Finance 3301
Describe the field of finance
Finance is important to business people. Financial decisions about how to raise, spend, and allocate money can affect every aspect of a business—from personnel to products. Finance also offers career opportunities in three main areas: financial management, financial markets and institutions, and investments. Financial management focuses on managing the finances of a business
How is finance related to the disciplines of accounting and economics?
Financial management is essentially a combination of accounting and economics. First, financial managers use accounting information—balance sheets, income statements, and so on—to analyze, plan, and allocate financial resources for business firms. Second, financial managers use economic principles to guide them in making financial decisions that are in the best interest of the firm. In other words, finance is an applied area of economics that relies on accounting for input.
What are the three main areas of career opportunities in finance?
Financial management, financial markets and institutions, and investment
Discuss the duties of financial managers.
Financial managers use accounting information and economic principles to guide their financial decisions. They measure the firm's financial condition, forecast, budget, raise funds, and determine the financial goals of the firm's owners. They also work closely with other managers to further the firm's goals. At medium and large firms, more than one person usually handles the financial management duties. In some firms a chief financial officer (CFO) supervises the financial activities, including cash and credit management, financial planning, and accounting.
What happens to the riskiness of a portfolio if assets with very low correlations (even negative correlations) are combined?
How successfully diversification reduces risk depends on the degree of correlation between the two variables in question. When assets with very low or negative correlations are combined in portfolios, the riskiness of the portfolios (as measured by the coefficient of variation) is greatly reduced.
Define risk, risk aversion, and the risk-return relationship.
In everything you do, or don't do, there is a chance that something will happen that you didn't count on. Risk is the potential for unexpected events to occur. Given two financial alternatives that are equal except for their degree of risk, most people will choose the less risky alternative because they are risk averse. Risk aversion is a common trait among almost all investors. Most investors avoid risk if they can, unless they are compensated for accepting risk. In an investment context, the additional compensation is a higher expected rate of return. The risk-return relationship refers to the positive relationship between risk and the required rate of return. Due to risk aversion, the higher the risk, the more return investors expect.
To minimize risk, why don't most firms simply finance their growth from the profits they earn?
In most cases, profits are insufficient to provide the funds needed, especially with large projects. Financial markets provide access to external sources of funds.
Financial Intermediaries
Institutions that take in funds from surplus economic units and make those funds available to defi-cit economic units.
If your company's stock were not listed on the New York Stock Exchange, how could investors purchase the shares?
Investors would simply purchase the shares on another exchange, or over the counter from a dealer. (Investors simply call their brokers to purchase stock. Brokers decide where to get it.)
Why are trend analysis and industry comparison important to financial ratio analysis?
It helps financial managers and analysts see whether a company's current financial situation is improving or deteriorating and the other allows analysts to put the value of a firm's ratios in the context of its industry.
Explain how ratio analysis helps to assess the financial health of a company.
Just as doctors assess a patient's health, financial analysts assess the financial health of a firm. One of the most powerful assessment tools is financial ratio analysis. Financial ratios are comparative measures that allow analysts to interpret raw accounting data and identify strengths and weaknesses of the firm.
C corporations
Large corporations that are taxed separately, via the corporate income tax, from their owners.
Assets = ______ + Shareholders' Equity
Liabilities
Current liabilities
Liabilities that are coming due soon, usually within one year.
Current assets
Liquid assets of an economic entity (e.g., cash, accounts receivable, inventory, etc.) usually converted into cash within one year.
What alternatives does Microsoft, a very large and secure firm, have for obtaining $3 million for 60 days?
Microsoft could: • obtain a 60-day loan from a financial institution • delay payments to its suppliers • sell commercial paper notes in the money market
Which investment is preferred?
Norwood, Inc. is preferred due to its lower coefficient of variation.
Limited Partnerships (LPs)
Partnerships that include at least one partner whose liability is limited to the amount invested. They usually take a less active role in the running of the business than do general partners.
Dividends
Payments made to stockholders at the discretion of the board of directors of the corporation.
Compute profitability, liquidity, debt, asset activity, and market value ratios.
Profitability, liquidity, debt, asset activity, and market value ratios show different aspects of a firm's financial performance. Profitability, liquidity, debt, and asset activity ratios use information from a firm's income statement or balance sheet to compute the ratios. Market value ratios use market and financial statement information. Profitability ratios measure how the firm's returns compare with its sales, asset investments, and equity. Liquidity ratios measure the ability of a firm to meet its short-term obligations. Debt ratios measure the firm's debt financing and its ability to pay off its debt. Asset activity ratios measure how efficiently a firm uses its assets. Finally, market value ratios measure the market's perception about the future earning power of a business. The Du Pont system analyzes the sources of ROA and ROE. Two versions of the Du Pont equation were covered in this chapter. The first analyzes the contributions of net profit margin and total asset turnover to ROA. The second version analyzes how the influences of net profit margin, total asset turnover, and leverage affect ROE.
Identify the different forms of business organization.
Proprietorships are businesses owned by one person. The owner is exposed to unlimited liability for the firm's debts. • Partnerships are businesses owned by two or more people, each of whom is responsible for the firm's debts. The exception is a limited partner, a partner who contracts for limited liability. • Corporations are separate legal entities. They are owned by stockholders, who are responsible for the firm's debts only to the extent of their investment. • Limited liability companies are hybrids between partnerships and corporations.
Why do analysts calculate financial ratios?
Ratios are comparative measures. Because the ratios show relative value, they allow financial analysts to compare information that could not be compared in its raw form. For example, ratios may be used to compare one ratio to a related ratio, a firm's performance to management's goals, a firm's past and present performance, or a firm's performance to similar firms
Mark to Market
Recording an asset or liability according to its recent market price.
What are retained earnings? Why are they important?
