Finance EOC Questions: Concept Reviews

Suppose two athletes each sign 10-year contracts for $80 million. In one case, we're told that the $80 million will be paid in 10 equal installments. In the other case, we're told that the $80 million will be paid in 10 installments, but the installments will increase by 5 percent per year. Who got the better deal?

2nd (FV= $130,311,570.14) vs 1st FV is 80 mil

Explain what it means for a firm to have a current ratio equal to .50. Would the firm be better off if the current ratio were 1.50? What if it were 15.0? Explain your answers.

A current ratio of .50 means that the firm has twice as much in current liabilities as it does in current assets; the firm potentially has poor liquidity. If pressed by its short-term creditors and suppliers for immediate payment, the firm might have a difficult time meeting its obligations. A current ratio of 1.50 means the firm has 50 percent more current assets than it does current liabilities. This probably represents an improvement in liquidity; short-term obligations can generally be met completely with a safety factor built in. A current ratio of 15.0, however, might be excessive. Any excess funds sitting in current assets generally earn little or no return. These excess funds might be put to better use by investing in productive long-term assets or distributing the funds to shareholders.

Under what circumstances might a company choose not to pay dividends?

In general, companies that need the cash will often forgo dividends since dividends are a cash expense. Young, growing companies with profitable investment opportunities are one example; another example is a company in financial distress. This question is examined in depth in a later chapter.

If you were an athlete negotiating a contract, would you want a big signing bonus payable immediately and smaller payments in the future, or vice versa?

If the total money is fixed, you want as much as possible as soon as possible. The team wants the opposite.

One of the assumptions of the two-stage growth model is that the dividends drop immediately from the high growth rate to the perpetual growth rate. What do you think about this assumption? What happens if this assumption is violated?

If this assumption is violated, the two-stage dividend growth model is not valid. In other words, the price calculated will not be correct. Depending on the stock, it may be more reasonable to assume that the dividends fall from the high growth rate to the low perpetual growth rate over a period of years, rather than in one year.

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

Yes, they should. APR's generally don't provide the relevant rate. The only advantage is that they are easier to compute, but, with modern computing equipment, that advantage is not very important.

There are 4 pieces to an annuity PV. What are they?

present value(PV), periodic cash flow (C), discount rate (r), number of payments or life of the annuity (t)

There are many ways of using standardized financial information beyond those discussed in this chapter. The usual goal is to put firms Page 85on an equal footing for comparison purposes. For example, for auto manufacturers, it is common to express sales, costs, and profits on a per-car basis. For each of the following industries, give an example of an actual company and discuss one or more potentially useful means of standardizing financial information: Public utilities. Large retailers. Airlines. Online services. Hospitals. College textbook publishers.

. For an electric utility such as Con Ed, expressing costs on a per-kilowatt-hour basis would be a way to compare costs with other utilities of different sizes. b. For a retailer such as Sears, expressing sales on a per-square-foot basis would be useful in comparing revenue production against other retailers. c. For an airline such as Southwest, expressing costs on a per-passenger-mile basis allows for comparisons with other airlines by examining how much it costs to fly one passenger one mile. For an online service provider such as Comcast, using a cost per internet session would allow for comparisons with smaller services. A per subscriber basis would also make sense. For a hospital such as Holy Cross, revenues and costs expressed on a per-bed basis would be useful. For a college textbook publisher such as McGraw-Hill Education, the leading publisher of finance textbooks for the college market, the obvious standardization would be per book sold.

Which has greater interest rate risk, a 30-year Treasury bond or a 30-year BB corporate bond?

All else the same, the Treasury security will have lower coupons because of its lower default risk, so it will have greater interest rate risk.

How does a bond issuer decide on the appropriate coupon rate to set on its bonds? Explain the difference between the coupon rate and the required return on a bond

Bond issuers look at outstanding bonds of similar maturity and risk when setting coupon rates. The yields on such bonds are used to establish the coupon rate necessary for a particular issue to initially sell for par value. Bond issuers also ask potential purchasers what coupon rate would be necessary to attract them. The coupon rate is fixed and determines the value of the bond's coupon payments. The required return is what investors actually demand on the issue, and it will fluctuate through time. The coupon rate and required return are equal only if the bond sells exactly at par.

What types of information do common-size financial statements reveal about the firm? What is the best use for these common-size statements? What purpose do common-base year statements have? When would you use them?

