finance midterm

Non-cash items are expenses that directly affect net income but do not directly affect cash flow.

true

Future value of an annuity of $100 per year for 10 years at 10% per year same as above but also solve for annuity due value

$1,593.74 1,753.11

If you deposit $5,000 at the end of each year for the next 20 years into an account paying 9.6 percent interest, how much money will you have in the account in 20 years?

$273,685.74

You want to have $40,000 for a down payment on a house 4 years from now. If you can earn 5.6 percent, compounded annually on your savings, how much do you need to deposit today to reach your goal?

$32,166.54

Gilmore, Inc., just paid a dividend of $2.35 per share on its stock. The dividends are expected to grow at a constant rate of 4.1 percent per year, indefinitely. If investors require a return of 10.4 percent on this stock, what is the current price? What will the price be in three years? In 15 years?

$38.83 in 3 years so P3 but t should be 4 $43.81 in 15 years, so t=16 and p=15 $70.95

Marcie's has sales of $179,600, depreciation of $14,900, costs of goods sold of $138,200, and other costs of $28,400. The tax rate is 35 percent. What is the net income?

-1,235

Although appealing to more refined tastes, art as a collectible has not always performed so profitably. Assume that in 2015, an auction house sold a statute at auction for a price of $10,521,500. Unfortunately for the previous owner, he had purchased it in 2009 at a price of $12,567,500. What was his annual rate of return on this sculpture?

-2.92%

Quoted interest rate is 2% per month (12 months in a year), what is the APR?

.02(12)=.24 24%

You borrow $100 and agree to payback loan in 2 weeks for 10% interest over that 2 week period. What is your stated annual interest rate?

.05(52)=2.6 260%

What will the aftertax yield be on corporate bond currently priced to yield 7%, if you're in the 25% tax bracket.

.07 X (1-.25) .07(.75) =5.25%

Annuity payment of $35 per year, annual interest rate of 3% and present value of $130, it will last for?

4 years

A $1,000 face value bond is currently quoted at 100.8. The bond pays semiannual payments of $22.50 each and matures in six years. What is the coupon rate?

4.5%

If Joan owns 100 shares of ABC company and the company is electing 4 directors, under cumulative voting, Joan would usually have ____ votes.

400

Suppose that in 2015, a $10 silver certificate from 1898 sold for $11,700. For this to have been true, what would the annual increase in the value of the certificate have been?

6.22%

Bleu Berri Farms had equity of $58,900 at the beginning of the year. During the year, the company earned net income of $8,200 and paid $2,500 in dividends. Also during the year, the company repurchased $3,500 of stock from one of its shareholders. What is the value of the owners' equity at year end?

61,100 Ending owners' equity = $58,900 + 8,200 -2,500 -3,500 = $61,100

For the year, Movers United has net income of $31,800, net new equity of $7,500, and an addition to retained earnings of $24,200. What is the amount of the dividends paid?

7,600 addition to retained earnings= net income-dividends 24,200= 31,800-x

Present value interest factor for a 30 year annuity with an interest rate of 10% per year is?

9.427

Confirmation bias

A psychological phenomenon that explains why people tend to seek out information that confirms their existing opinions and overlook or ignore information that refutes their beliefs. •It affects perceptions and decision making in all aspects of our lives and can cause us to make less than optimal choices.

Which statement is true? An indenture is a contract between a bond's issuer and its holders. Collateralized bonds are called debentures. A current list of all bondholders is maintained whenever a firm issues bearer bonds. A bondholder has the right to determine when his or her bond is called. Bonds are generally called at par value.

An indenture is a contract between a bond's issuer and its holders.

Ricky Ripov's Pawn Shop charges an interest rate of 15.25 percent per month on loans to its customers. Like all lenders, Ricky must report an APR to consumers. What rate should the shop report? What is the effective annual rate?

Annual percentage rate 183.00 Effective annual rate 449.00

Which one of the following situations is most apt to create an agency conflict? Hiring an independent consultant to study the operating efficiency of the firm Giving all employees a bonus if a certain level of efficiency is maintained Basing management bonuses on the length of employment Laying off employees during a slack period Compensating a manager based on his or her division's net income

Basing management bonuses on the length of the employment

What are crossover bonds?

Bonds that have both an investment grade and a junk bond rating

Triad common stock is selling for $27.80 a share and has a dividend yield of 2.8 percent. What is the dividend amount?

D1/Po= .028 D1/27.80= .028 D1= $0.78

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?

The dividend growth model makes the implicit assumption that the stock price will grow at the same constant rate as the dividend. What this means is that if the cash flows on an investment grow at a constant rate through time, the value of that investment grows at the same rate as the cash flows.

What is the primary objective of an auction market?

To bring buyers and sellers together

Ralph has $1,000 in an account that pays 10% per year. 3 equal donations at end of next 3 years. How much will Ralph give to the charity each year?

Use PV of annuity 1,000/[(1-1/1.10^3)/.10] =402.11

Economic wealth

control over economic assets

What is the relationship between the price of a bond and its YTM?

oThe bond price is the present value when discounting the future cash flows from a bond; YTM is the interest rate used in discounting the future cash flows (coupon payments and principal) back to their present values.

Which three of the following are common shapes for the term structure of interest rates?

oUpward sloping oDownward sloping oHumped

Debenture

unsecured bond bond that is NOT secured with collateral

Calculating Annuity Present Values. An investment offers $5,450 per year for 15 years, with the first payment occurring one year from now. If the required return is 8 percent, what is the value of the investment?

$46,649.16

$3.65 per share next year increase dividend by 5.1% per year indefinitely. If you require of 11% a return, how much will you pay for the stock today?

$61.86

Assume a project will produce cash flows of $22,400, $28,700, $30,300, $10,900 at the end of Years 1 to 4, respectively. If the discount rate is 14.7 percent, what is the current value of these cash flows?

$67,721.24

7% coupon bond, 9 years left to maturity. Annual payments. Par value $1,000. YTM: 8.4%. Current bond price?

$913.98

If the interest rate is 10% per year and there are 10 years, what is the present value discount factor?

0.386 (1)/(1+r)^n 1/(1.10)^10 0.386

You invest in a bond paying 6% interest paid semiannually with a face value of 1,000. The bond matures in 8 years and similar bonds yield 5%. What is current value of bond?

1,065.28

Present value of an interest payment on a bond is $320 and present value of the par value to be paid at maturity is $900, total value of bond must be _________.

1,220

The sensitivity of a bond's price to interest rate changes is dependent on which of the following two variables?

1. Coupon rate 2. Time to maturity

Three ways to alter future values

1. Increasing the amount of cash you have (increasing the initial investment--> increases future value) 2. Saving for a longer period of time (increasing amount of time she saves with allow savings amount to grow at a faster rate) 3. Locating an investment that earns more interest

Three Forms of Primary Market Transactions (1. Initial Public Offering, 2. Seasoned Public Offering 3. Rights Offering)

1. Initial Public Offering (This is an unseasoned, new issue where a company decides to 'go public' and issue securities that can be bought by investors. A company can do this only if it registers the stock issue with the Securities and Exchange Commission (SEC), the federal agency that regulates investments) 2. Seasoned Public Offering (This is also called a Seasoned Equity Offering, which is an issue of new shares of stock by a company that has already issued public stock) 3. Rights Offering (A rights offer is initially only offered to investors who already hold stock. Rights offerings allow existing shareholders to preserve their proportional ownership stake in the company.)

In the United States, bonds issued to the public are rated for their default risk. These ratings are split into two levels. What are they?

1. Investment Grade Bonds: Investment grade bonds have a relatively low probability of default and are acceptable to prudent investors such as pension funds. 2. Speculative Bonds: Speculative bonds, sometimes called junk bonds, have a higher probability of default, and thus a higher rate of interest. These bonds would be attractive to investors who have a high tolerance for risk, but would not be held by companies with fiduciary obligations, such as pension funds.

Sources of Efficiency (2)

1. Their organization of collective effort (the efficiency of businesses depends on how they are formally organized) (3 major types of organizational form: sole proprietorship, partnership, corporations) 2. How they raise investment capital

S&S Furniture is offering a bedroom suite for $3,200. The credit terms are 60 months at $55 per month. What is the interest rate on this offer?

1.22% Used present value calculator on calkoo

Next dividend payment $2.48 per share, growth rate 4.5% forever currently sells $39.85 per share, required return? What is dividend yield and capital gains yield?

10.7% Dividend yield: 6.2% Capital gains yield: 4.5%

What is the present value?Discounted 6%. $100 in year 1 and year 2. Followed by $200 in years 3 and 4.

100/(1.06)+100/(1.06)^2+ 200/(1.06)^3+ 200/(1.06)^4 =509.68

Assume current assets= 11,300; long-term liabilities=45,000, and total debt=54,800. What is the current ratio?

11,300( 54,800-45,000) = 1.15

The December 31, 2015, balance sheet of Maria's Tennis Shop, Inc., showed current assets of $1,155 and current liabilities of $940. The December 31, 2016, balance sheet showed current assets of $1,370 and current liabilities of $1,045. What was the company's 2016 change in net working capital, or NWC?

