Financial Management
In project analysis, a financial manager should strive to achieve two objectives when combining projects according to their risk-return characteristics?
1. Achieve the highest possible return at the given risk level, 2. Allow the lowest possible risk at a given return level.
Evaluation of projects involves the inclusion of all cash flows (both incremental and decremental) that will occur as a result of an investment. While sunken costs and accounting income are ignored, opportunity costs and benefits are included. Name 5 evaluation techniques?
1. Average accounting rate of return, 2. Payback method, 3. Net present value, 4. Internal rate of return, 5. Profitability index.
The risk adjusted discount rate is the most commonly employed method of adjusting for risk. Name 4 other risk-evaluation techniques?
1. Certainty equivalents, 2. Computer simulations, 3. Sensitivity analysis, 4. Decision trees.
Net present value rankings should always be used because:
1. Net present value is the closet measure of the actual value added to a firm, 2. Assumptions about the reinvestment rate when using the internal rate of return may skew results, 3. Certain cash flow patterns may generate multiple internal rates of return.
Common stock dividends can vary, four possible cases are:
1. No growth in dividends (valued like preferred stock) 2. Constant growth in dividends 3. Variable growth in dividends 4. A period of supernormal growth in dividends
What are the three factors that influence the required (demanded) rate of return by investors?
1. The real rate of return charged as rent for the use of the investors' funds 2. The inflation premium 3. The risk premium based on the investors' perception of risk associated with the security
Why might investors demand a lower rate of return for an investment in BCE as compared to Air Canada?
Because BCE has less risk than Air Canada, BCE has relatively high returns and a strong market position; Air Canada is improving but still has financial difficulties.
Methods using discounted cash flow techniques (NPV, IRR, and PI) provide superior decision criteria, why?
Because they consider the time value of money.
Within the capital asset pricing model:
Beta measures the volatility of an individual stock relative to a stock market index
_______ ________ ________ _________ presents some difficulties in implementation. A financial manager's awareness of these difficulties will help mitigate their effects.
Net present value analysis.
The term "risk averse" means that:
an individual will seek to avoid risk or be compensated with a higher return.
The aftertax cost of preferred stock to the issuing corporation is:
the same as the before-tax cost
What are liquidity ratios?
Liquidity ratios measure a firm's ability to meet its short-term debt obligation. The ideal liquidity ratios fall within a range. They are large enough to provide security against default of debt obligations in the coming year, and they are low enough so most of an investment is in more productive assets. Two liquidity ratios are current ratio and quick ratio.
What are long-term lenders (as users of ratios) most interested in, and for what reasons?
Long-term lenders are most interested in leverage because they are concerned with the relationship of debt to total assets. They also examine profitability to ensure that interest payments can be made.
Tax consideration are a _________ __________ in capital budgeting decisions.
Major factor.
Explain why retained earnings have an associated opportunity cost?
Retained earnings belong to the existing common shareholders. If the funds are paid out instead of reinvested, shareholders can earn a return on them. Thus, we say retaining funds for reinvestment carries an opportunity cost.
What is the appropriate discount rate for a bond?
The appropriate discount rate is the investor's required rate of return. The required rate of return is based on the risk-free rate plus an appropriate risk premium to compensate investors for the additional business and financial risk they are taking on.
List 3 features of corporate bonds that impact retirement before maturity?
Sinking-fund, call, or conversion features.
Discuss the use of the cost of capital as the discount rate in capital budgeting analysis?
The appropriate discount rate to use in capital budgeting is the weighted average cost of the capital because it evaluates projects against the cost of raising the funds to invest in the project.
Using the constant dividend growth model for common stock, if Po goes up:
The assumed cost goes down
What is the portfolio effect?
Management must consider not only the risk inherent in a given project, but also the impact of a new project on the overall risk of the firm.
Why use certainty equivalents in a capital budgeting analysis?
A discount rate combines the effects of risk and time value of money in one evaluation tool. A certainty equivalent deals with risk by converting uncertain cash flows to "certainty equivalents," and then discounts at the risk-free rate to consider the time value of money.
