Principles of Finance Exam #2

Average Inventory

-Average Inventory=(EOQ/2)+Safety Stock OR -Average Inventory=(Max Inventory-Minimum Inventory)/2

Ordering Cost

-Ordering Costs include the cost to order inventory and processing inventory into stock. -# of orders=(# Unites to be ordered)/(# Units in each order). -If we maintain low inventory on hand, we will have to place more orders which will thus increase the ordering costs.

Compensating Balance

-A bank requirement that business customers maintain a minimum average balance. The required amount is usually computed as a % of customer loans outstanding or as a % of the future loans to which the bank has committed itself. -Because a minimum balance is required, you must actually borrow a greater amount of money in order to actually have use of the desired amount of funds. -Amount to be Borrowed=(Amount Needed)/(1-C) Where C is the Compensating Balance expressed as a Decimal. -Effective Rate with Compensating Balances=[($ Interest on total amount borrowed including minimum balance)/(Principal-Compensating Balance in Dollars)] x [(360 days)/(Days loan is outstanding)]

Zero-Coupon Bond

-A bond that is initially sold at a deep discount from face value. The return to the investor is the difference between the investor's cost and the face value received at the end of the life of the bond. -A Zero-Coupon Bond is a bond which makes NO annual interest payments.

Trust Receipts

-An instrument acknowledging that the borrower holds the inventory and proceeds for sale in trust for the lender. -The bank or finance company gives you a loan while you tag or identify what inventory will be used as collateral. The inventory is still physically held by the borrower, but inventory is still used as collateral for the loan.

Installment Loan

-A borrowing arrangement in which a series of equal payments are used to pay off a loan with the entire amount of interest paid at the end of the loan. -Ex. If you borrow $1,000 for 1 year at 6% interest on an installment loan, you will be paying back $1,000/12 each month as well as $60 at the end of the year-->Although you are paying $60 interest at the end, you do NOT have the use of $1,000 throughout the year which means you have an average outstanding loan balance of about $500 throughout the period of the loan. This means that you are paying $60 interest on less than $1,000 which means the effective rate is far above 6%. -Effective Rate on Installment Loan=[(2)(Annual # of payments)($Interest)]/[(Total # of payments + 1)(Principal)]

Cash Discount

-A cash discount allows a reduction in price if payment is made within a specified time period. -Ex. If we have terms of 2/10 net 30, we can deduct 2% off the price if we pay within 10 days. If the bill was $100, if we pay in 10 days we only have to pay $98. -If we DONT take the discount and pay in 30 days instead, we get to use $98 for 20 extra days at a $2 fee. The cost of failing to take a cash discount can be calculated by a specific formula. -In this case, the cost of failing to take the discount would be 36.72%. -In considering the cost of borrowing the $98 for another 20 days, we must ask ourselves whether bypassing the discount and using the money for a longer period of time is the cheapest means of financing-->For example, if we can find a $98 loan for 20 days at some lesser rate, say at 10%, we would be better off borrowing at this rate and paying $0.54 ((20 days/360 days)x(10%)x($98)=$0.54) in interest as opposed to $2 (which means we would be better off paying our bill in 10 days as opposed to 30).

Preferred Stock

-A fixed-income security like a Bond-->Pays the same dividend each year to Preferred Stock Holders. -Unlike a Bond, however, Preferred Stock NEVER matures (so you never get your principal payment back)-->Preferred Stock in this sense is a PERPETUITY.

Collateral Loan

-A loan in which an asset such as Accounts Receivable or Inventory is put up as a security against default on a short-term loan by the borrower. -Collateralized loans (secure loans) are more expensive than non-collateralized loans (non-secure loans) b/c only companies who are unable to gain access to a non-secure loan offer up short-term assets as collateral.

Discounted Loan

-A loan in which the calculated interest payment is subtracted, or discounted, in advance. Because this lowers the amount of available funds, the effective interest rate is increased. -Effective Rate on Discounted Loan=[($ Interest)/(Principal-Interest)] x [(360 days)/(Days loan is outstanding)]

Annuity Due

-A payment stream with payments that occur at the beginning of each year.

Ordinary Annuity

-A payment stream with payments that occur at the end of each year.

Components of Required Rate of Return/Yield to Maturity: Risk Premium

-A premium associated with the special risks of an investment. Of primary interest are 2 types of risk. 1) Business Risk: Relates to the inability of the firm to maintain its competitive position and sustain stability and growth in earnings. 2) Financial Risk: Relates to the inability of the firm to meet its debt obligations as they come due. The Risk Premium differs for different types of investments.