Common-size financial statements express all balance sheet accounts as a percentage of total assets and all income statement accounts as a percentage of total sales. Using these percentage values rather than nominal dollar values facilitates comparisons between firms of different size or business type. Common-base year financial statements express each account as a ratio between their current year nominal dollar value and some reference year nominal dollar value. Using these ratios allows the total growth trend in the accounts to be measured.

What is compounding? What is discounting?

Compounding refers to the growth of a dollar amount through time via reinvestment of interest earned. It is also the process of determining the future value of an investment. Discounting is the process of determining the value today of an amount to be received in the future.

In comparing accounting net income and operating cash flow, name two items you typically find in net income that are not in operating cash flow. Explain what each is and why it is excluded in operating cash flow.

Depreciation is a noncash deduction that reflects adjustments made in asset book values in accordance with the matching principle in financial accounting. Interest expense is a cash outlay, but it's a financing cost, not an operating cost.

A firm's enterprise value is equal to the market value of its debt and equity, less the firm's holdings of cash and cash equivalents. This figure is particularly relevant to potential purchasers of the firm. Why?

Enterprise value is the theoretical takeover price. In the event of a takeover, an acquirer would have to take on the company's debt but would pocket its cash. Enterprise value differs significantly from simple market capitalization in several ways, and it may be a more accurate representation of a firm's value. In a takeover, the value of a firm's debt would need to be paid by the buyer. Thus, enterprise value provides a much more accurate takeover valuation because it includes debt in its value calculation.

As you increased the length of time involved, what happens to future values? What happens to present values?

FV will increase, PV will decrease

What happens to a future value if you increase the rate r? What happens to a present value?

FV will increase, PV will decrease

A project has perpetual cash flows of C per period, a cost of I, and a required return of R. What is the relationship between the project's payback and its IRR? What implications does your answer have for long-lived projects with relatively constant cash flows?

For a project with future cash flows that are an annuity: Payback = I/C And the IRR is: 0 = - I + C/IRR Solving the IRR equation for IRR, we get: IRR = C/I Notice this is just the reciprocal of the payback. So: IRR = 1/PB For long-lived projects with relatively constant cash flows, the sooner the project pays back, the greater is the IRR.

Suppose a company's cash flow from assets is negative for a particular period. Is this necessarily a good sign or a bad sign?

For a successful company that is rapidly expanding, for example, capital outlays will be large, possibly leading to negative cash flow from assets. In general, what matters is whether the money is spent wisely, not whether cash flow from assets is positive or negative.

Could a company's change in NWC be negative in a given year? (Hint: Yes.) Explain how this might come about. What about net capital spending?

For example, if a company were to become more efficient in inventory management, the amount of inventory needed would decline. The same might be true if it becomes better at collecting its receivables. In general, anything that leads to a decline in ending NWC relative to beginning would have this effect. Negative net capital spending would mean that more long-lived assets were liquidated than purchased.

In preparing a balance sheet, why do you think standard accounting practice focuses on historical cost rather than market value?

Historical costs can be objectively and precisely measured whereas market values can be difficult to estimate, and different analysts would come up with different numbers. Thus, there is a trade-off between relevance (market values) and objectivity (book values).

Despite its shortcomings in some situations, why do most financial managers use IRR along with NPV when evaluating projects? Can you think of a situation in which IRR might be a more appropriate measure to use than NPV?

IRR is frequently used because it is easier for many financial managers and analysts to rate performance in relative terms, such as "12%", than in absolute terms, such as "$46,000." IRR may be a preferred method to NPV in situations where an appropriate discount rate is unknown or uncertain; in this situation, IRR would provide more information about the project than would NPV .

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

IRR is the interest rate that causes NPV for a series of cash flows to be zero. NPV is preferred in all situations to IRR; IRR can lead to ambiguous results if there are non-conventional cash flows, and it also ambiguously ranks some mutually exclusive projects. However, for stand-alone projects with conventional cash flows, IRR and NPV are interchangeable techniques.

Could a company's cash flow to stockholders be negative in a given year? (Hint: Yes.) Explain how this might come about. What about cash flow to creditors?

If a company raises more money from selling stock than it pays in dividends in a particular period, its cash flow to stockholders will be negative. If a company borrows more than it pays in interest, its cash flow to creditors will be negative.

