FIN320F Test 1 application questions

Your company gives you the option of receiving your salary at the beginning of each month or at the end of each month. Which option should you choose?

$1 in salary at the beginning of each month is worth more to you than a dollar received at the end of the month. If you were to receive $1 at the beginning of the month you could invest it to earn interest. It would thus be worth more than a dollar at the end of the month, and would thus be preferable to receiving only $1 at the end of the month.

The bribe. As an incentive for you to stay in school your Uncle Henry offers to pay you $5,000 in one year. If the interest rate is 4%, how much is the $5,000 payment worth to you today?

$4,807.69

You receive $750 today and deposited it in your savings account that has an interest rate of 3%. What will your savings account balance be in one year?

$772.5

What are the three types of financial management decision? for each type of decision give an example of a business transaction that would be relevant

1. Capital Budgeting-What productive assets should the business invest in? Managers must develop a product/service that is attractive to their potential customers. The product/service will exist only if the business invests in productive assets to produce the product/service. Examples would include the following. Should a business invest in developing a new service such as self-driving trucks? Should the business invest in an assembly line with workers or one with robots? Should the company establish a call center in the US or in the Dominican Republic? Should the business invest in viral marketing or print advertising? Non-profits and governments also must invest in productive assets. A charity applying for a grant from the Bill and Melinda Gates Foundation must specify the resources needed to protect pregnant women from the Zika virus. Should Austin invest in a passenger rail system? 2. Capital Structure- ow should a business raise the capital needed to invest in productive assets and finance its operations?Should managers issue financial securities—debt and equity—to raise capital? Is there an optimal mix of debt and equity? Instead of financial securities, should the business take out a bank loan? Issue equity and use the proceeds to retire outstanding debt? 3. Working Capital Management- How can the company maintain its liquidity—its ability to ensure enough cash comes in on a daily basis to satisfy its short claims?While the capital budgeting and capital structure decisions involve the long-term focus of the business, working capital management focuses instead on the ability to run the business on a daily basis. Examples would be how the business manages it trade credit policy, its short-terms lines of credit, inventory levels, etc.

A coat of paint. Your house needs a new coat of paint. You could hire a painter for $1,200 or spend $300 for materials and devote 8 hours of your time to the project. (It's a small house!). If you normally make $200/hour at your consulting job, what is the opportunity cost of having the house painted by the professional painter?

700

FastDrop NPV. Given the project's opportunity cost and cash flows, determine the project's acceptability using Net Present Value.

80000(1.10)^-1-70,000=2,727 When you state the present value of the benefits ($80,000 in one year) to what you'd have to pay today to receive those benefits ($70,000) you find that this is a wealth-increasing investment and should be adopted.

Two distributions. You have two distributions available to you: a frequency distribution and a probability distribution. Please define each and identify which one you'd use to make your investment decision.

A frequency distribution presents a measure of how frequently historical returns have occurred over a given time period. From this distribution you can determine the average return earned over a given periods and how variable realized returns were from this average. To generalize, using a frequency distribution assumes that the future expected return will be the same as the historic average return. A probability distribution presents an estimate of the future. Possible rates of return are identified along with the likelihood of the returns. From the probability distribution we can calculate the expected return and how the realized return might vary from the expected return.

Annuity Period. As you increase the length of time involved, what happens to the present value of an annuity? What happens to the future value?

Assuming positive cash flows and a positive interest rate, both the present and the future value will rise. This makes perfect sense when we realize that annuities are a stream of regular payments at regular intervals. When you add an additional period to an annuity, you're also adding an additional

Describe how NPV is calculated and describe the information this measure provides about a sequence of cash flows. What is the NPV criterion decision rule?

Calculation: NPV is simply economic cost-benefit analysis. All of the benefits (cash inflows) and costs (cost outflows) are identified. All amounts are taken to their present value using an appropriate discount rate, which is the project's opportunity cost. With all amounts stated at the same point in time the benefits and costs can be compared. Decision rule: If the present value of benefits exceed the present value of costs, then the project is wealth creating. If the present value of benefits is less than the costs, then the project would reduce wealth. Therefore, accept projects with positive NPVs and reject projects with negative NPVs. We would also accept projects with zero NPV, as they are offering us a fair rate of return. As we'll see later on in our course, earning a fair rate of return is actually a quite acceptable outcome!

What is the Internal Rate of Return? What is the IRR criterion decision rule?