Blanket Lien

-A secured borrowing arrangement in which the lender has a general claim against the inventory of the borrower. -In this agreement, the borrower has complete control over inventory. -ALL of the inventory of a firm is collateral in this case even if the value of the inventory is MORE than the value of the loan.

Market Segmentation Theory

-A theory which describes the shape of the Yield Curve. -Theorizes that Treasury securities are divided into market segments by the various financial institutions investing in the market. -->Commercial banks prefer short-term securities (1 year or less) to match their short-term lending strategies. -->Savings and loans and mortgage-oriented institutions prefer intermediate length securities (5-7 years). -->Pension funds and life insurance firms prefer long-term securities (20-30 years) to match their long-term commitments to customers.

Liquidity Premium Theory

-A theory which describes the shape of the Yield Curve. -Theorizes that long-term interest rates should be higher than short-term interest rates because short-term securities have greater liquidity, so higher rates must be offered to long-term bond buyers to entice them to hold these less liquid and more price-sensitive securities.

Expectations Hypothesis

-A theory which describes the shape of the Yield Curve. -Theorizes that long-term rates reflect the average of short-term expected interest rates over the time period that the long-term security is outstanding. -->When long-term rates are much higher than short-term rates, the Expectations Hypothesis says that the market is saying it expects short-term rates to rise. -->When long-term rates are lower than short-term rates, the Expectations Hypothesis says that the market is expecting short-term rates to fall.

Accounts Payable and Net Trade Credit

-Accounts Payable is the MOST important source of short-term financing, especially for small businesses (Trade-Credit). -Small companies tend to have NEGATIVE Net Trade Credit (Their Accounts Payable > Accounts Receivable). -Large companies tend to have POSITIVE Net Trade Credit (Their Accounts Payable < Accounts Receivable).

Accounts Receivable Balance

-Accounts Receivable Balance=(Daily Credit Sales)(Collection Period in Days) -Ex. If a firm makes on average $5,000 in credit sales every day and collects payment in 30 days, the Accounts Receivable Balance over that time period is (5,000)(30)=$150,000.

Accounts Receivable Equation

-Accounts Receivable=(Sales)/(Receivable Turnover Ratio) -The dollar amount of a Accounts Receivable for a given increase in sales tells us the investment we have to make in order to attain this new level of sales. -Ex. If we find that by increasing sales by $10,000 that we will gain $500 in Annual Incremental Sales after Tax, and we have an Receivables Turnover Ratio of 6 to 1: ($10,000)/(6)=$1,667 will be our average Accounts Receivable Balance. This means we only need to invest $1,667 (through extra financing) to gain $500 in Annual Incremental Sales After Tax. This means that the return on this investment is $500/$1,667=30%.

Spontaneous Changes as a result of Increased Sales

-As sales increase, Accounts Receivable will spontaneously increase whereas Inventory will spontaneously decrease.

Carrying Cost

-Carrying Cost=(Average Inventory in Units)(Carrying Cost per Unit) -Carrying costs include the cost per unit to store and secure inventory, as well as interest on funds tied up in inventory etc... -The larger the order a firm places, the greater the average inventory we will have on hand, and thus the higher the Carrying Cost.

Marketable Securities: CD's and Negotiable CD's

-Certificates of Deposit are certificates which are offered by banks, savings and loans, and other financial institutions for the deposit of funds at a given interest rate over a specified time period. CD's are normally intended to be held until maturity.

Marketable Securities: Commercial Paper

-Commercial Paper are unsecured promissory notes issued to the public by large business corporations. These notes are comparable in yield and quality to large CD's. -Major source of financing for many large corporations and even finance firms. Used largely by corporations for short-term loans. -Advantages: 1) Interest Rates on Commercial Paper for loans of under a year are sometimes lower than the Prime Rate. 2) Commercial Paper issuances have no Compensating Balance requirements. -Drawbacks: 1) Recessions, corporate bankruptcies, major corporate fraud, and other events cause lenders in the Commercial Paper market to become risk-averse. 2) Only the most prestigious and credit-worthy companies can access the Commercial Paper market. Companies who have had their credit-ratings downgraded can no longer sell their commercial paper and are forced to draw down more expensive lines of credit. 3) The Commercial Paper market is impersonal. If you can't pay back the loan, because a relationship doesn't exist as in bank loans, no exceptions are made for being late on payment.

Valuing a Bond

-Composed of 2 calculations: 1) PV of an Annuity calculation to determine Interest Received per Year-->PVa=(Interest in dollars based on the printed rate on the bond)(Interest Factor using the length of the bond and the Market Interest Rate NOT the printed rate) 2) PV calculation of the Principal received at maturity-->PV=(Principal which is typically $1000)(Interest Factor using the length of the bond and the Market Interest Rate NOT the printed rate). -The sum of the 2 calculations is the price of the bond on the open market!

