Financial Management Midterm
What is the present value of $1,000 to be received in 10 years if the interest rate is 12 percent, compounded semiannually?
$1,000/[1 + (.12/2)]10 × 2 = $311.80
A firm has cash flows of $100 at the end of years 1 - 4. What is the net present value of an investment in this firm if we pay $300 to purchase the firm and the discount rate is 10 percent?
$100 × [(1 - (1/1.10)4))/.10] - $300 = $16.99
What is the difference in the future value of $100 at 7 percent interest for 5 years if the interest is compounded semiannually rather than annually?
$.80 Reason: ($100 × 1.03510) - ($100 × 1..075) = $.80
In a shareholder-manager relationship, who is the agent?
Managers
A zero-coupon bond is a bond that ____.
makes no interest payments
When using nominal cash flows, the NPV will be _____ when using real cash flows.
the same as
In general, which shape does the term structure of interest rates usually have?
upward sloping
Which of the following represents an infinite and constant stream of cash flows?
A perpetuity
What are three important features of Treasury notes and bonds?
Highly liquid Default-free Taxable
What are the advantages of the payback period method for management?
It allows lower level managers to make small decisions effectively. The payback period method is easy to use. The payback period method is ideal for minor projects.
What is the difference between nominal cash flow and real cash flow?
Nominal cash flow is the actual dollars to be received. Real cash flow refers to the cash flow's purchasing power.
How are TIPS different from traditional bonds?
Promised payments are specified in real terms
Which of the following institutions issue bonds that are traded in the bond market?
Public corporations The federal government State governments
According to the bottom-up approach, what is the OCF if EBIT is $600, depreciation is $1,800, and the tax rate is 30 percent?
Reason: Note that depreciation has already been subtracted in calculating EBIT, so it must be added back. OCF = EBIT - taxes + depreciation, or EBIT(1-t) + depreciation$600 × (1−.30)1-.30 + $1,800 = $2,220
What is the depreciation tax shield if EBIT is $600, depreciation is $1,800, and the tax rate is 30 percent?
Tax shield = $1,800 × .3 = $540
What does a bond's rating reflect?
The ability of the firm to repay its debt and interest on time
Among the three main sources of cash flow, which source of cash flow is the most important and also the most difficult to forecast?
The operating cash flows from net sales over the life of the project
What key assumption makes the promised yield different from the expected return?
The promised yield assumes no default risk.
Which of the following is (are) true about allocated costs?
These costs are allocated to more than one project. These costs benefit more than one project.
Which of the following positions generally report to the chief financial officer (CFO)?
Treasurer Controller
What is a corporate bond's yield to maturity (YTM)?
YTM is the expected return for an investor who buys the bond today and holds it to maturity. YTM is the prevailing market interest rate for bonds with similar features.
A firm evaluating two mutually exclusive projects can ___.
accept one of the projects reject one of the projects reject both projects
Incremental cash flows of a project are changes in a firm's cash flows that occur as a direct consequence of
accepting a project
The relationship between stockholders and management can best be described as a(n) ______ relationship.
agency
A firm's balance sheet shows a snapshot of its finances:
at a point in time
Corporate finance emphasizes _____ while financial accounting emphasizes ______.
cash flows; earnings
The purpose of a firm is to:
create value for the owner
Discounting is the process of converting ______ dollars into a ______ value.
future; present
Accept a project if its NPV is ______ zero.
greater than
An increase in depreciation expense will ____ cash flows from operations.
increase
As the compounding frequency increases, the future value will:
increase
If a firm increases its debt-equity ratio it will _____ its sustainable rate of growth.
increase
In general, a corporate bond's coupon rate ____,
is fixed until the bond matures
The Fisher effect hypothesizes that the real rate of return ____.
is invariant to the rate of inflation
The federal government can raise money from financial markets to finance its deficits by ___.
issuing bonds
If reinvestment of interest or dividends does not occur, then the future value of an investment will be _____ and the realized yield will be ____ than if reinvestment had occurred.
lower; lower If there is no reinvestment, there will be less money in the investment at the end of the time period, so the realized yield will be less.
One of the flaws of the payback period method is that cash flows after the cutoff date are ___.
not considered in the analysis
The equation for determining the real interest rate has the nominal interest rate in the _____ and the inflation rate in the ______.
numerator; denominator
Allocated costs must be treated as relevant or incremental costs ___.
only if the costs being allocated are affected by the proposed project
In general, NPV is ___.
positive for discount rates below the IRR. negative for discount rates above the IRR. equal to zero when the discount rate equals the IRR.
