interest and maturity value) with the current market price of the bond. The expected rate of return for a bond is also the rate of return the investor will earn if the bond is held to maturity, or the yield to maturity. We may also compute the current yield as the annual interest payment divided by the bond’s current market price, but this is not an accurate measure of a bondholder’s expected rate of return. Certain key relationships exist in bond valuation, these being: 1. A decrease in interest rates (the required rates of return) will cause the value of a bond to increase; by contrast, an interest rate increase will cause a decrease in value. The change in value caused by changing interest rates is called interest rate risk. 2. If the required rate of return (current interest rate): a. Equals the coupon interest rate, the bond will sell at par, or maturity value. b. Exceeds the bon’s coupon rate, the bond will sell below par value, or at a discount. c. Is less than the bond’s coupon rate, the bond will sell above par value, or at a premium. 3. A bondholder owning a long-term bond is exposed to greater interest rate risk than one owning a short-term bond. Self Test 80 Introduction to Financial Management Multiple Choice Questions (Circle the correct answer) 1) If a firm were to experience financial insolvency, the legal system provides an order of hierarchy for the payment of claims. Assume that a firm has the following outstand- ing securities: mortgage bonds, common stock, debentures, and preferred stock. Rank the order in which investors that own mortgage bonds would have their claim paid? a. First b. Second c. Third d. Fourth 2) A corporate bond has a coupon rate of 9%, a yield to maturity of 11.1%, a face value of $1,000, and a market price of $850. Therefore, the annual interest payment is: a. $111 b. $90 c. $76.50 d. $109 3) A company with a bond rating of BBB is more likely to have which of the following qualities compared to a company with a bond rating of B? a. little use of subordinated debt b. large firm size c. greater reliance on equity financing d. high variability in past earnings 4) An individual investor considers investing in an XYZ Corp. bond and decides not to purchase the bond.
Which of the following statements is most correct? a. The intrinsic value of the bond for the investor is less than the par value of the bond. b. The intrinsic value of the bond for the investor is less than the market value of the bond. c. The intrinsic value of the bond for the investor is greater than the book value of the bond. d. The liquidation value of the bond is greater than the market value of the bond. 5) What is the value of a bond that has a par value of $1,000, a coupon of $100 (annu- ally), and matures in 12 years? Assume a required rate of return of 13%. a. $943.22 b. $970.00 c. $810.58 d. $822.47 Self Test 81 Introduction to Financial Management 6) A bond issued by Cornwallis, Inc. 15 years ago has a coupon rate of 7% and a face value of $1,000. The bond will mature in 10 years. What is the value (to the nearest dollar) to an investor with a required return of 10%? a. $772 b. $886 c. $728 d. $816 7) International Cruise Lines sold an issue of 15-year $1,000 par bonds to build new ships. The bonds pay 6.85% interest, semi-annually. Today’s required rate of return is 8.35%. How much should these bonds sell for today? Round off to the nearest $1. a. $1,065 b. $936 c. $873 d. $918 8) Which of the following statements is true? a. Interest rate risk is highest during periods of high interest rates. b. All bonds have equal interest rate risk. c. Short-term bonds have greater interest rate risk than do long-term bonds. d. Long-term bonds have greater interest rate risk than do short-term bonds. 9) A corporate bond has a coupon rate of 9%, a face value of $1,000, a market price of $850, and the bond matures in 15 years. Therefore, the bond’s yield to maturity is: a. 11.1% b. 13.45% c. 24% d. 9% 10) The correct relationship for a premium bond is: a. coupon rate > current yield > yield to maturity b. current yield > yield to maturity > coupon rate c. coupon rate > yield to maturity > current yield d. current yield > coupon rate > yield to maturity Answer Keys 82 Introduction to Financial Management Key Term Definitions Bond: A long-term (10-year or more) promissory note issued by the borrower, promising to pay the owner of the security a predetermined, fixed amount of interest each year. Debenture: Any unsecured long-term debt. Subordinated debenture: A debenture that is subordinated to other debentures in terms of its payments in case of insolvency. Mortgage bond: A bond secured by a lien on real property. Eurobond: A bond issued in a country different from the one in which the currency of the bond is denominated. Zero and very low coupon bond: a bond issued at a substantial discount from its $1,000 face value and that pays little or no interest. Junk bond: Any bond rated BB or below. High-yield bond: Junk bond. Convertible bond: A debt security that can be converted into a firm’s stock at a pre-specified price. Par value: On the face of a bond, the stated amount that the firm is to repay upon the maturity date. Coupon interest rate: The interest rate contractually owed on a bond as a percent of its par value. Maturity: The length of time until the bond issuer returns the par value to the bondholder and terminates the bond. Callable bond (redeemable bond): An option available to a company issuing a bond whereby the issuer can call (redeem) the bond before it matures. Call protection period: A pre-specified time period during which a company cannot recall a bond. Indenture: The legal agreement between the firm issuing bonds and the bond trustee who represents the bondholders, providing the specific terms of the loan agreement. Book value: (1) the value of an asset as shown on the firm’s balance sheet. (2) The depreciated value of a company’s assets (original cost less accumulated depreciation) less outstanding liabilities. Liquidation value: The dollar sum that could be realized if an asset were sold. Market value: The value observed in the marketplace. Intrinsic, or economic, value: the present value of an asset’s expected future cash flows. This value is the amount the investor considers to be fair value, given the amount, timing, and riskiness of future cash flows. Answer Keys 83 Introduction to Financial Management Fair value: The present value of an asset’s expected future cash flows. Expected rate of return: (1) the discount rate that equates the present value of the future cash flows (interest and maturity value) of a bond with its current market price. (2) the rate of return the investor expects to receive on an investment by paying the existing market price of the security. Yield to maturity: The rate of return a bondholder will receive if the bond is held to maturity. Current yield: The ratio of a bond’s annual interest payment to its market price. Interest rate risk: (1) the variability in a bond’s value (risk) caused by changing interest rates. (2) The uncertainty that envelops the expected returns from a security caused by changes in interest rates. Discount bond: A bond that sells at a discount, or below par value. Premium bond: A bond that is selling above its par value. Answer Keys 84 Introduction to Financial Management Answers to Self Test 1) a 2) b 3) d 4) b 5) d 6) d 7) c 8) d 9) a 10) a Notes 85 Introduction to Financial Management Objectives 86 Introduction to Financial Management Chapter Number Eight The Valuation and Characteristics of Stock Learning Objectives Upon successful completion of this chapter, you should be able to: 1. Identity the basic characteristics of preferred stock. 2. Value preferred stock. 3. Identify the basic characteristics of common stock. 4. Value common stock. 5. Calculate a stock’s expected rate of return. Instructions to Students • Read pages 228-255 of your textbook • Reference: Foundations of Finance: The Logic and Practice of Financial Management, by Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr., 6th Edition 2008 Overview 87 Introduction to Financial Management This chapter continues the introduction of concepts underlying asset valuation begun in Chapter 7. We are specifically concerned with valuing preferred stock and common stock. We also look at the concept of a stockholder’s expected rate of return on an investment. Key Terms 88 Introduction to Financial Management The key terms listed below are terms you should be familiar with. Write your definition below each item. Check your answers at the end of this chapter. Preferred stock: Cumulative feature: Protective provisions: Convertible preferred stock: Call provision: Sinking-fund provision: Common stock: Limited liability: Proxy: Proxy fight: Majority voting: Cumulative voting: Preemptive right: Right: Internal growth: Profit-retention rate: Dividend-payout ratio: Free cash flow valuation: Competitive-advantage period: Residual value: Summary 89 Introduction to Financial Management Valuation is an important process in financial management. An understanding of valuation, both the concepts and procedures, supports the financial officer’s objective of maximizing the value of the firm. Preferred stock has no fixed maturity date, and the dividends are fixed in amount. Some of the more common characteristics of preferred stock include the following: 1. There are multiple classes of preferred stock. 2. Preferred stock has a priority claim on assets and income over common stock. 3. Any dividends, if not paid as promised, must be paid before any common stock dividends may be paid; that is, they are cumulative. 4. Protective provisions are included in the contract with the shareholder to reduce the inves- tor’s risk. 5. Many preferred stocks are convertible into common stock shares. In addition, there are provisions frequently used to retire an issue of preferred stock, such as the ability of the firm to call its preferred stock or to use a sinking-fund provision. Value is the present value of future cash flows discounted at the investor’s required rate of return. Although the valuation of any security entails the same basic principles, the procedures used in each situation vary. For securities with cash flows that are constant in each year but w
ith no specified maturity, such as preferred stock, the present value equals the dollar amount of the annual dividend divided by the investor’s required rate of return of investors. Common stock involves ownership in the corporation. In effect, bondholders and preferred stockholders can be viewed as creditors, whereas common stockholders are the owners of the firm. Common stock does not have a maturity date but exists as long as the firm does. Nor does common stock have an upper limit on its dividend payments. Dividend payments must be declared by the firm’s board of directors before they are issued. In the event of bankruptcy, the common stockholders, as owners of the corporation cannot exercise claims on assets until the firm’s creditors, including its bondholders and preferred shareholders, have been satisfied. However, common stockholders’ liability is limited to the amount of their investment. The common stockholders are entitled to elect the firm’s board of directors and are, in general, the only security holders given a vote. Common stockholders also have the right to approve any change in the company’s corporate charter. Although each share of stock carries the same number of votes, the voting procedure is not always the same from company to company. The preemptive right entitles the common shareholder to maintain a proportionate share of ownership in the firm. The expected rate of return on a security is the required rate of return of investors who are willing to pay the present market price for the security, but no more. This rate of return is important to the financial manager because it equals the required rate of return of the firm’s investors. Self Test 90 Introduction to Financial Management Multiple Choice Questions (Circle the correct answer) 1) Keyes Corporation preferred stock pays an annual dividend of $5 per share. Which of the following statements is true for an investor with a required return of 8%? a. The value of the preferred stock is $5 because the dividend is fixed at $5 each year. b. The value of the preferred stock is $4 per share because of the 8% required return. c. The value of the preferred stock is $40.00 per share. d. The value of the preferred stock is $62.50 per share. 2) Which of the following statements concerning preferred stock is most correct? a. If a corporation issues 4% preferred stock with a par value of $100, the dividend will increase by 4% per year. b. Preferred stock is valued the same as zero coupon bonds because the cash flow pat- terns are similar. c. Preferred stock dividends are typically the same each year, allowing a preferred stock to be valued as a perpetuity. d. Preferred stock dividends are calculated as a percentage of common stock dividends, although the preferred stock dividends must be paid first. 3) What is the value of a preferred stock that pays a $3.50 dividend to an investor with a required rate of return of 9%? (round your answer to the nearest $1) a. $39 b. $31.50 c. $17 d. $23 4) Preferred stock differs from common stock in that a. preferred stock usually has a maturity date. b. preferred stock investors have a higher required return than common stock investors. c. common stock investors have a required return and preferred stock investors do not. d. preferred stock dividends are fixed. 5) A financial analyst expects Kacie Co. to pay a dividend of $3 per share one year from today, a dividend of $3.50 per share in years two, and estimates the value of the stock at the end of year two to be $28. If your required return on Kacie Co stock is 15%, what is the most you would be willing to pay for the stock today if you plan to sell the stock in two years? a. $26.43 b. $34.00 c. $28.90 d. $26.09 Self Test 91 Introduction to Financial Management 6) Kilsheimer Company just paid a dividend of $4 per share. Future dividends are expected to grow at a constant rate of 6% per year. What is the value of the stock if the required return is 12%? a. $40.00 b. $70.67 c. $33.33 d. $66.67 7) Modem Development, Inc. paid a dividend of $5.00 per share on its common stock yesterday. Dividends are expected to grow at a constant rate of 4% for the next two years, at which point the stock is expected to sell for $56.00. If investors require a rate of return on Modem’s common stock of 18%, what should the stock sell for to- day? a. $44.76 b. $48.51 c. $50.22 d. $40.22 8) You observe Golden Flashes Common Stock selling for $40.00 per share. The next dividend is expected to be $4.00, and is expected to grow at a 5% annual rate for- ever. If your required rate of return is 12%, should you purchase the stock? a. Yes, because the present value of the expected future cash flows is less than $40. b. No, because the present value of the expected future cash flows is less than $40. c. No, because the present value of the expected future cash flows is greater than $40. d. Yes, because the present value of the expected future cash flows is greater than $40. 9) Butler Corp. paid a dividend today of $3.50 per share. The dividend is expected to grow at a constant rate of 8% per year. If Butler Corp. stock is selling for $75.60 per share, the stockholders’ expected rate of return is a. 13.00%. b. 12.63%. c. 12.53%. d. 14.38%. 10) ADR Bank preferred stock pays an annual dividend of $2.50 per share. If the stock is currently selling for $21.95 per share, what is the expected rate of return on this stock? a. 11.4% b. 12.5% c. 13.6% d. 8.78% Answer Keys 92 Introduction to Financial Management Key Term Definitions Preferred stock: A hybrid security with characteristics of both common stock and bonds. Preferred stock is similar to common stock in that it has no fixed maturity date, the nonpayment of dividends does not bring on bankruptcy, and dividends are not deductible for tax purposes. Preferred stock is similar to bonds in that dividends are limited in amount. Cumulative feature: A requirement that all past, unpaid preferred stock dividends be paid before any common stock dividends are declared. Protective provisions: Provisions for preferred stock that protect the investor’s interest. The provisions generally allow for voting in the event of nonpayment of dividends, or they restrict the payment of common stock dividends if sinking-fund payments are not met or if the firm is in financial difficulty. Convertible preferred stock: Preferred shares that can be converted into a predetermined number of shares of common stock, if investors so choose. Call provision: A provision that entitles the corporation to repurchase its preferred stock from investors at stated prices over specified period. Sinking-fund provision: A protective provision that requires the firm periodically to set aside an amount of money for the retirement of its preferred stock. This money is then used to purchase the preferred stock in the open market or through the use of the call provision, whichever method is cheaper. Common stock: Shares that represent the ownership in a corporation. Limited liability: A protective provision whereby the investor is not liable for more than the amount he or she has invested in the firm. Proxy: A means of voting in which a designated party is provided with the temporary power of attorney to vote for the signee at the corporation’s annual meeting. Proxy fight: A battle between rival groups for proxy votes in order to control the decisions made in a stockholders’ meeting. Majority voting: Voting in which each share of stock allows the shareholder one vote, and each position on the board of directors is voted on separately. Cumulative voting: Voting in which each share of stock allows the shareholder a number of votes equal to the number of directors being elected. Preemptive right: The right entitling the common shareholder to maintain his or her proportionate share of ownership in the firm. Right: A certificate issued to common stockholders giving them an option to purchase a stated number of new shares at a specified price during a 2- to 10-week period. Internal growth: A firm’s growth rate resulting from reinvesting the company’s profits rather than distributing them as dividend