Retained earnings represents the sum of all the earnings available to common stockholders of a business during its entire history, minus the sum of all the common stock dividends which it has ever paid. Those earnings that were not paid out were, by definition, retained. Retained earnings are important because they represent amounts reinvested in a company on behalf of the company's owners instead of being paid out in the form of dividends.
______is the potential for unexpected events to occur.
Risk
What is risk aversion? If common stockholders are risk averse, how do you explain the fact that they often invest in very risky companies?
Risk aversion is the tendency to avoid additional risk. Risk-averse people will avoid risk if they can, unless they receive additional compensation for assuming that risk. In finance, the added compensation is a higher expected rate of return. People are not all are equally risk averse. For example, some people are willing to buy risky stocks, while others are not. The ones that do, however, almost always demand an appropriately high expected rate of return for taking on the additional risk
Measure risk using the standard deviation and coefficient of variation.
Risk is the chance, or probability, that outcomes other than what is expected will occur. This probability is reflected in the narrowness or width of the distribution of the possible values of the financial variable. In a distribution of variable values, the standard deviation is a number that indicates how widely dispersed the possible values are around the expected value. The more widely dispersed a distribution is, the larger the standard deviation, and the greater the probability that an actual value will be different than the expected value. The standard deviation, then, can be used to measure the likelihood that some outcome substantially different than what is expected will occur. When the degrees of risk in distributions of different sizes are compared, the coefficient of variation is a statistic used to measure relative riskiness. The coefficient of variation measures the standard deviation's percentage of the expected value. It relates the standard deviation to its mean to give a risk measure that is independent of the magnitude of the possible returns.
De Marco Corporation has total assets of $5 million and an asset turnover ratio of 4. If net income is $2 million, what is the value of the net profit margin?
Sales ÷ $5,000,000 = 4, therefore sales = $20,000,000 $2,000,000 net income ÷ $20,000,000 sales = .1 = 10% net profit margin
Treasury bills
Securities issued by the federal government in minimum denominations of $100 in maturities of 4, 13, 26, and 52 weeks
Bonds
Securities that promise to pay the bearer a certain amount at a time in the future and may pay interest at regular intervals over the life of the security
Describe how society's interests can influence financial managers.
Sometimes the interests of a business firm's owners are not the same as the interests of society. For instance, the cost of properly disposing of toxic waste can be so high that companies may be tempted to simply dump their waste in nearby rivers. In so doing, the companies can keep costs low and profits high, and drive their stock prices higher (if they are not caught). However, many people suffer from the polluted environment. This is why we have environmental and other similar laws: So that society's best interests take precedence over the interests of individual company owners. When businesses take a long-term view, the interests of the owners and society often (but not always) coincide. When companies encourage recycling, sponsor programs for disadvantaged young people, run media campaigns promoting the responsible use of alcohol, and contribute money to worthwhile civic causes, the goodwill generated as a result of these activities causes long-term increases in the firm's sales and cash flows, which translate into additional wealth for the firm's owners.
Professional corporations (PCs)
Special corporations for businesses that provide professional services.
An employee, a customer, and a supplier are all ______ of a firm.
Stakeholders
Explain why accounting profits and cash flows are not the same thing.
Stock value depends on future cash flows, their timing, and their riskiness. Profit calculations do not consider these three factors. Profit, as defined in accounting, is simply the difference between sales revenue and expenses. It is true that more profits are generally better than less profits, but when the pursuit of short-term profits adversely affects the size of future cash flows, their timing, or their riskiness, then these profit maximization efforts are detrimental to the firm.
A business or household that has more income than expenses is called a ______ economic unit.
Surplus
Discuss risk from the perspective of the Capital Asset Pricing Model (CAPM).
The Capital Asset Pricing Model, or CAPM, can be used to calculate the appropriate required rate of return for an investment project given its degree of risk as measured by beta (β). A project's beta represents its degree of risk relative to the overall stock market. In the CAPM, when the beta term is multiplied by the market risk premium term, the result is the additional return over the risk-free rate that investors demand from that individual project. High-risk (high-beta) projects have high required rates of return, and low-risk (low-beta) projects have low required rates of return.
Under what circumstances would market to book value ratios be misleading? Explain.
The Market to Book ratio is useful, but it is only a rough approximation of how liquidation and going concern values compare. This is because the Market to Book ratio uses accounting-based book values. The actual liquidation value of a firm is likely to be different than the book value. For instance, the assets of a firm may be worth more or less than the 2 value at which they are currently carried on the company's balance sheet. In addition, the current market price of the company's bonds and preferred stock may also differ from the accounting value of these claims.
market risk premium
The additional return above the risk-free rate demanded by investors for assuming the risk of invest-ing in the market
financial risk
The additional volatility of a firm's net income caused by the presence of fixed financial costs.
Economic Value Added (EVA)
The amount of profit remaining after accounting for the return expected by the firm's investors.
Face value, or par value, or principal
The amount the bond issuer promises to pay to the investor when the bond matures.
Identify the basic goal of a business firm.
The basic goal of the business firm is to maximize the wealth of the firm's owners by adding value; it is not to maximize profits. The value of a firm is measured by the price investors are willing to pay to own the firm. For businesses that sell stock to the general public, stock price indicates the firm's value because shares of stock are units of ownership. So the basic financial goal of such firms is to maximize the price of the firm's stock.
Uncertainty
The chance, or probability, that outcomes other than what is expected will occur.
Explain how net income and common stock dividends paid from the current income statement affect the balance sheet item retained earnings.
The change in the retained earnings account from one balance sheet to the next equals net income less common stock dividends.
Interest
The compensation lenders demand and borrowers pay when money is lent.
Maturity Date
The date the bearer of a security is to be paid the principal, or face value, of a security.
correlation
The degree to which one variable is linearly related to another.
Maturity Risk Premium
The extra (or sometimes lesser) inter-est that lenders demand on longer-term securities.