The formula for the ______ value interest factor of an annuity is {1-[1/(1+r)t]r}1-[1/(1+r)t]r.
present
The value of a firm can be found by taking the _____ value of all _____ cash flows.
present; future
Depreciation × Tax rate represent the depreciation tax
shield
As depreciation ______, operating cash flows will _______.
decrease; decrease increase; increase
Corporate finance addresses the following three questions
1.In what long-lived assets should the firm invest? 2.How can the firm raise cash for required capital expenditures? 3.How should short-term operating cash flows be managed?
According to the top-down approach, what is the operating cash flow if sales are $200,000, total cash costs are $190,636, and the tax bill is $1,144?
8220
Which of the following is a perpetuity?
A constant stream of cash flows forever
The EAR is meaningful by itself, but the ______ is only meaningful when the number of compounding periods per year is given.
APR
___________cash flows are the difference between the cash flows of the firm with the project and the cash flows of the firm without the project.
Incremental
What is a real rate of return?
It is a percentage change in buying power. It is a rate of return that has been adjusted for inflation.
When calculating NPV, the present value of the nth cash flow is found by dividing the nth cash flow by 1 plus the ______ rate raised to the nth power.
discount
Opportunity costs are classified as:
relevant costs Opportunity costs are relevant - they are losses that occur because the firm has foregone all the opportunities it didn't pursue.
According to the Fisher effect hypothesis, the real rate of return ______ as inflation increases.
remains the same
How is a conventional bond different from a zero coupon bond?
Conventional bonds can sell at par, at a discount from par, or at a premium over par while zeroes can not. A conventional bond pays periodic coupon interest whiles zeroes make no interest payments.
What information is needed to compute a bond's yield to maturity?
Coupon rate Time to maturity The bond's current price
Which of the following is an example of an opportunity cost?
Rental income likely to be lost by using a vacant building for an upcoming project
Which of the following can be used to encourage managers to act in the best interests of shareholders?
Stock options and bonuses Managerial compensation tied to performance
True or false: The formula for finding the net present value of a cash outflow now, a positive cash flow in 1 year, and a positive cash flow in 2 years is -C0+ C1/(1 + r)1 + C2/(1 + r)2.
TRUE
What are the two sets of accounting books?
Tax books Shareholders' books
Why does a bond's value fluctuate over time?
The coupon rate and par value are fixed, while market interest rates change
The payback period rule ______ a project if it has a payback period that is less than or equal to a particular cutoff date.
accepts
When evaluating a project with an initial cash inflow followed by cash outflows, the NPV will _____ as the discount rate rises.
increase
According to the basic investment rule for NPV, a firm should ____.
be indifferent towards accepting a project if NPV is equal to zero accept a project if the NPV is greater than zero. reject a project if NPV is less than zero.
Allocated costs arise when a specific expenditure ____.
benefits more than one project or division
Which of the following is given greater importance in capital budgeting problems in corporate finance?
cash flows
A treasury bond is:
debt issued by the US government with a typical maturity of between 2-30 years
Which of these risks is addressed by bond ratings?
default risk
Interest expenses incurred on debt financing are ______ when computing cash flows from a project.
ignored In order to separate the investment from the financing of that investment, you must ignore any costs associated with financing. Cash flows from the project should be completed without taking into account the costs associated with the financing of the project.
The primary responsibility of financial managers is to increase the value of _____.
the existing shares of stock
In many public companies, _______ is dispersed among many shareholders. This dispersion arguably means that management effectively controls the firm.
ownership
This capital budgeting method allows lower management to make smaller, everyday financial decisions easily is:
payback method
According to Graham and Harvey's 1999 survey of 392 CFOs, which of the following capital budgeting techniques is least used.
profitability index
Nominal interest rate - Inflation rate approximates the _________interest rate
real
Erosion will ______ the sales of existing products.
reduce
What part of the capital structure design helps answer the questions "how can the firm raise cash for required capital expenditures?"
Current Liabilities Long-term Debt Shareholder's Equity
Which of the following are annuities?
Monthly rent payments in a lease Installment loan payments
The _________ identity can help to explain why two firms with the same return on equity may not be operating in the same way.
Dupoint
True or false: A firm evaluating two mutually exclusive projects can accept both projects.
False
The __________ rule summarizes the information about a project in a single rate of return. This single rate gives people a simple way of discussing the rate of return of projects. (Enter abbreviation only.)
IRR
If you invest $100 at a stated annual rate of 10 percent compounded quarterly, how much more money will you have in 10 years than if the rate was compounded annually?
$100 × (1 + .10/4)40 - $100 × (1.10)10 = $9.13
Weston's financial planning model shows assets are projected to increase by $2.7 million while liabilities and equity increase by $1.5 million. What is the external financing need (EFN)?