Calculation: The IRR is the rate of return earned on an investment. The return is "internal" to the timeline as the calculation of the IRR does not involve the opportunity cost/discount rate. For simple one period time lines the calculation involves determining the difference between the ending and beginning value, and then dividing the beginning value into the difference: Decision rule: The IRR decision rule is to accept projects with IRRs greater than the discount rate, and to reject projects with IRRs less than the discount rate. This makes sense when you consider that the discount rate is the opportunity cost—the return required to compensate the investor for not investing in other projects equivalent to the one being evaluated. If a project's IRR = 9%, and the discount rate is 6%, the project is a good deal, as you are earning 3% more that you should expect to receive from the project given the other alternatives available to you.

Compounding. What is compounding? What is discounting?

Compounding is the exponential increase in the value of an investment because interest earned is added to the principle, which produces an increased interest payment in the subsequent period. It is also the process of determining the future value of an investment. Discounting is the process of determining the value today of an amount to be received in the future. As many of financial decisions are made today, many problems involve taking present values and the rate used in time value calculations is often referred to as the "discount rate" whether or not you're taking present values or future values.

Your final choice. Given your financial situation, you can only make one investment. You want to consider both profitability and safety. You only have enough funds to invest in one of these attractive projects. Which investment should you choose? Hive Bliss FastDrop

Considering safety: Hive Bliss is the riskier investment, with a risk premium of 14%. FastDrop is safer, with a risk premium of only 6%. If you were thinking of safety, then FastDrop is the safest investment and should be chosen. Considering wealth: The NPV of FastDrop is $2,727; the NPV of Hive Bliss is $6,694. Thus, Hive Bliss would have a far greater positive impact on your wealth. Even though it is the riskier investment, Hive Bliss offers a better risk-return tradeoff. The higher risk of the Hive Bliss investment is taken into account in the discount rate that places a lower value on future cash flows. This discussion will make more and more sense as we go through our course.

One word continuously comes up in this course: efficiency. Please discuss efficiency in terms of how society organizes economic activity, how businesses are organized and why society allows corporations to focus on maximizing stockholder wealth.

Efficiency is the efficient use of resources to produce the goods and services demanded by the members of society. Efficiency is at the heart of most economic decisions. We face a general scarcity of resources—there is never enough to go around to satisfy the infinite demand in society for tangible and intangible items that we need/want. Here are the major points. Other points could be brought up in support of this discussion.

A friend offers you a Coke, a Pepsi, or a Diet Coke. You don't like Diet Coke, so you take the Pepsi. What is the opportunity cost of your choice? Zero, because the drink was free. The Pepsi. The Coke. The Coke plus the Diet Coke.

Fortunately, in this example you do have some positive choices and would reject the drink you don't like, Diet Coke. Eliminating the undesirable alternative leaves your choice between Coke and Pepsi. As Opportunity Cost is defined as the best alternative foregone, if you chose Pepsi, you have chosen it rather than the best other alternative available, Coke.

Values and Interest Rates. What happens to a future value if you increase the rate, r? What happens to a present value?

Future values are positively related to interest rates, as the higher the interest rate, the higher the amount of interest earned in each period. Present values are inversely related to interest rates, as calculating present values involves dividing (1 + r)T.

Values and Periods. As you increase the length of time involved, what happens to future values? What happens to present values?

Future values: Future values are positively related to the length of time of the investment, as each additional period additional interest is earned. This can be seen in the Future Value Factor = (1 + r)T, which is multiplied by the present value to get the future value. Present values: Present values are inversely related to the length of time of the investment. The Present Value Factor = 1/[(1 + r)T)] is the inverse of the Future Value Factor. This shows that discounting is the inverse of compounding.

What are the differences between the IRR and NPV? Are there any situations in which you might prefer one method over the other? Explain?

IRR, a measures the rate of return on an investment, answers the first question. Intuitively, the higher the rate the better; however, rates of return are a relative measure. Saying that you're earning 6% does not tell you whether or not 6% is a good return. To make effective decisions the IRR must be compared to the rate of return available from equivalent investments, the opportunity cost. The NPV, as cost/benefit analysis, answers the second question. NPV takes every aspect of economic value into account: the cash flows, their timing, and the opportunity cost. As there is a time value of money, amounts can be compared only when they occur at the same point in time. NPV therefore consolidates all cash flows today, and allow a proper comparison of inflows and outflows.NPV is a dollar measure of wealth created, stated in the current time. As the goal is to increase wealth, NPV is better than IRR. As the penny pitching example in the last Key Concepts shows, a high rate of return on a small investment will not benefit you as an investment with a higher NPV.

Interest rates and future values. As the interest rate rises, the present value of a future cash flow: Goes up. Goes down. Stays the same. Could either rise or fall.