Why is the concept of the time value of money important to the investment decision?
A dollar invested today at compound interest will grow to have a larger value in the future. That future value, discounted at compound interest, is equated to a present value today.
What is Beta?
A measure of the volatility of returns on an individual stock relative to the market. Stocks with a beta of 1.0 are sold to have risk equal to that of the market (equal volatility). Stocks with betas greater than 1.0 have more risk than the market, while those with betas of less than 1.0 have less risk
A common stock that pays a constant dividend can be valued as if it were:
A preferred stock
What is the difference between a primary and a secondary market?
A primary market refers to the use of the financial markets to raise new funds. After securities are sold to the public, they trade in the secondary market between investors. In the secondary market, prices are continually changing as investors buy and sell securities based on the expectations of corporate prospects. A liquid secondary market promotes a successful primary market.
Explain the concept of tax savings as a "reduction of taxes otherwise payable" in terms of cash flow.
A tax-saving is the reduction of taxes otherwise payable as a result of an allowable deduction of an expense from taxable income items.
Net present value, internal rate of return, and the profitability index all yield the same...?
Accept/reject decisions for capital budgeting.
What are asset utilization ratios?
Asset utilization ratios measure how productively a firm is using its assets - both in general and with respect to specific assets. Like profitability ratios, asset utilization ratios are an indicator of return. In contrast to profitability ratios, asset utilization ratios should be within an optimal range that will maximize return and minimize risk.
What is ratio analysis aimed at measuring?
All ratio analysis is aimed at measuring risk and return - and the trade-offs between the two. Although financial analysis may not answer specific questions, it leads to further directed inquiry.
Why do we use the overall cost of capital for investment decisions even when an investment will be funded by only one source of capital (e.g. debt)?
Although an investment financed by low-cost debt might appear acceptable at first glance, the use of debt could increase the overall risk of the firm and eventually make all forms of financing more expensive. Each project must be measured against the overall cost of funds to the firm.
Why do we use the overall cost of capital for investment decisions, even when an investment will be funded by only one source of capital (e.g. debt)?
Although an investment financed by low-cost debt might appear acceptable at first glance, the use of debt could increase the overall risks of the firm and eventually make all forms of financing more expensive. Each project must be measured against the overall cost of funds to the firm.
What role does an analyst or banker play in free cash flows?
An analyst or banker normally looks at free cash flow to determine whether sufficient excess funds are available to pay back a loan associated with a leveraged buyout.
The cost of capital is used as a discount rate because:
As long as the cost of capital is earned, the common stock value of the firm will be maintained
If the investor desires less risk than the market, he or she:
Buys stocks with betas less than 1.0
Why does capital budgeting analysis relay on cash flows rather than net income effects?
Cash flow rather than net income is used in capital budgeting analysis because the primary concern is with the amount of actual dollars generated. For example, amortization is subtracted from revenue to arrive at net income, but this non-cash deduction should be added back to net income to determine the cash flow or actual dollars generated.
Explain why cash flows, rather than accounting earnings are evaluated in the capital budgeting decision?
Capital budgeting emphasizes the amounts and timing of cash flows, and opportunity costs and benefits. Capital budgeting emphasizes the fact that investment usually requires a large initial cash outflow with an expectation of future cash inflows. Capital budgeting considers only those cash flows that will change as a result of the investment on an aftertax basis.
What is capital budgeting?
Capital budgeting is the process of planning and managing a firm's long-term assets. The financial manager must try to identify opportunities that will return more wealth to a firm than they cost to acquire.
Define capital budgeting decisions as long-term investment decisions?
Capital budgeting represents a long-term investment decision, such as buying a new computer system. It involves the planning of expenditures for a project with a life of 1 or more years.
Capital cost allowance, investment tax credits, and other tax policies have _______ ________ ________ for a firm. Accounting for these policies is critical to making an investment decision.
Cash flow implications.
If three investment alternatives all have some degree of risk and different expected returns, which measure could best be used to rank the risk levels of the projects?