110

Precision Engineering invested $125,000 at 6 percent interest, compounded annually for 3 years. How much interest on interest did the company earn over this period of time?

125,000(1.06)^3=148,877 148,877-125,000= 23,877 125,000(0.06)=7,500(3)= 22,500 23,877-22,500= 1,377 1,377

Pharrell, Inc., has sales of $599,000, costs of $259,000, depreciation expense of $64,000, interest expense of $31,000, and a tax rate of 30 percent. The firm paid out $43,000 in cash dividends. What is the addition to retained earnings?

128,500

Do you prefer to pay $28,000 today for work to be done in the future. Or do you prefer a payment plan. Six payments totaling $31,000. Time 0: $2,000. Time 1: $3,000 Time 2: $4,000. Time 3: $7,000. Time 4: $7,000. Time 5: $8,000. Interest rate 6%.

2,000+ 3,000/(1.06)+4,000/(1.06)^2 + 7,000(1.06)^3+ 7,000(1.06)^4+ 8,000 (1.06)^5 =$25,790.23 Prefer this over $28,000 paid because lower PV. You want lower PV because you are the one paying the money, not getting the money.

Wes Motors has total assets of $98,300, net working capital of $11,300, owners' equity of $41,600, and long-term debt of $38,600. What is the value of the current assets?

29,400 Current liabilities = $98,300-38,600 -41,600 = $18,100 Current assets = $11,300 + 18,100 = $29,400

AV Sales has net revenue of $513,000 and costs of $406,800. The depreciation expense is $43,800, interest paid is $11,200, and dividends for the year are $4,500. The tax rate is 33 percent. What is the addition to retained earnings?

29,804

The 6.5 percent bond of ABCO has a yield to maturity of 6.82 percent. The bond matures in seven years, has a face value of $1,000, and pays semiannual interest payments. What is the amount of each coupon payment?

32.50

Arts and Crafts Warehouse wants to issue 15-year, zero-coupon bonds that yield 7.5 percent. What price should it charge for these bonds if the face value is $1,000? Assume semiannual compounding.

331.40

Best Ever Toys just paid its annual dividend of $1.78 per share. The required return is 10.6 percent and the dividend growth rate is 1.23 percent. What is the expected value of this stock five years from now?

5 years from now, so P5 and year 6 (t=6) P5= D5 (1+g)/(r-g) 1.78(1.0123)^6/(.106-.0123) = 1.915/0.0937 =$20.44

The $1,000 face value bonds of Galaxies International have coupon of 6.45 percent and pay interest semiannually. Currently, the bonds are quoted at 103.4 and mature in 4 years. What is the yield to maturity?

5.49%

Annual payment, 12 years to maturity, par value pf 1,000, price of 963, YTM 6.14%, coupon rate?

5.7%

A corporate issues 50,000 bonds at $1,000 each. Bond matures in 5 years and have a coupon rate of 7%. What will the total annual interest expense be?

50,000 x (1,000 x .07) = 3.5 million

Curly's Life Insurance Co. is trying to sell you an investment policy that will pay you and your heirs $39,000 per year forever. A representative for Curly's tells you the policy costs $640,000. At what interest rate would this be a fair deal?

6.09%

he Timberlake-Jackson Wardrobe Co. has 7 percent coupon bonds on the market with 9 years left to maturity. The bonds make annual payments and have a par value of $1,000. If the bonds currently sell for $961.50, what is the YTM?

7.61%

Lisa has $1,000 in cash today. Which one of the following investment options is most apt to double her money? 8 percent interest for 9 years 6 percent interest for 3 years 7 percent interest for 9 years 6 percent interest for 10 years 12 percent interest for 5 years

8 percent interest for 9 years

The Timberlake-Jackson Wardrobe Co. has 10.3 percent coupon bonds on the market with eight years left to maturity. The bonds make annual payments and have a par value of $1,000. If the bonds currently sell for $1,132.17, what is the YTM?

8%

Barnes Enterprises has bonds on the market making annual payments, with 14 years to maturity, a par value of $1,000, and a price of $958. At this price, the bonds yield 8.9 percent. What must the coupon rate be on the bonds?

8.36%

Volbeat Corporation has bonds on the market with 11.5 years to maturity, a YTM of 9.6 percent, a par value of $1,000, and a current price of $947. The bonds make semiannual payments. What must the coupon rate be on the bonds?

8.83%

The 4.5 percent bond of JL Motors has a face value of $1,000, a maturity of 7 years, semiannual interest payments, and a yield to maturity of 6.23 percent. What is the current market price of the bond?

903.05

Dockside Warehouse has net working capital of $42,400, total assets of $519,300, and net fixed assets of $380,200. What is the value of the current liabilities?

96,700

Charges 18% interest per year (APR), 1.5% each month. What is the EAR?

=(1+ .18/12)^12-1 =.196 19.6%

Default risk

A bond is a promise of future payments: here is a risk that this promise may not be kept. Many governments, corporations and other institutions have defaulted on bonds, causing substantial losses to their creditors. Creditors are thus interested in the probability of default.

What is a premium bond?

A bond that sells for more than face value

Amortized loan

An amortized loan has a scheduled number of equal payments. Each payment includes both interest payments and a bit of payment on the amount you owe. Once the loan matures, you've not only paid interest, but also paid off the loan.

Annuities

An annuity is a finite, regular, cash flow stream. This means that the cash flows involved in the annuity follow a regular pattern. Annuities take different forms based on whether the cash flows appear at the beginning or end of each period, and whether each cash flow is the same or the cash flows grow at a given rate.

What are municipal bonds?

Bonds that have been issued by state or local governments They are issued by state and local governments The interest on municipal bonds is exempt from federal taxes. The interest on municipal bonds is, in some cases, exempt from state taxes in the state of issue.

What is a discount bond?

Bonds that sells for less than face value

For the following annuity calculate the annual cash flow. Future value: $30,000. Years 8. Interest 5%.

C= $3,141.65

Calculate the annual cash flow for this annuity. Present value: $24,500. Years 6. Interest rate 11%.

C= $5,791.23

Which of the following are components of cash flow from assets

Change in net working capital Capital spending Operating cash flow

Companies pay rating agencies such as Moody's and S&P to rate their bonds, and the costs can be substantial. However, companies are not required to have their bonds rated in the first place; doing so is strictly voluntary. Why do you think they do it?

Companies pay to have their bonds rated because unrated bonds can be difficult to sell. Many large investors are prohibited from investing in unrated issues, such as pension funds which can usually invest only in bonds with investment grade ratings.

Financial securities Types of Financial Securities

Companies raise capital by issuing financial securities which are claims against the future cash flow provided by the company's productive assets 1. Bond 2. Preferred Stock 3. Common Stock 4. Bank loan

Privately held companies vs publicly held companies Two major types of transactions in public security markets (Primary Market Transaction and Secondary Market transaction)

Company can issue stock to the general public oThere are two major types of transactions in public security markets. In a Primary Market Transaction the company creates the security and sells it to investors, thus raising capital. • In a Secondary Market Transaction one investor sells an already-issued security to another investor. While the company is not directly involved in this transaction, it is very much impacted.

Convertible bonds

Convertible bonds are, in fact, convertible. Under the right conditions this type of bond can be exchanged for common stock offered by the bond-issuing company. This feature provides the stable income and fixed payment of debt, and it also allows the bondholder to share in a company's growth

Bond issued 5 years ago with total maturity of 25 years, at the end it promises to pay $1,000. Annual coupon rate 10%, yield annual rate of 12%. Current market price of bond? Current market price with semiannual payments?

Coupon payment= face value of bond X coupon rate $100= $1,000 x 0.10 D0= $100(PVFA .12,20)+ $1,000(PVF..12,20) =$850.61 Semiannual $50(PVFA .06,40)+ $1,000(PVF .06,40) =$849.54

Suppose you know that a company's stock currently sells for $65.70 per share and the required return on the stock is 9 percent. You also know that the total return on the stock is evenly divided between capital gains yield and dividend yield. If it's the company's policy to always maintain a constant growth rate in its dividends, what is the current dividend per share?

D0= $2.83 #11 unit 9 quiz, look at notes

First City Bank pays 6 percent simple interest on its savings account balances, whereas Second City Bank pays 6 percent interest compounded annually. If you made a deposit of $11,000 in each bank, how much more money would you earn from your Second City Bank account at the end of 11 years?

