Finance 3113 - Exam 3

How do you calculate the arithmetic mean or average?

(Σ ri) / N Sum of all observations divided by total number of observations

How do you calculate the population and sample standard deviation and variance assuming equal weights? Historical data?

1. Find the mean 2. Find the squared differences from the mean 3. Find the average of all the squared differences 4. The value from (3) is the variance 5. The square root of this is the standard deviation σ = √((Σ ([ri - mean]^2)) / N)

What is a current asset? List the four main current assets?

A balance sheet account that represents the value of all assets that are reasonably expected to be converted into cash within one year in the normal course of business. Current assets include (1) cash, (2) accounts receivable, (3) inventory, and (4) marketable securities.

What is a zero-balance account and what is it designed to accomplish?

A checking account in which a balance of zero is maintained by automatically transferring funds from a master account in an amount only large enough to cover checks presented. They (1) achieve better control over cash payments, (2) reduce excess cash balances held in regional banks, and (3) possibly increase disbursing float.

What is the contribution margin?

A cost accounting concept that allows a company to determine the profitability of individual products. It is calculated as follows: CM = Product revenue - Product variable costs

Describe a cost-benefit analysis in evaluating a decision with respect to accounts receivable.

A cost-benefit analysis must be performed to determine whether a change should be made. Factors that will influence the decision are: changes in sales, sales discounts, accounts receivable average balance, bad debt expense, and collection expense. By evaluating the terms themselves, the firm can determine if cash discounts will be taken.

Revolving credit agreement

A line of credit where the customer pays a commitment fee and is then allowed to use the funds when they are needed. It is usually used for operating purposes, fluctuating each month depending on the customer's current cash flow needs.

What is net working capital (NWC)?

A measure of both a company's efficiency and its short-term financial health. The working capital is calculated as: NWC = current assets - current liabilities

What is the coefficient of variation, how is it used, and how is it calculated?

A measure of risk per unit of expected return. It compares the amount of variation in expected returns with the amount of the expected return. The higher the coefficient of variation, the riskier the investment is. CV = standard deviation / mean

What is the Capital Asset Pricing Model and how can it be used?

A model that describes the relationship between risk and expected return and that is used in the pricing of risky securities. The CAPM shows that the expected return for a particular asset depends on three things: 1. The pure time value of money: As measured by the risk-free rate, Rf, this is the reward for merely waiting for your money, without taking any risk. 2. The reward for bearing systematic risk: As measured by the market risk premium, E(RM) − Rf, this component is the reward the market offers for bearing an average amount of systematic risk in addition to waiting. 3. The amount of systematic risk: As measured by βi, this is the amount of systematic risk present in a particular asset or portfolio, relative to that in an average asset.

What is the reward-to-risk ratio?

A ratio used by many investors to compare the expected returns of an investment to the amount of risk undertaken to capture these returns. Slope = (E(RA) - Rf) / (βA - 0)

Describe and explain the correlation coefficient.

A statistical index of the relationship between two things (from -1 to +1). Positive - variables have direct correlation and rise/fall together Negative - variables are inversely related

What is commercial paper? What is the significance of a maturity of 270 days or less?

An unsecured, short-term debt instrument issued by a corporation, typically for the financing of accounts receivable, inventories and meeting short-term liabilities. The debt is usually issued at a discount, reflecting prevailing market interest rates. It is exempt from SEC registration if its maturity does not exceed 270 days.

Describe a field warehouse arrangement and a terminal warehouse arrangement.

Field warehouse arrangement: A financing arrangement in which company segregates a portion of a borrower's warehouse area with a fence. All inventory within the fence is collateral for a loan from the finance company to the borrower. Terminal warehouse agreement: The collateral is being stored within an approved facility.

What are the two costs of holding cash?

Fixed costs: A transaction costs of obtaining cash to replenish the checking account. Cash can be obtained in one of two ways: obtaining a short-term loan at the bank or selling marketable securities. Variable costs: The opportunity costs of holding cash balances. The more cash held, the more interest foregone from not investing.

Floating or blanket lien

Floating lien: A legal claim placed on a set of assets rather than on a single asset. A floating lien is used when the smaller components of the general asset can change over time, such as in the case of the outstanding balances in a company's accounts receivable.

What is the rate of return on the market?

In equilibrium, all assets and portfolios must have the same reward-to-risk ratio, and they all must equal the reward-to-risk ratio for the market. E (RA) - Rf = E (RM - Rf) _________ _________ βA βM

What are the two current assets most commonly used as collateral for a secured loan?