What effect would the following actions have on a firm's current ratio? Assume that net working capital is positive. Inventory is purchased. A supplier is paid. A short-term bank loan is repaid. A long-term debt is paid off early. A customer pays off a credit account. Inventory is sold at cost. Inventory is sold for a profit.

If inventory is purchased with cash, then there is no change in the current ratio. If inventory is purchased on credit, then there is a decrease in the current ratio if it was initially greater than 1.0. Reducing accounts payable with cash increases the current ratio if it was initially greater than 1.0. Reducing short-term debt with cash increases the current ratio if it was initially greater than 1.0. As long-term debt approaches maturity, the principal repayment and the remaining interest expense become current liabilities. Thus, if debt is paid off with cash, the current ratio increases if it was initially greater than 1.0. If the debt has not yet become a current liability, then paying it off will reduce the current ratio since current liabilities are not affected. Reduction of accounts receivables and an increase in cash leaves the current ratio unchanged. Inventory sold at cost reduces inventory and raises cash, so the current ratio is unchanged. Inventory sold for a profit raises cash in excess of the inventory recorded at cost, so the current ratio increases

In the context of capital budgeting, what is an opportunity cost?

In this context, an opportunity cost refers to the value of an asset or other input that will be used in a project. The relevant cost is what the asset or input is actually worth today, not, for example, what it cost to acquire the asset.

Suppose a company lengthens the time it takes to pay suppliers. How would this affect the statement of cash flows? How sustainable is the change in cash flows from this practice?

Increasing the payables period increases the cash flow from operations. This could be beneficial for the company as it may be a cheap form of financing, but it is basically a one-time change. The payables period cannot be increased indefinitely as it will negatively affect the company's credit rating if the payables period becomes too long.

A substantial percentage of the companies listed on the NYSE and NASDAQ don't pay dividends, but investors are nonetheless willing to buy shares in them. How is this possible given your answer to the previous question?

Investors believe the company will eventually start paying dividends (or be sold to another company).

Suppose a company's operating cash flow has been negative for several years running. Is this necessarily a good sign or a bad sign?

It's probably not a good sign for an established company, but it would be fairly ordinary for a start- up, so it depends.

Suppose a financial manager is quoted as saying, "Our firm uses the stand-alone principle. Because we treat projects like minifirms in our evaluation process, we include financing costs because they are relevant at the firm level." Critically evaluate this statement.

Management's discretion to set the firm's capital structure is applicable at the firm level. Since any one particular project could be financed entirely with equity, another project could be financed with debt, and the firm's overall capital structure remains unchanged. Financing costs are irrelevant in the analysis of a project's incremental cash flows according to the stand-alone principle.

Under standard accounting rules, it is possible for a company's liabilities to exceed its assets. When this occurs, the owners' equity is negative. Can this happen with market values? Why or why not?

Market values can never be negative. Imagine a share of stock selling for -$20. This would mean that if you placed an order for 100 shares, you would get the stock along with a check for $2,000. How many shares do you want to buy? More generally, because of corporate and individual bankruptcy laws, net worth for a person or a corporation cannot be negative, implying that liabilities cannot exceed assets in market value.

Why is NPV considered a superior method of evaluating cash flows from a project? Supposed the NPV for a project's cash flows is copied too be $2,500. What does this number represent with respect to the firm's shareholders?

NPV is superior to the other methods of analysis presented in the text because it has no serious flaws. The method unambiguously ranks mutually exclusive projects, and can differentiate between projects of different scale and time horizon. The only drawback to NPV is that it relies on cash flow and discount rate values that are often estimates and not certain, but this is a problem shared by the other performance criteria, as well. A project with NPV = $2,500 implies that the total shareholder wealth of the firm will increase by $2,500 if the project is accepted.

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

NPV is the present value of a project's cash flows. NPV specifically measures, after considering the time value of money, the net increase or decrease in firm wealth due to the project. The decision rule is to accept projects that have a positive NPV, and reject projects with a negative NPV .

Is it true that a U.S. Treasury security is risk-free?

No. As interest rates fluctuate, the value of a Treasury security will fluctuate. Long-term Treasury securities have substantial interest rate risk.

What is the relationship between the profitability index and NPV? Are there any situations in which you might prefer one method over the other? Explain.