Cost of Failing to Take a Cash Discount

-Cost of Failing to Take a Cash Discount=[(Discount %)/(100%-Discount %)] x [(360)/(Total amount of days to pay full amount - Discount Period)] -Ex. On a 2/10 n/30, the cost of failing to take a cash discount is: [(2%)/(100%-2%)] x [(360)/(30 days - 10 days)] x [360 days/20 days]

Permanent Current Assets

-Current Assets that will not be reduced or converted to cash within the normal operating cycle of the firm. -The minimum amount of current assets a company needs to continue operations. Permanent current assets are current assets that are always replaced with like assets within one year.

Dividend-Yield Ratio

-Dividend Yield=(Dividend Payment per share)/(Price of a Share of Common Stock). -Dividend Yield indicates the percentage return that a stockholder will receive on dividends alone.

Economic Ordering Quantity (EOQ)

-EOQ=(2SO/C)^(1/2) Where S=Total Sales in Units; O=Ordering Cost for each order; C=Carrying Cost per unit in dollars. -The Economic Ordering Quantity is the most advantageous amount for a firm to order each time it places an order for inventory. -EOQ does NOT minimize ordering or carrying costs, but rather finds an optimal combination of the two costs to minimize overall inventory costs.

Future Value of a Lump Sum Equation

-FV=PV(IF) -A future value problem is one where you know how much you will invest today, but you want to figure out how much your investment will grow to in n years.

Future Value of an Annuity

-FVa=A(IF) -A future value problem is one where you know how much you will invest today, but you want to figure out how much your investment will grow to in n years.

Semiannual Compounding and Quarterly Compounding

-For Semi-Annual Compounding, we DIVIDE the Annual Interest Rate by 2 and MULTIPLY the time period by 2. -For Quarterly Compounding, we DIVIDE the Annual Interest Rate by 4 and MULTIPLY the time period by 4.

Bond valuation and changes in interest rates

-If the interest rates in the economy rise, the value of outstanding bonds will decrease. -If the interest rates in the economy fall, the value of outstanding bonds will increase.

Just-In-Time-Inventory Management

-Just-in-Time Inventory has 3 basic requirements: 1) Quality Production that continually satisfies customer requirements. 2) Close ties between suppliers, manufacturers, and customers. 3) Minimization of the level of inventory. -Benefits of JIT: 1) Cost savings from having to hold less inventory on hand and a resulting decrease in financing costs. 2) May reduce costs such as for overhead, construction of warehouses etc...-->Less physical space is needed by firms employing JIT. -Drawbacks of JIT: 1) Creates massive inefficiencies when sales increase much more rapidly than predicted causing massive shortages in inventory down the supply chain. 2) Vulnerability to the environment if suppliers are affected by a natural disaster-->Firms supplied by them won't have enough inventory to carry on while the suppliers are unable to send new inventory to the firm as a result of a natural disaster.

Marketable Securities

-Marketable Securities are a very important Current Asset held by corporations. They serve as a place to invest excess cash in the short-term in particular. -The key goals of corporations investing in short-term marketable securities are to 1) Have a high level of security (invest in very low-risk securities) 2) Have a high level of liquidity (in the case where the excess cash is suddenly needed in the short-term). -Common low-risk securities in which corporations invest: 1) CD's and Negotiable CD's 2) Money Market Accounts and Money Market Mutual Funds 3) Treasury Bills 4) Commercial Paper -Excess cash should NEVER be invested in: 1) Stocks-->Far too risky and volatile 2) Treasury Bonds-->Last too long (30 years) 3) Treasury Notes-->Last too long (5 years)

Marketable Securities: Money Market Accounts and Money Market Mutual Funds

-Money Market Account: Accounts at banks, savings and loans, and credit unions in which the depositor receives competitive money market rates on a typical minimum deposit of $1000. These accounts may generally have 3 deposits and 3 withdrawals per month and are not meant to be transaction accounts, but a place to keep minimum and excess cash balances. The interest rates offered in such accounts are generally higher than those in Savings Accounts which makes the attractive for companies to place excess cash into.

Calculating the Value of Preferred Stock

-P=(D/K) Where P=Price of Preferred Stock; D=Yearly Dividend Payment; K=Required Rate of Return -As the Required Rate of return increases, the price of Preferred increases (just like with bonds, due to the fact that interest rates largely determine the Required Rate of Return). -This formula, P=(D/K) can be used to determine Price of Preferred Stock, the yearly Dividend Payment of preferred stock, or the Required Rate of Return.