s. Answer Keys 93 Introduction to Financial Management Profit-retention rate: The company’s percentage of profits retained. Dividend-payout ratio: Dividends as a percentage of earnings. Free cash flow valuation: Valuing a firm as the present value of its expected future cash flows. Competitive-advantage period: The number of years a firm’s managers believes it can sustain a competitive advantage, given the company’s present strategies. Residual value: The present value of a firm’s post-competitive-advantage period cash flows. Answer Keys 94 Introduction to Financial Management Answers to Self Test 1) d 2) c 3) a 4) d 5) a 6) b 7) b 8) d 9) a 10) a Notes 95 Introduction to Financial Management Unit 2 Examination Instructions 96 Introduction to Financial Management The Unit Examination The Unit Examination contains 25 questions, either multiple choice or true/false as well as a writing assignment. Your grade on the examination will be determined by the percentage of correct answers. There is no penalty for guessing. The University utilizes the following grading system: A = 90% – 100% correct B = 80% – 89% correct C = 70% – 79% correct D = 60% – 69% correct F = 59% and below correct 4 grade points 3 grade points 2 grade points 1 grade point 0 grade points Completing Unit Two Examination Before beginning your examination, we recommend that you thoroughly review the textbook chapters and other materials covered in each Unit and following the suggestions in the “Mastering the Course Content” section of the course Syllabus. This Unit Examination consists of objective test questions as well as a comprehensive writing assignment selected to reflect the Learning Objectives identified in each chapter covered so far in your textbook. Additional detailed information on completing the examination, writing standards, how to challenge test items and how to submit your completed examination may be found in the Syllabus for this course. If you have additional questions feel free to contact Student Services at (714) 547-9625. Unit 2 Examination 97 Introduction to Financial Management Multiple Choice Questions (Enter your answers on the enclosed answer sheet) 1) Which of the following conclusions would be true if you earn a higher rate of return on your investments? a. The greater the present value would be for any lump sum you would receive in the future. b. The lower the present value would be for any lump sum you would receive in the future. c. Your rate of return would not have any effect on the present value of any sum to be received in the future. d. The greater the present value would be for any annuity you would receive in the future. 2) At what rate must $500 be compounded annually for it to grow to $1,079.46 in 10 years? a. 6 percent b. 7 percent c. 8 percent d. 5 percent 3) What is the present value of $12,500 to be received 10 years from today? Assume a discount rate of 8% compounded annually and round to the nearest $10. a. $17,010 b. $9,210 c. $11,574 d. $5,790 4) The appropriate measure for risk according to the capital asset pricing model is: a. the standard deviation of a firm’s cash flows b. alpha c. the standard deviation of a firm’s stock returns d. beta 5) How much money must you pay into an account at the end of each of 20 years in order to have $100,000 at the end of the 20th year? Assume that the account pays 6% per year, and round to the nearest $1. a. $2,195 b. $1,840 c. $2,028 d. $2,718 Unit 2 Examination 98 Introduction to Financial Management 6) You have the choice of two equally risk annuities, each paying $5,000 per year for 8 years. One is an annuity due and the other is an ordinary annuity. If you are going to be receiving the annuity payments, which annuity would you choose to maximize your wealth? a. The annuity due b. Either one because they have the same present value. c. The ordinary annuity d. Since we don’t know the interest rate, we can’t find the value of the annuities and hence we cannot tell which one is better. 7) If you put $1,000 in a savings account that yields 8% compounded semi-annually, how much money will you have in the account in 20 years (round to nearest $10)? a. $4,660 b. $4,801 c. $2,190 d. $1,480 8) You want $20,000 in 5 years to take your spouse on a second honeymoon. Your investment account earns 7% compounded semiannually. How much money must you put in the investment account today? (round to the nearest $1) a. $14,178 b. $15,985 c. $13,349 d. $12,367 9) You invest $1,000 at a variable rate of interest. Initially the rate is 4% compounded annually for the first year, and the rate increases one-half of one percent annually for five years (year two’s rate is 4.5%, year three’s rate is 5.0%, etc.). How much will you have in the account after five years? a. $1,462 b. $1,359 c. $1,276 d. $1,338 10) Assume that you have $165,000 invested in a stock that is returning 11.50%, $85,000 invested in a stock that is returning 22.75%, and $235,000 invested in a stock that is returning 10.25%. What is the expected return of your portfolio? a. 14.8% b. 12.9% c. 18.3% d. 15.6% Unit 2 Examination 99 Introduction to Financial Management 11) Which of the following statements is most correct concerning diversification and risk? a. Risk-averse investors often select portfolios that include only companies from the same industry group because the familiarity reduces the risk. b. Risk-averse investors often choose companies from different industries for their port- folios because the correlation of returns is less than if all the companies came from the same industry. c. Only wealthy investors can diversify their portfolios because a portfolio must contain at least 50 stocks to gain the benefits of diversification. d. Proper diversification generally results in the elimination of risk. 12) The yield to maturity on a bond ________. a. is fixed in the indenture b. is lower for higher risk bonds c. is the required rate of return on the bond d. is generally below the coupon interest rate 13) You are considering buying some stock in Continental Grain. Which of the following are examples of non-diversifiable risks? I. Risk resulting from a general decline in the stock market. II. Risk resulting from a possible increase in income taxes. III. Risk resulting from an explosion in a grain elevator owned by Continental. IV. Risk resulting from a pending lawsuit against Continental. a. III and IV b. II, III, and IV c. I and II d. I only 14) Of the following, which differs in meaning from the other three? a. Systematic Risk b. Market Risk c. Asset-unique Risk d. Undiversifiable Risk Unit 2 Examination 100 Introduction to Financial Management 15) You must add one of two investments to an already well- diversified portfolio. Security A Security B Expected Return = 12% Expected Return = 12% Standard Deviation of Standard Deviation of Returns = 20.9% Returns = 10.1% Beta = .8 Beta = 2 If you are a risk-averse investor, which one is the better choice? a. Security A b. Security B c. Either security would be acceptable. d. Cannot be determined with information given. 16) Which of the following is true of a zero coupon bond? a. The bond has a zero par value. b. The bond sells at a premium prior to maturity. c. The bond makes no coupon payments. d. The bond has no value until the year it matures because there are no positive cash flows until then. 17) In an efficient securities market the market value of a security is equal to a. par value. b. its intrinsic value. c. its book value. d. its liquidation value. 18) In 1998 Fischer Corp. issued bonds with an 8 percent coupon rate and a $1,000 face value. The bonds mature on March 1, 2023. If an investor purchased one of these bonds on March 1, 2008, determine the yield to maturity if the investor paid $1,050 for the bond. a. 8.5% b. The yield to maturity must be greater than 8% because the price paid for the bond exceeds the face value. c. The yield to maturity is $950 ($1,000 interest less $50 capital loss). d. 7.44% Unit 2 Examination 101 Introduction to Financial Management 19) A bond’s yield to maturity depends upon all of the following except: a. the maturi
ty of the bond b. the coupon rate c. the individual investor’s required return d. the bond’s risk as reflected by the bond rating 20) A bond will sell at a discount (below par value) if: a. The economy is booming. b. Current market interest rates are moving in the same direction as bond values. c. The market value of the bond is less than the present value of the discount rate of the bond. d. Investor’s current required rate of return is above the coupon rate of the bond. 21) How is preferred stock similar to bonds? a. Investors can sue the firm if preferred dividend payments are not paid (much like bondholders can sue for non-payment of interest payments). b. Dividend payments to preferred shareholders (much like bond interest payments to bondholders) are tax deductible. c. Preferred stockholders receive a dividend payment (much like interest payments to bondholders) that is usually fixed. d. Preferred stock is not like bonds in any way. 22) Many preferred stocks have a feature that requires a firm to periodically set aside an amount of money for the retirement of its preferred stock. What is the name of this feature? a. Callable b. Cumulative c. Sinking fund d. Convertible 23) How is preferred stock affected by a decrease in the required rate of return? a. The value of a share of preferred stock increases. b. The dividend increases. c. The dividend yield increases. d. The dividend decreases. Unit 2 Examination 102 Introduction to Financial Management 24) Modem Development, Inc. paid a dividend of $5.00 per share on its common stock yesterday. Dividends are expected to grow at a constant rate of 10% for the next two years, at which point the dividends will begin to grow at a constant rate indefinitely. If the stock is selling for $50 today and the required return is 15%, what it the ex- pected annual dividend growth rate after year two? a. 5.000% b. 3.365% c. 4.556% d. 3.878% 25) Market efficiency implies which of the following? a. book value = intrinsic value b. market value = intrinsic value c. book value = market value d. liquidation value = book value Unit 2 Examination 103 Introduction to Financial Management Written Assignment for Unit Two Be sure to refer to this course syllabus for instructions on format, length, and other information on how to complete this assignment. Please answer ONE of the following: 1. What is an annuity? Give some examples of annuities. Distinguish between an annuity and a perpetuity. 2. Distinguish between debentures and mortgage bonds. 3. What factors determine a bond’s rating? Why is the rating important to the firm’s man- ager? You Can Do It 104 Introduction to Financial Management With Unit 2 complete, you are half way through the course. Take a break and reward yourself for a job well done! Objectives 105 Introduction to Financial Management Chapter Number Nine Capital-Budgeting Techniques and Practice Learning Objectives Upon successful completion of this chapter, you should be able to: 1. Discuss the difficulty encountered in finding profitable projects in competitive markets and the importance of the search. 2. Determine whether a new project should be accepted or rejected using the payback period, the net present value, the profitability index, and the internal rate of return. 3. Explain how the capital-budgeting decision process changes when a dollar limit is placed on the capital budget. 4. Discuss the problems encountered in project ranking. 5. Explain the importance of ethical considerations in capitalbudgeting decisions. 6. Discuss the trends in the use of different capital-budgeting criteria. 7. Explain how foreign markets provide opportunities for finding new capital-budgeting projects. Instructions to Students • Read pages 258-295 of your textbook • Reference: Foundations of Finance: The Logic and Practice of Financial Management, by Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr., 6th Edition 2008 Overview 106 Introduction to Financial Management Capital budgeting involves the decision-making process with respect to investment in fixed assets; specifically, it involves measuring the incremental cash flows associated with investment proposals and evaluating the attractiveness of these cash flows relative to the project’s costs. This chapter focuses on the various decision criteria. It also examines how to deal with complications in the capital budgeting process including mutually exclusive projects and capital rationing. Key Terms 107 Introduction to Financial Management The key terms listed below are terms you should be familiar with. Write your definition below each item. Check your answers at the end of this chapter. Capital budgeting: Payback period: Net present value (NPV): Profitability index (PI) or benefit-cost ratio: Internal rate of return (IRR): Net present value profile: Capital rationing: Mutually exclusive projects: Equivalent annual annuity (EAA): Summary 108 Introduction to Financial Management The process of capital budgeting involves decision making with respect to investments in fixed assets. Before a profitable project can be adopted, it must be identified or found. Unfortunately, coming up with ideas for new products, for ways to improve existing products, or for ways to make existing products more profitable is extremely difficult. In general, the best source of ideas for new, potentially profitable products is within the firm. We examine four commonly used criteria for determining the acceptance or rejection of capitalbudgeting proposals. The first method, the payback period, does not incorporate the time value of money into its calculations. However, the net present value, profitability index, and internal rate of return methods do account for the time value of money. There are several complications related to the capital-budgeting process. First, we examined capital rationing and the problems it can create by imposing a limit on the dollar size of the capital budget. Although capital rationing does not, in general, maximize shareholders’ wealth, it does exist. The goal of maximizing shareholders’ wealth remains, but it is now subject to a budget constraint. There are a number of problems associated with evaluating mutually exclusive projects. Mutually exclusive projects occur when different investments, if undertaken, would serve the same purpose. In general, to deal with mutually exclusive projects, we rank them by means of the discounted cash flow criteria and select the project with the highest ranking. Conflicting rankings can arise because of the projects’ size disparities, time disparities, and unequal lives. The incomparability of projects with different life spans is not simply a result of the different life spans; rather, it arises because future profitable investment proposals will be rejected without being included in the initial analysis. Replacement chains and equivalent annual annuities can solve this problem. Ethics and ethical decisions continuously crop up in capital budgeting. Just as with all other areas of finance, violating ethical considerations results in a loss of public confidence, which can have a significant negative effect on shareholder wealth. Over the past 40 years, the discounted capital-budgeting techniques have continued to gain in popularity and today dominate in the decision-making process. Self Test 109 Introduction to Financial Management Multiple Choice Questions (Circle the correct answer) 1) Zellars, Inc. is considering two mutually exclusive projects, A and B. Project A costs $75,000 and is expected to generate $48,000 in year one and $45,000 in year two. Project B costs $80,000 and is expected to generate $34,000 in year one, $37,000 in year two, $26,000 in year three, and $25,000 in year four. Zellars, Inc.’s required rate of return for these projects is 10%. The internal rate of return for Project A is: a. 11.43% b. 17.45% c. 15.81% d. 13.87% 2) The net present value method a. uses all of a project’s cash flows. b. recognizes the time value of money. c. is consistent with the goal of shareholder wealth maximization. d. all of the above 3) Arguments against using th