Inventory and accounts receivable

Use the cash cycle model to explain the relationships between the various current asset and current liability strategies.

Inventory strategy = Maximize inventory turnover without stockouts Accounts Receivable strategy = Collect as quick as possible (shorten ACP) without losing sales Accounts Payable strategy = Stretch payables (increase APP) as long as possible without hurting your credit rating. All three of these strategies are consistent with each other, as well as, the strategy of minimizing the average cash balance.

What is the strategy of the firm for inventory?

Maximize inventory turnover without losing sales due to not having items on hand when a customer wants to make a sale and they go somewhere else. Too low of inventory turnover can be the result of too high of price, too much inventory on hand, obsolete inventory, and other reasons why inventory is not selling.

When using only the mean and standard deviation to represent a distribution, we are assuming what kind of distribution?

Reasonably symmetric, bell-shaped distribution

What is the risk-free rate?

Risk-free interest rate is the theoretical rate of return of an investment with no risk of financial loss. One interpretation is that the risk-free rate represents the interest that an investor would expect from an absolutely risk-free investment over a given period of time. - risk-free rate = expected return - risk premium

What is a safety stock and what is it designed to accomplish?

Safety / buffer stock: An level of extra stock that is maintained to mitigate risk of stockouts (lost sales due to not having items on hand when a customer wants to make a sale and they go somewhere else).

Rank the following from high to low risk: T-Bills, Large-company common stocks, T-Bonds, Small-company common stocks, Long-term corporate bonds

Small company common stocks Large company common stocks Long-term corporate bonds Long-term government bonds (T-Bonds) US Treasury bills (T-Bills)

What is the strategy of the firm for accounts receivable?

The basic strategy for cash inflows is to collect cash as quickly as possible (shorten ACP) without losing sales. Can offer percentage discounts to encourage early payment, like 2/10 net 45.

What is the strategy of the firm for accounts payable?

The basic strategy for cash outflows is stretch payables (increase APP) as long as possible without hurting your credit rating. If it is net 45, wait until the 45th day to cut the check.

What is the implicit cost of accounts payable?

The cost of foregoing the cash discount is the cost of accounts payable. It's an implicit cost, in that, it is not paid in cash but it is incurred, i.e., an opportunity cost.

What is remote disbursing what is it designed to accomplish?

The firm intentionally draws its checks on a bank in a location that is geographically remote from whomever it needs to send checks to. It does this to maximize disbursement float, which represents a reduction in book cash but no current change in actual cash in the bank.

When would a firm prefer to hold cash and not invest in marketable securities, and vice versa?

There is a trade-off between opportunity cost of holding cash relative to the transaction cost of converting marketable securities to cash for transactions.

The 5 C's of credit are: ________, ________, ________, ________, and ________.

• character • capacity • capital • collateral • condition

An ________ _________ _________ is the market in which security prices reflect available information.

efficient capital market

A firm must have a credit policy in place to manage accounts receivable. What components should be included in a credit policy?

1. Determining who the firm will extend credit to (Credit standards) 2. Determine what terms to extend to customers, for example, 2/10, n/30 3. Establishing collection policies for past due accounts.

Compare and contrast a lock-box system and concentration banking.

A company which has multiple chain stores across the country and each store deposits its cash into local banks. The company can set it up so that these funds can be concentrated or deposited into one account, usually called a concentration account, at a concentration bank. In the lock-box system, the checks go directly from the customers to the lock-box.

What is a current liability? List the two main current liabilities?

A company's debts or obligations that are due within one year. Current liabilities include (1) accounts payable and (2) notes payable.

Line of credit agreement

An arrangement between a financial institution, usually a bank, and a customer that establishes a maximum loan balance that the bank will permit the borrower to maintain. The borrower can draw down on the line of credit at any time, as long as he or she does not exceed the maximum set in the agreement.

Describe the just-in-time (JIT) inventory management technique.

An inventory strategy companies employ to increase efficiency and decrease waste by receiving goods only as they are needed in the production process, thereby reducing inventory costs.

Describe and explain the standard deviation and variance and how are they used.

Commonly used measures of variation that take into account how all of the values of the data are distributed. They measure the "average" scatter around the mean. Standard deviation is the average distance of data points from the mean. Variance is how larger values fluctuate above it and how smaller values distribute below it. Measure of the spread of a set of scores based on the squared deviation of each score from the mean. Most stable measurement of variability.

