Principals of Finance Final

Business risk is the residual effect of what?

(1) company's cost structure (2) product demand characteristics (3) intra-industry competitive position The firm's asset structure is the primary determinant of its business risk.

Financial risk can be identified by what two key attributes?

(1) the added risk of insolvency assumed by the common stockholder when the firm chooses to use financial leverage (2) the increased variability in the stream of earnings available to the firm's common stockholders.

The advantages associated with the payback period are:

1. It deals with cash flows rather than accounting profits and, therefore, focuses on the true timing of the project's benefits and costs. 2. It is easy to calculate and understand. 3. It can be used as a rough screening device, eliminating projects whose returns do not materialize until later years.

The criticisms of using the payback period as a capital-budgeting technique are:

1. It ignores the timing of the flows that occur during the payback period. 2. It ignores all flows occurring after the payback period.

Flotation Cost

A flotation cost is any transaction cost incurred when a firm raises funds by issuing a type of security. With a flotation cost, the YTM is always greater than without a flotation cost.

Cost of Capital

AKA weighted average cost; the required rate of return that must be earned on additional investment for a firm's value to remain the same.

Does the firm use financial leverage if preferred stock is present in its capital structure?

Anytime the firm makes its preferred dividend payment, financial leverage is provided by the use of preferred stock.

A break-even analysis assumes linear revenue and cost functions. In reality, these linear functions deviate over large output and sales levels. Why?

As the sales of a firm increase, two things occur that bias the cost and revenue functions toward a curvilinear shape. First, sales will increase at a decreasing rate. As the market approaches saturation, the firm must cut its price to generate sales revenue. Second, as production approaches capacity, inefficiencies occur that result in higher labor and material costs. Furthermore, the firm's operating system may have to bear higher administrative and fixed costs. The result is higher per unit costs as production output increases. Weighted average cost of capital, at the same time maximizes the shareholders costs.

What different types of businesses operate in the international environment?

Banks, corporations, government, and personal investors have the ability to operate in the international market.

How do these risks differ from those encountered in domestic investment?

Business risk and financial risk apply to both domestic and international firms.

Distinguish between business risk and financial risk. What gives rise to, or causes, each type of risk?

Business risk is the uncertainty that envelops the firm's stream of earnings before interest and taxes (EBIT). One possible measure of business risk is the coefficient of variation in the firm's expected level of EBIT.

Why is capital budgeting such an important process? Why are capital-budgeting errors so costly?

Capital-budgeting decisions involve investments requiring rather large cash outlays at the beginning of the life of the project and commit the firm to a particular course of action over a relatively long time horizon. As such, they are both costly and difficult to reverse because: (1) their large cost and (2) the fact that they involve fixed assets, which cannot be liquidated easily.

How do you think the company should approach the determination of its cost of capital for making new capital investment decisions?

Difference between cost of the company and cost of the department. Department cost may be different than the company cost.

What is meant by exchange risk?

Exchange rate risk arises from the spot/current exchange rate on a future date being a random variable or unknown.

What risks are associated with direct foreign investment?

Exchange rate risk, political risk and international diversification.

What additional factors are encountered in international as compared with domestic financial management? Discuss each briefly?

Exchange rates, direct/indirect quotes, forward or future exchange rates, asked and bid rates and finally cross rates. All those deal with the time value of money and how much each currency translates to another currency at a given time. The rates can influence the prices of securities or any goods for that matter and rates flux all the time due to many market factors. An international investment manager must monitor all these factors to make smart investment decisions, whereby a domestic investment manager does not have to deal with different currencies, exchange rates, or how multiple markets are doing.

Financial Leverage

Financial leverage is financing a portion of the firm's assets with securities bearing a fixed (limited) rate of return.

Internal Rate of Return

IRR tells us the rate of return that the project earns.

What are the advantages and disadvantages of using each of these methods (NPV, PI, IRR)?

In the capital-budgeting area, these methods generally give us the same accept-reject decision on projects but many times rank them differently. As such, they have the same general advantages and disadvantages, although the calculations associated with the internal rate of return method can become quite tedious.

Distinguish between internal common equity and new common stock.

Internal common equity is the retention and reinvestment of firm earnings. There is no flotation cost. New common stock is created through the sale of new shares. Has flotation cost. The cost of new common stock is larger than retained earnings because of flotation cost.

Why is it used so frequently?

It is easy to calculate and understand and It can be used as a rough screening device, eliminating projects whose returns do not materialize until later years.

Why is there a cost associated with internal common equity?

It is the opportunity cost, although you are getting the money from retained earnings.

What are mutually exclusive projects? Why might the existence of mutually exclusive projects cause problems in the implementation of the discounted cash-flow capital-budgeting criteria?

Mutually exclusive projects involve two or more projects where the acceptance of one project will necessarily mean the rejection of the other project. This usually occurs when the set of projects perform essentially the same task. Relating this to our discounted cash flow criteria, it means that not all projects with positive NPVs, profitability indexes greater than 1.0, and IRRs greater than the required rate of return, will be accepted. Moreover, since our discounted cash flow criteria do not always yield the same ranking of projects, one criterion may indicate that the mutually exclusive project A should be accepted while another criterion may indicate that the mutually exclusive project B should be accepted. Serve the same purpose so you only need to choose one of them.