e net present value and internal rate of return methods include that a. they fail to consider how the investment project is to be financed. b. they fail to use accounting profits. c. they require detailed long-term forecasts of the incremental benefits and costs. d. they fail to use the cash flow of the project. 4) A project requires an initial investment of $347,500. The project generates free cash flow of $600,000 at the end of year 3. What is the internal rate of return for the proj- ect? a. 72.66% b. 28.44% c. 19.97% d. 42.08% 5) What is the payback period for a project with an initial investment of $180,000 that provides an annual cash inflow of $40,000 for the first three years and $25,000 per year for years four and five, and $50,000 per year for years six through eight? a. 5.59 years b. 5.20 years c. 5.40 years d. 5.80 years Self Test 110 Introduction to Financial Management 6) The disadvantage of the IRR method is that: a. the IRR gives equal regard to all returns within a project’s life. b. the IRR will always give the same project accept/reject decision as the NPV. c. the IRR deals with cash flows. d. the IRR requires long, detailed cash flow forecasts. 7) All of the following are criticisms of the payback period criterion except: a. It deals with accounting profits as opposed to cash flows. b. Cash flows occurring after the payback are ignored. c. Time value of money is not accounted for. d. None of the above; they are all criticisms of the payback period criteria. 8) Your company is considering a project with the following cash flows: Initial Outlay = $3,000,000 Cash Flows Year 1-8 = $547,000 Compute the internal rate of return on the project. a. 9.25% b. 12.34% c. 6.38% d. 8.95% 9) Your firm is considering an investment that will cost $750,000 today. The invest- ment will produce cash flows of $250,000 in year 1, $300,000 in years 2 through 4, and $100,000 in year 5. The discount rate that your firm uses for projects of this type is 13.25%. What is the investment’s internal rate of return? a. 25.9% b. 12.8% c. 23.4% d. 21.6% 10) Your firm is considering investing in one of two mutually exclusive projects. Project A requires an initial outlay of $3,500 with expected future cash flows of $2,000 per year for the next three years. Project B requires an initial outlay of $2,500 with expected future cash flows of $1,500 per year for the next two years. The appropriate discount rate for your firm is 12% and it is not subject to capital rationing. Assum- ing both projects can be replaced with a similar investment at the end of their respec- tive lives, compute the NPV of the two chain cycle for Project A and three chain cycle for Project B. Self Test 111 Introduction to Financial Management a. $2,865 and $94 b. $2,232 and $85 c. $5,000 and $1,500 d. $3,528 and $136 Answer Keys 112 Introduction to Financial Management Key Term Definitions Capital budgeting: The process of decision making with respect to investments made in fixed assets – that is, should a proposed project be accepted or rejected. Payback period: The number of years it takes to recapture a project’s initial outlay. Net present value (NPV): The present value of an investment’s annual free cash flow less the investment’s initial outlay. Profitability index (PI) or benefit-cost ratio: The ratio of the present value of an investment’s future free cash flows to the investment’s initial outlay. Internal rate of return (IRR): The rate of return that the project earns. Net present value profile: A graph showing how a project’s NPV changes as the discount rate changes. Capital rationing: Placing a limit on the dollar size of the capital budget. Mutually exclusive projects: Projects that, if undertaken, would serve the same purpose. Thus, accepting one will necessarily mean rejecting the others. Equivalent annual annuity (EAA): An annuity cash flow that yields the same present value as the project’s NPV. Answer Keys 113 Introduction to Financial Management Answers to Self Test 1) c 2) d 3) c 4) c 5) b 6) d 7) a 8) a 9) d 10) b Notes 114 Introduction to Financial Management Objectives 115 Introduction to Financial Management Chapter Number Ten Cash Flows and Other Topics in Capital Budgeting Learning Objectives Upon successful completion of this chapter, you should be able to: 1. Identify guidelines by which we measure cash flows. 2. Explain how a project’s benefits and costs—that is, its free cash flows—are calculated. 3. Explain the importance of options, or flexibility, in capital budgeting. 4. Explain what the appropriate measure of risk is for capitalbudgeting purposes. 5. Determine the acceptability of a new project using the riskadjusted discount method of adjusting for risk. 6. Explain the use of simulation for imitating the performance of a project under evaluation. 7. Explain why a multinational firm faces a more difficult time estimating cash flows along with increased risks. Instructions to Students • Read pages 296-331 of your textbook • Reference: Foundations of Finance: The Logic and Practice of Financial Management, by Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr., 6th Edition 2008 Overview 116 Introduction to Financial Management Capital budgeting involves the decision-making process with respect to investment in fixed assets; specifically, it involves measuring the incremental cash flows associated with investment proposals and evaluating the attractiveness of these cash flows relative to the project’s cost. This chapter focuses on the estimation of those cash flows based on various decision criteria and how to adjust for the riskiness of a given project or combination of projects. Key Terms 117 Introduction to Financial Management The key terms listed below are terms you should be familiar with. Write your definition below each item. Check your answers at the end of this chapter. Incremental after-tax cash flows: Initial outlay: Project standing alone risk: Contribution-to-firm risk: Systematic risk: Risk-adjusted discount rate: Pure play method: Simulation: Scenario analysis: Sensitivity analysis: Summary 118 Introduction to Financial Management In this chapter, we examined the measurement of the incremental cash flows associated with a firm’s investment proposals and methods used to evaluate those proposals. We focused only on the incremental, or differential, after-tax cash flows attributed to an investment proposal. Care is taken to beware of cash flows diverted from existing products, look for incidental or synergistic effects, consider working-capital requirements, consider incremental expenses, ignore sunk costs, account for opportunity costs, examine overhead costs carefully, and ignore interest payments and financing flows. Options, or flexibility, can make it worthwhile to pursue projects that would otherwise be rejected or make projects undertaken more valuable. Three of the most common types of options that can add value to a capital-budgeting project are (1) the option to delay a project until the future cash flows are more favorable (this option is common when the firm has an exclusive right, perhaps a patent, to a product or technology); (2) the option to expand a project, perhaps in size or even to introduce new products that would not have otherwise been feasible; and (3) the option to abandon a project if its future cash flows fall short of expectations. There are three types of capital-budgeting risk: the project standing alone risk, the project’s contribution-to-firm risk, and the project’s systematic risk. In theory systematic risk is the appropriate risk measure, but bankruptcy costs and the issue of un-diversified shareholders also give weight to considering a project’s contribution-to-firm risk as the appropriate risk measure. Both measures of risk are valid, and we avoid making any specific allocation of the importance between the two. The risk-adjusted discount rate involves an upward adjustment of the discount rate to compensate for risk. This method is based on the concept that investors demand higher returns for riskier projects. Thus projects are evaluated usi
ng the appropriate, or risk-adjusted, discount rate. The simulation method is used to provide information about the location and shape of the distribution of possible outcomes of the project. Decisions can be based directly on this method or used as an input to make decisions using the risk-adjusted discount rate method. The process of measuring the free cash flows to the company as a whole becomes more complicated when we are dealing with competition from abroad. One area in which this is certainly true is in calculating the right base case – that is, what the firm’s free cash flows would be if the project is not taken on. Another complication involves the risks associated with currency fluctuations. Self Test 119 Introduction to Financial Management Multiple Choice Questions (Circle the correct answer) 1) The calculation of incremental free cash flows over a project’s life should include a. labor and material saving. b. additional revenue. c. interest to bondholders. d. A and B 2) A new project is expected to generate $600,000 in revenues, $200,000 in cash operating expenses, and depreciation expense of $100,000 in each year of its 10 year life. The corporation’s tax rate is 40%. The project will require an increase in net working capital of $75,000 in year one and a decrease in net working capital of $50,000 in year ten. What is the free cash flow from the project in year one? a. $280,000 b. $205,000 c. $105,000 d. $355,000 3) Which of the following is NOT considered in the calculation of incremental cash flows? a. tax saving due to increased depreciation expense b. increased dividend payments if additional preferred stock is issued c. interest payments if new debt is issued d. B and C 4) When terminating a project for capital budgeting purposes, the working capital outlay required at the initiation of the project will a. not affect the cash flow. b. decrease the cash flow because it is a historical cost. c. decrease the cash flow because it is an outlay. d. increase the cash flow because it is recaptured. 5) Zinc, Inc. is considering the acquisition of a new processing line. The processor can be purchased for $3,750,000. It will cost $165,000 to ship and $85,250 to in- stall the processor. A recently completed feasibility study that was performed at a cost of $65,000 indicated that the processor would produce a positive NPV. Studies have shown that employee-training expenses will be $125,000. What is the total investment in the processing line for capital budgeting purposes? a. $3,980,000 b. $4,125,250 c. $3,875,000 d. $4,190,250 Self Test 120 Introduction to Financial Management 6) Nickel Industries is considering the purchase of a new machine that will cost $178,000, plus an additional $12,000 to ship and install. The new machine will have a 5-year useful life and will be depreciated using the straight-line method. The machine is expected to generate new sales of $85,000 per year and is expected to increase operating costs by $10,000 annually. Nickel’s income tax rate is 40%. What is the projected incremental cash flow of the machine for year 1? a. $66,350 b. $68,200 c. $60,200 d. $54,800 7) Creighton Industries is considering the purchase of a new strapping machine, which will cost $120,000, plus an additional $7,500 to ship and install. The new machine will have a 5-year useful life and will be depreciated to zero using the straight-line method. The machine is expected to generate new sales of $25,000 per year and is expected to save $17,000 in labor and electrical expenses over the next 5-years. The machine is expected to have a salvage value of $30,000. Creighton’s income tax rate is 40%. What is the machine’s IRR? a. 18.3% b. 15.0% c. 13.5% d. 12.0% 8) Your company is considering the replacement of an old delivery van with a new one that is more efficient. The old van cost $30,000 when it was purchased 5 years ago. The old van is being depreciated using the simplified straight-line method over a useful life of 10 years. The old van could be sold today for $5,000. The new van has an invoice price of $75,000, and it will cost $5,000 to modify the van to carry the company’s products. Cost savings from use of the new van are expected to be $22,000 per year for 5 years, at which time the van will be sold for its esti- mated salvage value of $15,000. The new van will be depreciated using the sim- plified straight-line method over its 5-year useful life. The company’s tax rate is 35%. Working capital is expected to increase by $3,000 at the inception of the project, but this amount will be recaptured at the end of year five. What is the tax effect of selling the old machine? a. a savings of $3,500 b. a tax savings of $1,200 c. additional taxes paid of $1,750 d. a savings of $1,750 Self Test 121 Introduction to Financial Management 9) Which of the following is NOT an important consideration in measuring risk for a capital budgeting project for a well-diversified firm? a. Total project risk b. Systematic risk c. Contribution to firm risk d. None of the above – all may be important in measuring project risk 10) One method of accounting for systematic risk for a project involves identifying a publicly traded firm that is engaged in the same business as that project and using its required rate of return to evaluate the project. This method is referred to as ________. a. the accounting beta method b. sensitivity analysis c. the pure play method d. scenario analysis Answer Keys 122 Introduction to Financial Management Key Term Definitions Incremental after-tax cash flows: The funds that the firm receives and is able to reinvest, as opposed to accounting profits, which are shown when they are earned rather than when the money is actually in hand. Initial outlay: The immediate cash outflow necessary to purchase the asset and put it in operating order. Project standing alone risk: A project’s risk ignoring the fact that much of this risk will be diversified away as the project is combined with the firm’s other projects and assets. Contribution-to-firm risk: The amount of risk that the project contributes to the firm as a whole; this measure considers the fact that some of the project’s risk will be diversified away as the project is combined with the firm’s other projects and assets, but ignores the effects of diversification of the firm’s shareholders. Systematic risk: The risk of the project from the viewpoint of a well-diversified shareholder; this measure takes into account that some of a project’s risk will be diversified away as the project is combined with the firm’s other projects, and, in addition, some of the remaining risk will be diversified away by shareholders as they combine this stock with other stocks in their portfolios. Risk-adjusted discount rate: A method of risk adjustment when the risk associated with the investment is greater than the risk involved in a typical endeavor. Using this method, the discount rate is adjusted upward to compensate for this added risk. Pure play method: A method for estimating a project’s or division’s beta that attempts to identify publicly traded firms engaged solely in the same business as the project or division. Simulation: A method for dealing with risk where the performance of the project under evaluation is estimated by randomly selecting observations from each of the distributions that affect the outcome of the project and continuing with this process until a representative record of the project’s probable outcome is assembled. Scenario analysis: A simulation approach for gauging a project’s risk under the worst, best, and most likely outcomes. The firm’s management examines the distribution of the outcomes to determine the project’s level of risk and then makes the appropriate adjustment. Sensitivity analysis: A method for dealing with risk where the change in the distribution of possible net present values or internal rates of return for a particular project resulting from a change in one particular input variable is calculated. This is done by changing the value of one input variable while holding all other input variables constant. Answe