Calculating the Value of Common Stock

-P=(D1)/(K-g) Where P=Price of Common Stock; D1=Expected Dividend Payment; K=Required Rate of Return; g=Expected growth in dividend payment. -This method assumes a CONSTANT growth model of dividend payments (which is simply not accurate for most companies as most companies tend to keep dividend payments the same for many years in a row). -This formula, P=(D1)/(K-g), can be used to determine the Price, Expected Dividend, Required Rate of Return, or expected growth of dividend payments.

Present Value of a Lump Sum Equation

-PV=FV(IF) -A present value problem is one in which we know (or can estimate) the amount of money that will come to us in the future, but wish to know how much we should spend to get it--at some desired interest rate.

Present Value of an Annuity

-PVa=A(IF) -A present value problem is one in which we know (or can estimate) the amount of money that will come to us in the future, but wish to know how much we should spend to get it--at some desired interest rate.

Asset-Backed Securities

-Public Offerings backed by Receivables as collateral. Essentially, a firm factors (sells) its receivables in the securities market. -Advantages: 1) Interest paid to the owners of these securities is not taxable by the Federal Government-->Allows some firms to raise cash at below market-rates. 2) Lower costs for acquiring funds even for low credit score companies (because the securities are backed by assets). -Drawbacks: 1) Uncertainty of receivables being paid to the issuing firm in the first place (as there is usually an allowance for bad debt when firms extend credit to their suppliers)-->Disadvantage for buyers of these securities.

Safety Stock

-Safety Stock Inventory is extra inventory held by a firm in order to protect against the rick of a "stockout" which occurs when a firm is out of a specific item and is unable to sell or deliver the product.

Factoring

-Selling Accounts Receivable to a finance company or a bank. -A business sells its accounts receivable to a third party (called a factor) at a discount. A business will sometimes factor its receivable assets to meet its present and immediate cash needs.

Marketable Securities: Treasury Bills

-T-Bills are the lowest risk security on the market.

Credit Policy Administration: Credit Standards and the 5 C's of Credit

-The 5 C's of Credit are the principle guidelines to consider when deciding who to consider credit to or not. 1) Character 2) Capital 3) Capacity 4) Conditions 5) Collateral

Required Rate of Return

-The rate of return that investors demand from an investment to compensate them for the amount of risk involved in holding the bond.

Credit Policy Administration: Terms of Trade

-The repayment provisions that are part of a credit arrangement. An example would be a 2/10, net 30 arrangement in which the customer may deduct 2% from the invoice price if payment takes place in the first 10 days. Otherwise the full amount is due. -The longer the credit terms a company may extend to its customers, the greater the average accounts receivable balance will be at any given time. This higher balance will require a larger amount of additional financing to support the company as it waits to collect its Accounts Receivable. -"For example, if we allow our customers 5 extra days to clear their accounts, our accounts receivable balance will increase--draining funds from marketable securities and perhaps drawing down the inventory level. We must ask whether we are optimizing our return, in light of appropriate risk and liquidity considerations."

Yield to Maturity/Market Rate of Interest/Discount Rate

-The required rate of return on a bond issue. It is the discount rate used in present-valuing future interest payments and the principal payment at maturity.

Lead Time

-The time between when a company places an inventory order and the time when it actually arrives. -Businesses must make inventory orders with adequate Lead Time in order to ensure they never "Stock Out." -Businesses must have enough inventory on hand to cover for lead time as well as for fluctuations in lead time.

Pledging Accounts Receivable

-Using Accounts Receivable as collateral for a loan. The firm usually may borrow 60-80% of the value of acceptable collateral.

Long-Term Financing (Conservative Approach)

-Using long-term sources of financing to finance Fixed Assets, Permanent Current Assets, and a portion of Temporary Current Assets (the rest of which is financed by short term financing) is a more conservative approach to financing. -Firms using this model of financing tend to have higher Current Ratios than they would otherwise. -This approach to financing is safer, but less profitable (as long-term loans have higher interest rates than short-term loans)

Short-Term Financing (Riskier Approach)

-Using short-term sources of financing to finance Temporary Current Assets and a portion of Permanent Current Assets (the rest of which is financed by long-term financing) is a riskier approach to financing. -Firms using this model of financing tend to have lower Current Ratios than they would otherwise. -This approach to financing is riskier, but more profitable (as short-term loans have lower interest rates than long-term loans)

Warehousing

-When the banker or financier gives you a loan, but inventory held as collateral is specifically identified, segregated, and stored under the direction of an independent warehousing company. -In this agreement, the loaning agent holds complete control over the inventory.

