Corporate Finance Test 2
22 multiple choice questions (9 conceptual, 13 multiple choice)
6 questions each from Ch. 4 & 6 10 questions from Ch. 5
When equal payments are made at the beginning of each period for a certain time period, they are treated as
An annuity due
Perpetuities
Annuities with an extended or unlimited life
Payments made at the beginning of each month
Annuity Due
Uneven Cash Flows
Calculator 1. CF 2. Put in #, enter 3. CPT, NPV 4. Interest, down arrow 5. CPT
Market/Book Ratio
Companies that are well regarded by investors (which means low risk and high growth) have high market to book ratios. Book value per share = Common Equity / Shares Outstanding Market/Book Ratio = Market price per share / Book Value per share Companies with high research and development expenses tend to have high P/E ratios
Default Risk Premium (DRP)
Difference between the interest rate on a US treasury bond and a corporate bond of the same profile-- that is, the same maturity and marketability Reflects the possibility that the issuer will not pay the promised interest of principal at the stated time
The process of calculating the present value of a cash flow or a series of cash flows to be received in the future
Discounting
Return on Invested Capital
EBIT (1-T) / Total Invested Capital
Operating Margin
EBIT / Sales (want it to be higher than industry average)
Basic Earning Power Ratio
EBIT / Total Assets
After the end of the second year and all other factors remaining equal, a future value based on compound interest will never exceed the future value based on simple interest
False
Annuities are structured to provide fixed payments for a
Fixed period of time
Asset Management Ratio
Give an idea of how efficiently the firm is using its assets. Good asset management ratios are necessary for the firm to keep its costs low and thus its net income high Answer the question: "Does the amount of each type of asset seem reasonable, too high, or too low in view of current and projected sales?" These ratios are important because when company's acquire assets, they must obtain capital from banks or other sources and capital is expensive. Therefore, if a company has too many assets, its cost of capital will be too high, which will depress its profits. On the other hand, if its assets are too low, profitable sales will be lost.
Profitability Ratios
Give an idea of how profitably the firm is operating and utilizing its assets. Reflect the net results of all of the firm's financing policies and operating decisions A higher operating margin than the industry average indicates either lower operating costs, higher product pricing, or both. If a company's operating margin increases but its profit margin decreases, it could mean that the company paid more in interest or taxes
Debt Management Ratios
Give an idea of how the firm has financed its assets as well as the firm's ability to repay its long term debt. Indicate how risky the firm is and how much of its operating income must be paid to bondholders rather than stockholders. The use of debt will increase a firm's ROE if the firm earns more on its assets than the interest it pays on debt. However, debt exposes the firm to more risk than if it financed only with equity. Un-leveraged = no debt Leveraged = has debt Firms with relatively high debt ratios typically have higher expected returns when the economy is normal, but lower returns and possibly bankruptcy if the economy goes into recessions. Interest on debt is a tax deductible expense, which means that it can reduce a firm's taxable income and tax obligation. The US tax structure influences a firm's willingness to finance with debt. The tax structure encourages more debt.
Market Value Ratio
Give an idea of what investors think about the firm and its future prospects. Tell us what investors think about the company and its prospects. Relate the stock price to earnings and book value price Used by investors when they are deciding to buy or sell a stock, by investment bankers when they are setting the share price for a new stock issue, and by firms when they are deciding how much to offer for another firm in a potential merger.
Yield Curve
Graphical representation of the relationship between the yields and the maturities of securities issued by a given borrower in a given currency on a given date
* Current Ratio
Indicates the extent to which current liabilities are covered by those assets expected to be converted to cash in the near future. Current Ratio = Current Assets / Current Liabilities (want number to be higher than industry average) Current assets include cash, marketable securities, accounts receivable, and inventories Current Liabilities consist of accounts payable, accrued wages and taxes, and short term notes payable A high current ratio generally indicates a very strong, safe liquidity position; it might also indicate that the firm has too much old inventory that will have to be written off and too many old accounts receivable that may turn into bad debts. Or the high current ratio might indicate that the firm has too much cash, receivables, and inventory relative to its sales, in which case these assets are not being managed efficiently.
Flat Yield Curve
Long term rates are equal to short term rates
Normal Yield Curve
Long term rates are greater than short term rates
* Quick (acid) Test Ratio
Measures the firm's ability to pay off short term obligations without relying on the sale of inventories Current Assets - Inventories / Current Liabilities (you want it to be higher than industry average) Inventories are typically the least liquid of a firm's current assets; and if sales slow down, they might not be converted to cash as quickly as expected. Also, inventories are the assets on which losses are most likely to occur in the event of liquidation. If a company's average is below industry average, if the accounts receivable can be collected, the company can pay off its current liabilities even if it has trouble disposing of its inventories An increase in the quick ratio over time usually means that the company's liquidity position is improving and that the company is managing its short term assets well.
Return on Common Equity
Net Income / Common Equity
Profit Margin
Net Income / Sales (want it to be higher than industry average) If profit margin for company is below industry average, 1) the firms operating costs are too high; 2) negatively impacted by heavy use of debt
Return on Total Assets
Net Income / Total Assets (want it to be higher than industry average)
Payment made at the end of each month
Ordinary Annuity
Liquidity Risk Premium (LP)
Premium added to the equilibrium interest rate on a security that cannot be brought or sold quickly enough to prevent or minimize loss
Inflation Premium (IP)
Premium added to the risk free rate that reflects the average sustained increase in the general level of prices for goods and services expected over the security's entire life.