r Keys 123 Introduction to Financial Management Answers to Self Test 1) d 2) b 3) d 4) d 5) b 6) c 7) b 8) a 9) a 10) c Notes 124 Introduction to Financial Management Objectives 125 Introduction to Financial Management Chapter Number Eleven The Cost of Capital Learning Objectives Upon successful completion of this chapter, you should be able to: 1. Describe the concepts underlying the firm’s cost of capital (technically, its weighted average cost of capital) and the purpose for its calculation. 2. Calculate the after-tax cost of debt, preferred stock, and common equity. 3. Calculate a firm’s weighted average cost of capital. 4. Describe the procedure used by PepsiCo to estimate the cost of capital for a multidivisional firm. 5. Use the cost of capital to evaluate new investment opportunities. 6. Compute the economic profit earned by the firm and use this quantity to calculate incentive-based compensation. 7. Calculate equivalent interest rates for different countries. Instructions to Students • Read pages 332-371 of your textbook • Reference: Foundations of Finance: The Logic and Practice of Financial Management, by Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr., 6th Edition 2008 Overview 126 Introduction to Financial Management In Chapters 7 and 8, we considered the valuation of debt and equity instruments. The concepts advanced there serve as a foundation for determining the required rate of return for the firm and for specific investment projects. The objective in this chapter is to determine the required rate of return to be used in evaluating investment projects. Key Terms 127 Introduction to Financial Management The key terms listed below are terms you should be familiar with. Write your definition below each item. Check your answers at the end of this chapter. Financial policy: Weighted average cost of capital: Capital structure: Market value added (MVA): Economic profit: Summary 128 Introduction to Financial Management In Chapter 9, we learned that the proper way to evaluate whether to undertake the investment involves calculating its net present value (NPV). To calculate NPV, we must estimate both project cash flows and an appropriate discount rate. In this chapter, we have learned that the proper discount rate is a weighted average of the after-tax costs of all the firm’s sources of financing. In addition, we have learned that the cost of capital for any source of financing is estimated by first calculating the investor’s required rate of return, then making appropriate adjustments for flotation costs and corporate taxes (when appropriate). Common equity can be obtained by the firm in one of two ways. First, the firm can retain a portion of its net income after paying common dividends. The retention of earnings constitutes a means of raising common-equity financing internally – that is, no capital market issuance of securities is involved. Second, the firm can also raise equity capital through the sale of a new issue of common stock. We discussed two methods for estimating the cost of common equity. The first involved using the dividend growth model. When a new issue of common shares is issued, the firm incurs flotation costs. These costs reduce the amount of funds the firm receives per share. Consequently, the cost of external common equity using the dividend growth model requires that we substitute the net proceeds per share, for share price. The second method for estimating the cost of common equity involves the use of the capital asset pricing model (CAPM), which we first discussed in Chapter 9. There we learned that the CAPM provides a basis for evaluating investors’ required rates of return on common equity. The firm’s weighted average cost of capital will reflect the operating or business risk of the firm’s present set of investments and the financial risk attendant upon the way in which those assets are financed. Therefore, this cost of capital estimate is useful only for evaluating new investment opportunities that have similar business and financial risks. Remember that the primary determinant of the cost of capital for a particular investment is the risk of the investment itself, not the source of the capital. Multidivisional firms such as PepsiCo resolve this problem by calculating a different cost of capital for each of their major operating divisions. How can we tell whether a firm’s management is creating or destroying wealth? We found that a very commonsense measure known as market value added, or MVA, can be used for this purpose. MVA is simply the difference in the market value of the firm’s securities (debt and equity) and the sum total of the funds that have been invested in the firm since its creation. If the market value of the firm’s investments exceeds the total capital invested in the firm, then shareholder wealth has been created to the extent of this difference. Likewise, when the difference is negative, shareholder wealth has been destroyed. If borrowers and lenders can freely choose where they borrow and lend money, why aren’t interest rates the same all over the world? The answer lies in differences in the anticipated rates of inflation between countries. In fact, the international Fisher effect states that the differences in the rates of interest charged for the same loan in two different countries is equal to the difference in the anticipated rates of inflation in the countries. So, rates of interest are equal around the world only after we account for differences in rates of inflation between countries. Of course, the international Fisher effect does not hold exactly due to political and other risk considerations that can serve to restrict capital flow between countries. However, the Fisher effect does provide a useful starting point for understanding why there are differences in interest rates throughout the world. Self Test 129 Introduction to Financial Management Multiple Choice Questions (Circle the correct answer) 1) Clanton Company is financed 40 percent by equity and 60 percent by debt. If the firm expects to earn $20 million in net income next year and retain 40% of it, how large can the capital budget be before common stock must be sold? a. $12.0 million b. $8.0 million c. $20.0 million d. $50.0 million 2) Kelly Corporation will issue new common stock to finance an expansion. The exist- ing common stock just paid a $1.50 dividend, and dividends are expected to grow at a constant rate 8% indefinitely. The stock sells for $45, and flotation expenses of 5% of the selling price will be incurred on new shares. What is the cost of new common stock be for Kelly Corp.? a. 11.79% b. 11.51% c. 11.60% d. 12.53% e. 11.33% 3) Cost of capital is commonly used interchangeably with all of the following terms except a. the firm’s required rate of return. b. the firm’s opportunity cost of funds. c. the internal rate of return for new investments. d. the hurdle rate for new investments. 4) Acme Conglomerate Corporation operates three divisions. One division involves sig- nificant research and development, and thus has a high-risk cost of capital of 15%. The second division operates in business segments related to Acme’s core business, and this division has a cost of capital of 10% based upon its risk. Acme’s core busi- ness is the least risky segment, with a cost of capital of 8%. The firm’s overall weight- ed average cost of capital of 11% has been used to evaluate capital budgeting proj- ects for all three divisions. This approach will a. not favor any division over the other because they all use the same company-wide weighted average cost of capital. b. favor projects in the core business division because that division is the least risky. c. favor projects in the research and development division because the higher risk proj- ects look more favorable if a lower cost of capital is used to evaluate them. d. favor projects in the related businesses division because the cost of capital for this division is the closest to the firm’s weighted average cost of capital. Self Test 130 Introduction to Financial Management 5) Using the weighted
average cost of capital as the required rate of return for every project will a. cause a firm to accept projects that were too risky. b. cause a firm to reject projects that should have been accepted. c. result in maximization of shareholder wealth. d. A and B above 6) Benji’s Discount Club reported net operating profit after-tax of $15,000,000. One of its smaller competitors, Joe’s Discount Club, reported net operating profit after-tax of $3,000,000. Both companies have the same cost of capital. Based on this infor- mation, which of the following statements concerning economic profit is true? a. Joe’s could have a higher economic profit if the amount of invested capital is small relative to the invested capital for Benji’s. b. Benji’s has a higher economic profit than Joe’s. c. Joe’s has a higher economic profit than Benji’s. d. Both companies have the same economic profit, otherwise their costs of capital would not be the same. 7) All of the following are ways for a firm to increase its economic profits except a. operating machinery and equipment more efficiently. b. increasing the firm’s cost of capital by restructuring the firm’s financing sources. c. cutting down on waste and damaged products. d. growing the firm’s investments in projects that earn returns in excess of the firm’s cost of capital. 8) A firm with positive MVA is a. likely to have an unhappy group of common stockholders. b. using investments to produce what investors perceive to be positive net present val- ues. c. controlling operating expenses extremely well. d. experiencing monetary volatility acceleration. 9) Which of the following would be a method of improving a firm’s economic profit? As- sume all else equal. a. Increase sales. b. Dispose of under utilized assets. c. Recapitalize the firm to reduce its cost of capital. d. Identify and improve operating efficiencies. e. all of the above Self Test 131 Introduction to Financial Management 10) The interest rate on a one year security in the United States is 4%, while the inter- est rate on a one year security in German is 10%. If the current exchange rate is 1 EURO = $1.30, then the future exchange rate in one year, according to the interna- tional Fisher effect, is: a. $1.375 b. $1.058 c. $1.275 d. $1.229 Answer Keys 132 Introduction to Financial Management Key Term Definitions Financial policy: The firm’s policies regarding the sources of financing it plans to use and the particular mix (proportions) in which they will be used. Weighted average cost of capital: A composite of the individual costs of financing incurred by each capital source. A firm’s weighted cost of capital is a function of (1) the individual costs of capital, (2) the capital structure mix, and (3) the level of financing necessary to make the investment. Capital structure: The mix of long-term sources of funds used by the firm. This is also called the firm’s capitalization. The relative total (percentage) of each type of fund is emphasized. Market value added (MVA): MVA is the difference in the market value of a firm’s total assets and their book value. Economic profit: Differs from accounting profit in that it incorporates explicit consideration for opportunity cost of equity financing, as well as debt financing. Answer Keys 133 Introduction to Financial Management Answers to Self Test 1) c 2) a 3) c 4) c 5) d 6) a 7) b 8) b 9) e 10) d Notes 134 Introduction to Financial Management Unit 3 Examination Instructions 135 Introduction to Financial Management The Unit Examination The Unit Examination contains 25 questions, either multiple choice or true/false as well as a writing assignment. Your grade on the examination will be determined by the percentage of correct answers. There is no penalty for guessing. The University utilizes the following grading system: A = 90% – 100% correct B = 80% – 89% correct C = 70% – 79% correct D = 60% – 69% correct F = 59% and below correct 4 grade points 3 grade points 2 grade points 1 grade point 0 grade points Completing Unit Three Examination Before beginning your examination, we recommend that you thoroughly review the textbook chapters and other materials covered in each Unit and following the suggestions in the “Mastering the Course Content” section of the course Syllabus. This Unit Examination consists of objective test questions as well as a comprehensive writing assignment selected to reflect the Learning Objectives identified in each chapter covered so far in your textbook. Additional detailed information on completing the examination, writing standards, how to challenge test items and how to submit your completed examination may be found in the Syllabus for this course. If you have additional questions feel free to contact Student Services at (714) 547-9625. Unit 3 Examination 136 Introduction to Financial Management Multiple Choice Questions (Enter your answers on the enclosed answer sheet) 1) Zellars, Inc. is considering two mutually exclusive projects, A and B. Project A costs $75,000 and is expected to generate $48,000 in year one and $45,000 in year two. Project B costs $80,000 and is expected to generate $34,000 in year one, $37,000 in year two, $26,000 in year three, and $25,000 in year four. Zellars, Inc.’s required rate of return for these projects is 10%. The net present value for Project A is: a. $5,826 b. $6,347 c. $18,000 d. $9,458 2) Zellars, Inc. is considering two mutually exclusive projects, A and B. Project A costs $75,000 and is expected to generate $48,000 in year one and $45,000 in year two. Project B costs $80,000 and is expected to generate $34,000 in year one, $37,000 in year two, $26,000 in year three, and $25,000 in year four. Zellars, Inc.’s required rate of return for these projects is 10%. The net present value for Project B is: a. $18,097 b. $42,000 c. $34,238 d. $21,378 3) Zellars, Inc. is considering two mutually exclusive projects, A and B. Project A costs $75,000 and is expected to generate $48,000 in year one and $45,000 in year two. Project B costs $80,000 and is expected to generate $34,000 in year one, $37,000 in year two, $26,000 in year three, and $25,000 in year four. Zellars, Inc.’s required rate of return for these projects is 10%. The internal rate of return for Project B is: a. 18.64% b. 16.77% c. 20.79% d. 26.74% 4) All of the following are criticisms of the payback period criterion except: a. Time value of money is not accounted for. b. It deals with accounting profits as opposed to cash flows. c. Cash flows occurring after the payback are ignored. d. None of the above; they are all criticisms of the payback period criteria. 5) A significant disadvantage of the payback period is that it: a. Does not properly consider the time value of money. b. Is complicated to explain. c. Increases firm risk. d. Provides a measure of liquidity. Unit 3 Examination 137 Introduction to Financial Management 6) A one-sign-reversal project should be accepted if it ________. a. generates an internal rate of return that is higher than the profitability index b. produces an internal rate of return that is greater than the firm’s discount rate c. results in an internal rate of return that is above a project’s equivalent annual annuity d. results in a modified internal rate of return that is higher than the internal rate of return 7) A significant disadvantage of the internal rate of return is that it: a. It does not give proper weight to all cash flows. b. It is expressed as a percentage. c. Does not fully consider the time value of money. d. Can result in multiple rates of return (more than one IRR). 8) The recapture of net working capital at the end of a project will ________. a. increase terminal year free cash flow b. decrease terminal year free cash flow by the change in net working capital times the corporate tax rate c. increase terminal year free cash flow by the change in net working capital times the corporate tax rate d. have no effect on the terminal year free cash flow because the net working capital change has already been included in a prior year 9) Determine the five-year equivalent annual annuity of the follo
wing project if the ap- propriate discount rate is 16%: Initial Outflow = $150,000 Cash Flow Year 1 = $40,000 Cash Flow Year 2 = $90,000 Cash Flow Year 3 = $60,000 Cash Flow Year 4 = $0 Cash Flow Year 5 = $80,000 a. $9,872 b. $8,520 c. $7,058 d. $9,454 Unit 3 Examination 138 Introduction to Financial Management 10) A project would be acceptable if: a. The net present value is positive. b. The payback is greater than the discounted equivalent annual annuity. c. The equivalent annual annuity is greater than or equal to the firm’s discount rate. d. The profitability index is greater than the net present value. 11) Which of the following methods of evaluating investment projects can properly evalu- ate projects of unequal lives? a. The equivalent annual annuity. b. The internal rate of return. c. The payback. d. The net present value. 12) Taste Good Chocolates develops a new candy bar and plans to sell each bar for $1. Taste Good predicts that 1 million candy bars will be sold in the first year if the new candy bar is produced and sold, and includes $1 million of incremental revenues in its capital budgeting analysis. A senior executive in the company believes that 1 mil- lion candy bars will be sold, but lowers the estimate of incremental revenue to $700,000. What would explain this change? a. excessive marketing costs to sell the 1 million candy bars b. a lower discount rate c. cannibalization of 300,000 of Taste Good Chocolates’ other candy bars d. a higher selling price for the new candy bars 13) JW Enterprises is considering a new marketing campaign that will require the addition of a new computer programmer and new software. The programmer will occupy an office in JW’s current building and will be paid $8,000 per month. The software license costs $1,000 per month. The rent for the building is $4,000 per month. JW’s computer system is always on, so running the new software will not change the current monthly electric bill of $900. The incremental expenses for the new market- ing campaign are: a. $8,000 per month. b. $13,000 per month. c. $13,900 per month. d. $9,000 per month. 