Difference $ 2,621.28

The net present value profile illustrates how the net present value of an investment is affected by which one of the following? Inflation rate Timing of the project's cash inflows Discount rate Project's initial cost Real rate of return

Discount rate

The capital gains yield equals which one of the following? Dividend growth rate Required rate of return Dividend yield Market rate of return Total yield

Dividend growth rate

The required return on a stock is equal to which one of the following if the dividend on the stock decreases by a constant percent per year? Dividend yield × Capital gains yield Dividend yield + Capital gains yield (D1/P0)/g (P0/D1) - g Dividend yield - Capital gains yield

Dividend yield + Capital gains yield

Find the APR, or stated rate, in each of the following cases: EAR 14%, compounded semi annually EAR 9% compounded monthly

EAR = .14 = [1 + (APR / 2)]2 - 1 APR = 2[(1.14)1/2 - 1] = .1354, or 13.54% EAR = .09 = [1 + (APR / 12)]12 - 1 APR = 12[(1.09)1/12 - 1] = .0865, or 8.65%

If quoted interest rate is 2% per month (APR=24%). What is the EAR?

EAR= (1+quoted rate/m)^m-1 (1+.24/12)^12-1 .268= 26.8%

Find EAR. 1 year, quarterly compounding, annual 18%.

EAR=[1+quoted rate/m]^m-1 EAR= [1+.18/4]^4-1 =.1925=19.25%

EPS is $2.50, rate of return is 8%. Pays out all of it's earnings in dividends. What is company's stock price? Also find PE ratio

EPS is only equal to Div. if pay out all earnings in dividends. P0= Div/r = EPS/r = $2.50/0.08 =$31.25 Po/EPS 31.25/2.50 PE ratio= 12.50

Expects to earn $100,000 this year. Earnings will grow 3% indefinitely if firm makes no new investments. Firm's discount rate is 10% and 250,000 share outstanding. What is the price per share of stock, assuming that all earnings are paid out as dividends?

EPS= net income/ shares outstanding 100,000/250,000 =0.4 Po= Do(1+g)/(r-g) 0.4(1.03)/(.10-.03) =.412/.07 =5.89

Compass Bank is offering an APR of 0.8 percent, compounded daily, on its savings accounts. If you deposit $2,500 today, how much will you have in the account in 15 years?

FV = $2,500 ×[1 + (.008/365)]5,475 = $2,818.74

First National Bank charges 10.1 percent compounded monthly on its business loans. First United Bank charges 10.3 percent compounded semiannually. As a potential borrower, which bank would you go to for a new loan?

First National: EAR = [1 + (.101 / 12)]12 - 1 = .1058, or 10.58% First United: EAR = [1 + (.103 / 2)]2 - 1 = .1057, or 10.57% For a borrower, First United would be preferred since the EAR of the loan is lower. Notice that the higher APR does not necessarily mean the higher EAR. The number of compounding periods within a year will also affect the EAR.

Is it possible for a company to pay dividends when it has a negative net income for the year? Could this happen for longer periods?

For a particular year, this can (and often does) happen. Going back to the cash flow identity, the dividend payments depend on operating cash flow, capital spending, the change in net working capital, and the cash flow to creditors. The firm could have positive operating cash flow with negative earnings, sell fixed assets, reduce net working capital, or raise cash from creditors in order to pay dividends. While this is possible in the short term, as a practical matter over the longer term, the company would probably need to have a positive net income (at least on average) in order to maintain a dividend.

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? How about looking at it from the team's perspective?

From the athlete's point of view, if the total amount of money is fixed, you want as much as possible as soon as possible. The team (or, more accurately, the team owner) wants just the opposite. Given a fixed amount, splitting it up into future payments means that the present value is less. These differences in perspectives makes sense when we know that a dollar received today is more valuable than a dollar received in the future.

What should you keep in mind when examining an income statement?

GAAP Cash versus non-cash items Time and costs

Connection between productive assets and financial securities

Given the relationship of the economic balance sheet, the market value of the company's productive assets should equal the market claims against those assets as represented by the company's securities. For example: if the company's bonds are worth $4 and the stock is worth $6, the market value of the firm's assets must be worth $10.

What is the IRR for a project with an initial investment of $500 and subsequent cash inflows of $145 per year for 5 years.

IRR 13.82% IRR calculator: Initial investment cash out: 500 5 years, 145 cash in in each year plugged in.

If the required rate of return is 11%, should the firm accept a project that requires an investment today of $158,500 and has an expected cash inflow in one year of $175,000?

IRR is 10.4% Overvalued-- pay more so reject.

One year $1,000 CD for price of $980. Opportunity cost is 4%.

IRR is 2% Use IRR calculator Bad deal: over valued. Would earn a return less than 4%. When IRR is less than opportunity cost is it overvalued. Investors paying more than you should

$1,000 CD for the price of $961.53. Opportunity cost of this CD is 4%. What is IRR? Is this a fairly valued deal?

IRR is 4% Use IRR calculator This is a fairly valued deal

Find IRR. Bank requires an investment of $920 for a $1,000 CD. Opportunity cost 4%

IRR is 8.7% If IRR is greater than opportunity cost than undervalued. Investors like undervalued--> means paying less than worth

Internal rate of return

IRR is the rate at which your NPV is zero. oYou increase your wealth if the rate of return that you earn on an investment—its internal rate of return—is greater than your opportunity cost—the rate you would earn on equivalent investments. oThe IRR is the rate of return earned on an investment adjusted for time value.

After successfully completing your corporate finance class, you feel the next challenge ahead is to serve on the board of directors of Schenkel Enterprises. Unfortunately, you will be the only individual voting for you. If the company has 540,000 shares outstanding and the stock currently sells for $34, how much will it cost you to buy a seat if the company uses straight voting? Assume that the company uses cumulative voting and there are four seats in the current election; how much will it cost you to buy a seat now?

If the company uses straight voting, you will need to own one-half of the shares, plus one share, in order to guarantee enough votes to win the election. So, the number of shares needed to guarantee election under straight voting will be: Shares needed = (540,000 shares / 2) + 1 Shares needed = 270,001 And the total cost to you will be the shares needed times the price per share, or: Total cost = 270,001 × $34 Total cost = $9,180,034 If the company uses cumulative voting, you will need 1 / (N + 1) percent of the stock (plus one share) to guarantee election, where N is the number of seats up for election. So, the percentage of the company's stock you need will be: Percent of stock needed = 1 / (N + 1) Percent of stock needed = 1 / (4 + 1) Percent of stock needed = .20, or 20% So, the number of shares you need to purchase is: Number of shares to purchase = (540,000 × .20) + 1 Number of shares to purchase = 108,001 And the total cost to you will be the shares needed times the price per share, or: Total cost = 108,001 × $34 Total cost = $3,672,034

Secondary Market Transactions and why they are important

In secondary markets, an investor buys a financial security from another investor. The company issuing the financial security is not involved in this transaction and does not receive any funds. However, secondary markets are crucial because they do the following: 1. Provide liquidity. oLiquidity is the degree to which an asset or security can be bought or sold in the market without affecting the asset's price. Liquidity is important not just in an asset but in the markets. For example, during the recent Great Recession, the sub-prime mortgage and related credit markets experienced trouble. Investors wanted to sell those securities. Investors found that everyone else wanted to sell these securities as well, and prices promptly collapsed. Investors in other markets saw these difficulties and decided to sell their assets, even those not directly connected to housing. The result was a huge market crash. One of the greatest fears of investors is that they can't get out, which is why liquid secondary markets are essential. 2. Determine the ability of the company to raise additional capital. Good security prices in the secondary market provide a favorable foundation for a company to issue additional securities and raise additional capital. If investors are not attracted to the stock already in the market, then they are unlikely to want even more securities. For example, Netflix made some bad business decisions, which caused its stock price to decline. This poor secondary market performance would make it difficult for Netflix to issue additional securities in a primary market transaction. o 3. Provide a market price by which managerial and company performance is measured. Investors make daily investment decisions. They buy and sell based on their estimates of the future cash flows provided by their investment and the risks of those investments. The secondary market security price is a continuing referendum on the quality of the firm's managerial decisions. If good information is provided, then the stock price goes up. oIf the information provided about a company is not positive, then prepare for stock prices to go down. Investors may decide it's time to sell their shares.

Why is a dollar received today worth more than a dollar received in the future?

Inflation will make a dollar in the future worth less than a dollar today Today's dollar can be reinvested, yielding a greater amount in the future

A key difference between interest payments and dividend payments is

Interest is tax deductible Dividends is not tax deductible

Economic activity

Involves the production, distribution, and consumption of goods and services

Price-Earnings (P-E) ratio

It tells investors how much they are paying for $1 of current earnings. The P-E ratio allows relative analysis of stock prices and is directly related to the present value of a company's growth prospects

On March 28, 2008, Toyota Motor Credit Corporation (TMCC), a subsidiary of Toyota Motor, offered some securities for sale to the public. Under the terms of the deal, TMCC promised to repay the owner of one of these securities $100,000 on March 28, 2038, but investors would receive nothing until then. Investors paid TMCC $24,099 for each of these securities; so they gave up $24,099 on March 28, 2008, for the promise of a $100,000 payment 30 years later. Why would TMCC be willing to accept such a small amount today ($24,099) in exchange for a promise to repay about four times that amount ($100,000) in the future

It's a reflection of the time value of money—TMCC hopes to earn a higher rate of return than what they pay to their creditors. If the creditors lend $24,099 and receive $100,000 in thirty years they would earn an IRR of 4.86%. If TMCC takes the $24,099 and invests wisely, they would earn more than the 4.86% they pay to the creditors. If The rate of growth in TMCC's investment was 6%, the $24,099 would grow to $138,412.