Default Risk Premium
The extra interest lenders demand to compensate for assuming the risk that promised interest and principal payments may be made late or not at all.
balance sheet
The financial statement that shows an economic unit's assets, liabilities, and equity at a given point in time
Nominal Risk-Free Rate of Interest
The interest rate without any premiums for the uncertainties associated with lending.
secondary market
The market in which previously issued securities are traded from one investor to another.
Capital Market
The market where long-term securities are traded.
Money Market
The market where short-term securities are traded.
beta (β)
The measure of nondiversifiable risk. The stock market has a beta of 1.0. Betas higher than 1.0 indicate more nondiver-sifiable risk than the market, and betas lower than 1.0 indicate less. Risk-free portfolios have betas of 0.0.
correlation coefficient
The measurement of degree of correla-tion, represented by the letter r. Its values range from + 1.0 (per-fect positive correlation) to -1.0 (perfect negative correlation).
What are the responsibilities of an agent?
The owners whom the agents represent are the principals. Agents have a legal and ethical responsibility to make decisions that further the interests of the principals.
Who is a "principal" in an agent-principal relationship?
The person who hires the agent to act on the principal's behalf. The principal is the person to whom the agent owes a duty.
What is the basic goal of a business?
The primary financial goal of the business firm is to maximize the wealth of the firm's owners. Wealth, in turn, refers to value. If a group of people owns a business firm, the contribution that firm makes to that group's wealth is determined by the market value of that firm.
Underwriting
The process by which investment banking firms purchase a new security issue in its entirety and resell it to inves-tors. The risk of the new issue is transferred from the issuing company to the investment bankers.
Initial Public Offering (IPO)
The process whereby a private corporation issues new common stock to the general public, thus becoming a publicly traded corporation.
Capital Gains
The profit made when an asset is sold at a price higher than the price paid at the time of purchase.
Nominal Interest Rate
The rate observed in the financial mar-ketplace that includes the real rate of interest and various pre-miums.
Explain the risk-return relationship
The relationship between risk and required rate of return is known as the risk-return relationship. It is a positive relationship because the more risk assumed, the higher the required rate of return most people will demand. Risk aversion explains the positive risk-return relationship. It explains why risky junk bonds carry a higher market interest rate than essentially risk-free U.S. Treasury bonds.
Compare and contrast the potential liability of owners of proprietorships, partnerships (general partners), and corporations.
The sole proprietor has unlimited liability for matters relating to the business. This means that the sole proprietor is responsible for all the obligations of the business, even if those obligations exceed the amount the proprietor has invested in the business. Each partner in a partnership is usually liable for the activities of the partnership as a whole. Even if there are a hundred partners, each one is technically responsible for all the debts of 3 the partnership. If ninety-nine partners declare personal bankruptcy, the hundredth partner still is responsible for all the partnership's debts. A corporation is a legal entity that is liable for its own activities. Stockholders, the corporation's owners, have limited liability for the corporation's activities. They cannot lose more than the amount they paid to buy the corporation's stock.
coefficient of variation
The standard deviation divided by the mean. A measure of the degree of risk used to compare alterna-tives with possible returns of different magnitudes.
Which of the following is the best definition of operating leverage?
The tendency of fixed operating expenses to magnify risk.
List factors that affect the value of a firm.
The value of a firm is affected by the size of future cash flows, their timing, and their riskiness. • Cash inflows increase a firm's value, whereas cash outflows decrease it. • The sooner cash flows are expected to be received, the greater the value. The later those cash flows are expected, the less the value. • The less risk associated with future cash flows, the higher the value. The more risk, the lower the value.
What market would a firm most probably go to if it needed cash for 90 days? If it needed cash for 10 years?
To obtain cash for 90 days, a business firm would most probably go to the money market, in which it would sell a 90-day security. To obtain cash for 10 years, a firm would sell a security in the capital market
Compare financial information over time and among companies.
Trend analysis compares past and present financial ratios to see how a firm has performed over time. Industry analysis compares a firm's ratios with the ratios of companies in the same industry. Summary analysis, one of the most useful financial analysis tools, combines trend and industry analysis to measure how a company performed over time in the context of the industry.
Identify the types of risk that business firms encounter.
Business risk is the risk that a company's operating income will differ from what is expected. The more volatile a company's operating income, the more business risk the firm contains. Business risk is a result of sales volatility, which translates into operating income volatility. Business risk is increased by the presence of fixed costs, which magnify the effect on operating income of changes in sales. Financial risk occurs when companies borrow money and incur interest charges that show up as fixed expenses on their income statements. Fixed interest charges act on a firm's net income the same way fixed operating expenses act on operating income—they increase volatility. The additional volatility of a firm's net income caused by the presence of fixed interest expense is called financial risk. Portfolio risk is the chance that investors won't get the return they expect from a portfolio. Portfolio risk can be measured by the standard deviation of possible returns of a portfolio. It is affected by the correlation of returns of the assets making up the portfolio. The less correlated these returns are, the more gains on some assets offset losses on others, resulting in a reduction of the portfolio's risk. This phenomenon is known as the diversification effect. Nondiversifiable risk is risk that remains in a portfolio after all diversification benefits have been achieved. Nondiversifiable risk is measured by a term called beta (β). The market has a beta of 1.0. Portfolios with betas greater than 1.0 contain more nondiversifiable risk than the market, and portfolios with betas less than 1.0 contain less nondiversifiable risk than the market.
What is the difference between business risk and financial risk?
Business risk refers to the uncertainty a company has with regard to its operating income (also known as earnings before interest and taxes or EBIT). Business risk is brought on by sales volatility and intensified by the presence of fixed operating costs. Financial risk is the additional volatility of net income caused by the presence of interest expense. Firms that have only equity financing have no financial risk because they have no debt on which to make fixed interest payments. Conversely, firms that operate primarily on borrowed money are exposed to a high degree of financial risk.
partnership
Two or more people who join together to form a business make up a partnership. This can be done on an informal basis without a written partnership agreement, or a contract can spell out the rights and responsibilities of each partner.