Coefficient of variation
When interpreting financial ratios, what do they mean collectively?
Collectively, financial ratios provide an evaluation for the firm's investors, creditors, and management. Ratios must be viewed in light of the fact that they are based on historical information and that they often are prepared on the basis of financial information from only one point in time.
The residual income of the firm belongs to:
Common shareholders
What are common-size financial statements?
Common-size financial statements are sometimes prepared to identify relative changes in the components of the financial statements.
What is the purpose of using simulation analysis?
Computers make it possible to simulate various economic and financial outcomes using a large number of variables. Simulation is one way of dealing with the uncertainty involved in forecasting the outcomes of capital budgeting projects or other types of decisions.
What does debt to assets (debt ratio) measure?
Debt ratio measures percentage of assets financed by debt.
What are debt utilization ratios?
Debt utilization ratios measure a firms ability to meet its overall debt obligations with its current earnings.
Why might an analyst set up a decision tree to help make a decision?
Decision trees help to lay out the sequence of decisions that are to be made, and provide a tabulator or graphical comparison resembling the branches of a tree, which highlights the difference between investment choices.
During conditions of capital rationing, the three methods (NPV, IRR, and PI) may yield ______________ rankings.
Different.
Why is the cost of debt less than the cost of preferred stock if both securities are priced to yield 10% in the market?
Even though debt and preferred stock may both be priced to yield 10% in the market, the cost of debt is less because the interest on debt is a tax-deductible expense. A 10% market rate of interest on debt will only cost a firm (in a 40% tax bracket) an aftertax rate of 6%. The answer is the yield multiplied by the difference (one minus the tax rate).
Discuss how finance builds on the disciplines of economics and accounting to improve decision making in a firm?
Finance builds its analytical techniques for decision making from economics and the financial data produced from accounting statements. Finance links these two disciplines and enables us to make decisions based on their synthesis.
Discuss the implications of risk and return for valuing financial assets as outlined in the capital asset pricing model?
Financial assets are valued or priced within a risk-return framework. The capital asset pricing model is a useful way to analyze the risk premium associated with securities, and holds that investors wish to be compensated for taking on additional risk. Higher risk assets will have higher required rates of return. The required rate of return is the appropriate discount rate to use when valuing financial assets.
Identify the major role/function of the financial manager?
Financial managers are involved in raising funds for a firm and in investing those funds in an efficient way. The activities of a financial manager include; working capital management, capital budgeting, and capital structure financing decisions.
Outline the role that financial markets play in the business environment?
Financial markets are the meeting places for people, corporations, or institutions that need money or have money to invest. Financial markets reflect the risk/return trade-off in that prices of securities reflect the collective judgement of the participants.
What does fixed charge coverage measure?
Fixed charge coverage applies even stricter criterion to the numerator in that it also includes all fixed obligations, like leases.
What is Financial Management?
Focuses on the financial needs of the Corporation.
Describe how a firm has an optimal capital structure based on the market of its proporation of funds raised through debt?
For publicly traded debt instruments, the yield is determined by investors in the market - it is the investor's current required rate of return. If a debt instrument is not publicly traded, its yield must be estimated by other means, including a comparison to traded instruments and a request of quotes from financial institutions.
What is free cash flow? Why is it important for leveraged buyouts?
Free cash flow is the cash flow from operating activities minus the capital expenditures required to maintain the productive capacity of the firm; and minus the dividends required to maintain the payout on common stock and to cover any preferred stock obligation.
If a corporation has projects that will earn more than the cost of capital, should it ration capital?
From a purely economic viewpoint, a firm should not ration capital. Instead, it should be able to find additional funds and increase its overall profitability and wealth through accepting investments to the point where the marginal return equals the marginal cost. In reality, capital rationing often is the result of a shortage of management talent to grow the firm, and a reluctance to approach the market too often for external funding because of the loss of control and dilution to existing shareholders.
An investment project has a positive net present value. The internal rate of return is:
Greater than the cost of capital
When evaluating two mutually exclusive acceptable capital projects, the project with the ________________ net present value is superior.