Level annuity

Its cash flows are the same in each period. For this course, level annuities are further classified by when their cash flows occur. An ordinary annuity is cash flow that occurs at end of each period. An annuity due is cash flow that occurs at beginning of each period.

Growing annuity

Its cash flows increase at a regular growth rate. A growing annuity is similar to a growing perpetuity (is a series of periodic payments that grow at a proportionate rate and are received for an infinite amount of time), except that a growing annuity has a finite life.

Often junk bonds are not rated, why?

Junk bonds often are not rated because there would no point in an issuer paying a rating agency to assign its bonds a low rating (it's like paying someone to kick you!). As discussed in the course, these bonds provide a higher rating, but also have higher risk.

Which one of the following is an advantage of being a limited partner? Unlimited profits without risk of incurring a loss Control over the daily operations of the firm Active market for ownership interest Nontaxable share of any profits Losses limited to capital invested

Losses limited to capital invested

Which one of the following is the most important source of risk from owning bonds?

Market interest rate fluctuations

What does the AAA rating assigned by S&P mean?

Means that the firm is in a strong position to meet its debt obligations. Very few companies have this rating

Investment today $158,500 and has an expected cash inflow in one year of $175,000. Required rate of return of 14%. Project NPV. Should the firm accept the project?

NPV= PV-initial cost -4,992=153,508-158,500 Reject NPV because NPV is -$4,992

What is the NPV of a project with an initial investment of $95, a cash flow in one year of $107, and a discount rate of 6%?

NPV=6 NPV= PV-initial cost PV(1+r)^n= FV PV(1.06)^1= 107 PV= $101 NPV= PV-initial cost 6= 101-95 (good investment because NPV is positive)

Net Present Value

NPV=PV-initial cost Net Present Value is a decision-making process used to measure whether or not a decision will increase your wealth. NPV= Present Value (inflows) minus present value (outflows) If the NPV is positive, then you should accept the project, as it increases wealth measured in dollars stated as of today. If the NPV is negative, then you should reject the project as it would actually reduce wealth As an investor** want higher NPV

Pharrell, Inc. has sales of $634,000, costs of$328,888, depreciation expense of $73,000, interest expense of $38,000, and a tax rate of 35 percent. Suppose Pharrell, Inc. paid out $43,000 in cash dividends. What is the addition to retained earnings?

Net income = Dividends + Addition to retained earnings Addition to retained earnings = $126,750 - 43,000 Addition to retained earnings = $83,750

4% riskless rate of return (Rf) $80,000 at end of year. Risk premium 6%. What is present value? Offers to sell business for 70,000, calculate NPV

OC= Rf + risk premium 10%= 4% + 6% PV(1.10)=FV PV(1.10)=80,000 PV= $72, 727 NPV=PV-initial investment 72,727-70,000= $2,727

The Expresso Roast Corporation (ERC) is considering expanding its product lines by investing in Mellow-Man Tea. The company's founder is obscenely wealthy and will operate these lines for only one year before retiring and will therefore use only a one-year planning horizon. . Mellow-Man Tea has a cost of $80,000 and is expected to produce benefits of $65,000 in one year. While this line is not as immediately profitable as the other alternative, it is estimated that this line could be sold upon the founder's retirement in one year for $20,000. The health benefits of tea make this a less risky investment and ERC's CFO has recommended a risk-premium of 10%. All future cash benefits will occur at the end of the year. The rate of return on US T-Bills is 4%. What is the NPV of this investment?

OC= Rf+ risk premium 14%= 4% +10% NPV= PV-initial investment PV(1+r)^t= FV PV(1.14)=65,000+20,000 PV=74561 74,561-80,000= -5439

Breakfast Hut pays a constant annual dividend of $1.39 per share. How much are you willing to pay for one share if you require a rate of return of 14.6 percent?

PO= D/R 1.39/0.146 =9.52

Which one of the following is the correct formula for the current value of $600 invested today at 5 percent interest for 6 years? PV = $600/ [(1 + .06) ×5] PV = $600/ (.06 ×5) PV = $600 / (1 + .05)^6 PV = $600 / (1 + .06)^5 PV = $600/ [(1 +.05) ×6

PV = $600 / (1 + .05)^6

Curly's Life Insurance Co. is trying to sell you an investment policy that will pay you and your heirs $30,000 per year forever. If the required return on this investment is 5 percent. Suppose Curly's told you the policy costs $645,000. At what interest rate would this be a fair deal?

PV for perpetuity= C/R

Curly's Life Insurance Co. is trying to sell you an investment policy that will pay you and your heirs $30,000 per year forever. If the required return on this investment is 5 percent, how much will you pay for the policy?

PV for perpetuity=C/R 30,000/.05= 600,000

What is the FV? $100 deposited each year for 2 years beginning next year, then $200 deposited for the next 2 years if you can earn 6% per year.

PV(1+r)^t=FV 100(1.06)^3+ 100(1.06)^2+ 200(1.06)^1 +200 =643.46 Clarification: First calculation is to ^3 because looking for FV, NOT PV, and the first year is 3 years away from FV. so would be ^3. Second calculation is 2 years away from FV so ^2. 3rd calculation^1 because 1 year away. Fourth calculation simply 200 and no interest because get on the day, interest happens at the end remember Remember this is the t for FV. For PV you don't have to think about "how many years away". It's simply the first year so it's ^1. or second year ^2.

Imprudential, Inc., has an unfunded pension liability of $763 million that must be paid in 15 years. To assess the value of the firm's stock, financial analysts want to discount this liability back to the present. If the relevant discount rate is 7 percent, what is the present value of this liability?

PV= 276,546,037.01

Bond offers $1,000 in 30 years and current YTM of 6%.

PV= FV (PVF r,t) 1,000/(1.06)^30 =174.11

Find zero coupon bond with par value of $10,000 and 17 years to maturity, YTM is 4,9%, what is the price of bond? Semiannual coupon period.

PV= FV/(1+r)^t =10,000/(1.0245)^34 =4,391

15 year bonds one year ago, coupon rate 6.1%, semi-annual payments. YTM 5.3%, par value 1,000, current price?

PV=1,078.37

PV Growing annuity equation

PV=C[(1/r-g)-(1/r-g)(1+g/1+r)^t]

Eulis Co. has identified an investment project with the following cash flows. If the discount rate is 10 percent, what is the present value of these cash flows? Year 1: $680. Year 2: $490. Year 3: $975. Year 4: $1,160.

PV=FV/(1+r)^t 680/(1.10)+ 490/(1.10)^2+ 975(1.10)^3+ 1160(1.10)^4 =$2,547.96

Car loan is for $1,000 over 5 months, at at least 1% monthly interest. What is her monthly car payment? Amortized loan. Present value of car loan: 1,000 loan is an ordinary annuity loan interest rate: 1% time period: 5 months

PVA= C (PVFA .01, 5) C= 206.04 (this is how much she pays each month for the interest and the amount she owes the car) Interest 1,000 x 0.01 =$10 206.04-10= 196.04 (1st month) $10 going to bank 196.04 going to car place 1,000-196.04= 803.96 (Goes into 2nd month owing this) 803.96 X 0.01= 8.04 206.04-8.04= 198 (2nd month) 803.96-198= 605.96 605.96X 0.01= 6.06 206.04-6.06= 199.98 (3rd month) 605.96-199.98= 405.98 405.98 x .01= 4.06 206.04- 4.06= 201.98 (4th month) 405.96-201.98= 203.98 203.98 x .01= 2.04 206.04- 2.04= 204 (5th month) loan is paid off now.

E-Eyes.com (Links to an external site.)Links to an external site. has a new issue of preferred stock it calls 20/20 preferred. The stock will pay a $20 dividend per year, but the first dividend will not be paid until 20 years from today. If you require a return of 7.1 percent on this stock, how much should you pay today?

Po= D/R P19= 20/.071 =$28.17 PV= FV/(1+r)^t 28.17/ (1.071)^19 PV= 76.52

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.

The Sleeping Flower Co. has earnings of $2.65 per share. The benchmark PE for the company is 18. What stock price would you consider appropriate? What if the benchmark PE were 21?

Price at time t= benchmark PE x EPS P= 18 x 2.65 P= 47.70 P= 21 (2.65) P= 55.65

You've probably noticed coverage in the financial press of an initial public offering (IPO) of a company's securities. Social networking company Facebook is a relatively recent example. Is an IPO a primary market transaction or a secondary market transaction?