List and explain the three financial factors that influence the value of a business.
Cash Flow Timing Risk The Importance of Cash Flow: In business, cash is what pays the bills. It is also what the firm receives in exchange for its products and services. Cash is therefore of ultimate importance, and the expectation that the firm will generate cash in the future is one of the factors that gives the firm its value. The Effect of Timing on Cash Flows: Owners and potential investors look at when firms can expect to receive cash and when they can expect to pay out cash. All other factors being equal, the sooner companies expect to receive cash and the later they expect to pay out cash, the more valuable the firm and the higher its stock price will be. The Influence of Risk: Risk affects value because the less certain owners and investors are about a firm's expected future cash flows, the lower they will value the company. The more certain owners and investors are about a firm's expected future cash flows, the higher they will value the company. In short, companies whose expected future cash flows are doubtful will have lower values than companies whose expected future cash flows are virtually certain.
What is non-diversifiable risk? How is it measured?
Unless the returns of one-half the assets in a portfolio are perfectly negatively correlated with the other half—which is extremely unlikely—some risk will remain after assets are combined into a portfolio. The degree of risk that remains is non-diversifiable risk, the part of a portfolio's total risk that can't be eliminated by diversifying. Non-diversifiable risk is measured by a term called beta (β). The ultimate group of diversified assets, the market, has a beta of 1.0. The betas of portfolios, and individual assets, relate their returns to those of the overall stock market. Portfolios with betas higher than 1.0 are relatively more risky than the market. Portfolios with betas less than 1.0 are relatively less risky than the market. (Risk-free portfolios have a beta of zero.)
stock
Certificates of ownership interest in a corporation.
Explain how the TCJA of2017 affected the way corporations are taxed.
Corporations now pay a flat rate of 21% on taxable income. Interest expenses are no longer fully deductible in the year incurred.
Public Corporations
Corporations that make their shares available to the general public and that have reporting and disclosure requirements private corporations do not.
What does it mean when we say that the correlation coefficient for two variables is -1? What does it mean if this value were zero? What does it mean if it were +1?
Correlation is measured by the correlation coefficient, represented by the letter r. The correlation coefficient can take on values between +1.0 (perfect positive correlation) to -1.0 (perfect negative correlation). The closer r is to +1.0, the more the two variables will tend to move with each other at the same time. The closer r is to -1.0, the more the two variables will tend to move opposite each other at the same time. An r value of zero indicates that the variables' values aren't related at all. This is known as statistical independence.
Cantwell Corporation has sales revenue of $2 million. Cost of goods sold is $1,500,000. What is Cantwell Corporation's gross profit?
Cost of goods sold = $1,500,000 Gross profit = $2,000,000 sales revenue - $1,500,000 cost of goods sold = $500,000
The wealth of a firm refers to its ______.
Value
Pendell Company has total sales of $4 million. One-fourth of these are credit sales. The amount of accounts receivable is $100,000. What is the average collection period for the company? Use a 365-day year
Credit sales = $4,000,000 ÷ 4 = $1,000,000 Average collection period = accounts receivable ÷ average daily credit sales = $100,000 Accounts receivable ÷ ($1,000,000 annual credit sales ÷ 365 days per year) = 36.5 days
Which ratios would a potential long-term bond investor be most interested in? Explain.
Current and potential lenders of long-term funds, such as banks and bondholders, are interested in debt ratios. When a business's debt ratios increase significantly, bondholder and lender risk increases because more creditors compete for that firm's resources if the company runs into financial trouble.
If one-half the current assets in ST-2 consist of inventory, what is the value of the quick ratio?
Current assets - inventory = $50,000 - (.5 × $50,000) = $25,000 $25,000 ÷ $20,000 current liabilities = 1.25 quick ratio
Sheth Corporation has a return on assets ratio of 6 percent. If the debt to total assets ratio is .5, what is the firm's return on equity?
Debt ÷ assets = .5, therefore equity ÷ assets = .5, therefore assets ÷ equity = 1 ÷ .5 = 2 ROE = ROA × (A/E) = .06 × 2 = .12, or 12%
A portfolio of three stocks has an expected value of 14 percent. Stock A has an expected return of 6 percent and a weight of .25 in the portfolio. Stock B has an expected return of 10 percent and a weight of .5 in the portfolio. Stock C is the third stock in this portfolio. What is the expected rate of return of Stock C?
WT of Stock C must be .25 for the total of the weights to equal 1: .14 = (.06 × .25) + (.10 × .5) + [E(RC ) × .25] .14 = .065 + [E(RC ) × .25] .075 = E(RC ) × .25 E(RC ) = .30 = 30%
Discuss how depreciation affects cash flow and compute depreciation expense
Depreciation is a noncash, tax-deductible expense. Because depreciation is tax deductible, it affects cash flow—the greater a firm's depreciation, the greater its cash flow. Cash flow, in turn, affects the value of the firm. The more cash a firm has, the greater its value. To allocate the cost of an asset over time, accountants use different depreciation methods, such as straight-line depreciation or the modified accelerated cost recovery system (MACRS). Whatever method is used, accountants must first find the depreciation basis—the total cost of the asset plus setup and delivery costs. Then they calculate the percentage of that total allocated for the time period at issue, as determined by either the straight-line depreciation method or MACRS.
What is accumulated depreciation?
Depreciation is the allocation of an asset's initial cost over time. Accumulated depreciation is the total of all the depreciation expense that has been recognized to date.
Compare diversifiable and non-diversifiable risk. Which do you think is more important to financial managers in business firms?
Diversifiable risk can be dealt with by, of course, diversifying. Non-diversifiable risk is generally compensated for by raising one's required rate of return. Both types of risk are important to financial managers.
Which of the following statements are true?
When comparing a company ratio to the industry average, a company ratio value that is equal to the industry average is not necessarily good.
Explain how the capital asset pricing model (CAPM) relates risk and return.