Net Present Value method

NPV gives an absolute dollar value for a project by taking the present value of the benefits and subtracting the present value of the costs.

What is the best method?

NPV is the best method.

Operating Leverage

Operating leverage is the use of operating fixed costs in the firm's cost structure.

Profitability Index

PI compares these benefits and costs through division and comes up with a measure of the project's relative value—a benefit/cost ratio.

What is meant by political risk?

Political risk is the expropriation and/or blockage of profits, blocked funds, and local equity participation requirements.

In computing the cost of capital, which sources of capital should be considered?

The Company should approach the determination of its cost of capital the sources of capital that should be considered are retained earnings, preferred stock, new common stock, and cost of debt. Bonds, common stock and preferred stock, all the components.

Advantages of NPV, PI, IRR

The advantages associated with these discounted cash flow methods are: 1. They deal with cash flows rather than accounting profits. 2. They recognize the time value of money. 3. They are consistent with the firm's goal of shareholder wealth maximization. 4. Accounts for all the cash flows coming in.

How much will the new bond issue increase AT&T's debt-to-total-assets ratio?

The debt to total assets ratio is commonly used as an indicator of a firm's use of financial leverage or borrowed funds.

What is the objective of capital structure management?

The objective of capital structure management is to mix the permanent sources of funds used by the firm in a manner that will maximize the company's common stock price.

How do purchasing-power parity, interest rate parity, and the Fisher effect explain the relationships among the current spot rate, the future spot rate, and the forward rate?

The price of a good, assuming no market imperfections such as quotas, tariffs, transaction costs, would be equal in all countries after the rate of inflation and the exchange rate were adjusted. This theory states that in the long run, exchange rate changes tend to reflect international differences in inflation rates. Interest rates across the nations tend to be equal after adjusting for the rate of inflation and exchange rate, assuming no market imperfections. This theory states that the forward premium or discount should be equal but opposite in size to the national interest rate differential. Any interest rate differential across the nations is mainly because of inflation differentials. This Fisher effect assumes no market imperfections like quotas, embargo, tariffs and no transaction costs.

Why are the techniques and strategies available to these firms different?

Their strategies are different because their goals and identities are different, which shouldn't be subject to the same rules.

What are common reasons for capital rationing?

There are three principal reasons for imposing a capital-rationing constraint. First, the management may feel that market conditions are temporarily adverse. In the early and mid-seventies, this reason was fairly common, because interest rates were at an all-time high and stock prices were at a depressed level. The second reason is a manpower shortage; that is, there is shortage of qualified managers to direct new projects. The final reason involves intangible considerations. For example, the management may simply fear debt, avoiding interest payments at any cost. Or the common stock issuance may be limited in order to allow the current owners to either maintain strict voting control over the company or to maintain a stable dividend policy.

Why do firms calculate their weighted average cost of capital?

They use weighted average cost of capital because they wanted to include all the costs form certain capitals. Must at least earn the rated cost of capital for every project they have.

How does a firm's tax rate affect its cost of capital? What is the effect of the flotation costs associated with a new security issue on a firm's weighted average cost of capital?

When a firm borrows money to finance the purchase of an asset, the interest expense is deductible for federal income tax calculations. The higher the tax rate, the more the company can deduct. The lower the tax rate, the less the company can deduct. Only debt is tax deductible. Flotation cost would cost the company more than without flotation cost.

What type of effect occurs when the firm uses operating leverage?

When operating leverage is present, any percentage fluctuation in sales will result in a greater percentage fluctuation in EBIT.

Is capital rationing rational?

Whether or not this is a rational move depends upon the extent of the rationing. If it is minor and noncontinuing, then the firm's share price will probably not suffer to any great extent. However, it should be emphasized that capital rationing and rejection of projects with positive net present values is contrary to the firm's goal of maximization of shareholders' wealth.

In some countries, the expropriation (seizure) of foreign investments is a common practice. If you were considering an investment in one of the those countries, would the use of the payback period criterion seem more reasonable that it otherwise might? why or why not?

Yes. The payback period eliminates projects whose returns do not materialize until later years, thus, emphasizing the earliest returns, which in a country experiencing frequent expropriations, would certainly have the most amount of uncertainty. In this case, the payback period could be used as a rough screening device to filter out those riskier projects, which have long lives.

A manager in your firm decides to employ a break-even analysis. Of what shortcomings should this manager be aware?

a. The cost-volume-profit relationship is assumed to be linear over the entire range of output. b. All of the firm's production is assumed to be salable at the fixed selling price. c. The sales mix and production mix are assumed constant. d. The level of total fixed costs and the variable-cost-to-sales ratio are held constant over all output and sales ranges.

Debt Capacity

the maximum proportion of debt that the firm can include in its capital structure and still maintain its lowest composite cost of capital

Financial Structure

the mix of all items that appear on the right-hand side of the company's balance sheet

Optimal Capital Structure

the mix of long-term funds that will minimize the composite cost of capital for raising a given amount of funds

Capital Structure

the mix of long-term funds used by the firm

Describe two approaches that could be used in computing the cost of common equity.

two approaches are dividend growth model [kcs = (d1/p0-f) + g]and CAPM [rj = rf + (rm -rf) bj]