14) Increased depreciation expenses affect tax-related cash flows by a. increasing taxable income, thus increasing taxes. b. decreasing taxable income, thus reducing taxes. c. pushing a corporation into a higher tax bracket. d. decreasing taxable income, with no effect on cash flow since depreciation is a non- cash expense. Unit 3 Examination 139 Introduction to Financial Management 15) When terminating a project for capital budgeting purposes, the working capital outlay required at the initiation of the project will a. not affect the cash flow. b. decrease the cash flow because it is an outlay. c. increase the cash flow because it is recaptured. d. decrease the cash flow because it is a historical cost. 16) If depreciation expense in year one of a project increases for a highly profitable company, ________. a. net income decreases and incremental free cash flow decreases b. net income increases and incremental free cash flow increases c. the book value of the depreciating asset increases at the end of year one d. net income decreases and incremental free cash flow increases 17) Which of the following is NOT considered in the calculation of incremental cash flows? a. tax saving due to increased depreciation expense b. interest payments if new debt is issued c. increased dividend payments if additional preferred stock is issued d. both b and c 18) If bankruptcy costs and/or shareholder under diversification are an issue, what mea- sure of risk is relevant when evaluating project risk in capital budgeting? a. Total project risk b. Beta risk c. Capital rationing risk d. Contribution-to-firm risk 19) The average cost associated with each additional dollar of financing for investment projects is ________. a. the incremental return b. the marginal cost of capital c. CAPM required return d. the component cost of capital Unit 3 Examination 140 Introduction to Financial Management 20) A firm with positive MVA is ________. a. controlling operating expenses extremely well b. using investments to produce what investors perceive to be positive net present values c. experiencing monetary volatility acceleration d. likely to have an unhappy group of common stockholders 21) Two factors that cause the investor’s required rate of return to differ from the company’s cost of capital are ________. a. taxes and risk b. taxes and transactions costs c. transactions costs and risk d. risk and opportunity cost differences 22) Royal Mediterranean Cruise Line’s common stock is selling for $22 per share. The last dividend was $1.20, and dividends are expected to grow at a 6% annual rate. Flotation costs on new stock sales are 5% of the selling price. What is the cost of Royal’s retained earnings? a. 12.09% b. 11.45% c. 11.78% d. 5.73% 23) Cost of capital is a. the average cost of the firm’s assets. b. a hurdle rate set by the board of directors. c. the coupon rate of debt. d. the rate of return that must be earned on additional investment if firm value is to remain unchanged. Unit 3 Examination 141 Introduction to Financial Management 24) Acme Conglomerate Corporation operates three divisions. One division involves sig- nificant research and development, and thus has a high-risk cost of capital of 15%. The second division operates in business segments related to Acme’s core business, and this division has a cost of capital of 10% based upon its risk. Acme’s core busi- ness is the least risky segment, with a cost of capital of 8%. The firm’s overall weight ed average cost of capital of 11% has been used to evaluate capital budgeting proj- ects for all three divisions. This approach will a. favor projects in the core business division because that division is the least risky. b. favor projects in the research and development division because the higher risk proj- ects look more favorable if a lower cost of capital is used to evaluate them. c. not favor any division over the other because they all use the same company-wide weighted average cost of capital. d. favor projects in the related businesses division because the cost of capital for this division is the closest to the firm’s weighted average cost of capital. 25) Market value added is equal to a. the current stock price per share minus the par value per share of stock. b. the total market value of the company minus total invested capital. c. the total market value of the company less retained earnings. d. the total market value of the company minus the debt owed by the company. Unit 3 Examination 142 Introduction to Financial Management Written Assignment for Unit Three Be sure to refer to this course syllabus for instructions on format, length, and other information on how to complete this assignment. Please answer ONE of the following: 1. Compare and contrast the NPV, PI and IRR criteria. What are the advantages and disadvantages of using each of these methods? 2. Explain how simulation works. What is the value in using a simulation approach? 3. How does a firm’s tax rate affect its cost of capital? What is the effect of the flotation costs associated with a new security issue? You Can Do It 143 Introduction to Financial Management Unit 3 is done! You’re close to the finish line and we’re cheering you on to victory! Objectives 144 Introduction to Financial Management Chapter Number Twelve Determining the Financing Mix Learning Objectives Upon successful completion of this chapter, you should be able to: 1. Understand the difference between business risk and financial risk. 2. Use the technique of break-even analysis in a variety of analytical settings. 3. Distinguish among the financial concepts of operating leverage, financial leverage, and combined leverage. 4. Calculate the firm’s degree of operating leverage, financial leverage, and combined leverage. 5. Understand the concept of an optimal capital structure. 6. Explain the main underpinnings of capital structure theory. 7. Understand and be able to graph the moderate position on capital structure importance. 8. Incorporate the concepts of agency c
osts and free cash flow into a discussion on capital structure management. 9. Use the basic tools of capital structure management. 10. Understand how business risk and global sales impact the multinational firm. Instructions to Students • Read pages 374-413 of your textbook • Reference: Foundations of Finance: The Logic and Practice of Financial Management, by Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr., 6th Edition 2008 Overview 145 Introduction to Financial Management This chapter focuses on useful aids to the financial manager in his or her determination of the firm’s proper financial structure. It includes the definitions of the different kinds of risk, a review of break-even analysis, the concepts of operating leverage, financial leverage, the combination of both leverages, and their effect on (earnings per share) EPS. Then the chapter concentrates on the way the firm arranges its sources of funds. The cost of capital-capital structure argument is highlighted in a straightforward manner without dwelling excessively on pure theory. A moderate view of the effect of financial leverage on the firm’s overall cost of capital is highlighted and explained. Later, techniques useful to the financial officer faced with the determination of an appropriate financing mix are described. Agency theory and the concept of free cash flow as they relate to capital structure determination are also discussed. An overview of actual practice is also included. Key Terms 146 Introduction to Financial Management The key terms listed below are terms you should be familiar with. Write your definition below each item. Check your answers at the end of this chapter. Business risk: Fixed costs: Variable costs: Total revenue: Volume of output: Operating leverage: Financial leverage: Financial structure: Capital structure: Optimal capital structure: Tax shield: Optimal range of financial leverage: Debt capacity: EBIT-EPS indifference point: Summary 147 Introduction to Financial Management In this chapter we studied the process of arriving at an appropriate financial structure for the firm, and we examined tools that can assist the financial manager in this task. We are concerned with assessing the variability in the firm’s residual earnings stream (either earnings per share or earnings available to the common shareholders) as a result of the use of operating and financial leverage. This assessment builds on the tenets of break-even analysis. We then dealt with the design of the firm’s financing mix, emphasizing the management of the firm’s permanent sources of funds – that is, its capital structure. The objective of capital structure management is to arrange the company’s sources of funds so that its common stock price is maximized. A break-even analysis permits the financial manager to determine the quantity of output or the level of sales that will result in an EBIT level of zero. This means the firm has neither a profit nor a loss before any tax considerations. The effect of price changes, cost structure changes, or volume changes on profits (EBIT) can be studied. But to do so it is necessary to first classify the firm’s costs as fixed or variable. Not all costs fit neatly into one of these two categories. Over short planning horizons, though, the preponderance of costs can be assigned to either the fixed or variable classification. Once the cost structure has been identified, the break-even point can be found. Operating leverage is the responsiveness of the firm’s EBIT to changes in sales revenues. It arises from the firm’s use of fixed operating costs. When fixed operating costs are present in the company’s cost structure, increases in sales are magnified into even greater changes in EBIT. But leverage is a two-edged sword. For example, when sales decrease by some percentage, the negative impact on EBIT is again even larger. A firm employs financial leverage when in finances a portion of its assets with securities bearing a fixed rate of return. The presence of debt and/or preferred stock in the company’s financial structure means that it is using financial leverage. When financial leverage is used, changes in EBIT translate into larger changes in earnings per share. Very simply, the firm’s use of financial leverage makes its earnings per share more sensitive to changes in EBIT higher. All other things equal, the more fixed-charge securities the firm employs in its financial structure, the greater its financial leverage. Clearly, EBIT can rise or fall. If it falls, and financial leverage is used, the firm’s shareholders endure negative changes in earnings per share that are larger than the relative decline in EBIT. Again, leverage is a two-edged sword. Firms use operating and financial leverage in various degrees. The joint use of operating and financial leverage is reflected in the percentage change in earnings per share divided by the percentage change in sales. This measure indicates the combined effects of financial leverage on top of operating leverage. Can the firm affect its composite cost of capital by altering its financing mix? Attempts to answer this question have surrounded capital structure theory for over 3 decades. Those taking extreme positions say that the firm’s stock price is either unaffected or continually affected as the firm infinitely increases its reliance on leverage. However, in the real world, interest expense is tax deductible, and market imperfections operate to restrict the amount of fixed-income obligations a firm can issue. Consequently, most financial officers and financial academics subscribe to the concept of an optimal capital structure. The optimal capital structure minimizes the firm’s composite cost of capital. Searching for a proper range of financial leverage, then, is an important financial management activity. Summary 148 Introduction to Financial Management Complicating the manager’s search for an optimal capital structure are conflicts that lead to agency costs. A natural conflict exists between stockholders and bondholders (the agency costs of debt). To reduce excessive risk taking by managers on behalf of stockholders, it may be necessary to include several protective covenants in bond contracts that serve to restrict managerial decision making. Another type of agency cost is related to “free cash flow.” Managers, for example, have an incentive to hold onto free cash flow and enjoy it, rather than pay it out in the form of higher cash dividend payments. This conflict between managers and stockholders leads to the concept of the free cash flow theory of capital structure. This same theory is also known as the control hypothesis and the threat hypothesis. The ultimate resolution of these agency costs affects the specific form of the firm’s capital structure. The decision to use debt financing in the firm’s capital structure causes two types of financial leverage effects. The first is the added variability in the earnings-per-share stream that accompanies the use of fixed-charge securities. The second financial-leverage effect relates to the level of earnings per share (EPS) at a given EBIT under a specific capital structure. Via an EBIT-EPS analysis, the decision maker can inspect the impact of alternative financing plans on EPS over a full range of EBIT levels. A second tool of capital structure management is the calculation of comparative leverage ratios. Comparing these ratios with industry standards enables the financial officer to determine if the firm’s key ratios are in line with accepted practice. CFO indicate that several factors influence the decision to issue debt. The top two are the firm’s financial flexibility and its credit rating. If the firm has the flexibility to choose either debt or equity, then it is in a better financial position. Maintaining the firm’s credit rating reflects the CFO’s recognition that interest costs vary inversely with the firm’s credit rating. If the firm has AA credit, then dropping to A or lower will drive up the firm’s cost of borrowing. Business risk is both multidimensional and inte
rnational. It is directly affected by several factors, including (1) sensitivity of the firm’s product demand to general economic conditions, (2) the degree of competition to which the firm is exposed, (3) product diversification, (4) growth prospects, and (5) global sales. On the last factor, we explored how the Coca-Cola Company related the firm’s commercial strategy to include sales prospects in the huge markets of China and Russia. Self Test 149 Introduction to Financial Management Multiple Choice Questions (Circle the correct answer) 1) Business risk refers to: a. The risk associated with financing a firm with debt. b. The uncertainty associated with a firm’s CAPM. c. The variability of a firm’s expected earnings before interest and taxes. d. The variability of a firm’s stock price. 2) Amish Enterprises makes wooden play sets. The company pays annual rent of $350,000 per year and pays administrative salaries totaling $120,000 per year. Each play set requires $300 of wood, ten hours of labor at $50 per hour, and variable overhead costs of $50. Fixed advertising expenses equal $40,000 per year. Each play set sells for $2,350. What is Amish Enterprises’ break-even output level? a. 217 play sets b. 270 play sets c. 159 play sets d. 340 play sets 3) Potential applications of the break-even model include a. pricing policy. b. optimizing the cash-marketable securities position of a firm. c. replacement for time-adjusted capital budgeting techniques. d. all of the above 4) Based on the data contained in Table A, what is the break-even point in sales dollars? TABLE A Average selling price per unit $15.00 Variable cost per unit $10.00 Units sold 200,000 Fixed cost $450,000 Interest expense $ 40,000 a. $1,470,000 b. $1,350,000 c. $690,000 d. $950,000 5) Operating leverage has to do with: a. The incurrence of fixed operating costs in the firm’s income stream. b. Borrowing money to finance a firm’s growth. c. Using preferred stock to increase sales volume. d. Financing with fixed cost sources of capital. Self Test 150 Introduction to Financial Management 6) Financial leverage has to do with: a. A high gross profit margin. b. The usage of fixed cost financial securities to finance a portion of a firm’s assets. c. The incurrence of fixed operating costs in the firm’s income stream. d. Using common stock to finance a portion of a firm’s assets. 7) Abrams Steel Company has very high operating leverage due to the capital intensive nature of the steel business. Abrams’ CEO is concerned about the variability in the firm’s EPS if sales should drop, and decides to take action. Which of the following will reduce the variability in the firm’s EPS for a given change in sales? a. The CEO may issue more corporate bonds and use the proceeds to pay off short-term liabilities. b. The CEO may increase the firm’s total leverage by raising money from the sale of com- mon stock. c. The CEO may increase the firm’s financial leverage and hence reduce the variability by using non-shareholder money to support the business. d. The CEO may decrease the firm’s financial leverage, thus lowering the firm’s total leverage. 8) According to the moderate view of capital costs and financial leverage, as the use of debt financing increases a. the cost of capital continuously increases. b. the cost of capital continuously decreases. c. there is an optimal level of debt financing. d. the cost of capital remains constant. 9) Optimal capital structure is: a. the mix of permanent sources of funds used by the firm in a manner that will maxi- mize the company’s common stock price. b. the mix of all items that appear on the right-hand side of the company’s balance sheet. c. the mix of funds that will maximize the firm’s interest tax shield. d. the mix of funds that will minimize the firm’s cost of equity capital. 10) Which of the following would not be a part of a firm’s capital structure? a. Common stock b. Long-term bonds c. Preferred stock d. Short-term notes payable Answer Keys 151 Introduction to Financial Management Key Term Definitions Business risk: The relative dispersion or variability in the firm’s expected earnings before interest and taxes (EBIT). The nature of the firm’s operations causes its business risk. This type of risk is affected by the firm’s cost structure, product demand characteristics, and intra-industry competitive position. Fixed costs: Costs that do not vary in total dollar amount as sales volume or quantity of output changes. Variable costs: Costs that are fixed per unit of output but vary in total as output changes. Total revenue: Total sales dollars. Volume of output: A firm’s level of operations expressed either in sales dollars or as units of output. Operating leverage: The incurring of fixed operating costs in a firm’s income stream. Financial leverage: The use of securities bearing a fixed (limited) rate of return to finance a portion of a firm’s assets. Financial leverage can arise from the use of either debt or preferred stock financing. Financial structure: The mix of all funds sources that appears on the right-hand side of the balance sheet. Capital structure: The mix of long-term sources of funds used by the firm. This is also called the firm’s capitalization. The relative total (percentage) of each type of fund is emphasized. Optimal capital structure: The capital structure that minimizes the firm’s composite cost of capital (maximizes the common stock price) for raising a given amount of funds. Tax shield: The element from the federal tax code that permits interest costs to be deductible when computing a firm’s tax bill. Optimal range of financial leverage: The range of various capital structure combinations that yield the lowest overall cost of capital for the firm. Debt capacity: The maximum proportion of debt that the firm can include in its capital structure and still maintain its lowest composite cost of capital. EBIT-EPS indifference point: The level of earnings before interest and taxes (EBIT) that will equate earnings per share (EPS) between two different financing plans. Answer Keys 152 Introduction to Financial Management Answers to Self Test 1) c 2) d 3) a 4) b 5) a 6) b 7) d 8) c 9) a 10) d Notes 153 Introduction to Financial Management Objectives 154 Introduction to Financial Management Chapter Number Thirteen Dividend Policy and Internal Financing Learning Objectives Upon successful completion of this chapter, you should be able to: 1. Describe the trade-off between paying dividends and retaining the profits within the company. 