When investors adjust their required rates of return to compensate for risk, the question arises as to how much return is appropriate for a given degree of risk. The capital asset pricing model (CAPM) is a model that measures the required rate of return for an investment or project, given its degree of nondiversifiable risk as measured by beta (β).
What legal and ethical factors may influence a firm's financial decisions?
Environmental, safety, and civil rights laws. Examples of ethical considerations include fair treatment of workers, environmental sensitivity, and support for the community.
In the modified Du Pont equation, ROE is the product of net profit margin, total asset turnover, and the ______ ______.
Equity Multiplier
Why is the coefficient of variation often a better risk measure when comparing different projects than the standard deviation?
Whenever we want to compare the risk of investments that have different means, we use the coefficient of variation (CV). The CV represents the standard deviation's percentage of the mean. Because the CV is a ratio, it adjusts for differences in means, while the standard deviation does not. Therefore the CV provides a standardized measure of the degree of risk that can be used to compare alternatives.
The federal corporate income tax is
a flat rate of 21%
Which of the following is an example of a primary market transaction?
a surplus economic unit gets a T-bill through the weekly Treasury auction
Selling expenses are subtracted:
before operating income
proprietorship
business owned by one person.
Net income is $100,000 and common stock dividends paid are $100,000 for the year. Retained earnings were $500,000 at the beginning of the year.The end of year balance in retained earnings would be:
$500,000
Candy Corporation had pretax profits of $1.2 million, an average tax rate of 34 percent, and it paid preferred stock dividends of $50,000. There were 100,000 shares outstanding and no interest expense. What were Candy Corporation's earnings per share?
$7.42
Adams Computer Store had accumulated depreciation of $75,000 at the end of 2018, and at the end of 2017, this figure was $60,000. Earnings before interest and taxes for 2018 were $850,000. Assuming that no assets were sold in 2018, what was the amount of depreciation expense for 2018?
$75,000 end-of-2018 accumulated depreciation - $60,000 end-of-2017 accumulated depreciation = $15,000 2018 depreciation expense
Hayes Company recently bought a new computer system. The total cost, including setup, was $8,000. If this is five-year asset class equipment, what would be the amount of depreciation taken on this system in year 2 using MACRS rules?
$8,000 depreciation basis × .32 (second-year MACRS depreciation percentage for a five-year class asset) = $2,560 year - depreciation expense
Brother Mel's Bar-B-Q Restaurant has $80,000 in assets and $20,000 in liabilities. What is the equity of this firm?
$80,000 assets - $20,000 liabilities = $60,000 equity
The mean of the normal probability distribution of possible returns of Gidney and Cloyd Corporation common stock is 18 percent. The standard deviation is 3 percent. What is the range of possible values that you would be 95 percent sure would capture the return that will actually be earned on this stock
.18 + (2 × .03) = .24 = 24% .18 - (2 × .03) = .12 = 12% Therefore, we are 95% confident that the actual return will be between 12% and 24%.
What is the coefficient of variation of the following income statement sales projection given the following information? Possible Sales Level (in 000's) Probability 1000 10% 2000 15% 2500 50% 2800 20% 3000 5%
.22
The nominal interest rate is 8%. If the expected inflation is 2% and the risk premium equals 5%, then the risk-free rate equals:
3 percent
A firm with total assets of $1,500,000, total liabilities of $750,000, and net income of $30,000, has a return on equity of _______ (assume total equity equals common equity, i.e. the firm has no preferred stock).
4 percent
If the expected inflation is 2% and the real rate of interest is 3%; the nominal risk-free rate is _______
5 percent
A firm with total assets of $1,500,000, total liabilities of $750,000, and net income of $60,000, has a return on equity of _______ (assume total equity equals common equity, i.e. the firm has no preferred stock).
8%
Corporation
A business chartered by the state that is a separate legal entity having some, but not all, of the rights and responsibilities of a natural person.
Proprietorship
A business that is not incorporated and is owned by one person.
surplus economic unit
A business, household, or government unit with income greater than its expenditures.
Hillary Rotteneggs wishes to form a company that will specialize in toxic waste removal and storage. Which type of business form would be most advantageous?
A corporation due to its limited liability.
What is a benefit corporation?
A corporation organized under state law such that it declares that it has goals related to social and environmental values in addition to the pursuit of profit for its owners.
S Corporation
A corporation so designated with income that passes through the entity that is subsequently taxed to the owners, with no separate corporate income tax assessed to the company itself.
Private Corporation
A corporation that does not offer its shares to the general public and that can keep its financial statements confidential
Benefit Corporation
A corporation with a charter that allows the board of directors to take into account the interests of a wider range of stakeholders, not just the common stock shareholders, when making corporate decisions. Some states allow such a designation so that workers, suppliers, customers, and community members' interests are considered.
Negotiable CDs
A deposit security issued by financial institu-tions that comes in minimum denominations of $100,000 and can be traded in the money market.
security
A document that establishes the bearer's claim to receive funds in the future.
Investment Banking Firm
A firm that helps issuers sell their securities and that provides other financial services.
Deficit Economic Unit
A government, business, or household unit with expenditures greater than its income.
What is a bond and how does it work?
A long-term debt instrument! It is essentially an IOU that promises to pay the owners a certain amount of money on some specified date in the future, and in the mean time, pays regular interest payments. So, if you were going to buy a bond, you would pay the $1000 par value to the company issuing the bond. That company, in exchange, would pay you regular interest (coupon) payments and then at the end of the bond period, the company would pay back your original investment of $1000 (par price).
Over-the-counter market
A network of dealers around the world who purchase securities and maintain inventories of secu-rities for sale.
Stakeholder
A party having an interest in a firm (for example, owners, workers, management, creditors, suppliers, customers, and the community as a whole).
Broker
A person who brings buyers and sellers together.
Agent
A person who has the implied or actual authority to act on behalf of another
What is an agent?