Greatest.
Explain the effect of the risk-return trade-off on the market value of common stock?
High profits alone will not necessarily lead to a high market value for common stock. To the extent that large or unnecessary risks are taken, a higher discount rate and lower valuation may be assigned to shares. Only by attempting to match the appropriate levels for risk and return can we hope to maximize our overall value in the market.
It often has been said that if a company can't earn a rate of return greater than the cost of capital, it should not make investments. Explain?
If a firm cannot earn the overall cost of financing on a given project, the investment will have a negative impact on that firm's operations and will lower the overall wealth of its shareholders. Clearly, it is undesirable to invest in a project yielding 8% if the financing cost is 10%.
What are the important administrative considerations in the capital budgeting process?
Important administrative considerations relate to the search for and discovery of investment opportunities, collection of data, evaluation of projects, and re-evaluation of prior decisions.
In computing the cost of capital, do you think we should use the historical costs of existing debt and equity or the current costs as determined in the market? Why?
In computing the cost of capital, we should use the current costs for the various sources of financing, rather than the historical costs. These current costs include both the current required rate of return for the component cost, and the current value or price in the weighting for capital structure. We must consider what these funds will cost us to finance projects in the future, rather than their past costs.
What else, besides the forecast IRR and NPV, might top management consider in making capital budgeting decisions?
In evaluating the forecast IRR and NPV, management must carefully review the assumptions that determined the timing and the amount of estimated cash flows. In addition, it must carefully consider the particular project in relation to the firm's overall business. Although the overall effects may be impossible to quantify, they may be critically important in deciding whether or not to invest.
When interpreting financial ratios, what do they mean individually?
Individually, financial ratios convey little meanings. Ratios must be viewed in light of the fact that they are based on historical information and that they often are prepared on the basis of financial information from only one point in time.
Describe the valuation of a financial asset as a function of the risk-based required rate of return?
Inherent in the valuation process is a determination of the rate of return (aka discount rate/yield to maturity) demanded by investors. The required rate of return is a composite of a real rate of return, an inflation premium, and a risk premium based on the risk of uncertainty of the future expected cash flows. Financial markets reflect the risk-return trade-off in that prices of securities reflect the collective judgement of the participants. When we have identified the rate of return required by investors, we know what it will cost the corporation to raise capital.
What does times interest earned (interest coverage) measure?
Interest coverage measures how many times we can cover our interest payment with current earnings. This is an indicator of how much sales could drop and still provide safety to pay debts.
Why does an interest expense cost a firm substantially less than the actual expense, whereas dividends cost it 100% of the outlay?
Interest expense is a tax-deductible item for a corporation, whereas dividend payments are not. The net cost of interest expense for a corporation is the amount paid multiplied by 1 minus the applicable tax rate. The firm must bear the full burden of the cost of dividend payments.
What is the justification for using market value weightings rather than book value weightings?
Investors base their expected returns on their market value investment, rather than on how much they had invested at some time in the past. The costs of financing in an efficient market are based on the market value capital structure, rather than on how the books report that structure.
Explain the traditional, U-shaped approach to the cost of capital?
It is assumed that as we initially increase the debt-to-equity mix, the cost of capital will go down. After we reach an optimal point, the increased use of debt will increase the overall cost of financing for a firm. Thus, we say the weighted average cost of capital curve is U-shaped.
In terms of the life of securities offered, what is the difference between a money market and a capital market?
Money markets are markets that deal with short-term securities that have a life of 1 year or less, whereas capital markets deal with securities with a life of more than 1 year.
Describe the risk/return trade-off decision making that financial managers always face?
Most financial management decisions involve a risk/return trade-off, which means that to gain higher returns, a financial manager often is faced with taking higher risks. The balance between risk and return influences the course of actions financial managers, corporations, and shareholders will take.
What does the term mutually exclusive investments mean?
Mutually exclusive investments means that the selection of one investment precludes the selection of other alternative investments.