Yield Curves (Upward and Downward Sloping)

-Yield Curves plot Interest Rates (%) on the vertical axis and Time Period of the loan on the horizontal axis. -Normal Yield curves are upward sloping (Because long-term loans tend to have higher interest rates than short-term loans). -Inverted Yield curves also exist especially in times of drastic inflation (short-term loans have higher interest rates because there is the expectation that eventually inflation will stop and interest rates will fall once again in the future). -Yield Curves change daily to reflect current competitive conditions in the money and capital markets, expected inflation, and changes in economic conditions.

U.S. Government Securities

1) T-Bills 2) Treasury Notes 3) Treasury Bonds -These securities are all very low risk but are NOT risk-free! -->No Default Risk. -->Interest Rate Risk does exist, however. If interest rates rise , the value of T-Bonds and Notes plunges (the longer the life of the security, the more dramatic the price fluctuation if interest rates change).

Components of Required Rate of Return/Yield to Maturity: Inflation Premium

A premium to compensate the investor for the eroding effect of inflation on the value of the dollar.

London Interbank Offered Rate (LIBOR)

An interbank rate applicable for large deposits in the London market. It is a benchmark rate, just like the Prime Rate in the U.S.. Interest rates on Eurodollar loans are determined by adding premiums to this basic rate. Most often, LIBOR is lower than the U.S. Prime Rate.

Approximate Yield to Maturity (on a Bond) Equation

Approximate Yield to Maturity=[(Annual Interest Payment)+((Principal Payment-Price of the Bond)/(# of Years to Maturity))]/[(0.6)(Price of the Bond)+(0.4)(Principal Payment)]

Credit Policy Administration: Collection Policy

Assessing the Collection Policy of a firm and whether or not it is benefitting or harming the firm may depend on multiple factors and the analysis of quantitative measures such as: 1) Average Collection Period= (Accounts Receivable)/(Average Daily Credit Sales) -Ex. An increase in the Average Collection Period may be the result of a predetermined plan to expand credit terms or the consequenc of poor credit administration. 2) Ratio of Bad Debts to Credit Sales -Ex. An increasing ratio may indicate too many weak accounts or an aggressive market expansion policy 3) Aging of Accounts Receivable -Ex. If there is a buildup in receivables beyond normal credit terms, cash inflows will suffer and more stringent credit terms and collection procedures may have to be implemented.

Temporary Current Assets

Current Assets that will be reduced or converted to cash within the normal operating cycle of the firm.

Future Value of an Annuity for an Annuity Due*****

FVa=A(IF) But we ADD 1 Extra compounding period and SUBTRACT 1 from the Interest Factor

Effective Interest Rate Equation

General Effective Interest Rate=($Interest/Principal) x (360 Days/Days loan is outstanding)

Interest Rate Risk

Interest rate risk affects the value of bonds more directly than stocks, and it is a major risk to all bondholders. As interest rates rise, bond prices fall and vice versa. The rationale is that as interest rates increase, the opportunity cost of holding a bond decreases since investors are able to realize greater yields by switching to other investments that reflect the higher interest rate. For example, a 5% bond is worth more if interest rates decrease since the bondholder receives a fixed rate of return relative to the market, which is offering a lower rate of return as a result of the decrease in rates.

General Equation for Determining Interest Rates

K=RF+Risk Premium Where K=Interest Rate; RF=Risk-Free Interest Rate (Composed of the Real Interest Rate + The Expected Rate of Inflation over the term of the loan); Risk Premium=Extra interest added based on the risk taken in lending to a firm given their financial situation.

Present Value of an Annuity for an Annuity Due*****

PVa=A(IF) But we ADD 1 Extra compounding period and ADD 1 to the Interest Factor

Simple Interest Equation

Simple Interest=P (Principle) x R (Rate) x T (Time). -Ex. Simple Interest= ($10,000)(0.12)(90 days/360 days)= $300

Float

The difference between the corporation's recorded cash balance on its books and the amount credited to the corporation by the bank. This is often caused by the delay between the time a firm sends a check to the bank and the time when the bank clears the check and credits the account of the corporation.

Prime Rate

The rate a bank charges its most creditworthy customers. As a benchmark rate, interest rates on loans are typically stated in comparative terms to the Prime Rate (such as 5 % above the Prime Rate, for example).

Components of Required Rate of Return/Yield to Maturity: Real Rate of Return

The rate of return the investor demands for giving up the current use of the funds on a non-inflation adjusted basis.