If you expect to receive $10 in one year, the present value is $10/(1 + r). Note that the $10 is divided by (1+r). The higher the interest rate, the lower the present value, as you are discounting a future cash flow to get its value today, and your denominator just increased.

Borrowing. Your little sister Tiffany is beginning to cause you some concern. She wants to borrow $480 from you today and promises to pay you $500 in one year. You earn 3% on your deposits. Disregarding what your 9 year-old sister would need $480 for, would this be a good loan for you to make?

If you made the loan you would receive $500 in one year. Given your interest rate of 3%, the present value of this payment is: $500/(1 + r) = $500/(1.03) = $485.43.This is a good deal. You would give Tiffany $480, but receive a future cash flow that has a present value of $485.43. Economically, you're better off by $485.43 - $480 = $5.44, a comparison we'll make more explicit when we introduce Net Present Value Analysis in Lesson 2.

Future Values. Suppose you deposit a large sum in an account that earns a low interest rate and simultaneously deposit a small sum in an account with a high interest rate. Which account will have the larger future value?

It depends on the length of time involved. The large deposit will have a larger future value for some period, but after time, the smaller deposit with the larger interest rate will eventually become larger due to the effect of compound interest. The length of time for the smaller deposit to overtake the larger deposit depends on the amount deposited in each account and the interest rates.

Hive Bliss. You are very popular with entrepreneurs! Just as you are ready to finalize your deal with FastDrop, another entrepreneur offers you another business deal: Hive Bliss, a company that sells home bee hives as a personal source of honey. Hive Bliss would require an investment of $95,000 and offers a cash inflow of $120,000 at the end of the year. An apiculture consultant advises that this is a fairly risky investment and suggests a risk premium of 14%. What is its NPV?

R = 4% + 14%= 18% NPV = $6,694

The stockholders have the legal right to control the firm and to receive dividends and potential capital gains in return. How can this arrangement benefit society as a whole?

Residual: The stockholders are the legal "owners" of the firm, have the ability to control the firm, and receive the residual earnings of the firm after all other claimants of the firm have been satisfied. They thus have an incentive to drive the firm to maximize its productive function to benefit society. Efficient production: The stockholders have the natural desire to maximize this residual and will therefore direct their managers to: -Produce goods and services which are desired by the consumers. Customers are interested in good value, and also in many cases socially responsible production -Be efficient in the use of scarce resources needed used the production of these items. Efficient capital allocation: In addition, the corporation needs capital from investors. Only profitable corporations will attract investors and survive. Firms that do not produce profit will not be supported by investors. If the firm does not improve it will go out of business.

Time Value of Money: From the company's point of view. Why would TMCC be willing to accept such a small amount today ($24,099) in exchange for a promise to repay about four times that amount ($100,000) in the future

TMCC borrows money because it hopes to earn a higher rate of return in its capital budgeting projects than the rate payed to their creditors.If the creditors lend $24,099 and receive $100,000 in thirty years they would earn an IRR of 4.86%.If TMCC takes the $24,099 and invests it wisely in projects that produce desirable products for its customers it would earn more than the 4.86% they pay to the creditors. If rate of return on TMCC's projects was 6%, the borrowed $24,099 would grow to an inflow $138,412.

Project NPV. For the investment in the previous problem, suppose the firm uses the NPV decision rule. At the same required rate of return of 14 percent, should the firm accept the project? What if the required rate of return was 8 percent?

The NPV of a project is the PV of the outflows minus by the PV of the inflows. The equation for the NPV of this project at a 14 percent opportunity cost/discount rate is:NPV = -$158,500 + $175,000 /1.14 = -$158,500 + $153,509 = -$4,991 At a 14 percent required return, the NPV is negative, so we would reject the project.The equation for the NPV of the project at an 8% percent required return is:NPV = -$158,500 + $175,000 /1.08 = -$158,500 + $162,037 = $3,537.At an 8 percent required return, the NPV is positive, so we would accept the project.

The payment. Your friend wants to pay back the money she borrowed from you. She offers you $300 today or $315 in one year. If you could save at 6%, which one should you choose?

The bottom line: $300 today is a better deal than $315 in one year given your interest rate of 6%. Using present values and future values will give you the same decision!!

What goal should always motivate the actions of the firm's financial manager?

The corporation has a clear goal: maximizing the wealth of its shareholders, with wealth measured by the share price set in competitive stock markets. his focus on profitability as measured by markets can lead to (1) the efficient use of society's scarce resources and (2) the raising of large amounts of capital, thus leading to a higher standard of living for society.