$2.7m - 1.5m = $1.2m
If a firm needs $500 million in new assets and has projected retained earnings of $200 million, what is the external financing needed?
$300
If the nominal rate is 5 percent and the annual rate of inflation is 2 percent, what is the real rate of return?
(1.05/1.02)-1 = 2.94%
The formula for finding the net present value of a cash outflow now, a positive cash flow in 1 year, a positive cash flow in 2 years, and a positive cash flow in 3 years is:
-C0+ C1/(1 + r)1 + C2/(1 + r)2+ C3/(1 + r)3
A bad financial decision is defined as a decision that ______ owners' equity.
decreases
How does depreciation affect the operating cash flows?
Depreciation expense reduces the taxable income and taxes, and increases the operating cash flow.
True or false: The Rule of 72 is a short cut approach to estimate the time needed to double your interest rate.
FALSE
Which of the following are traditional financial ratio categories?
Financial leverage ratios Liquidity ratios Turnover ratios
The future value of $100 at 10 percent compounded semiannually is ______ the future value of $100 at 10 percent compounded annually.
greater than
PV = C/(r - g) is the formula for the present value of a:
growing perpetuity.
When interest rates and inflation rates are _____, the approximation of the real interest rate becomes _____.
high poor low good
For a positive annual percentage rate (APR) and multiple (more than one) compounding periods per year, the EAR is always ______ the APR.
larger than
A dollar received one year from today has ______ value than a dollar received today.
less
When cash flows are conventional, NPV is ______ if the discount rate is above the IRR.
negative
Which of the following are true for a project with a negative initial cash flow followed by positive cash flows?
Accept if NPV is greater than zero. Reject if IRR is less than market rate of financing.
In a financial plan using the percentage of sales approach, why is it assumed that some assets increase with sales?
Additional working capital and fixed assets are needed to support growth
Which of the following correctly describes the relationship between depreciation, income, taxes, and investment cash flows?
As depreciation expense increases, net income and taxes will decrease, while investment cash flows will increase. Need help? Review these concept resources.Read About the Concept Feedback Next Question Reading
In large firms, financial activity is usually associated with which top officer?
Chief financial officer
Which of the following items are used to compute the current ratio?
Cash Accounts payable
Which of the following are weaknesses of the payback method?
Cash flows received after the payback period are ignored. The cutoff date is arbitrary. Time value of money principles are ignored.
Which three of the following are most apt to create problems when comparing financial statements for multiple firms?
Differing fiscal years Seasonality Differing accounting methods
Which capital budgeting decision method finds the present value of each cash flow before calculating a payback period?
Discounted payback period
How is sustainable growth calculated when equity used in the calculation of ROE is the beginning value?
ROE × b
If a firm needs $300 million in new assets and has projected retained earnings of $72.4 million, what is the external financing needed?
Reason: 300 - 72.4 = 227.6
Vera's has earnings per share of $3 and dividends per share of $1.20. The stock sells for $30 a share. What is the PE ratio?
Reason: Current Price of Share/ $30/$3 = 10 times
True or false: NPV will be the same regardless of whether nominal or real cash flows are used.
True Reason: As long as nominal cash flows are discounted at the nominal rate and real cash flows are discounted at the real rate, the NPV will be the same.
You must know the discount rate to compute ____, while the discount rate is necessary to apply ___.
You must know the discount rate to compute NPV, while the discount rate is necessary to apply IRR (because you need it for the decision rule).
According to the Rule of 72, to find the amount of time required for a sum of money to double in value, you:
divide 72 by the interest rate (%)
All else equal, when the rate of growth in sales or assets in a financial plan is higher, _________________financing needs will be greater
external
A growing annuity has a(n) ____.
finite number of growing cash flows
The bottom-up approach to calculating OCF starts with:
net income
Under capital budgeting, required working capital is classified as a cash ______.
outflow
The decision rule for a project for which the first cash flow is an inflow and subsequent cash flows are negative states that we should ____ the project when the IRR is ____ than the discount rate.
reject; greater accept; less
Because shareholders get paid last after all other obligations are satisfied, they are often called:
residual owners
Common-size statements are used for comparing firms with differing ____.
sizes
Agency costs refer to the costs of the conflict of interest between
stockholders or shareholders and Management or managers
One of the most basic principles of finance is that rational individuals prefer to receive a dollar ____ than a dollar ______.
today; tomorrow
The first cash flow at the end of week 1 is $100, the second cash flow at the end of month 2 is $100, and the third cash flow at the end of year 3 is $100. This cash flow pattern is a(n) ______ type of cash flow.
uneven
Which one of these will decrease a firm's sustainable rate of growth?
An increase in the dividend payout ratio
Which of the following should be discounted when determining the feasibility of a capital budgeting project(s)?