A person who has the implied or actual authority to act on behalf of another
Dealer
A person who makes his or her living buying and selling assets.
Banker's Acceptance
A security that represents a promise by a bank to pay a certain amount of money, if the original note maker doesn't pay.
Commercial Paper
A short-term, unsecured debt instrument issued by a large corporation or financial institution.
The depreciable life of an asset is of concern to the financial manager of for-profit firms. In general,
A shorter depreciable life is preferred, because it will result in a faster receipt of cash flows.
What is a Subchapter S corporation?
A small corporation that is taxed as if it were a partnership. As a result, the owners avoid double taxation of corporate income paid to stockholders.
Standard Deviation
A statistic that indicates how widely dis-persed actual or possible values are distributed around a mean.
Define depreciation expense as it appears on the income statement. How does depreciation affect cash flow?
Accounting depreciation is the allocation of an asset's initial cost over time. Depreciation expense on an income statement is the amount of the assets initial cost allocated to the period covered by the income statement. Depreciation expense is not a cash flow. Depreciation as an expense category affects cash flow, however, because it is tax-deductible. Depreciation expense lowers a company's taxable income and, therefore its income tax liability. In this way depreciation reduces cash outflows.
Given that risk-averse investors demand more return for taking on more risk when they invest, how much more return is appropriate for, say, a share of common stock, than is appropriate for a Treasury bill?
Although we know that the risk-return relationship is positive, the question of much return is appropriate for a given degree of risk is especially difficult. Unfortunately, no one knows the answer for sure. One well-known model used to calculate the required rate of return of an investment, given its degree of risk, is the Capital Asset Pricing Model (CAPM).
Which of the following is correct?
Assets = Liabilities + Equity
Why do total assets equal the sum of total liabilities and equity? Explain.
Assets = Liabilities + Equity Assets are the items of value a business owns. Liabilities are claims on the business by nonowners, and equity is the owners' claim on the business. The sum of the liabilities and equity is the total capital contributed to the business, which, by definition, equals the total value of the assets.
Ron's In-Line Skating Corporation had retained earnings at the end of 2018 of $120,000. At the end of 2017, this figure was $90,000. If the company paid $5,000 in dividends to common stockholders during 2018, what was the amount of earnings available to common stockholders?
Beginning retained earnings + net income - dividends paid = ending retained earnings Therefore: Net income = ending retained earnings - beginning retained earnings + dividends paid So, for Ron's In-Line Skating Corporation: Net income = $120,000 - $90,000 + $5,000 = $35,000
Municipal bonds
Bonds issued by a state, city, county, or other nonfederal government authority, including specially created municipal authorities such as a toll road or industrial develop-ment authority.
limited liability partnership (LLPs)
Business entities that are usually formed by professionals such as doctors, lawyers, or accountants and that provide limited liability for the partners.
Corporations
legal entities separate from their owners. To form a corporation, the owners specify the governing rules for the running of the business in a contract known as the articles of incorporation. They submit the articles to the government of the state in which the corporation is formed, and the state issues a charter that creates the separate legal entity.
Which of the following is least related to the valuation of a firm's stock for most corporations?
market share
Currently XYZ Company has a required return of 12% and a beta of 1.2. According to the CAPM, XYZ is:
more risky than the market
Examples of agency problems for a corporation include all of the following except:
overtime hours worded by salaried management
Positive coupon rate bonds:
pay annual interest in the amount of the coupon rate times the face value
When we compare the risk of two investments that have the same expected return, the coefficient of variation:
provides no additional information when compared with the standard deviation
The Modified DuPont Equation is most accurately described as a function of:
return on assets and debt load
The coefficient of variation is best represented by:
standard deviation/mean
Value maximization as a goal of the firm:
takes a long-run perspective that focuses on the owners
The conflict between the goals of a firm's owners and the goals of its non-owner managers is
the agency problem
The economy is growing robustly:
the default rate on junk bonds decreases
A Debt/Equity ratio of 8.1 means:
the firm has 8.1 times more debt than equity
If the Inventory Turnover Ratio is very high relative to industry averages:
the firm may be losing sales if its inventory is too low
A firm increases its debt ratio from 50% to 75%. Which of the following statements is most correct:
the firm's positive ROE will increase
The higher the coefficient of variation of possible operating income values
the greater the business risk of the firm
Return on Equity is most accurately described as a measure of:
the return on common stockholder investment
The variability of a company's operating income can be measured by calculating:
the standard deviation of operating income
Investors in Tyrion Industries common stock have a .2 probability of earning a return of 4 percent, a .6 probability of earning a return of 10 percent, and a .2 probability of earning a return of 20 percent. What is the mean of this probability distribution (the expected rate of return)?
μ = (.2 × .04) + (.6 × .10) + (.2 × .20) = .108 = 10.8%
What is the standard deviation for the Tyrion Industries common stock return probability distribution described in ST-2?
σ = ([.2 × (.04 - .108)2] + [.6 × (.10 - .108)2] + [.2 × (.20 - .108)2]).5 = [(.2 × .004624) + (.6 × .000064) + (.2 × .008464)].5 = .002656.5 = .0515 = 5.15%
The standard deviation of the possible returns of Boris Company common stock is .08, whereas the standard deviation of possible returns of Natasha Company common stock is .12. Calculate the standard deviation of a portfolio comprised of 40 percent Boris Company stock and 60 percent Natasha Company stock. The correlation coefficient of the returns of Boris Company stock relative to the returns of Natasha Company stock is -.2.
σp = [(.42 × .082) + (.62 + .122) + (2 × .4 × .6 × (-.2) × .08 × .12)].5 = [(.16 × .0064) + (.36 × .0144) + (-.0009216)].5 = .0052864.5 = .0727 = 7.27%
Discuss the legal and ethical challenges financial managers face.