What influences the effective rate of a short-term loan?

Discount loan, compensating balances, additional bank fees, etc.

What is diversification?

Diversification can substantially reduce the variability of returns without an equivalent reduction in expected returns.

What is the relationship between NWC and liquidity risk?

If either NWC or liquidity increases, the firm's risk decreases.

undervalued, above

If the required return < expected return of an asset, then the security is ______ valued and plots ______ the security market line.

What is the difference between an explicit cost and an implicit cost?

Implicit cost: A cost that is represented by lost opportunity in the use of a company's own resources, excluding cash. (opportunity cost) Explicit cost: A business expense that is easily identified and accounted for. Explicit costs represent clear, obvious cash outflows from a business that reduce its bottom-line profitability.

What is the measure of market risk?

In equilibrium, all assets and portfolios must have the same reward-to-risk ratio, and they all must equal the reward-to-risk ratio for the market. E (RA) - Rf = E (RM - Rf) _________ _________ βA βM

Describe and explain how Blume's formula can be used?

It uses the arithmetic and geometric returns along with the number of observations to approximate a holding period return. When predicting a holding period return, the arithmetic return will tend to be too high and the geometric return will tend to be too low. Blume's formula statistically adjusts these returns for different holding period expected returns.

What is the relationship between risk and return?

Low levels of uncertainty (low-risk) are associated with low potential returns, whereas high levels of uncertainty (high-risk) are associated with high potential returns.

Disbursement float

Money that a person or company has spent but that has not yet been taken out of one's bank account.

Describe the materials requirements planning (MRP) inventory management technique.

One of the first software based integrated information systems designed to improve productivity for businesses. A materials requirement planning (MRP) information system is a sales forecast-based system used to schedule raw material deliveries and quantities, given assumptions of machine and labor units required to fulfill a sales forecast.

What are the two methods of using accounts receivable as collateral for a secured loan?

Pledging is the designation of all or certain accounts as collateral. The firm retains the risk of the accounts not being paid off. Generally, debt payments are made when accounts are paid off. Factoring is the actual sale of accounts receivable. Since the ownership of these accounts now rests with another company, the risk is assumed by the purchaser of these accounts.

How many and what kind of securities are needed to have a diversified portfolio?

Portfolio diversification is the investment in several different asset classes or sectors. For example, if you own 5 airline stocks, you are not diversified. However, if you own 50 stocks that span 20 different industries, then you are diversified.

Define unsecured vs. secured sources of short-term financing.

Secured debt is backed up with collateral, whereby assets support the debt. If a loan is in default, the lender can take possession of the collateral assets and sell them in an attempt to satisfy the debt. Unsecured debt is backed by the promise of the borrower, therefore borrowers with high credit standings are eligible for unsecured debt. Unsecured short-term debt agreements include accounts payable, notes payable, and commercial paper.

Define and list some examples of marketable securities?

Securities or debts that are to be sold or redeemed within a year. These are financial instruments that can be easily converted to cash such as: • Banker's acceptances • Certificates of deposit (CDs) • Commercial paper • Treasury bills • Common stock • Repurchase agreements • Short-term tax exempts

What is meant by short-term funds? Long-term funds?

Short-term funds invest in ventures with high quality and low risk. The goal of this type of fund is to protect capital with low-risk investments while achieving a return that beats a relevant benchmark such as a Treasury bill index. Long-term bond funds primarily invest in bonds that have maturities longer than 10 years and have greater interest rate risk. When interest rates are expected to fall, long-term bonds are an investor's best bet for higher relative returns.

Describe the lock-box system and what is it designed to accomplish?

Strategic lox boxes placed in specific locations and companies mail their checks to those locations, rather than the home office. The firm's bank has access to the lock-box. This reduced mailing/transit float because the companies get the checks faster.

What kind of risk is most relevant for a diversified investor?

Systematic risk: The possibility that an event at the company level could trigger severe instability or collapse an entire industry or economy.

What is the purpose of the BAT model and the Miller-Orr model?

The BAT Model is designed to minimize the costs of cash (fixed costs and variable costs). It is assumed in the BAT Model that cash flows are known, evenly distributed, or not random. C* = √(2FT/r) The Miller-Orr Model is also designed to minimize the costs of cash, but with variable, uncertain, or random cash flows. In the Miller-Orr Model, the minimum cash balance is the return point.

evenly distributed, variable

The BAT model assumes that cash balances are _________ and the Miller-Orr model assumes that cash balances are _________?