2. Explain the relationship between a corporation’s dividend policy and the market price of its common stock. 3. Describe practical considerations that may be important to the firm’s dividend policy. 4. Distinguish among the types of dividend policies corporations frequently use. 5. Specify the procedures a company follows in administering the dividend payment. 6. Describe why and how a firm might pay non-cash dividends (stock dividends and stock splits) instead of cash dividends. 7. Explain the purpose and procedures related to stock repurchases. 8. Understand the relationship between a policy of low dividend payments and international capital budgeting opportunities that confront the multinational firm. Instructions to Students • Read pages 414-435 of your textbook • Reference: Foundations of Finance: The Logic and Practice of Financial Management, by Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr., 6th Edition 2008 Overview 155 Introduction to Financial Management In determining the firm’s dividend policy, two issues are important: the dividend payout ratio and the stability of the dividend payment over time. In this regard, the financial manager should consider the investment opportunities available to the firm and any preference that the company’s investors have for dividend income or capital gains. Also, stock dividends, stock splits, or stock repurchases can be used to supplement or replace cash dividends. Key Terms 156 Introduction to Financial Management The key terms listed below are terms you sh
ould be familiar with. Write your definition below each item. Check your answers at the end of this chapter. Dividend payout ratio: Perfect capital markets: Bird-in-the-hand dividend theory: Residual dividend theory: Clientele effect: Information asymmetry: Agency costs: Expectations theory: Constant dividend payout ratio: Stable dollar dividend per share: Small, regular dividend plus a year-end extra: Declaration date: Date of record: Ex-dividend date: Payment date: Stock split: Stock dividend: Stock repurchase (stock buyback): Tender offer: Summary 157 Introduction to Financial Management A company’s dividend decision has an immediate impact on the firm’s financial mix. If the dividend payment is increased, fewer funds are available internally for financing investments. Consequently, if additional equity capital is needed, the company has to issue new common stock. In perfect markets, the choice between paying or not paying a dividend does not matter. However, when we realize that in the real world there are costs of issuing stock, we have a preference to use internal equity to finance our investment opportunities. Here the dividend decision is simply a residual factor, in which the dividend payment should equal the remaining internal capital after the firm finances all of its investments. Other market imperfections that may cause a company’s dividend policy to affect the firm’s stock price include (1) the deferred tax benefit of capital gains, (2) agency costs, (3) the clientele effect, and (4) the informational content of a given policy. Other practical considerations that may affect a firm’s dividend payment decision include: • Legal restrictions • The firm’s liquidity position • The company’s accessibility to capital markets • The stability of the firm’s earnings • The desire of investors to maintain control of the company In practice, managers have generally followed one of three dividend policies: (1) A constant dividend payout ratio, whereby the percentage of dividends to earnings is held constant, (2) A stable dollar dividend per share, whereby a relatively stable dollar dividend is maintained over time, and (3) A small, regular dividend plus a year-end extra, whereby the firm pays a small, regular dollar dividend plus a year-end extra in prosperous years. Of the three dividend policies, the stable dollar dividend is by far the most common. The Jobs and Growth Tax Relief Reconciliation Act of 2003 reduced the top tax rate on dividend income to 15 percent and placed the top tax rate on realized long-term capital gains at this same 15 percent rate. This helped level the investment landscape for dividend income relative to qualifying capital gains. Taxes paid on capital gains, however, are still deferred until realized, but dividend income is taxed in the year that it is received by the investing taxpayer. Generally, companies pay dividends on a quarterly basis. The final approval of a dividend payment comes from the board of directors. The critical dates in this process are as follows: • Declaration date – the date when the dividend is formally declared by the board of directors • Date of record – the date when the stock-transfer books are closed to determine who owns the stock • Ex-dividend date – two working days before the date of record, after which the right to receive the dividend no longer goes with the stock • Payment date – the date the dividend check is mailed to the stockholders Stock dividends and stock splits have been used by corporations either in lieu of or to supplement cash dividends. At present, no empirical evidence identifies a relationship between stock dividends and splits and the market price of the stock. Yet a stock dividend or split could conceivably Summary 158 Introduction to Financial Management be used to keep the stock price within an optimal trading range. Also, if investors perceive that the stock dividend contains favorable information about the firm’s operations, the price of the stock could increase. As an alternative to paying a dividend, the firm can repurchase stock. In perfect markets, an investor would be indifferent between receiving a dividend or a share repurchase. The investor could simply create a dividend stream by selling stock when income is needed. If, however, market imperfections exist, the investor may have a preference for one of the two methods of distributing the corporate income. A stock repurchase can also be viewed as a financing decision. By issuing debt and then repurchasing stock, a firm can immediately alter its debt-equity mix toward a higher proportion of debt. Also, many managers consider a stock repurchase an investment decision – buying the stock when they believe it to be undervalued. During periods of general economic prosperity, financially strong firms tend to focus their business strategies on growth. As a result, dividend yields and cash dividend payments can decline. With internally generated cash to invest, the multinational firm will look to international markets for prospective high-NPV projects. This may allow the firm to (1) spread country-related economic risks by diversifying geographically and (2) achieve a cost advantage over competitors. Self Test 159 Introduction to Financial Management Multiple Choice Questions (Circle the correct answer) 1) The dividend irrelevance hypothesis is based on all of the following assumptions except: a. borrowing decisions will not be altered by the amount of dividend payments. b. investment decisions will not be altered by the amount of dividend payments. c. perfect capital markets. d. investors do not need cash dividends to supplement their current income. 2) JB Corporation has a retained earnings balance of $1,000,000. The company report- ed net income of $200,000, sales of $2,000,000, and has 100,000 shares of com- mon stock outstanding. The company announced a dividend of $1 per share. There- fore, the company’s dividend payout ratio is a. 20%. b. 10%. c. 100%. d. 50%. 3) A corporation with very high growth prospects and many positive NPV projects to fund may want to increase its dividend based on a. the very low agency costs of the corporation. b. the residual dividend theory. c. the information effect. d. the tax bias against capital gains. 4) Assume that a firm has a steady record of paying stable dividends for years. Market analysts had expected management to increase the dividend by 7.5% in the latest quarter. However, management announced a 15% increase in the current year’s divi- dend. The market value of the stock rose 20% on the day of the announcement. Which of the following would best explain the stock market’s reaction to the anounce- ment? a. Dividend Irrelevance theory b. Expectations theory c. Agency theory d. Residual Dividend theory 5) Assume that the tax on dividends and the tax on capital gains is the same. All else equal, what would a prudent investor prefer? a. The prudent investor would prefer capital gains, i.e., the capital gain tax liability can be deferred until gains are realized. b. The prudent investor would prefer dividends, i.e., a dollar today is always worth more than a dollar to be received in the future. c. The prudent investor would be indifferent between receiving dividends or capital gains. d. More information is needed. Self Test 160 Introduction to Financial Management 6) LAW, Inc. settled a large lawsuit that caused earnings to be negative for the quarter. This quarterly loss was the first in 22 years. In addition, the company has a record of 48 consecutive quarters of dividend payments. Which of the following is correct? a. The company cannot pay dividends this quarter since the company had no earnings. b. The clientele effect says that investor choice of investment vehicle is independent of dividend policy and therefore the payment/omission of the dividend is immaterial. c. The company can use cash generated through prior retention of earnings, or borrowed funds to pay the dividend. d. The company can omit the dividend; shareholders are always understanding about the riskiness of business. 7) JLI Corp. had earnings
per share of $4 per share last year and paid a dividend of $1 per share. For the current year, JLI Corp. generated earnings per share of $6 and paid a dividend of $1 per share. This is an example of what type of dividend policy? a. small, regular dividend plus a year-end extra b. payout ratio equal to zero c. constant dividend payout ratio d. stable dollar dividend per share 8) The CEO of Marletti Pasta Company wants a dividend policy that minimizes the likeli- hood of decreasing the company’s dividend per share. Which of the following policies should the CEO select? a. stable dollar dividend per share b. regular dividend plus a year-end extra c. constant dividend payout ratio d. All policies have the same likelihood of a dividend decrease because dividend chang- es are dependent on changes in earnings. 9) All of the following are rationales given for a stock dividend or split except: a. there is positive informational content associated with the announcement. b. conservation of corporate cash. c. the price will not fall proportionately to the share increase. d. an optimum price range does not exist. 10) Which of the following will result from a stock repurchase? a. Corporate cash is conserved. b. Earnings per share will rise. c. Number of shares will increase. d. Ownership is diluted. Answer Keys 161 Introduction to Financial Management Key Term Definitions Dividend payout ratio: The amount of dividends relative to the company’s net income or earnings per share. Perfect capital markets: An assumption that allows one to study the effect of dividend decisions in isolation. It assumes that (1) investors can buy and sell stocks without incurring any transaction costs, such as brokerage commissions; (2) companies can issue stocks without any cost of doing so; (3) there are no corporate or personal taxes; (4) complete information about the firm is readily available; (5) there are not conflicts of interest between management and stockholders; and (6) financial distress and bankruptcy costs are nonexistent. Bird-in-the-hand dividend theory: the view that dividends are more certain than capital gains. Residual dividend theory: A theory that a company’s dividend payment should equal the cash left after financing all the investments that have positive net present values. Clientele effect: The belief that individuals and institutions that need current income will invest in companies that have high dividend payouts. Other investors prefer to avoid taxes by holding securities that offer only small dividend income but large capital gains. Thus, we have a “clientele” of investors. Information asymmetry: The difference in accessibility to information between managers and investors, which may result in a lower stock price than would be true in conditions of certainty. Agency costs: The costs, such as a reduced stock price, associated with potential conflict between managers and investors when these two groups are not the same. Expectations theory: The concept that, no matter what the decision area, how the market price responds to management’s actions is not determined entirely by the action itself; it is also affected by investors’ expectations about the ultimate decision to be made by management. Constant dividend payout ratio: A dividend payment policy in which the percentage of earnings paid out in dividends is held constant. The dollar amount fluctuates from year to year as profits vary. Stable dollar dividend per share: A dividend policy that maintains a relatively stable dollar dividend per share over time. Small, regular dividend plus a year-end extra: A corporate policy of paying a small regular dollar dividend plus a year-end extra dividend in prosperous years to avoid the connotation of a permanent dividend. Declaration date: The date upon which a dividend is formally declared by the board of directors. Date of record: Date at which the stock transfer books are to be closed for determining the investor to receive the next dividend payment. Ex-dividend date: The date upon which stock brokerage companies have uniformly decided to terminate the right of ownership to the dividend, which is two days prior to the date of record. Answer Keys 162 Introduction to Financial Management Payment date: The date on which the company mails a dividend check to each investor of record. Stock split: A stock dividend exceeding 25 percent of the number of shares currently outstanding. Stock dividend: A distribution of shares of up to 25 percent of the number of shares currently outstanding, issued on a pro rata basis to the current stockholders. Stock repurchase (stock buyback): The repurchase of common stock by the issuing firm for any of a variety of reasons, resulting in reduction of shares outstanding. Tender offer: A formal offer by the company to buy a specified number of shares at a predetermined and stated price. The tender price is set above the current market price in order to attract sellers. Answer Keys 163 Introduction to Financial Management Answers to Self Test 1) d 2) d 3) c 4) b 5) a 6) c 7) d 8) a 9) d 10) b Notes 164 Introduction to Financial Management Objectives 165 Introduction to Financial Management Chapter Number Fourteen Short-Term Financial Planning Learning Objectives Upon successful completion of this chapter, you should be able to: 1. Use the percent of sales method to forecast the financing requirements of a firm. 2. Describe the limitations of the percent of sales forecast method. 3. Prepare a cash budget and use it to evaluate the amount and timing of a firm’s financing needs. Instructions to Students • Read pages 438-459 of your textbook • Reference: Foundations of Finance: The Logic and Practice of Financial Management, by Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr., 6th Edition 2008 Overview 166 Introduction to Financial Management This chapter is divided into two sections. The first section includes an overview of the role played by forecasting in the firm’s planning process. The second section focuses on the construction of detailed financial plans, including budgets and pro forma financial statements for future periods of the firm’s operations. A budget is a forecast of future events and provides the basis for taking corrective action and can also be used for performance evaluation. The cash budget and pro forma financial statements provide the necessary information to determine estimates of future financing requirements of the firm. These estimates are the key elements in our discussion of financial planning and budgeting. Key Terms 167 Introduction to Financial Management The key terms listed below are terms you should be familiar with. Write your definition below each item. Check your answers at the end of this chapter. Percentage of sales method: Spontaneous financing: Discretionary financing: External financing needs: Budget: Cash budget: Summary 168 Introduction to Financial Management This chapter developed the role of forecasting within the context of the firm’s financial-planning activities. Forecasts of the firm’s sales revenues and related expenses provide the basis for projecting future financing needs. The most popular method for forecasting financial variables is the percent of sales method. The percent of sales method presumes that the asset or liability being forecast is a constant percent of sales for all future levels of sales. There are instances when this assumption is not reasonable and, consequently, the percent of sales method does not provide reasonable predictions. One such instance arises when there are economies of scale in the use of the asset being forecast. For example, the firm may need at least $10 million in inventories to open its doors and operate even for sales as low as $100 million per year. If sales double to 4200 million, inventories may only increase to $15 million. Thus, inventories do not increase with sales in a constant proportion. A second situation in which the percent of sales method fails to work properly is when asset purchases are lumpy. That is, if plant capacity must be purchased in say, $50 million increments, t