PI = (NPV + cost)/cost = 1 + (NPV/cost). If a firm has a basket of positive NPV projects and is subject to capital rationing, PI may provide a good ranking measure of the projects, indicating the "bang for the buck" of each particular project.

The basic present value equation has four parts. What are they?

PV, FV, rate (r), and time (t)

Explain what peer group analysis is. As a financial manager, how could you use the results of peer group analysis to evaluate the performance of your firm? How is a peer group different from an aspirant group?

Peer group analysis involves comparing the financial ratios and operating performance of a particular firm to a set of peer group firms in the same industry or line of business. Comparing a firm to its peers allows the financial manager to evaluate whether some aspects of the firm's operations, finances, or investment activities are out of line with the norm, thereby providing some guidance on appropriate actions to take to adjust these ratios if appropriate. An aspirant group would be a set of firms whose performance the company in question would like to emulate. The financial manager often uses the financial ratios of aspirant groups as the target ratios for his or her firm; some managers are evaluated by how well they match the performance of an identified aspirant group.

Evaluate the following statement: Managers should not focus on the current stock value because doing so will lead to an overemphasis on short-term profits at the expense of long-term profits.

Presumably, the current stock value reflects the risk, timing and magnitude of all future cash flows, both short-term and long-term. If this is correct, then the statement is false.

Fully explain the kind of information the following financial ratios provide about a firm: Quick ratio. Cash ratio. Total asset turnover. Equity multiplier. Long-term debt ratio. Times interest earned ratio. Profit margin. Return on assets. Return on equity. Price-earnings ratio.

Quick ratio provides a measure of the short-term liquidity of the firm, after removing the effects of inventory, generally the least liquid of the firm's current assets. Cash ratio represents the ability of the firm to completely pay off its current liabilities with its most liquid asset (cash). Total asset turnover measures how much in sales is generated by each dollar of firm assets. Equity multiplier represents the degree of leverage for an equity investor of the firm; it measures the dollar worth of firm assets each equity dollar has a claim to. Long-term debt ratio measures the percentage of total firm capitalization funded by long-term debt. 2 SOLUTIONS MANUAL Times interest earned ratio provides a relative measure of how well the firm's operating earnings can cover current interest obligations. Profit margin is the accounting measure of bottom-line profit per dollar of sales. Return on assets is a measure of bottom-line profit per dollar of total assets. Return on equity is a measure of bottom-line profit per dollar of equity. Price-earnings ratio reflects how much value per share the market places on a dollar of accounting earnings for a firm.

Why is the DuPont identity a valuable tool for analyzing the performance of a firm? Discuss the types of information it reveals compared to ROE considered by itself.

Return on equity is probably the most important accounting ratio that measures the bottom-line performance of the firm with respect to the equity shareholders. The DuPont identity emphasizes the role of a firm's profitability, asset utilization efficiency, and financial leverage in achieving an ROE figure. For example, a firm with ROE of 20 percent would seem to be doing well, but this figure may be misleading if it were marginally profitable (low profit margin) and highly levered (high equity multiplier). If the firm's margins were to erode slightly, the ROE would be heavily impacted.

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

The IRR is the discount rate that causes the NPV of a series of cash flows to be exactly zero. IRR can thus be interpreted as a financial break-even rate of return; at the IRR, the net present value of the project is zero. The IRR decision rule is to accept projects with IRRs greater than the discount rate, and to reject projects with IRRs less than the discount rate.

Referring back to the Boeing example used at the beginning of the chapter, note that we suggested that Boeing's stockholders probably didn't suffer as a result of the reported loss. What do you think was the basis for our conclusion?

The adjustments discussed were purely accounting changes; they had no cash flow or market value consequences unless the new accounting information caused stockholders to revalue the derivatives.

Why does the value of a share of stock depend on dividends?

The value of any investment depends on the present value of its cash flows; i.e., what investors will actually receive. The cash flows from a share of stock are the dividends.

Supposed a company has a preferred stock issue and a common stock issue. Both have just paid a $2 dividend. Which do you think will have a higher price, a share of the preferred or of the common?

The common stock probably has a higher price because the dividend can grow, whereas it is fixed on the preferred. However, the preferred is less risky because of the dividend and liquidation preference, so it is possible the preferred could be worth more, depending on the circumstances.

Under what 2 assumptions can we use the dividend growth model presented in the chapter to determine the value of a share of stock?