In a portfolio, risk is evaluated in a different way than with an individual project. In evaluating portfolio risk, we:
Need to consider the impact of a given project on the overall risk of the firm. And recognize that a risky investment may create a portfolio with less risk. And need to consider how the returns of the projects in the portfolio are correlated.
Outline the components of the business environment in terms of the forms of organizations?
Organizations can take one of three main forms: sole proprietorship, partnership (general or limited), and corporation. Each form has advantages and disadvantages, and a financial manager evaluates the needs of an organization by choosing the form that is the best fit.
Identify other variables (ratios) besides the debt/equity ratio that influence a company's cost of capital?
Other possible ratios influencing the cost of capital might be; times interest earned and fixed charge coverage.
There are several disadvantages to the payback period, one of which is that:
Payback ignores the time value of money
Using more than one evaluation technique does not necessarily produce better results, but it may help too?
Produce a broader understanding of the problem.
The Jersey Corp. is considering four investments. Which investment provides the highest aftertax return for Jersey Corp. if the company is in the 40% tax bracket? a) Government of Canada bonds at 12.0% b) Corporate bonds at 13.2% c) Municipal bonds at 8.4% d) Preferred stock at 10.8%
Preferred stock at 10.8%
Describe how a firm has an optimal capital structure based on the market value of its proportion of funds raised through preferred stock?
Preferred stock is similar to debt in that the preferred dividend is fixed and predictable, but dissimilar in that the dividends paid are not tax deductible. Since the shares have no maturity date, the dividends are expected to be perpetual.
In a general sense, the value of any asset is the:
Present value of the expected cash flows received from the asset
When a corporation uses the financial markets to raise new funds, the sale of securities is made in the:
Primary
What are profitability ratios?
Profitability ratios allow measurement of the firm's ability to earn an adequate return on investment. Profitability ratios may be sensitive to the age of the assets employed (ie book value may not reflect market value) as well as the level of fixed costs employed. Three profitability ratios are profit margin, return on assets, return on equity.
Assuming a tax rate of 35%, amortization expenses of $400,000 will:
Reduce taxes by $140,000
If risk is to be analyzed in a qualitative way, review these examples of investment decisions (arranged from lowest to highest risk)?
Repair old machinery, New equipment, Addition to normal product line, New product in related market, Completely new market, New product in foreign market.
Replacement decisions require special attention to what cash flows are ____________ in the capital budgeting evaluation. As in all capital project evaluations, careful attention must be paid to identifying and quantifying the cash flows.
Resultant.
In the equation Kj = Rf + βj (Rm - Rf), Rf is:
Rf is the risk-free rate of interest represented by a Canadian government treasury bill
Discuss the concept of risk and how it might be measured?
Risk may be defined in terms of the variability of outcomes from a given investment. The greater the variability is, the greater the risk. Risk may be measured in terms of the coefficient of variation by which we divide the standard deviation (or measure of dispersion) by the mean. We also may measure risk in terms of beta by which we determine the volatility of returns on an individual stock relative to a stock market index.
Explain how the concept of risk can be incorporated into the capital budgeting process?
Risk may be introduced into the capital budgeting process by requiring higher returns for risky investments. One method of achieving this is to use higher discount rates for riskier investments. This risk-adjusted discount rate approach specifies different discount rates for different risk categories as measured by the coefficient of variation or some other factor. Other methods, such as the certainty equivalent approach, also may be used.
If corporate managers are risk-averse, does this mean they will not take risks?
Risk-averse corporate managers are not willing to take risks, but they require a higher return from risky investments. A premium or additional compensation must be paid for risk taking.
Debt financing by major corporations often involves the sale of ____________ ___________ or ___________ _____________?
Secured bonds or unsecured bonds (debentures).
Why must one be careful when using sensitivity analysis?
Sensitivity analysis only adjusts one variable at a time. In all likelihood, variables are interdependent, and if one changes, the others will likely change as well. Sensitivity analysis does not assess risk; it only points out possible outcomes, and we are left to assign probabilities. With today's ease of spreadsheet production on a computer, one can turn out endless analysis, which will become meaningless without a plan.