Primary market transaction

Privately held vs publicly traded companies Privately held (ownership, information, sales, capital)

Privately held companies 1. Ownership (Privately held companies are generally owned by a small number of investors who control the board of directors. In fact, some large shareholders may actually have a seat on the board. These shareholders receive a substantial amount of information on the company, even about sensitive information concerning the company's future plans. Given the small number of owners, the company can move quickly to meet changing market conditions.) 2. Information (Privately held companies are not required to provide information to the public via annual reports or through reports to the Securities and Exchange Commission (SEC). This means that the investing public may not have much information on the internal workings or profitability of private companies.) 3. Sales (As private companies' securities are not registered with the SEC, they cannot be sold to the general investing public. Shareholders can sell their securities only by direct negotiation with potential purchasers or the company itself.) 4. Capital (Because a privately held company cannot issue publicly traded stock, it may be limited in the amount of capital it can raise. However, as you can see from these privately held companies, there is a lot of money invested in privately held companies!)

4.6% growth rate in its dividends, indefinitely. Dividend yield of 5.8%. What is the required return on the stock?

R= D1/PO + g R= dividend yield + g .058 + .046 =.104 10.4%

The stock price of Baskett Co. is $73. Investors require a return of 10.5 percent on similar stocks. If the company plans to pay a dividend of $4.25 next year, what growth rate is expected for the company's stock price?

R= D1/Po + g .105= 4.25/73 + g .105= .058 + g .047= g 4.7%

Limited liability company 1. pass through 2. extent of liability 3. potential for agency problem

S-Corp limitations do NOT apply 1. flexibility (no max on owners) 2. owners can be other companies, don't have to be persons 3. do not have to be US 1. yes 2. limited liability 3. yes

1,500 in your account 2 years from now. 2.5% interest compounded annually(SC bank) 2.5% simple interest (NB bank)

SC bank PV(1+r)=FV PV(1.025)^2=1500 PV=1427.72 NB bank x+0.025x+0.025x=1500 Solve for x= 1,428.57 x is PV

Self interest vs. opportunism

Self interest: seeking to benefit oneself while still respecting the rights of others. Opportunism: seeking an immoral gain via deception, deceit, and theft

First City Bank pays 6 percent simple interest on its savings account balances, whereas Second City Bank pays 6 percent interest compounded annually. If you made a deposit of $8,100 in each bank, how much more money would you earn from your Second City Bank account at the end of 10 years?

Simple interest: 8100 (.06)= $486 $486x10= $4860 8100+ 4860= 12,960 total Compound interest PV(1+r)^n 8100(1.06)^10= 14,505.87 14,505.87-12,960= 1,545 (this is how much more you would make)

You invest $500 at 10% interest. End of 2 years with simple interest? With compound interest?

Simple interest: $600 500(.10)=50X2=100 500+100=$600 Compound interest: $605 500(1.10)^2= $605

Two ways of applying interest rates to cash flow: simple interest vs. compound interest

Simple interest: interest earned on the original principal Compound interest: Interest earned on the accumulated interest added to the principal each period.

Computing the present value of a growing perpetuity is most similar to computing the current value of which one of the following? Stock with a constant dividend Stock with irregular dividends Non-dividend-paying stock Stock with a constant-growth dividend Stock with growing dividends for a limited period of time

Stock with a constant-growth dividend

What is the IRR decision rule?

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.

What does a bond's rating reflect?

The ability of the firm to repay its debt and interest on time

What condition must exist if a bond's coupon rate is to equal both the bond's current yield and its yield to maturity? Assume the market rate of interest for this bond is positive. The clean price of the bond must equal the bond's dirty price. The bond must be priced at par. The market price must exceed the par value by the value of one year's interest. There is no condition under which this can occur. The bond must be a zero coupon bond and mature in exactly one year

The bond must be priced at par

The cash flows are: The time value factors are:

The cash flows are: present values, future values, and periodic payments The time value factors are: interest rates and time periods

Investment X offers to pay you $3,400 per year for nine years, whereas Investment Y offers to pay you $5,200 per year for five years. Which of these cash flow streams has the higher present value if the discount rate is 6 percent?

To find the PVA, we use the equation: PVA = C({1 - [1/(1 + r)t]} / r At an interest rate of 6 percent: X@6%: PVA = $3,400{[1 - (1/1.06)9 ] / .06 } = $23,125.75 Y@6%: PVA = $5,200{[1 - (1/1.06)5 ] / .06 } = $21,904.29

Expected return

The future return, which is generally uncertain, that one expects to get from an investment. This is the return that is used in making most business decisions.

The TMCC security is bought and sold on the New York Stock Exchange. If you looked at the price today, do you think the price would exceed the $24,099 original price? Why? If you looked in 2018, do you think the price would be higher or lower than today's price? Why?

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 2018, 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

Under-valued investment with IRR

The price you pay for future cash flows gives an IRR that is greater than that of other equivalent investments.

Fairly valued investment with IRR

The price you pay for future cash flows gives an IRR that matches that of other equivalent investments. If IRR is equal to opportunity cost % its fairly valued.

Over-valued investment with IRR

The price you pay for future cash flows gives as IRR that is less that of other equivalent investments.

Realized return

The return that is actually received at the end of the investment period.

Crowdfunding

There are other ways of raising capital. Some companies are bypassing the financial markets and going directly to investors in a process called crowdfunding. With crowdfunding, entrepreneurs post their projects online for potential investors to view. If enough investors are willing to invest, then the project is taken on. These investors are in many cases willing to accept benefits other than cash dividends. One example of a crowdfunding In one famous project from this website, Pebble Technology, the investors did not receive dividends but each received a wristwatch instead

Zero-coupon bond

This bond has a 0% coupon payment! However, this doesn't mean that the investor will not earn a return. With a zero-coupon bond the investor is promised a payment of the bond's fixed value upon maturity. At maturity the investor collects not only the bonds face value, she also collects all of the accumulated interest earned during the life of the bond. oThese bonds are offered at what is called a deep discount price. The investor pays the low price (relative to the bond's face value) and then collects the face value, which is much, much higher.

Growing Perpetuities

Those with payments which increase at a regular rate. Each cash flow is the same percent larger than the previous cash flow PV= (C1)/(r-g)

Level Perpetuities

Those with regular payments that are the same in each period No change in the cash flows, each cash flow is the same Present value of perpetuity= (per period cash flow)/(interest rate)

Christie is buying a new car today and is paying a $500 cash down payment. She will finance the balance at 6.3 percent interest. Her loan requires 36 equal monthly payments of $450 each with the first payment due 30 days from today. Which one of the following statements is correct concerning this purchase? The $500 is the present value of the purchase. To compute the initial loan amount, you must use a monthly interest rate. The future value of the loan is equal to 36 ×$450. The car loan is an annuity due. The present value of the car is equal to $500 + (36 ×$450).

To compute the initial loan amount, you must use a monthly interest rate.

How net income and net cash flow are different

To determine the net cash flow, we must add back the non-cash depreciation charge we removed to find net income. net cash flow= net income + depreciation

During last year the bond's price changed to $935.80 Coupon rate 10%. Bond 19 year maturity. If Dianne purchased bond today, what is the YTM?

YTM: 10.8% Use YTM calkoo calculator

The Expresso Roast Corporation (ERC) is considering expanding its product lines by purchasing the Quick-Roast Coffee Company. The company's founder is obscenely wealthy and will operate these lines for only one year before retiring and will therefore use only a one-year planning horizon. Quick-Roast Coffee has a cost today of $75,000 and is expected to produce cash benefits of $80,000 in one year. A major government study may come out later on this year declaring coffee drinking a major health risk, so this is a risky investment and ERC's CFO has recommended a risk premium of 15%. What is the IRR of this investment?

Use IRR calculator. IRR is 6.67

Consumer loans vs. corporate bonds

While consumer loans are generally amortizing loans in which each period both principle and interest are paid, most corporate bonds are interest only loans, where only interest is paid during the life of the bond, with the principle paid at the maturity of the loan.

First Principle of Finance

a dollar received today is worth more than a dollar received in the future.

Risk premium

a rate of return that exceeds the riskless rate of return proportionally to the amount of risk perceived to be in the project. The risk premium is part of the opportunity cost. Opportunity cost= Rf (risk free rate) + Risk premium

The shareholders of Weil's Markets would benefit if the firm were to be acquired by Better Foods. However, Weil's board of directors rejects the acquisition offer. This is an example of: an agency conflict. a compensation issue. a capital structure issue. a working capital decision. a corporate takeover.

an agency conflict

The interest rate charged per period multiplied by the number of periods per year is the

annual percentage rate

Which of the following are true of financial ratios?

are used for comparison purposes are developed from a firm's financial information

Limited liability partnership 1. pass through 2. extent of liability 3. potential for agency problem

at least one general partner (they are the actual owners) and then limited liability partners (like junior partners) 1. yes 2. limited liability (can only lose what you put in, personal assets are not at risk) 3. yes

Burkhardt Corp. pays a constant $13.50 dividend on its stock. The company will maintain this dividend for the next 9 years and will then cease paying dividends forever. If the required return on this stock is 9.2 percent, what is the current share price?

because it says after 9 years, and does NOT continue perpetually, cant use equation, have to use present value calculator. FV:0 N:9 I/y: 9.2% PMT: 13.50 $80.28 If question said 3 years from now, n would be 6 because 6 more payments left.