Price/Earnings Ratio
Price per share / earnings per share High for firms with strong growth prospects and little risk but low for slowly growing and risky firms If below industry average, the firm is seen as risky
Nominal (quoted) Rate Formula
R= r* + IP + DRP + LP + MRP
Real Risk Free Rate (r*)
Rate on short term US treasury securities, assuming there is no inflation Not static Changes depending on economic conditions, especially 1) rate of return that corporations and other borrowers expect to earn on productive assets and 2) people's time preferences for current versus future consumptions will say "real rate of return", "risk-free", "base interest rate", "wants at least 5%"
* Days Sales Outstanding (average collection period)
Receivables / Average sales per day or Receivables / (Annual Sales/365) Represents the average length of time the firm must wait after making a sale before receiving cash (want DSO to be lower than industry average)
* Inventory Turnover Ratio
Sales / Inventories If a company's inventory turnover ratio is lower than the industry average, it suggests that it is holding too much inventory. Excess inventory is unproductive and represents an investment with a low or zero rate of return.
Fixed Assets Turnover Ratio
Sales / Net Fixed Assets (want this to be higher than industry average) If a company's average is above the industry's average, it indicates that it is using its fixed assets at least as intensively as other firms in the industry.
Total Asset Turnover Ratio
Sales / Total Assets (want it to be higher than industry average) When ratio is lower than industry average, it indicates that it is not generating enough sales given its total assets.
Humped Yield Curve
Short term rates are relatively low, intermediate term rates are much higher, and long term rates are much lower
Liquidity Ratios
Show the relationship of a firm's cash and other current assets to its current liabilities. Give an idea of the firm's ability to pay off debts that are maturing within a year. Satisfactory liquidity ratios are necessary if the firm is to continue operating. Answers the question: "Will the firm be able to pay off its debts as they come due and thus remain a viable organization?"
DuPont Equation
Shows the rate of return on equity can be found as the product of profit margin, total assets turnover, and the equity multiplier. It shows the relationships among asset management, debt management, and profitability ratios. ROE = ROA x Equity Multiplier ROE = Profit Margin x Total Assets Turnover x Equity Multiplier ROE = (Net Income / Sales) x (Sales / Total Assets) x (Total Assets / Total Common Equity)
Inverted Yield Curve
The yield curve exhibits a downward sloping curve
Total Debt to Total Capital (debt ratio)
Total Debt / Total Capital or Total Debt / Total Debt + Equity (want it to be lower than industry average) Total Debt includes all short term and long term interest bearing debt, but it does not include operating items such as accounts payable and accruals. Creditors prefer low debt ratios because the lower the ratio, the greater the cushion against creditors' losses in the event of liquidation. Stockholders, on the other hand, may want more leverage because it can magnify expected earnings.
Income Statement
Total Sales / Revenues - Cost of Goods Sold = Gross Profit / Gross Margin - Operating Expenses = Operating Income / EBIT - Tax & Internet = Net Income
A perpetuity is a stream of regular timed, equal cash flows that continues forever
True
All other factors being equal, both the simple interest and the compound interest methods will accrue the same amount of earned interest by the end of the first year
True
Countries with strong balance sheets and declining budget deficits tend to have lower interest rates
True
If inflation is expected to decrease in the future and the real rate is expected to remain steady, then the treasury yield curve is downward sloping
True
Long term interest rates are not as sensitive to booms and recessions as are short term interest rates
True
The current value of a perpetuity is based on the discounted value of its nearer (time) cash flows and less by the discounted value of its more distant (in the future) cash flows
True
The process of earning compound interest allows a depositor or investor to earn interest on any interest earned in prior periods
True
The value of a perpetuity is equal to the sum of the present value of its expected future cash flows
True
The yield curve for a BBB rated corporate bond is expected to be above the US Treasury bond yield curve
True
When the economy is weakening, the Fed is likely to decrease short term interest rates
True
Yield curves of highly liquid assets will be lower than yield curves of relatively illiquid assets
True
The number of compounding periods in one year is called
a compounding frequency
Mortgages
are examples of amortized loans ending balance of an amortized loan contract will be zero every payment made toward an amortized loan consists of two parts -- interest and repayment of principal
Maturity Risk Premium (MRP)
as interest rates rise, bond prices fall, and as interest rates fall, bond prices rise. Because interest rate changes are uncertain, this premium is added as a compensation for this uncertainity
Nominal Risk Free Rate (rRF)
calculated by adding the inflation premium to r* is the quoted rate on a risk free security such as US treasury bill
The process for converting present values into future values is called
compounding
Chapter 4 Computations * 2 conceptual
current ratio quick ratio days' sales outstanding inventory turnover
Inverted Yield
curved down
Normal Yield
curved upwards
Other things remaining equal, the present value of a future cash flow:
decreases if the investment time period increases
Chapter 5 Computations * 3 conceptual
future value of single sum interest rate number of periods present value of annuity amount of payment present value of uneven cash flows effective interest rate
Interest rates on short term maturities are
higher than rates on medium and long term maturities
An ordinary annuity of equal time earns
less interest than an annuity due
Liquid Asset
one that trades in an active market and thus can be quickly converted to cash at the going market price
Factors that affect the treasury yield curve
r*, IPt, and MRP
Factors that can affect the shape of the corporate yield curve
r*t, IPt, MRPt, DRPt, and LPt
Market Interest Rate
rate at which the supply of capital equals the demand for capital
Chapter 6 Computations * 4 conceptual
real risk free interest rate risk premium
Quoted or Nominal Rate of Interest (R)
will say "nominal interest rate", "quoted", "final interest rate", "i charged this person..."