What are shareholders (as users of ratios) most interested in, and for what reasons?
Shareholders are most interested in profitability, with a secondary consideration being given to debt utilization, liquidity, and other ratios. Since shareholders are the ultimate owners of the firm, they are primarily concerned with profits or the return on their investment.
What are short-term lenders (as users of ratios) most interested in, and for what reasons?
Short-term lenders are most interested in liquidity because their concern is with the firm's ability to pay short-term obligations as they come due.
Describe how a firm attempts to find a minimum cost of capital by varying the mix of different kinds of debt and equity?
Since the interest expense paid on debt financing lowers the explicit cost of debt (because its a tax deductible expense), it is often the lowest cost source of financing available to a firm. However, caution must be exercised in the heavy use of debt because of the implicit cost of the risk premium that may result from changes in the total capital structure of the firm.
Contrast the liability provisions for a sole proprietorship, partnership, limited partnership, and corporation?
Sole proprietorship and partnership forms of ownership have unlimited liability. In a limited partnership, only the general partners have unlimited liability, whereas limited partners are obligated only to the extent of their initial contribution. Finally, all shareholders in a corporation have limited liability, although owner/shareholders of small businesses often are required to provide personal guarantees to banks.
The coefficient of variation (V) can be defined as the:
Standard deviation divided by the mean (expected value)
What is the DuPont system of analysis? And what is its major feature?
The Dupont system of analysis is a specialized profitability ratio. A major feature of the DuPont system is that it helps us identify the source of our return, whether from profit margins (return on sales) or from efficient employment of assets (asset turnover). A firm can generate an adequate return overall from a combination of these factors, so we should not look at profit margin or asset turnover in isolation.
During cyclical downturns in the economy, corporations may consider refunding and reissuing their bonds. This is a capital budgeting decision for which the financial manager must assess the net present value of the refunding proposal. What is the appropriate discount rate?
The appropriate discount rate is the aftertax cost of debt.
What is the difference between a bond agreement and a bond indenture?
The bond agreement covers a limited number of items, whereas the bond indenture is a supplement that often contains over 100 pages of complicated legal wording, and specifies every minute detail concerning the bond issue. The bond indenture covers such topics as pledged collateral, methods of repayment, restrictions on the corporation, and procedures for initiating claims against the corporation.
What are some basic features of bond agreements?
The bond agreement specifies such basic items as the par value, coupon rate, and maturity date.
How does the capital asset pricing model help to explain different prices for the same expected future benefits?
The capital asset pricing model explains the relationship between risk and return and the relationship of the price adjustment of capital assets to changes in risk and return. Since the value or price of a financial asset is the present value of all future expected returns - evaluated at a discount rate of the investors' required rate of return - the higher the required rate of return is, the lower the expected price of the security. As investors' react to their economic environment and their willingness to take risk, they change the prices of financial assets like common stock, bonds, and preferred stock. The higher the risk, the higher the required rate of return is, and thus, the lower the price of the stock.
Generally, what effect does the capital cost allowance system have on the timing of CCA tax shield benefits?
The capital cost allowance system generally makes CCA tax shields available earlier than would a straight-line system tied to an economic life of an asset. In terms of our net present value analysis, this is an incentive to invest since earlier cash flows are discounted less than later cash flows.
What is the challenge of solving a time-value-of-money problem?
The challenge in solving a time-value-of-money problem is to get all cash flows to the same date, so they can be compared for decision-making purposes.
Outline the impact of corporate tax considerations on the aftertax cost and cash flow of the firm?
The corporate tax structure and the tax implications of interest, location, type of business, and amortization affect finance decisions. The aftertax cost and cash-flow implications of these items are important to your study of finance.
How does the cost of a source of capital relate to the valuation concepts presented earlier in this course?
The cost of a source of financing directly relates to the required rate of return for that means of financing. Of course, the required rate of return is used to establish valuation.
Define the cost of capital as the discount rate normally used to analyze an investment. It is an evaluation tool.