What are "fallen angel" bonds

bonds that have been dropped from investment grade to junk bond status

Which one of the following functions is generally a responsibility assigned to the corporate treasurer? Financial accounting Cost accounting Corporate taxes Capital expenditures Data processing

capital expenditures

The idea behind _____ is that interest is earned on interest

compounding

The reinvestment approach to the modified internal rate of return reinvests all the cash flows, including the initial cash flow, to the end of the project. compounds all of the cash flows, except for the initial cash flow, to the end of the project. discounts all negative cash flows back to the present and combines them with the initial cost. discounts all negative cash flows to the present and compounds all positive cash flows to the end of the project. individually discounts each separate cash flow back to the present.

compounds all of the cash flows, except for the initial cash flow, to the end of the project.

A bond's annual interest divided by its face value is referred to as the: current yield. market rate. call rate. yield-to-maturity. coupon rate.

coupon rate

Zero coupon bonds: are issued at a premium. are issued only by the U.S. Treasury. create a tax deduction for the issuer only at maturity. create annual taxable income to individual bondholders. are valued using simple interest.

create annual taxable income to individual bondholders.

If unpaid preferred dividends must be "caught up" before any common dividends can be paid, they are called _______ dividends.

cumulative

What is the current yield on a $1,000 par value bond that sells for $900 if the coupon rate is 10%?

current yield= bond's annual coupon/market price 1,000(.10)/900= 11.11%

When interest rates in the market rise, we can expect the price of bonds to ______

decrease note: interest rate in market they are talking about for bonds is the YTM

The net present value: is unaffected by the timing of an investment's cash flows. decreases as the required rate of return increases. method of analysis cannot be applied to mutually exclusive projects. ignores cash flows that are distant in the future. is equal to the initial investment when the internal rate of return is equal to the required return.

decreases as the required rate of return increases.

Calculating the present value of a future cash flow to determine its worth today is commonly called

discounted cash flow (DCF)

Lucas expects to receive a sales bonus of $7,500 one year from now. The process of determining how much that bonus is worth today is called: discounting. simplifying . extrapolating. compounding. aggregating.

discounting

The interest rate expressed as if it were compounded once per year is called the

effective annual rate

In almost all multiple cash flow calculations, it is implicitly assumed that the cash flows occur at the _______ of each period.

end

For a stated positive interest rate, the EAR is always ____the APR (annual percentage rate)

equal to or greater than

A limitation of bond ratings is that they ______

focus exclusively on default risk

When conducting a financial analysis of a firm, financial analysts cannot use accounting information as it is historical. rely solely on accounting information. ignore accounting information but do use marketing information. frequently use accounting information assume the future will be a repeat of the past as reflected in the firm's accounting reports.

frequently use account information

economic assets

function as stores of value and over which ownership rights are enforced.

Marcos is investing $5 today at 7 percent interest so he can have $35 later. This $35 is referred to as the: discounted value. future value. true value. complex value. present value.

future value

The amount an investment is worth after one or more periods is called

future value

If a bond is selling at a discount from its par value, the YTM must be _____ the coupon rate.

greater than

If the interest rate is greater than zero, the value of annuity due is always ______ an ordinary annuity.

greater than

Over the past year, a firm decreased its current assets and increased its current liabilities. As a result, the firm's net working capital:

had to decrease.

A bond with a BB rating has a higher or lower risk of default than a bond with a BBB rating?

higher risk of default further explanation "a bond with a BBB rating has a higher risk of default than a bond with an A rating"

Assume all else is equal. When comparing savings accounts, you should select the account that has the: highest effective annual rate. highest annual percent rate. highest stated rate. lowest annual percentage rate. lowest effective annual rate.

highest effective annual rate.

Perpetuities

is a regular stream of cash flow that is indefinite--it theoretically goes on forever. It is thus different from the annuity, which does have a finite life.

The interest rate risk premium is the additional compensation demanded by investors for holding _____ bonds.

longer term

The primary goal of financial management is most associated with increasing the: firm's liquidity. the fixed costs while lowering the variable costs. traffic flow within the firm's stores. market value of the firm. dollar amount of each sale.

market value of the firm

The price-earnings ratio (PE) is a _______

market value ratio

g= ROE (retention ratio)

memorize, not on formula sheet

A bond's indenture agreement generally includes all of the following except the: terms of repayment. description of property used as security. details of protective covenants. names of registered shareholders. total amount of the bond issue.

names of registered shareholders.

Shareholders' equity is equal to

net fixed assets minus long-term debt plus net working capital.

The dividend yield is defined as: next year's expected dividend divided by the current market price per share. next year's expected dividend divided by the par value per share. next year's expected dividend divided by the current book value per share. the last annual dividend divided by the current book value per share. the last annual dividend divided by the current market price per share.

next year's expected dividend divided by the current market price per share.

Which one of the following decreases net income but does not affect the operating cash flow of a firm that owes no taxes for the current year?

non cash item

In the dividend discount model, the expected return for investors comes from which two sources?

o Dividend yield o Growth rate

A zero-growth stock pays a dividend of $2 per share and has a discount rate of 10%. What will the stock's price be?

o P0= D/R o $2/.10=20

All else constant, the dividend yield will increase if the stock price_____

o decreases o dividend yield is D1/P0 • 5/20= .25 • 5/10= .50 • 5/30= .16

The dividend yield is determined by dividing the expected dividend (D1) by:

o the current price (P0)

Call Provision

oA call provision is often part of a bond indenture that allows the issuer to pay back the bond. oCall provision allows the issuer to a call a bond when current interest rates drop below the interest rate of the bond; essentially reducing the issuers cost of funds if interest rates change.

Common stock and 3 points about common stock dividends

oCommon stock, unlike preferred stock, may have growing dividends. This example shows how to value common stock as a growing perpetuity. oThree points about common stock dividends •1. Common shareholders get an increasing residual •2. Regular growth is often a managerial goal, and markets like steady performance •3. Each quarterly dividend may not grow at exactly the same rate, the average over time may approximate constant growth.

What is the relationship between the current yield and YTM for premium bonds? For discount bonds? For bonds selling at par value?

oCurrent yield is defined as the annual coupon payment divided by the current bond price. Current yield thus focuses on the return provided by coupon payments and does not factor in the principle payment when the bond matures. For premium bonds, the current yield exceeds the YTM, for discount bonds the current yield is less than the YTM, and for bonds selling at par value, the current yield is equal to the YTM. In all cases, the current yield plus the expected one-period capital gains yield of the bond must be equal to the required return

Clientele Effect

oHow companies attract a certain type of investor, this is called clientele effect. oBased on the type of stock a company issues, different types of investors will be attracted to that company based on the stock type. oIncome stock •Which is a stable cash flow stream in the form of dividends •Attract retirees and risk-averse investors •These kind of investors want stability and steady income oGrowth stock •Attract investors looking for price appreciation, capital gains. •A high growth •Like young investors wishing to beat the market

Explain why some bonds sell at a premium over par value while other bonds sell at a discount. What do you know about the relationship between the coupon rate and the YTM for premium bonds? What about for discount bonds? For bonds selling at par value?

oIf the coupon rate is higher than the required return on a bond, the bond will sell at a premium, since it provides periodic income in the form of coupon payments in excess of that required by investors on other similar bonds. If the coupon rate is lower than the required return on a bond, the bond will sell at a discount, since it provides insufficient coupon payments compared to that required by investors on other similar bonds. For premium bonds, the coupon rate exceeds the YTM; for discount bonds, the YTM exceeds the coupon rate, and for bonds selling at par, the YTM is equal to the coupon rate.

What is the price of a stock at the end of one year (P1) if the dividend for year 2 (D2) is $5, the price for year 2 (P2) is $20, and the discount rate is 10%?

oP0= (D1 + P1)/(1+R) oP0= ($5+$20)/(1+.10) •25/1.10 •22.73

In an over-the-counter market, which of the following is true?

oParticipations are called dealers oMost of the buying and selling is done by the dealer. Book explanation o There are two kinds of secondary markets: auction markets and dealer markets. Generally speaking, dealers buy and sell for themselves, at their own risk. A car dealer, for example, buys and sells automobiles. In contrast, brokers and agents match buyers and sellers, but they do not actually own the commodity that is bought or sold. A real estate agent, for example, does not normally buy and sell houses. oDealer markets in stocks and long-term debt are called over-the-counter (OTC) markets. Most trading in debt securities takes place over the counter. The expression over the counter refers to days of old when securities were literally bought and sold at counters in offices around the country. Today, a significant fraction of the market for stocks and almost all of the market for long-term debt have no central location; the many dealers are connected electronically. oAuction markets differ from dealer markets in two ways. First, an auction market, or exchange, has a physical location (like Wall Street). Second, in a dealer market, most of the buying and selling is done by the dealer. The primary purpose of an auction market, on the other hand, is to match those who wish to sell with those who wish to buy. Dealers play a limited role

What is the total return for a stock that currently sells for $100, is expected to pay a dividend in one year of $2, and has a constant growth rate of 8%?

oR= dividend yield+ capital gains yield oR= D1/P0 + g oR= $2/$100 +.08 o.02+.08= .10 =10%

Which of the following are reasons that make valuing a share of stock more difficult than valuing a bond?

oStock has no set maturity oThe required rate of return is unobservable oDividends are unknown and uncertain

Suppose today a 10 percent coupon bond sells at par. Two years from now, the required return on the same bond is 8 percent. What is the coupon rate on the bond now? The YTM?

oThe bond in this question has a coupon rate of 10%. This means that the bond promises to pay 10% interest per year. As bonds are set a face values of $1,000, the annual coupon paid would be 10% x $1,000 = $100. When a bond is first issued, it is generally issued at par, which means •Market value = Face value •RR/YTM = Coupon rate. oIf in two years the YTM drops to 8%, this means that the required rates of return on equivalent bonds has dropped to 8%. While newly issued bonds would have a coupon rate of 8%, our bond's coupon rate is fixed at 10%. However, given our bond offers $100, whereas other newly issued bonds now offer only $80, our 10% bond is more attractive and investors will pay more for it—it would sell at a premium. This higher price would produce a current YTM of 8%.