FastDrop economic value. You are planning to place your money in safe government securities, which currently offer a 4% risk less rate of return. Before making this investment, an entrepreneur approaches you and asks you to purchase her new business venture, FastDrop, a delivery service for legal documents that would produce a single cash inflow of $80,000 at the end of the year. You have determined that 6% is an appropriate risk premium for this investment. How much would you be willing to pay for Fast Drop?

The first step is to calculate the opportunity cost.R = risk-free rate + risk premium 10% = 4% + 6%Given the opportunity cost of 10%, you can determine that the economic value of this investment is: $80,000/1.10 = $72,727$72,727 is the value of the expected future cash flow and thus the economic value of the investment in FastDrop.

Calculating APR. Vandermark Credit Corp. wants to earn an effective annual return on its consumer loans of 14.2 percent per year. The bank uses daily compounding on its loans. What interest rate is the bank required by law to report to potential borrowers? Explain why this rate is misleading to an uninformed borrower.

This is deceptive because the borrower is actually paying annualized interest of 14.2 percent per year, not the 13.28 percent reported on the loan contract.

In a large corporate, what are the two distinct groups that report to the chief financial officer? What group is the focus of corporate finance?

This question is not about a corporate officer's title, but rather the two major financial functions within the corporation. The treasurer's office and the controller's office are the two primary organizational groups that report directly to the chief financial officer. The controller's office handles many of the functions that help control the corporation's operations, including cost and financial accounting, tax management, and management information systems. The treasurer's office is more focused on the corporation's outside activities, especially those involving raising and deploying capital, including cash and credit management, capital budgeting, and financial planning. Our course focuses on the capital budgeting and capital structure decisions and will thus focus more on the functions of the treasurer's office. (Chapter 1, 1.4)

APR and EAR. Should lending laws be changed to require lenders to report EARs instead of APRs? Why or why not?

Yes, they should. APRs generally don't provide the relevant rate. The only advantage is that they are easier to compute, but, with modern computing equipment, that advantage is not very important. Also, the APR's on debt generally look more attractive that the true rate charged. You'll find that, as a consumer, your understanding of the difference will save you money on anything—clothing car, house—that you buy on credit!

The piggy bank. Your little sister Tiffany has received a special Piggy bank with a $20 bill in it. This is a special locked Piggy and will unlock itself in one year. Tiffany has offered to sell you Piggy today. Unfortunately, this nice Piggy bank will completely destroy itself in one year and have no value, so plan on getting only the $20! If your savings rate is 5%, how much is the $20 in Piggy worth to you today if you can't get at it for a year?

You would offer Tiffany the present value of the $20. $20/(1+r) = $20/1.05) = $19.05. This is the economic value of the Piggy bank: the maximum amount that you'd pay.

disadvantages of corporations

double taxation- Corporations as separate legal entities from their owners, are taxed. Any profits distributed to their owners—shareholders—are then taxed as personal income. agency problem

What is the agency problem? How does this affect corporations and what can be done to minimize agency costs?

he corporation is a separate legal being that can raise capital from individuals--stockholders--who play no direct role in running the company but rather entrust the role to professional managers. This creates a substantial agency problem in that the managers (agents) who have fiduciary responsibility to the stockholders (Principles) may engage in opportunistic behavior and seek to enrich/protect themselves at the expense of the stockholders.

FastDrop Internal Rate of Return. In question 1 you determined the economic value of FastDrop Delivery Service, given its end-of-year cash inflow of $80,000 and its opportunity cost of 10%. In further negotiations the entrepreneur offers to sell you the business for $70,000. Calculate the IRR of this offer and decide if this is an acceptable investment.

he decision: The IRR rule states that the rate of return earned from the project's cash flows must at least equal the rate of return offered on equivalent investments.IRR = 14.29%Opportunity cost: 10%As this investment offers a rate of return higher than the opportunity cost it is a wealth-increasing investment and should be adopted.

advantages of corporations

limited liability, unlimited life, ease of transferability, ease of raising capital, specialization

advantages of proprietorships and partnerships

simple to establish less regulation no agency conflict taxes

Project IRR. A firm evaluates all of its projects by applying the IRR rule. If the required rate of return is 14 percent, should the firm accept a project that requires an investment today of $158,500 and has an expected cash flow in one year of $175,000?

the required rate of return—the opportunity cost offered on equivalent investments—is 14%, the IRR does not compare well with other equivalent investments, so this investment should be rejected.

disadvantages of proprietorships and partnerships

unlimited liability limited life difficulty in transferring ownership difficult to raise capital funds