The cost of capital is the standard against which all potential capital projects must be evaluated so to maximize shareholder wealth. It is an evaluation tool. A firm's required rate of return (its cost of capital) is determined in the market by the required rate of return for each source of capital, and depends on the market's perceived level of risk. The investors' required rate of return becomes the firm's cost of capital.
Describe how a firm has an optimal capital structure based on market value of its proportion of funds raised through common equity?
The cost of common equity is based on a constant dividend and the dividend valuation model. The model may be adapted for constant growth or supernormal growth and is based on the present value of a perpetuity. The cost of retained earnings is the cost of equity without the consideration of flotation costs.
What discount rate should be used in evaluating capital projects?
The discount rate used in evaluating capital projects should be the weighted average cost of capital. If the cost of capital is earned on all projects, shareholders will receive their required rate of return, and their wealth will be maximized.
Identify the interrelationships and limitations of accounting statements (income statement/balance sheet)?
The financial manager must be thoroughly familiar with the language of accounting to administer the financial affairs of the firm, and to prepare and interpret an income statement and balance sheet. The income statement provides a measure of the firm's profitability over a specified time period. Earnings per share represent the residual income available to the common shareholder that may be paid out in the form of dividends or reinvested to generate future profits and dividends. A limitation of the income statement is that it reports income and expenses primarily on a transaction basis, and thus may not recognize certain important economic changes as they occur. The balance sheet is a snapshot of the financial position of the firm at a point in time, with the shareholders' equity section claiming to represent ownership interest. Since the balance sheet is presented on a historical cost basis, it may not represent the true value of the firm.
Explain the concept of the time value of money?
The financial manager used the time value of money approach to value cash flows that occur at different points in time.
Although debt financing is usually the cheapest component of capital, it cannot be used in excess because:
The financial risk of the firm may increase and thus drive up the cost of all sources of financing
Assume a firm has several hundred possible investments and wants to analyze the risk-return trade-off for portfolios of 20 projects. How should this firm proceed with an evaluation?
The firm should attempt to construct a chart showing the risk-return characteristics for every possible set of 20. The firm can determine the best risk-return trade-offs or efficient frontier. Then, it can decide where it wants to be along this line.
Explain how the cost of capital represents the overall cost of financing for a firm?
The firm's overall cost of raising funds to invest is its cost of capital. The cost of capital is a composite rate of return based on individual costs and funds (through debt or equity) and the proportion in which it is employed.
Discuss the relationship between the coupon rate (original interest rate at time of issue) on a bond and its security provisions?
The greater the security provisions afforded to a given class of bondholders, the lower the coupon rate.
What is the investment tax credit? How does it affect the capital budgeting decision?
The investment tax credit represents direct dollar givebacks of a portion of an asset's capital cost, regardless of whether or not the firm is taxable. It reduces the amount of capital the firm has to invest in a project. It also reduces the amount of UCC in subsequent years, which in turn reduces the true CCA tax shield. To avoid double counting the investment tax credit (once as the credit itself and once in the CCA tax shield), we must employ the CCA tax shield formula against the amount of the investment tax credit - in effect, we claw back those savings that we claimed in the CCA tax shield calculation.
What is a net present value profile? What three point (characteristics) should be determined to create this profile?
The net present value profile enables a graphic portrayal of the net present value of a project at different discount rates. Net present values are shown along the vertical axis, and discount rates along the horizontal axis. The points that must be determined to graph the profile are the: 1. Net present value at zero discount rate, 2. Net present value as determined by a normal discount rate, 3. Internal rate of return for the investment.
What is the optimal capital structure (mix of debt and equity)?
The optimal capital structure (mix of debt and equity) is the mix that minimizes a firm's cost of capital.
The formula PV of the CCA tax shield calculates?
The present value of all the future tax savings of an investment.
Describe the primary goal of a firm?
The primary goal of a firm is the maximization of shareholder wealth, as measured by share price or "going concern" price. This measure is more satisfactory than profit maximization because it incorporates the risk and timing of cash flows, and because share value is objectively determined in the market place.