Conservative / flexible policy for financing current assets

The firm holds less short-term debt and more long-term debt.

Describe the aggressive / restrictive policy for financing current assets.

The firm holds more short-term debt and less long-term debt.

Altman Z Factor, bankruptcy

The _______ is a credit scoring model used to set credit standards. It was originally developed to predict ______.

Cash cycle

The amount of time between when we have a cash outflow to purchase raw materials until the time of a cash inflow in the sale of a finished good. Cash cycle = Average age of inventory (AAI) + Average collection period (ACP) - Average payment period (APP)

Operating cycle

The amount of time required for a business to make an initial outlay of cash to produce goods, sell the goods, and receive cash from customers in exchange for the goods. Operating Cycle = Average age of inventory (AAI) + Average collection period (ACP)

Which mean (average), arithmetic or geometric, is best as a measure of central tendency and why?

The arithmetic mean because it is sensitive to extreme observations.

What is the historical average return for inflation?

The average return for inflation per year over the last 85 years is 3.1%.

Collection/clearing float

The time period between the actual deposit in the payee's account and the clearing of the funds by the payer's bank.

Processing float

The time period between when a payee receives a payment from the payer and deposits it. The duration of the processing float is driven by the payee's internal processes, staff training, and the existence of any work backlog.

Mail float

The time required for a check payment to travel from the payer to the payee through the postal system.

What measure do we use to measure total risk?

The total risk is measured by the variance, or standard deviation of its return.

What is the market risk premium?

The variance between the predictable return on a market portfolio and the risk-free rate. E(RM) − Rf

Calculate the average return for a portfolio.

The weighted average of the expected returns of the investments within it, using the portfolio weights. E(Rp) = Σ rjPj = r1P1 + r2P2 + ... + rNPN = rAxA + rBxB + ... , where xA , xB, ... = percent invested in each asset A, B, ...

We can calculate areas under a symmetric bell curve by using the z-statistic. How do you calculate the z-statistic?

The z-score indicates how many standard deviations away from the mean the chosen sample lies. Z = (sample value - sample mean) / standard deviation

slowly, lengthen

There are different cash disbursement techniques designed to disburse cash _________ and _________ float.

What are the two components of total risk?

Total risk = systematic risk + unsystematic risk

What kind of risk is most relevant for an un-diversified investor?

Unsystematic risk: Company- or industry-specific hazard that is inherent in each investment. Examples of unsystematic risk include a new competitor, a regulatory change, a management change and a product recall.

What are the two costs of inventory?

Variable / carrying costs: all costs associated with holding inventory including storage costs, forgone interest, storage space, and deterioration and are directly related to the average inventory level Fixed / order costs: the fixed costs of placing orders

How do you calculate the geometric mean or average?

[(1 + r1) * (1 + r2) ... * (1 + rN)]^(1/N) - 1 The average of the logarithmic values of a data set converted back to a base 10 number.

In a correctly priced market, the reward-to-risk ratio is __________ for all securities.

constant

If the required return = expected return of an asset, then the security is ______ valued and plots ______ the security market line.

correctly, on

The Economic Order Quantity model is designed to __________ the costs of inventory.

minimize

The _________ distribution is represented by a symmetric bell curve.

normal

If the required return > expected return of an asset, then the security is ______ valued and plots ______ the security market line.

over-valued, below

There are different cash collection techniques designed to collect cash _________ and _________ float.

quickly, shortening

What is the beta of the market?

• A beta of 1 implies the asset has the same systematic risk as the overall market • A beta < 1 implies the asset has less systematic risk than the overall market • A beta > 1 implies the asset has more systematic risk than the overall market

What are the three components of terms of sale or credit terms?

• Credit period • Cash discount and discount period • Type of credit instrument

What are the two components of a rate of return?

• Income generated from holding the asset (e.g. coupon payments on a bond) • capital gain (or loss) from selling the asset

What are the three stages of inventory for a manufacturing firm?

• Raw material: starting point in production process • Work-in-progress • Finished goods: products ready to ship or sell

What are the three motives for holding cash and/or near cash (also known as marketable securities) as defined by Keynes?

• Speculative motive - hold cash to take advantage of unexpected opportunities • Precautionary motive - hold cash in case of emergencies • Transaction motive - hold cash to pay the day-to-day bills

Describe the three forms of market efficiency.

• Weak form: market level data, past price or volume information • Semi-strong form: public information, past information • Strong form: all public information, all non-public information