The general method for valuing a share of stock is to find the present value of all expected future dividends. The dividend growth model presented in the text is only valid (a) if dividends are expected to occur forever, that is, the stock provides dividends in perpetuity, and (b) if a constant growth rate of dividends occurs forever. An example of a violation of the first assumption might be a company that is expected to cease operations and dissolve itself some finite number of years from now. The stock of such a company would be valued by applying the general method of valuation explained in this chapter. An example of a violation of the second assumption might be a start-up firm that isn't currently paying any dividends but is expected to eventually start making dividend payments some number of years from now. This stock would also be valued by the general dividend valuation method explained in this chapter.

What are the difficulties in using the PE ratio to value stock?

The major difficulty in using price ratio analysis is determining the correct benchmark PE ratio. In a previous chapter, we showed how the sustainable growth rate is determined, and in a future chapter we will discuss the required return. Although not exact measures, the growth rate and required return have a solid economic basis. With the PE ratio, like any other ratio, it is difficult to determine the correct value for the ratio. Since a small difference in the PE ratio can have a significant effect on the calculated stock price, it is easy to arrive at an incorrect valuation.

The TMCC security is bought and sold on the NYSE. If you looked at the price today, do you think the price would exceed the $24,099 original price? Why? If you looked in the year 2019, do you think the price would be higher or lower than today's price?

The price would be higher because, as time passes, the price of the security will tend to rise toward $100,000. This rise is just a reflection of the time value of money. As time passes, the time until receipt of the $100,000 grows shorter, and the present value rises. In 2019, the price will probably be higher for the same reason. We cannot be sure, however, because interest rates could be much higher, or TMCC's financial position could deteriorate. Either event would tend to depress the security's price.

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

The profitability index is the present value of cash inflows relative to the project cost. As such, it is a benefit/cost ratio, providing a measure of the relative profitability of a project. The profitability index decision rule is to accept projects with a PI greater than one, and to reject projects with a PI less than one.

Why might the revenue and cost figures shown on a standard income statement not be representative of the actual cash inflows and outflows that occurred during a period?

The recognition and matching principles in financial accounting call for revenues, and the costs associated with producing those revenues, to be "booked" when the revenue process is essentially complete, not necessarily when the cash is collected or bills are paid. Note that this way is not necessarily correct; it's the way accountants have chosen to do it.

What difficulties might come up in actual applications of the various criteria we discussed in this chapter? Which one would be the easiest to implement in actual applications? The most difficult?

The single biggest difficulty, by far, is coming up with reliable cash flow estimates. Determining an appropriate discount rate is also not a simple task. These issues are discussed in greater depth in the next several chapters. The payback approach is probably the simplest, followed by the AAR, but even these require revenue and cost projections. The discounted cash flow measures (discounted payback, NPV, IRR, and profitability index) are really only slightly more difficult in practice.

What is the difference between the term structure of interest rates and the yield curve?

The term structure is based on pure discount bonds. The yield curve is based on coupon-bearing issues.

Based on the dividend growth model, what are the two components of the total return on a share of stock? Which do you think is typically larger?

The two components are the dividend yield and the capital gains yield. For most companies, the capital gains yield is larger. This is easy to see for companies that pay no dividends. For companies that do pay dividends, the dividend yields are rarely over 5 percent and are often much less.

What happens to the future value of a perpetuity if interest rates increase? What if interest rates decrease?

This is a trick question. The future value of a perpetuity is undefined since the payments are perpetual. Finding the future value at any particular point automatically ignores all cash flows beyond that point.

What happens to a future value of an annuity if you increase the rate r? What happens to a present value?

assuming positive cash flows, the present value will fall and the future value will rise.

In the context of the dividend growth model, is it true that the growth rate in dividends and the growth rate in the price of the stock are identical?

Yes. If the dividend grows at a steady rate, so does the stock price. In other words, the dividend growth rate and the capital gains yield are the same.

Are there any circumstances under which an investor might be more concerned about the nominal return on an investment than the real return?

Yes. Some investors have obligations that are denominated in dollars; that is, they are nominal. Their primary concern is that an investment provide the needed nominal dollar amounts. Pension funds, for example, often must plan for pension payments many years in the future. If those payments are fixed in dollar terms, then it is the nominal return on an investment that is important.

As you increased the length of time involved, what happens to PV of an annuity? FV?

assuming positive cash flows, both the present and the future values will rise