What is the most commonly employed method of adjusting for risk?
The risk-adjusted discount rate is the most commonly employed method of adjusting for risk. We use this method to adjust the discount rate based on the perceived risk level.
When is the coefficient of variation a better measure of risk than the standard deviation?
The standard deviation is an absolute measure of dispersion, whereas the coefficient of variation is a relative measure that allows us to relate the standard deviation to the mean. The coefficient of variation is a better measure of dispersion when we wish to consider the relative size of the standard deviation or compare two or more investments of different sizes.
Explain the importance of cash flows in making financial decisions?
The statement of changes in cash flow emphasizes the critical nature of cash flow to the operations of the firm. The three primary sections of the statement are cash flows from; operating activities, investing activities, and financing activities. An analysis of cash flow examines the sources and uses of funds to evaluate the firm's solvency, liquidity, and financial flexibility.
How is the valuation of any financial asset related to future cash flows?
The valuation of a financial asset is equal to the present value of future cash flows.
How is the valuation of financial assets by investors related to the cost of financing (or the cost of capital) for a firm?
The valuation of financial assets is based on the required rate of return to security holders. This, in turn, becomes the cost of financing (capital) for the corporation.
What is the value of a bond derived from?
The value of a bond is derived from the present value of the periodic interest payments plus the present value of the prepayment of principal.
What is the value of common stock?
The value of common stock is the present value of a stream of future benefits. In the dividend valuation model, the benefits are represented by dividends. Common stock dividends can vary, unlike preferred stock dividends.
What is the weighted average cost of capital?
The weighted average cost of capital is the rate that reflects a firm's overall cost of raising funds, based on the market value of its current capital structure, which is presumed to be within the optimal range.
How are the weights determined to arrive at the optimal weighted average cost of capital?
The weights are determined by examining the market value of a firm based on its existing capital structure. The market value of a component divided by the total market value of a firm determines the weighting of that component. All of this presumes that the firm has established its optimal capital structure as that capital structure that represents its minimum cost of capital, and will, therefore, maintain its existing capital structure.
What is the appropriate yield/rate of return for a bond?
The yield or required rate of return may vary as the marketplace and expectations change. The coupon rate, which determines periodic interest payments, remains the same for the life of the bond.
Identify the major goals of the financial manager
To increase the wealth of the organization's owners or shareholders. The maximization of this wealth is achieved by obtaining the highest possible market price for the organization's shares.
What does trend analysis consist of?
Trend analysis consists of computing the financial ratios of a firm at various points in time to determine whether the firm is improving or deteriorating.
Why is trend analysis helpful for analyzing ratios?
Trend analysis enables us to compare the present with the past and evaluate our progress through time. A profit margin of 5% may be particularly impressive if it has been running at only 3% in the last 10 years. Trend analysis must also be compared to industry patterns of change.
Describe the valuation of a financial asset as a function of the present value of future cash flows?
Valuation is based on the concept of determining the present value of the future cash flows.
Explain the use of financial ratio analysis to evaluate company performance?
We use financial ratio analysis to help us evaluate a firm's financial performance. Ratios are calculated using an income statement and balance sheet, and divide one value by another related value. The relationship between these values provides the information the financial manager needs. Ratios, trends, and other calculations are used to interpret and compare the financial performance of a company to its industry and to its past results.
When calculating the market value of a firm and its financing components, what is the weighting based on?
When calculating the market value of a firm and its financing components, the weighting must be based on the current market value of the components. This is achieved by taking the present value of all future expected benefits at the required rate of return. For a bond, this is most often achieved by calculating it market value. In equity situations when a security trades in a capital market, this is easily achieved by multiplying the market price by the number of outstanding shares.
Bond prices and _________ are inversely related, and based on the level of interest rates and bond ratings.
Yields.
Which of the following is an outflow of cash? a) Profitable operations b) Sale of Equipment c) Sale of company's common stock d) Payment of cash dividends
d) Payment of cash dividends
The profitability index will give the same investment decision as:
the net present value