• Legal and ethical considerations include the agency problem, the interests of other stakeholders, and the interests of society as a whole. • The agency problem exists when the interests of a firm's managers (the agents) are in conflict with those of the firm's owners (the principals). • Other stakeholders whose interests are often considered in financial decisions include employees, customers, and members of the communities in which the firm's plants are located. • Concerns of society as a whole—such as environmental or health problems—often influence business financial decisions.
Mitra Company has a quick ratio value of 1.5. It has total current assets of $100,000 and total current liabilities of $25,000. If sales are $200,000, what is the value of the inventory turnover ratio?
$100,000 current assets - inventory) ÷ $25,000 = 1.5 quick ratio, therefore inventory = $62,500 $200,000 sales ÷ $62,500 inventory = 3.2 inventory turnover ratio
Shattuck Corporation had operating income (EBIT) of $2,500,000 in 2018, depreciation expense of $500,000, and dividends paid of $400,000. What is Shattuck's operating cash flow (EBITDA) for 2018?
$2,500,000 EBIT + $500,000 = $3,000,000 cash flow from operations (Dividend payments are not operating cash flows; they are financial cash flows)
What is the market return given the following information? The investment's required return 12% Risk free rate is 7% Investment's beta 1
12%
The nominal risk-free rate is 5% and the real rate of interest is 2%; then the expected inflation is expected to be:
3 percent
A firm with total assets of $1,500,000, total liabilities of $750,000, and net income of $60,000, has a return on equity of _______ (assume total equity equals common equity, i.e. the firm has no preferred stock).
8 percent
Define depreciation expense as it appears on the income statement. How does depreciation affect cash flow?
Accounting depreciation is the allocation of an asset's initial cost over time. Depreciation expense on an income statement is the amount of the assets initial cost allocated to the period covered by the income statement. Depreciation expense is not a cash flow. Depreciation as an expense category affects cash flow, however, because it is tax-deductible. Depreciation expense lowers a company's taxable income and, therefore its income tax liability. In this way depreciation reduces cash outflows.
Why would an analyst use the Modified Du Pont system to calculate ROE when ROE may be calculated more simply? Explain.
Actually, an analyst would not use the Modified Du Pont equation to calculate ROE for precisely the reason stated above. What an analyst would use the Modified Du Pont equation for is to help analyze the factors that contribute to a firm's ROE. In other words, analysts use the Modified Du Pont system to "take apart" ROE to see what factors are influencing it.
Best efforts basis
An arrangement in which the investment banking firm tries its best to sell a firm's securities for the desired price, without guarantees. If the securities must be sold for a lower price, the issuer collects less money.
10-K reports
An audited set of financial statements submitted annually by all public corporations to the Securities and Ex-change Commission (SEC).
10-Q reports
An unaudited set of financial statements submit-ted quarterly by all public corporations to the Securities and Ex-change Commission (SEC).
Partnership
An unincorporated business owned by two or more people.
Wealth
Assets minus liabilities.
Which ratios would a banker be most interested in when considering whether to approve an application for a short-term business loan? Explain.
Bankers and other lenders use liquidity ratios to see whether to extend short-term credit to a firm. Liquidity ratios measure the ability of a firm to meet its short-term obligations. These ratios are important because failure to pay such obligations can lead to bankruptcy. Generally, the higher the liquidity ratio, the more able a firm is to pay its short-term obligations.
How do risk-averse investors compensate for risk when they take on investment projects?
Because of risk aversion, people demand higher rates of return for taking on higher-risk projects.
zero-coupon bonds
Bonds that pay face value at maturity and that pay no coupon interest.
Francisco Company has current assets of $50,000. Total assets are $200,000; and long-term liabilities and common stock collectively total $180,000. What is the value of the current ratio?
Current liabilities = $200,000 total assets - $180,000 LTD & CS = $20,000 $50,000 current assets ÷ $20,000 current liabilities = 2.5 current ratio
Financial Markets
Exchanges or over-the-counter mechanisms where securities are traded.
With respect to bonds, all of the following are true except:
Face value and par value often differ due to changes in economic conditions.
Explain how financial managers use the three basic accounting financial statements: the income statement, the balance sheet, and the statement of cash flows.
Financial managers need to understand the key elements of financial statements to analyze a firm's finances and plan for its future. • income statement shows the amount of revenues, expenses, and income a firm has over a specified period of time. • balance sheet describes the assets, liabilities, and equity values for a company at a specific point in time. • statement of cash flows describes a firm's cash inflows and outflows over a period of time.
Describe how firms compensate for assuming risk.
Firms almost always demand a higher rate of return to compensate for assuming risk. The more risky a project, the higher the return firms demand.
Explain methods of risk reduction.
Firms can reduce the degree of risk by taking steps to reduce the volatility of sales or their fixed costs. Firms also obtain insurance policies to protect against many risks, and they diversify their asset portfolios to reduce the risk of income loss.
capital
Funds supplied to a firm.
The main types of economic units include ______, businesses, and households.
Governments
On the balance sheet, net fixed assets represent
Gross fixed assets at cost minus accumulated depreciation
What is an LLC?
Hybrids between partnerships and corporations. They pass their profits and losses through to their owners, as partnerships do, without taxation of the LLC itself, and they provide limited liability for their owners, as corporations do.
What are the time dimensions of the income statement, the balance sheet, and the statement of cash flows? Hint: Are they videos or still pictures? Explain.
The income statement is like a video: It measures a firm's profitability over a period of time (which can be a week, a month, a year, or any other time period). The balance sheet is like a still photograph. The balance sheet shows the firm's assets, liabilities, and equity at a given point in time. This cash flow statement like the income statement, can be compared to a video: It shows how cash flows into and out of a company over a given period of time.
Treasurer
The manager responsible for financial planning, fund-raising, and allocation of money in a business.
Chief Financial Officer (CFO)
The manager who directs and coordinates the financial activities of the firm.
Controller
The manager who is responsible for the financial and cost accounting activities of a firm.