hen plant and equipment will not remain a constant percentage of sales. How serious are these possible problems and should we use the percent of sales method? Even in the face of these problems, the percent of sales method works reasonable well when predicted sales levels do not differ drastically from the level used to calculate the percentage of sales. For example, if the current sales level used in calculating the percentage of sales for inventories is $40 million, then we can feel more comfortable forecasting the level of inventories corresponding to a new sales level of $42 million than when sales are predicted to rise to $60 million. The cash budget is the primary tool of financial forecasting and planning. It contains a detailed plan of the firm’s future cash flow estimates and consists of four elements or segments: cash receipts, cash disbursements, net change in cash for the period, and new financing needed. Once prepared, the cash budget also serves as a tool for monitoring and controlling the firm’s operations. By comparing actual cash receipts and disbursements to those in the cash budget, the financial manager can gain an appreciation of how well the firm is performing. In addition, deviations from the plan can serve as an early warning system to signal the onset of financial difficulties ahead. Self Test 169 Introduction to Financial Management Multiple Choice Questions (Circle the correct answer) 1) The “percentage” used in the percent of sales calculation can come: a. from an analyst’s judgment. b. from the most recent financial statement item as a percent of current sales. c. from an average computed over several years. d. from any of the above or a combination of the above. 2) Which of the following is the initial and most important step in the preparation of pro- forma financial statements? a. Estimate the levels of investment in current and fixed assets. b. Approximate the cost of raw materials. c. Determine the rate of interest that will be required for borrowed funds. d. Project the firm’s sales revenues for the planning period. 3) Spontaneous sources of funds refers to all of the below except: a. accruals b. common stock c. accounts payable d. a bank loan 4) Which of the following is a limitation of the “percent of sales method” of preparing pro forma financial statements? a. A firm’s investment in accounts receivable is seldom related to sales volume. b. The dividend payout ratio may change from one year to the next. c. Not all assets and liabilities increase or decrease as a constant percent of sales. d. Inventory levels are seldom affected by changes in sales volume. 5) At a minimum, the sales forecast for the coming year would reflect a. any future trend in sales that is expected to begin in the new year. b. the influence of any anticipated events that might materially affect the sales trend. c. both of the above are correct. d. none of the above are correct 6) Dorian Industries’ projected sales for the first six months of 2008 are given below: Jan. $250,000 April $300,000 Feb. $340,000 May $350,000 Mar. $280,000 June $380,000 Self Test 170 Introduction to Financial Management 20% of sales are collected in cash at time of sale, 50% are collected in the month following the sale, and the remaining 30% are collected in the second month follow- ing the sale. Cost of goods sold is 85% of sales. Purchases are made in the month prior to the sales, and payments for purchases are made in the month of the sale. Total other cash expenses are $70,000/month. The company’s cash balance as of February 28, 2008 will be $10,000. Excess cash will be used to retire short-term borrowing (if any). Dorian has no short term borrowing as of February 28, 2008. Ignore any interest on short-term borrowing. The company must have a minimum cash balance of $40,000 at the beginning of each month. Dorian’s projected EBIT for March 2008? a. ($28,000) b. $23,000 c. $42,000 d. ($60,000) 7) Mercer, Inc. had the following sales for the past six months. Mercer collects its credit sales 30% in the month of sale, 60% one month after the sale, and 10% two months after the sale. Cash Sales Credit Sales January $40,000 $60,000 February $50,000 $90,000 March $35,000 $80,000 April $40,000 $100,000 May $60,000 $120,000 June $70,000 $140,000 What are Mercer’s total cash receipts for the month of March? a. $119,000 b. $115,000 c. $141,000 d. $129,000 8) ABC Corporation began operations on January 1st of this year. ABC had sales of $100,000 for the month of January, all on credit. ABC allows its customers 30 days to pay. In its cash budget for January, cash receipts should be equal to a. $100,000 because of GAAP accrual accounting rules. b. $0, because all of the sales are on credit and won’t be collected until February. c. $50,000, so the company can average out the sales over the month of sale and the month the accounts receivable are collected. d. $8,3333 ($100,000/12) because the monthly cash budget is part of the annual cash budget. Self Test 171 Introduction to Financial Management 9) Buster Enterprises’ projected sales for the first six months of 2008 are given below: Jan. $400,000 April $450,000 Feb. $540,000 May $480,000 Mar. $350,000 June $520,000 30% of sales are collected in cash at time of sale, 60% are collected in the month following the sale, and the remaining 10% are collected in the second month following the sale. Cost of goods sold is 70% of sales. Purchases are made in the month prior to the sales, and payments for purchases are made in the month of the sale. Total other cash expenses are $50,000/month. The company’s cash balance as of February 28, 2008 will be $30,000. Excess cash will be used to retire short-term borrowing (if any). Buster Enterprises has no short term borrowing as of February 28, 2008. Assume that the interest rate on short-term borrowing is 1% per month. The company must have a minimum cash balance of $20,000 at the beginning of each month. What is Buster Enterprises’ projected cash balance at the end of May 2008? a. $352,000 b. $287,000 c. $301,000 d. $224,000 10) In what way does a cash budget provide management with better information about financing requirements than a pro forma balance sheet? a. A pro forma cash budget utilizes superior methods in determining a firm’s income tax liability for the planned period. b. A pro forma cash budget not only delineates the financing that is needed but it also pinpoints in greater detail when the financing is needed. c. A pro forma cash budget does not offer better information to management regarding financing than a pro forma balance sheet. d. A pro forma cash budget gives greater details about the depreciation of fixed assets. Answer Keys 172 Introduction to Financial Management Key Term Definitions Percentage of sales method: A method of financial forecasting that involves estimating the level of an expense, asset, or liability for a future period as a percent of the sales forecast. Spontaneous financing: The trade credit and other accounts payable that arise “spontaneously” in the firm’s day-to-day operations. Discretionary financing: Sources of financing that require an explicit decision on the part of the firm’s management every time funds are raised. External financing needs: That portion of a firm’s requirements for financing that exceeds its sources of internal financing (i.e., the retention of earnings) plus spontaneous sources of financing (e.g., trade credit). Budget: An itemized forecast of a company’s expected revenues and expenses for a future period. Cash budget: A detailed plan of future cash flows. This budget is composed of four elements: cash receipts, cash disbursements, net change in cash for the period, and new financing needed. Answer Keys 173 Introduction to Financial Management Answers to Self Test 1) d 2) d 3) d 4) c 5) c 6) a 7) a 8) b 9) c 10) b Notes 174 Introduction to Financial Management Objectives 175 Introduction to Financial Management Chapter Number Fifteen Working-Capital Management Learning Objectives Upon successful completion of this chapter, you should be able to: 1. Describe the risk
–return trade-off involved in managing a firm’s working capital. 2. Explain the determinants of net working capital. 3. Calculate a firm’s cash conversion cycle and interpret its determinants. 4. Calculate the effective cost of short-term credit. 5. List and describe the basic sources of short-term credit. 6. Describe the special problems encountered by multinational firms in managing working capital. Instructions to Students • Read pages 460-485 of your textbook • Reference: Foundations of Finance: The Logic and Practice of Financial Management, by Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr., 6th Edition 2008 Overview 176 Introduction to Financial Management In this chapter, we introduce working-capital management in terms of managing the firm’s liquidity. Specifically, working capital is defined as the difference in current assets and current liabilities. The hedging principle is offered as one approach to addressing the firm’s liquidity problems. In addition, this chapter deals with the sources of short-term financing that must be repaid within one year. Key Terms 177 Introduction to Financial Management The key terms listed below are terms you should be familiar with. Write your definition below each item. Check your answers at the end of this chapter. Working capital: Net working capital: Hedging principle (principle of self-liquidating debt): Permanent investments: Temporary investments: Trade credit: Unsecured loans: Secured loan: Line of credit: Revolving credit agreement: Compensating balance: Transaction loan: Commercial paper: Pledging accounts receivable: Factoring accounts receivable: Factor: Inventory loans: Floating lien agreement: Chattel mortgage agreement: Field warehouse agreement: Terminal warehouse agreement: Summary 178 Introduction to Financial Management Working-capital management involves managing the firm’s liquidity, which in turn involves managing (1) the firm’s investment in current assets and (2) its use of current liabilities. Each of these problems involves risk-return trade-offs. Investing in current assets reduces the firm’s risk of illiquidity at the expense of lowering its overall rate of return on its investment in assets. By contrast, the use of long-term sources if financing enhances the firm’s liquidity while reducing its rate of return on assets. The hedging principle, or principle of self-liquidating debt, is a benchmark for working-capital decisions. Basically, this principle involves matching the cash-flow-generating characteristics of an asset with the maturity of the source of financing used to acquire it. The cash conversion cycle is a key measure of how efficient the firm is in managing its working capital. Specifically, it equals the number of days it takes to collect on credit sales plus the number of days items re in inventory less the number of days that payables are outstanding. The importance of the length of the conversion cycle is that this is the number of days that the firm has its cash tied up in inventories and accounts receivable for which it must provide financing. The key consideration in selecting a source of short-term financing is the effective cost of credit. The various sources of short-term credit can be categorized into two groups: unsecured and secured. Unsecured credit offers no specific assets as security for the loan agreement. The primary sources include trade credit, lines of credit, unsecured transaction loans from commercial banks, and commercial paper. Secured credit is generally provided to business firms by commercial banks, finance companies, and factors. The most popular sources of security involve the use of accounts receivable and inventories. Loans secured by inventories can be made using one of several types of security arrangements. Among the most widely used are the floating lien, chattel mortgage, field warehouse agreement, and terminal warehouse agreement. The form of agreement used depends on the type of inventories pledged as collateral and the degree of control the lender wishes to exercise over the collateral. The problems of working-capital management are fundamentally the same for multinational firms as they are for domestic firms, with some complications. The primary source of complication comes from the fact that the multinational receives and makes payment with foreign currencies. This means that the multinational firm must be concerned not only with having sufficient liquidity but also with the value of its cash and marketable securities in terms of the value of the currencies of the countries in which it does business. Specifically, the multinational firm faces three types of currency exposure risk: translation exposure, transaction exposure, and economic exposure. All three types of currency risk must be managed by the multinational in addition to the traditional risks of illiquidity. Self Test 179 Introduction to Financial Management Multiple Choice Questions (Circle the correct answer) 1) As a company accounts payable manager, which of the following credit terms are most likely to entice you to take the cash discount? a. 1/10 net 45 b. 1/10 net 30 c. 2/10 net 90 d. 2/10 net 60 2) JoLi Corp. purchases a new delivery van which is expected to increase cash flows for the next 10 years. JoLi can finance the purchase with a standard 48 month ve- hicle loan, or by getting a 10 year loan from the bank. According to the hedging prin- ciple, JoLi should a. avoid using either loan and finance the truck with current cash reserves to avoid inter- est expense. b. use either type of financing, but hedge the risk in the options market. c. use the 10-year financing in order to match the cash flow stream from the asset with the financing repayments. d. use the 48 month loan since it matches the type of asset with the type of loan. 3) Caylor Inc. needs to borrow $300,000 for the next 6 months. The company has a line of credit with a bank that allows the company to borrow funds with a 10% interest rate subject to a 25% of loan compensating balance. Currently, Caylor Inc. has no funds on deposit with the bank and will need the loan to cover the compensating bal- ance as well as their other financing needs. How much will Caylor Inc. need to bor- row? a. $400,000 b. $330,000 c. $375,000 d. $225,000 4) In the context of managing working capital, the hedging principle refers to which of the following? a. protecting the firm against the risk of rising interest rates b. speculation regarding the direction of short-term interest rates c. matching the maturity of the source of financing to the cash flow generating charac- teristics of the asset being financed d. the usage of interest rate swaps 5) Bigtime Corp. is considering borrowing $10,000 for a 45-day period. The firm will repay the $10,000 principal amount plus $90 in interest. What is the effective an- nual rate of interest? Use a 360-day year. a. 7.2% Self Test 180 Introduction to Financial Management b. 16.9% c. 40.5% d. 9.8% 6) According to the hedging principle, which of the following assets should be financed with permanent sources of financing? a. levels of inventory and accounts receivable the firm maintains throughout the year b. seasonal expansions of inventory c. seasonal increases in accounts receivable d. none of the above 7) Which of the following statements about factoring is true? a. Factoring involves the outright sale of a firm’s accounts receivable to the factor. b. The firm, not the factor, bears the risk of collecting bad receivables in a factoring ar- rangement. c. The borrowing firm is able to obtain a greater advance against inventory in a factoring arrangement than in a typical line of credit secured by accounts receivable. d. Factoring firms sell the receivables of other firms. 8) Which of the following is most likely to be a temporary source of financing? a. preferred stock b. commercial paper c. common stock d. long-term debt 9) Boeing Corp. buys on 2/10, net 30 days. What is the nominal cost of interest if Boe- ing does not take advantage of the trade discount offered? Assume a 360-day year. a. 2.0% b. 36.7% c. 72.3% d. 48