Cash flows
What is the coupon rate on a bond that has a par value of $1,000, a market value of $1,100, and a coupon interest payment of $100 per year?
Coupon rate = $100/$1,000 = 10%
Which of these affect a bond's yield to maturity?
Current price Coupon rate Par value
Which of the following are premiums determine the yield on a bond?
Default risk Expected future inflation Taxability Liquidity Interest rate risk
Which six factors determine the yield on a bond?
Default risk Real rate of return Taxability Expected future inflation Liquidity Interest rate risk
True or false: The real rate of return will generally be higher than the nominal rate of return.
False Since the inflation rate is generally positive, the nominal rate is generally higher than the real rate.
True or false: If the term structure of interest rates is downward-sloping, short-term rates will be lower than long-term rates.
False Reason: Short-term rates will be higher than long-term rates when the term structure is downward-sloping.
True or false: In an upward-sloping term structure, the long-term rates will be lower than the short-term rates.
False, long-term rates will be higher than the short-term rates
The shareholders' books in the US follow the rules of the ____.
Financial Accounting Standards Board (FASB)
In an inflationary environment, the nominal rate will be _________ the real rate.
In an inflationary environment, the nominal rate will be greater than the real rate, because the nominal rate adds the effects of inflation to the real rate.
A good financial decision will do which of the following?
Increase the value of the firm's existing stock Increase market value of shareholders' equity
What is the nominal rate of return on an investment?
It is the actual percentage change in the dollar value of an investment
Which is the promised yield on a bond?
It is the yield based on the current price and expected cash flows, assuming no default.
Which one of the following is the most important source of risk from owning bonds?
Market interest rate fluctuations
Which of the following, according to the textbook, are possible financial goals for a company?
Minimize costs Survival Maximize profits
Identify the three main sources of cash flows over the life of a typical project.
Net cash flows from sales and expenses over the life of the project. Cash outflows from investment in plant and equipment at the inception of the project Net cash flows from salvage value at the end of the project
What is the equation for estimating operating cash flows using the top-down approach?
OCF = Sales - Cash costs - Taxes
What are the cash flows involved in the purchase of a 5-year zero-coupon bond that has a par value of $1,000 if the current price is $800? Assume the market rate of interest is 5 percent.
Pay $800 today and receive $1,000 at the end of 5 years
What does ROE equal?
ROA × Equity multiplier
Which of the following variables are required to calculate the value of a bond?
Remaining life of bond Coupon rate Market yield
Which of the following statements regarding the relationship between book value, sales price, and taxes are true when a firm sells a fixed asset?
Taxes are based on the difference between the book value and the sales price. Book value represents the purchase price minus the accumulated depreciation. There will be a tax savings if the book value exceeds the sales price.
Which of these are required to calculate the current value of a bond?
Time remaining to maturity Par value Coupon Applicable market rate
What is the main goal of financial management?
To maximize current share value
What does TIPS stand for?
Treasury Inflation-Protected Securities
The US government borrows money by issuing:
Treasury bonds Treasury notes
True or false: A project with an initial cash outflow followed by a cash inflow has an NPV that is negatively related to the discount rate.
True
Discounting is the process of _____.
calculating the present value of either a lump sum or a series of cash flows.
The APR is meaningful for comparisons only when the number of ______ per year is given.
compounding
The idea behind ______ is that interest is earned on interest.
compounding
The current ratio computes the relationship between ____.
current assets and current liabilities.
A limitation of bond ratings is that they ____.
focus exclusively on default risk
Sunk costs are costs that ____.
have already occurred and are not affected by accepting or rejecting a project
Interest on municipal bonds is ______.
ignored for tax purposes but included as income for FASB accounting
If sales are made on credit, net working capital will _____.
increase
If the tax rate increases, the value of the depreciation tax shield will ____.
increase
Synergy will ______ the sales of existing products.
increase
A way to evaluate mutually exclusive projects is to analyze the __________cash flows.
incremental
The net present value of a project's cash flows is divided by the ______ to calculate the profitability index.
initial investment
Investment in net working capital arises when ___.
inventory is purchased cash is kept for unexpected expenditures credit sales are made
If the term structure of interest rates is upward-sloping, then ____.
long-term rates are higher than short-term rates
Using your personal savings to invest in your business is considered to have an________ ________ because you are giving up the use of these funds for other investments or uses, such as, a vacation or paying off a debt.
opportunity cost
Management may look _____ to shareholders and pay _____ tax on reported profit.
profitable; no
It is appropriate to use the approximate formula for estimating the real interest rate when:
the interest rate and inflation rate are low
The degree of interest rate risk depends on ____.
the sensitivity of the bond's price to interest rate changes