Primary Market
The market in which newly issued securities are sold to the public.
financial leverage
The phenomenon whereby a change in op-erating income causes net income to change by a larger percent-age because of the presence of fixed financial costs
nondiversifiable risk
The portion of a portfolio's total risk that cannot be eliminated by diversifying. Factors shared to a greater or lesser degree by most assets in the market, such as inflation and interest rate risk, cause nondiversifiable risk.
risk-return relationship
The positive relationship between the risk of an investment and an investor's required rate of return
Agency Problem
The possibility of conflict between the interests of a firm's managers and those of the firm's owners.
risk-free rate of return
The rate of return that investors de-mand in order to take on a project that contains no risk other than an inflation premium.
real rate of interest
The rate that the market offers to lenders to compensate for postponing consumption.
Market Efficiency
The relative ease, speed, and cost of trading securities. In an efficient market, securities can be traded easily, quickly, and at low cost. In an inefficient market, one or more of these qualities is missing.
Why does the riskiness of portfolios have to be looked at differently than the riskiness of individual assets?
The riskiness of portfolios has to be looked at differently than the riskiness of individual assets because the weighted average of the standard deviations of returns of individual assets does not result in the standard deviation of a portfolio containing the assets. There is a reduction in the fluctuations of the returns of portfolios which is called the diversification effect.
Which of the following are traded in money markets?
banker's acceptances
The coupon interest rate on a typical Treasury bond traded in the secondary market:
can be higher or lower than the current market interest rate
Money market securities include
commercial paper negotiable certificates of deposit Treasury bills
Depreciation expense:
is a tax deductible non-cash expense
Using the information provided in ST-6, what is the required rate of return on the common stock of Zack's Salt Corporation? This stock has a beta of .4.
ks = .04 + (.06 × .4) = .064 = 6.4%
Cercei Corporation common stock has a beta of 1.2. The market risk premium is 6 percent and the risk-free rate is 4 percent. What is the required rate of return on this stock according to the CAPM?
ks = .04 + (.06 × 1.2) = .112 = 11.2%
A zero-coupon bond:
makes no periodic interest payments
Once you learn a financial concept, you should be able to apply it to ______ situations.
many
Larger corporate profit and cash inflows than what had been expected usually:
mean a higher stock price
Gross profit equals ______ minus costs of goods sold.
revenues
The coefficient of variation is best represented by
standard deviation/mean
The expected return on an investment is:
the mean of the distribution of possible returns
Which of the following equations describes net working capital?
total assets - fixed assets - current liabilities
The narrowness or wideness of a distribution reflects the degree of ________ about the expected value of the variable in question.
uncertainty
In a financial setting, individuals tend to be risk-averse investors; that suggests the following:
we normally require a higher return in exchange of additional risk
capital asset pricing model (CAPM)
A financial model that can be used to calculate the appropriate required payment of re-turn for an investment project, given its degree of risk as mea-sured by beta (β).
Income Statement
A financial statement that presents the rev-enues, expenses, and income of a business over a specific time period.
B-Lab
A non-profit organization that offers certification to companies that meet the organizations' standards for social and environmental activities.
Locate ratio value data for specific companies and industries.
A number of organizations publish financial data about companies and industries. Many publications contain ratios that are already calculated.
financial ratio
A number that expresses the value of one finan-cial variable relative to the value of another.
What is a financial ratio?
A number that expresses the value of one financial variable relative to another. Put more simply, a financial ratio is the result you get when you divide one financial number by another. Calculating an individual ratio is simple, but each ratio must be analyzed carefully to effectively measure a firm's performance.
Principal
A person who authorizes an agent to act for him or her
Agency Costs
Costs incurred to monitor agents to reduce the conflict of interest between agents and principals.
Inflation Premium
The extra interest that compensates lenders for the expected erosion of purchasing power of funds due to inflation over the life of the loan.
Bearer
The holder of a security.
A limited liability company
hybrid between a partnership and a corporation. Profits and losses pass through to the members. Members generally enjoy limited liability.
Bubba's Sporting Goods Company had retained earnings of $3 million at the end of 2017. During 2018, the company had net income of $500,000 and of this paid out $100,000 in dividends. What is the retained earnings figure for the end of 2018?
$3,000,000 end-of-2017 retained earnings + $500,000 net income - $100,000 dividends paid = $3,400,000 end-of-2018 retained earnings
For Tyrion Corporation, the mean of the distribution of next year's possible sales is $5 million. The standard deviation of this distribution is $400,000. Calculate the coefficient of variation (CV) for this distribution of possible sales.
CV = σ ÷ μ = $400,000 ÷ $5,000,000 = .08 = 8%
What are the primary responsibilities of a person holding the title of treasurer at a large corporation?
Cash management, credit management, and financial planning
______make their living buying securities and reselling them to others.
Dealers
Yates Corporation has total assets of $500,000. Its equity is $200,000. What is the company's debt to total asset ratio?
Debt = $500,000 assets - $200,000 equity = $300,000 $300,000 debt ÷ $500,000 assets = .6 = 60% debt to total asset ratio
Gross profit equals:
Revenues - cost of goods sold
Preferred dividends
are an after-tax obligation
Changes in ______ accounts on the balance sheet indicate changes in the company's cash flow.
asset
Firms with a low return on assets and low net profit margin relative to their peers normally could improve their profitability by _____________, holding other things constant.
decrease costs and expenses as a proportion of sales
Cross-sectional analysis, also called benchmarking, is a comparison that pinpoints ______ from the norm that may indicate problems.
deviations
In terms of risk, labor union disputes, entry of a new competitor, and embezzlement by management are all examples of factors affecting:
diversifiable risk
One of the most important disadvantages of the corporate form of business is:
double taxation
Profit maximization fails because it ignores all EXCEPT
earnings per share
A general obligation municipal bond:
generally has a lower pre-tax yield than a corporate bond of similar default risk
Capital-intensive companies have ________ fixed expenses, service companies often have relatively low fixed expenses.
high