Which of the following are rights of common stock holders?

oThe right to share proportionally in any common dividends paid oThe right to share proportionally in any residual value in the event of liquidation oThe right to vote on matters of importance

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

oThe value of any investment depends on its cash flows; i.e., what investors will actually receive. The cash flows from a share of stock are the dividends. There are other cash flows to consider, such as capital gains and stock buybacks, but ultimately, the cash flow of an ongoing firm consists of dividends.

Dividends are: treated as a tax-deductible expense of the issuing firm. only partially taxable to high-income individual shareholders. paid out of net income. payable at the discretion of a firm's president. paid only to preferred stockholders.

paid out of net income.

What does it mean when we say the New York Stock Exchange is an auction market? How are auction markets different from dealer markets?

oThere are two types of markets. In auction markets like the NYSE, brokers and agents meet at a physical location (the exchange) to buy and sell their assets. Brokers don't own the asset, they serve the major function of getting buyers and sellers together, and earn their keep via commissions set as a portion of the price agreed to by the buyers and sellers. Think real estate brokers who get home buyers and sellers together. oDealer markets like NASDAQ represent dealers operating in dispersed locales who buy and sell assets themselves, usually communicating with other dealers electronically or literally over the counter. Dealers do own the traded asset, and will buy from some parties and sell to others from their inventory. Dealers make their profit by buying the asset from one party (bid price) and selling it to another party (ask price). The ask price is higher than the bid price and the dealer keeps the difference, which is called the bid-ask spread.

Equity

ownership, net worth, stock 1. Preferred stock (oPreferred stock has a higher, or preferred, claim on the company's profits before common stock. This preference means that preferred stockholders receive dividends before common stockholders. While preferred shares have a fixed par value and pay dividends as a percent of that value, they do not share in any increase in firm value.) 2. Common stock (Common shareholders have the right to all profits after the other claimants have been satisfied. Common stock profits may be paid out in dividends, or retained and reinvested in the company. They thus bear the residual risk of the company, an important concept we will continually build upon. When we use equity in this course, we mean common stock.) 3. Retained earnings

If a company has had negative earnings for several periods they might choose to use a _____

price-sales ratio

Return on assets (ROA) is a measure of ______

profitability

A floating-rate bond frequently has a: government guarantee. flexible deferred call period. fixed yield to maturity but a flexible coupon payment. fixed-dollar obligation. put provision.

put provision

An interest rate expressed in terms of the interest payment made each period is called an ________

quoted interest rate stated interest rate

What is the coupon rate on a bond that has a par value of $1,000, a market value of $1,100, and a coupon interest payment of $100 per year.

r= 0.1= 10%

Given an interest rate of zero percent, the future value of a lump sum invested today will always: be equal to $0. be infinite in value. decrease if the investment time period is shortened. decrease if the investment time period is lengthened. remain constant, regardless of the investment time period.

remain constant, regardless of the investment time period.

Net income increases when fixed costs increase. depreciation increases. dividends cease. revenue increases. the average tax rate increases.

revenue increases

There are two open seats on the board of directors. If two separate votes occur to elect the new directors, the firm is using a type of voting that is best described as _____ voting. sequential simultaneous cumulative straight proxy

straight

Growing 5% per year, how long will it take for the firm's sales to triple?

t= 22.517 use calculator

Annual percentage rate (APR)

the APR is simply equal to the interest rate per period multiplied by the number of periods in a year. For example, if a bank is charging 1.2 percent per month on car loans, then the APR that must be reported is 1.2% × 12 = 14.4%. So, an APR is in fact a quoted, or stated, rate in the sense we've been discussing. APR= (interest rate charged per period)x (# of periods)

Floating rate bonds

the coupon payments are adjustable In addition, the majority of floaters have the following features: 1. The holder has the right to redeem the note at par on the coupon payment date after some specified amount of time. This is called a put provision. The coupon rate has a floor and a ceiling, meaning that the coupon is subject to a minimum and a maximum. In this case, the coupon rate is said to be "capped," and the upper and lower rates are sometimes called the collar.

Net income

the difference between accounting revenues and accounting expenses recorded using GAAP and accrual method.

Net cash flow

the difference between cash received and cash paid out

A balance sheet reflects a firm's accounting value on a specific date.

true

T/F Junk bonds are rated below investment grade bonds

true

Bond

type of financial security A long term claim (liability) on balance sheet A bond is a security representing a debt of the firm. The company issuing the bond pays a fixed rate of interest on the bond. The bond also has a fixed maturity, and the firm must redeem (or pay off the bond) at its maturity. The bond's cash flows are a fixed commitment of the firm

Bank loan

type of financial security Securities are also created by bank loans. These securities represent a claim on the firm's cash flows, but are not directly traded in the financial markets.

Preferred Stock

type of financial security under equity on balance sheet Preferred Stock combines features of both bonds and common stocks. Preferred dividends are fixed and do not change with the company's fluctuating income. While preferred dividends can be delayed, they must be made up before the common stockholders receive dividends. Preferred stockholders have access to the firm's cash flows before the common stockholders, but they can only do so after the claims of the bondholders have been satisfied.

Common stock

type of financial security under equity on balance sheet The term 'stocks' generally refers to common stock, which represents an equity claim. Common stockholders are the owners of the firm and, as stockholders, they share in the profits of the firm. However, these stockholders also share in the firm's risks. Common stock dividends are a residual (also called profit) and are not guaranteed by the firm. Common stockholders have control of the company through their right to elect the board of directors

A stock is priced at $38.24 a share and has a market rate of return of 9.65 percent. What is the dividend growth rate if the company plans to pay an annual dividend of $.48 a share next year?

unit 9 quiz #10. look at notes g= 8.4%

economic value

value assigned by markets to economic assets Economic value is the maximum dollar price someone will pay for an economic asset. The price paid for an economic asset should not exceed the value obtained by the use of said economic asset!

Theo's BBQ has $48,000 in current assets and $39,000 in current liabilities. Decisions related to these accounts as referred to as: capital structure decisions. fixed account structure. working capital management. operating management. capital budgeting decisions.

working capital management

The market-required rate of return on a bond that is held for its entire life is called the: call premium. coupon rate. yield to maturity. dirty yield. current yield.

yield to maturity

If the growth rate (g) is zero, the capital gains yield is ____

zero o growth rate and capital gains yield is the same thing

Which one of the following terms applies to a bond that initially sells at a deep discount and only makes one payment to bondholders? Callable Tax-free Convertible Income Zero coupon

zero coupon

Three interest rates to track

•1. Stated Annual Interest Rate •the interest rate stated on an annual basis online (The stated interest rate is just what it says. It is the simple interest rate that the bank gives you as the interest rate on the loan. This interest rate does not take the effect of compound interest into account.) •2. Periodic Interest Rate •the interest rate applied each month to the principle • 3. Effective Annual Interest Rate the interest rate that reflects the effect of compounding over the entire annual period. •We just apply the quarterly interest rate for the number of compounding periods within a year. So what you have are two annual rates, one for the nominal rate stated on an annual basis, the other reflecting the effects of compounding. These two annual rates are connected through the periodic rate.

What are the two interest rates involved with every bond? The interaction of these two rates determines the bond's value

•1. The Coupon Rate o applied to the bond principle (face value) to determine the periodic coupon payments. •2. The Yield oThe Yield, which is really the bonds' opportunity cost, is the rate required by market participants to compensate them for investing in the bond. The yield involves the current risk-free rate and the bond's risk premium. The Yield-to-Maturity (YTM) is the rate of return earned on a bond if purchased and then held to maturity

What four variables are required to calculate the value of a bond?

•Coupon rate •Yield to maturity •Time remaining to maturity •Par value

Elements and Uses of the Yield Curve

•Elements oEntire range of interest rates that the government pays on its borrowings for different maturities •Uses oWe use it to value assets oWhat is the market expecting about interest rates in the future

Which of the following are true about a bond's face value?