.1% 10) Trade credit is an example of which of the following sources of financing? a. temporary b. spontaneous c. permanent d. discretionary Answer Keys 181 Introduction to Financial Management Key Term Definitions Working capital: A concept traditionally defined as a firm’s investment in current assets. Net working capital: The difference between the firm’s current assets and its current liabilities. Hedging principle (principle of self-liquidating debt): A working-capital management policy which states that the cash flow – generating characteristics of a firm’s investments should be matched with the cash flow requirements of the firm’s sources of financing. Very simply, short-lived assets should be financed with short-term sources of financing while long-lived assets should be financed with long-term sources of financing. Permanent investments: An investment that the firm expects to hold longer than one year. The firm makes permanent investments in fixed and current assets. Temporary investments: A firm’s investments in current assets that will be liquidated and not replaced within a period of one year or less. Examples include seasonal expansions in inventories and accounts receivable. Trade credit: Credit made available by a firm’s suppliers in conjunction with the acquisition of material. Trade credit appears on the balance sheet as accounts payable. Unsecured loans: Al sources of credit that have as their security only the lender’s faith in the borrower’s ability to repay the funds when due. Secured loan: Sources of credit that require security in the form of pledged assets. In the event the borrower defaults in payment of principal or interest, the lender can seize the pledged assets and sell them to settle the debt. Line of credit: Generally an informal agreement or understanding between a borrower and a bank as to the maximum amount of credit the bank will provide the borrower at any one time. Under this type of agreement there is no “legal” commitment on the part of the bank to provide the stated credit. Revolving credit agreement: An understanding between the borrower and the bank as to the amount of credit the bank will be legally obligated to provide the borrower. Compensating balance: A balance of a given amount that the firm maintains in its demand deposit account. It may be required by either a formal or informal agreement with the firm’s commercial bank. Such balances are usually required by the bank (1) on the unused portion of a loan commitment, (2) on the unpaid portion of an outstanding loan, or (3) in exchange for certain services provided by the bank, such as check-clearing or credit information. These balances raise the effective rate of interest paid on borrowed funds. Transaction loan: A loan where the proceeds are designated for a specific purpose – for example, a bank loan used to finance the acquisition of a piece of equipment. Commercial paper: Short-term unsecured promissory notes sold by large businesses in order to raise cash. Unlike most other money-market instruments, commercial paper has no developed secondary market. Answer Keys 182 Introduction to Financial Management Pledging accounts receivable: A loan the firm obtains from a commercial bank or a finance company using its accounts receivable as collateral. Factoring accounts receivable: The outright sale of a firm’s accounts receivable to another party (the factor) without recourse. The factor, in turn, bears the risk of collection. Factor: A firm that, in acquiring the receivable of other firms, bears the risk of collection and, for a fee, services the accounts. Inventory loans: Loans secured by inventories. Floating lien agreement: An agreement, generally associated with a loan, whereby the borrower gives the lender a lien against all its inventory. Chattel mortgage agreement: A loan agreement in which the lender can increase his or her security interest by having specific items of inventory identified in the loan agreement. The borrower retains title to the inventory but cannot sell the items without the lender’s consent. Field warehouse agreement: A security agreement in which inventories pledged as collateral are physically separated from the firm’s other inventories and placed under the control of a third-party field-warehousing firm. Terminal warehouse agreement: A security agreement in which the inventories pledged as collateral are transported to a public warehouse that is physically removed from the borrower’s premises. This is the safest (though costly) form of financing secured by inventory. Answer Keys 183 Introduction to Financial Management Answers to Self Test 1) b 2) c 3) a 4) c 5) a 6) a 7) a 8) b 9) b 10) b Notes 184 Introduction to Financial Management Unit 4 Examination Instructions 185 Introduction to Financial Management The Unit Examination The Unit Examination contains 25 questions, either multiple choice or true/false as well as a writing assignment. Your grade on the examination will be determined by the percentage of correct answers. There is no penalty for guessing. The University utilizes the following grading system: A = 90% – 100% correct B = 80% – 89% correct C = 70% – 79% correct D = 60% – 69% correct F = 59% and below correct 4 grade points 3 grade points 2 grade points 1 grade point 0 grade points Completing Unit Four Examination Before beginning your examination, we recommend that you thoroughly review the textbook chapters and other materials covered in each Unit and following the suggestions in the “Mastering the Course Content” section of the course Syllabus. This Unit Examination consists of objective test questions as well as a comprehensive writing assignment selected to reflect the Learning Objectives identified in each chapter covered so far in your textbook. Additional detailed information on completing the examination, writing standards, how to challenge test items and how to submit your completed examination may be found in the Syllabus for this course. If you have additional questions feel free to contact Student Services at (714) 547-9625. Unit 4 Examination 186 Introduction to Financial Management Multiple Choice Questions (Enter your answers on the enclosed answer sheet) 1) Which of the following is a fixed cost? a. packaging b. administrative salaries c. direct labor d. freight costs on products 2) Break-even analysis is used to study the effect on EBIT of changes in all of the fol- lowing except: a. corporate taxes b. cost structure c. volume d. prices 3) Based on the data contained in Table A, what is the break-even point in units pro- duced and sold? TABLE A Average selling price per unit $15.00 Variable cost per unit $10.00 Units sold 200,000 Fixed costs $450,000 Interest expense $ 40,000 a. 98,000 b. 30,000 c. 75,000 d. 90,000 4) The break-even point in sales dollars is convenient if a. the firm sells a large amount of one product. b. the price per unit is very low. c. the firm deals with more than one product. d. depreciation expense is high. 5) Which of the following would be considered a variable cost in a manufacturing setting? a. Direct labor b. Administrative salaries c. Rent d. Insurance Unit 4 Examination 187 Introduction to Financial Management 6) The primary purpose of a cash budget is to ________. a. determine the level of investment in current and fixed assets b. determine financing needs c. provide a detailed plan of future cash flows d. determine the estimated income tax for the year 7) Which of the following statements about financial leverage is true? a. Financial leverage reduces a firm’s risk. b. Financial leverage involves the incurrence of fixed operating costs in the firm’s income stream. c. Financial leverage is the responsiveness of the firm’s EBIT to fluctuations in sales. d. Financial leverage is the responsiveness of the firm’s EPS to fluctuations in EBIT. 8) The optimal capital structure is the funds mix that will a. maximize total leverage. b. minimize the firm’s composite cost of capital. c. minimize the use of debt. d. achieve an equal proportion of debt, preferred stock, and common equity. 9) Current ass
ets would usually not include: a. plant and equipment b. marketable securities c. accounts receivable d. inventories 10) Dividend changes may be used by management as a credible communication tool to signal investors about future earnings under which of the following dividend policy theories? a. The information effect b. The residual dividend theory c. The expectations theory d. The clientele effect Unit 4 Examination 188 Introduction to Financial Management 11) All of the following factors support the proposition that dividend policy matters except: a. perfect capital markets b. investors desire to minimize and defer taxes, and capital gains get preferential tax treatment over dividend income c. flotation costs significantly increase the cost of new common stock compared to re- tained earnings d. information asymmetry exists between shareholders and managers 12) According to the clientele effect, a. companies should change their dividend policies to please their target group of inves- tors. b. companies should have dividend payout ratios of either 100% or 0%. c. even if capital markets are perfect, dividend policy still matters. d. companies should avoid making capricious changes in their dividend policies. 13) Which of the following is true if dividend policy is irrelevant? a. The information effect exists. b. The clientele effect exists. c. Tax deferral on capital gains exists. d. Perfect capital markets exist. 14) Which of the following dividend policies will cause dividends per share to fluctuate the most? a. small, low, regular dividend plus a year-end extra b. constant dividend payout ratio c. stable dollar dividend d. no difference between the various dividend policies 15) All of the following are potential benefits of stock repurchases except a. an approach for maintaining the existing capital structure while still making a distri- bution to shareholders. b. a favorable impact on earnings per share. c. the elimination of a minority ownership group of stockholders. d. a means for providing an internal investment opportunity. Unit 4 Examination 189 Introduction to Financial Management 16) The first step involved in predicting financing needs is a. estimating the levels of investment in current and fixed assets that are necessary to support the projected sales. b. determining the firm’s financing needs throughout the planning period. c. estimating the cost of debt. d. project the firm’s sales revenues and expenses over the planning period. 17) Which of the following is the initial and most important step in the preparation of pro forma financial statements? a. Estimate the levels of investment in current and fixed assets. b. Determine the rate of interest that will be required for borrowed funds. c. Approximate the cost of raw materials. d. Project the firm’s sales revenues for the planning period. 18) A firm’s cash position would most likely be hurt by a. retiring outstanding debt. b. establishing stricter (shorter) credit terms. c. increasing the net profit margin. d. decreasing excess inventory. 19) Fielding Wilderness Outfitters had projected its sales for the first six months of 2008 to be as follows: Jan. $ 50,000 April $180,000 Feb. $ 60,000 May $240,000 Mar. $100,000 June $240,000 Cost of goods sold is 60% of sales. Purchases are made and paid for two months prior to the sale. 40% of sales are collected in the month of the sale, 40% are collected in the month following the sale, and the remaining 20% in the second month following the sale. Total other cash expenses are $40,000/month. The company’s cash balance as of March 1st, 2008 is projected to be $40,000, and the company wants to maintain a minimum cash balance of $15,000. Excess cash will be used to retire short-term borrowing (if any exists). Fielding has no short-term borrowing as of March 1st, 2008. Assume that the interest rate on short-term borrowing is 1% per month. What was Fielding’s projected loss for March? a. $84,000 b. $110,000 c. $184,000 d. none of the above Unit 4 Examination 190 Introduction to Financial Management 20) Which of the following items does not belong in a cash budget? a. Rent b. Depreciation c. Taxes d. Wages and salaries 21) Current assets would usually not include a. marketable securities. b. plant and equipment. c. accounts receivable. d. inventories. 22) A company that increases its liquidity by holding more cash and marketable securities is a. likely to achieve a higher return on equity because of higher interest income. b. going to maximize firm value because risk is decreased. c. going to have to sell common stock to raise the cash to become more liquid. d. likely to achieve a lower return on equity because of the smaller rates of return earned on cash and marketable securities compared to the firm’s other investments. 23) Which of the following is not a source of unsecured short-term credit? a. trade credit b. floating lien c. a line of credit d. commercial paper 24) The effective annual cost of not taking advantage of the 2/10, net 50 terms offered by a supplier is a. 18.37%. b. 14.69%. c. 20.45%. d. 2.27%. Unit 4 Examination 191 Introduction to Financial Management 25) The terminal warehouse agreement differs from the field warehouse agreement in that a. the warehouse procedure differs for both agreements. b. the borrower of the field warehouse agreement can sell the collateral without the con- sent of the lender. c. the terminal agreement transports the collateral to a public warehouse. d. the cost of the terminal warehouse agreement is lower due to the lower degree of risk. Unit 4 Examination 192 Introduction to Financial Management Written Assignment for Unit Four Be sure to refer to this course syllabus for instructions on format, length, and other information on how to complete this assignment. Please answer ONE of the following: 1. Distinguish between business risk and financial risk. What gives rise to, or causes, each type of risk? 2. What legal restrictions may limit the amount of dividends to be paid? 3. Discuss the shortcomings of the percent of sales method of financial forecasting. You Can Do It 193 Introduction to Financial Management Congratulations! You have completed Unit 4. Now let’s sharpen our pencils for the Final Exam. We are confident you will do well. Final Examination Instructions 194 Introduction to Financial Management About the Final Examination After you have successfully completed all of the Unit Examinations and the Essay Examination, it will be time for you to take the Final Examination. As you will notice, no Final Examination is included with your Study Guide. The Final Examination will be provided by Student Services only after you have submitted the Final Examination Scheduling Form. Scheduling a Final Examination When it is time to complete your Final Examination, please complete and submit the enclosed Final Examination Scheduling Form. On this form, indicate whether this Final Examination will be sent to you or your designated Proctor. Please submit this form at the end of Unit Test 4. Your Final Examination will then be mailed to you or to your designated Proctor, based upon your degree requirements. Submitting Your Final Examination After you have completed your Final Examination, you or your Proctor will submit your Final Examination (depending on whether the Final Examination was proctored or unproctored), directly to the University for grading. The Final Examination may be submitted by mail or fax. Additional Information Detailed information on completing the Final Examination, Proctor requirements, how to challenge test items and how to submit your completed examination may be found in the Syllabus for this course. If you have additional questions feel free to contact Student Services at (714) 547-9625. Final Examination Scheduling Form 195 Introduction to Financial Management The University requires a certain number of Final Examinations to be completed under the supervision of a Proctor. At the time you enrolled or reinstated your program, you were given the total number of proctored Final Examinations required for your degree program. If this Final Examination is to
be proctored, please provide information on your designated Proctor. Otherwise, please complete Student and Course Information only and submit this form with your Essay Examination. Date _____________________________ Student I.D. ______________________________________________ Student Name ________________________________________________________________________________ Student Address ______________________________________________________________________________ City __________________________________________________ State _________________________________ Zip Code ________________ Country ____________________________________________________________ Student E-Mail Address ________________________________________________________________________ Daytime Telephone _____________________________ Evening Telephone _____________________________ Course Information: Course __________________ Course Name _______________________________________________________ Textbook Title _________________________________________________________________________________ Textbook Edition ________________________ Please send the Final Examination to: Proctor’s Name _______________________________________________________________________________ Proctor’s Relationship to Student ________________________________________________________________ Proctor’s Street Address: _______________________________________________________________________ City ______________________________ State _________________ Zip Code __________________________ Country __________________________________ Proctor’s E-Mail Address: ___________________________ Daytime Telephone _________________________ Evening Telephone _________________________________ Student’s Signature ________________________________________________________________________ Notes 196 Introduction to Financial Management