•It is the principal amount repaid at maturity •It is also known as par value

When using trial and error to compute the yield to maturity (YTM) for a 6% coupon bond that trades at a premium, the process can be shortened if the initial guess is ______ 6%.

•Lower than •"the YTM is less than the coupon rate for a premium bond"

If you are holding two identical bonds, except that one matures in 10 years and the other matures in 5 years, which bond's price will be more sensitive to interest rate risk?

•The 10 year bond (The longer the term, the greater the interest rate sensitivity)

If you are holding two bonds—one with a 5% coupon rate and one with a 8% coupon rate—which is more sensitive to interest rate risk, all other things being equal?

•The bond with 5% coupon rate •Book keep in mind •1. All other thing being equal, the longer the time to maturity, the greater the interest rate risk . •2. All other things being equal, the lower the coupon rate, the greater the interest rate risk.

Corporate social responsibility

•This is the idea that a company is a guest in society and it has an obligation to mitigate the damage that it does in the pursuit of profit.

A corporate bond's yield to maturity:

•is usually not the same as a bond's coupon rate •changes over time •YTM is the expected return for an investor who buys the bond today and holds it to maturity. •YTM is the prevailing market interest rate for bonds with similar features

Rusty Antiques has a marginal tax rate of 39 percent and an average tax rate of 26.9 percent. If the firm owes $37,265 in taxes, how much taxable income did it earn?

$138,532

Financial management function (CFO, controller and treasurer)

(CFO) the vice president of finance coordinates the activities of the treasurer and the controller. The controller's office handles cost and financial accounting, tax payments, and management information systems. The treasurer's office is responsible for managing the firm's cash and credit, its financial planning, and its capital expenditures.

What are the three types of financial management decisions?

1. Capital budgeting: What productive assets should the business invest in? Managers must develop a product/service that is attractive to their potential customers. The product/service will exist only if the business invests in productive assets to produce the product/service. Examples would include the following. Should a business invest in developing a new service such as self-driving trucks? Should the business invest in an assembly line with workers or one with robots? Should the company establish a call center in the US or in the Dominican Republic? Should the business invest in viral marketing or print advertising? Non-profits and governments also must invest in productive assets. A charity applying for a grant from the Bill and Melinda Gates Foundation must specify the resources needed to protect pregnant women from the Zika virus. Should Austin invest in a passenger rail system? 2. Capital structure: How should a business raise the capital needed to invest in productive assets and finance its operations? Should managers issue financial securities—debt and equity—to raise capital? Is there an optimal mix of debt and equity? Instead of financial securities, should the business take out a bank loan? new equity and use the proceeds to retire outstanding debt), and 3. Working capital management: How can the company maintain its liquidity—its ability to ensure enough cash comes in on a daily basis to satisfy its short claims. While the capital budgeting and capital structure decisions involve the long-term focus of the business, working capital management focuses instead on the ability to run the business on a daily basis. Examples would be how the business manages it trade credit policy, its short-terms lines of credit, inventory levels, etc

Economic value is determined by 4 interrelated quantitative elements

1. Opportunity cost (An opportunity cost is the best alternative that is not chosen because another course of action is pursued. Any decision involves choice, and any choice involves a relative comparison between alternatives in order to choose the best alternative. Opportunity cost is often called the discount rate, the hurdle rate, the benchmark rate, or the required rate of return.) 2. Cash flows: cash is king! (It all comes down to cash. When making economic decisions, the focus is on incremental cash flows, which are those that occur if an investment is undertaken. Taxes play a major role in economic decisions. After-tax cash flows are used to make decisions because we all want to know how much cash we actually keep. Resourcefulness in the area of taxes is not always dishonest, as many companies take steps to legally minimize their tax bill. Minimizing the amount of taxes paid is a major goal of companies and individuals, and doing so is part of incremental cash flow analysis.) 3. Time value: only the future counts (Time value of money is a major element of economic decision-making. This is also the area that is most difficult for students to understand, as it involves thinking through time. To understand it, you must know that time and cash are related because most economic decisions involve multi-period cash flows. For example, investments involve paying out cash today in return for a promise to receive cash payments in future periods. Debt involves receiving cash today in return for a promise to pay the borrowed cash back with interest in future periods. Note that these cash flows are separated in time. The decision-maker must compare cash at one point in time with cash at other points in time.) 4. Risk: the future is uncertain. (Most decisions are focused on the future, and the future is unknown. This means that your cash flows are what you think they will be, not necessarily what they actually turn out to be. Risk is a large concern of economic value. This course devotes several units to various aspects of risk and how to factor risk into your decisions.)

Which of the following are traditional financial ratio categories?

1. Short-term solvency, or liquidity, ratios.(short-term solvency ratios as a group are intended to provide information about a firm's liquidity, and these ratios are sometimes called liquidity measures. The primary concern is the firm's ability to pay its bills over the short run without undue stress. Consequently, these ratios focus on current assets and current liabilities.) (example: current ratio, quick ratio, cash ratio) 2. Long-term solvency, or financial leverage, ratios. (Long-term solvency ratios are intended to address the firm's long-run ability to meet its obligations, or, more generally, its financial leverage.) 3. Asset management, or turnover, ratios. (What they are intended to describe is how efficiently, or intensively, a firm uses its assets to generate sales) 4. Profitability ratios.( In one form or another, they are intended to measure how efficiently the firm uses its assets and how efficiently the firm manages its operations. The focus in this group is on the bottom line—net income.) 5. Market value ratios

Given human nature, which of these systems (socialism and capitalism) for managing property rights might best organize economic activity? To answer this question, we examine two aspects of economic activity

1. The first aspect involves economic efficiency (this refers to getting the most output from productive resources). 2. The second aspect involves fairness (fairness refers to the idea that all humans have access to a decent standard of living) oEconomic activity is best conducted through markets. Countries with legal systems that support private property rights, that provide a nurturing regulatory foundation for the creation and growth of private businesses, and that limit government control of economic decisions and minimize the opportunity for corruption, produce a higher standard of living—wealth--for their citizens.

Three facets of human nature

1. evaluative 2. imperfectly maximizing 3. resourceful

3 key roles of the government

1. focus on economic welfare of citizens 2. limit opportunistic behavior (ex. worker safety, labor rights, product standards, consumer protection) 3. modify or replace markets (examples of how government modified economic activity: minimum wage, health care, student loans, mortgage assistance)

C- Corp 1. pass through 2. extent of liability 3. potential for agency problem

1. no (double taxation) 2. limited liability 3. yes

The structure of accounting allows participants to

1. record performance 2. establish value 3. report information to owners, stakeholders, and the government

Sole Proprietorship 1. pass through? (for purposes of paying taxes who is responsible to pay taxes over those profits. does company or owner pay for income tax? yes or no) 2. extent of liability 3. potential for agency problem (inherent conflict of interest between stockholders and owners) 4. access to capital (limited or unlimited needs) 5. access to capital (limited or unlimited life)

A business that is owned by a single person 1. yes 2. unlimited liability (If the company does not have enough assets to cover these debts, then the company's creditors will look to the personal assets of the proprietor to satisfy their claims.) 3. no 4. limited needs (The proprietor finances the company by borrowing as an individual, the same as you and me. If more money is needed, the proprietor may sell some of his/her possessions or take out a loan to finance business activities.) 5. limited life (If the proprietor dies, then legally the business dies with the owner.)

Cal's Market has return on equity of 15 percent. What does this mean?

Cal's generated $0.15 in profit for every $1 of book value of equity.

Pharrell, Inc. has sales of $634,000, costs of$328,888, depreciation expense of $73,000, interest expense of $38,000, and a tax rate of 35 percent. Suppose Pharrell, Inc. paid out $43,000 in cash dividends. Suppose Pharell, Inc. had 35,000 shares of common stock outstanding. What is the earnings per share, or EPS, figure? What is the dividends per share figure?

Earnings per share is the net income divided by the shares outstanding, so: EPS = Net income / Shares outstanding EPS = $126,750 / 35,000 EPS = $3.62 per share Dividends per share are the total dividends paid divided by the shares outstanding, so: DPS = Dividends/Shares outstanding DPS = $43,000 / 35,000 DPS = $1.23 per share

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

For a successful company that is rapidly expanding, capital outlays would typically 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. This question implicitly introduces a major difference between accounting and market values. Accounting statements look at values over a single point in time (balance sheet) or the flows of revenues and expenses over a defined period of time (income statement.) Market values, as we'll see in Part III, look at the entire life of an investment and include not only the initial investment but also the future cash flow to be received from the investment.

Hailey, Inc., has sales of $38,530, cost of $12,750, depreciation expense of $2,550, and interest expense of $1,850. If the tax rate is 35%, what is the operating cash flow, or OCF?

Income Statement Sales $38,530 Costs 12,750 Depreciation 2,550 EBIT $23,230 Interest 1,850 Taxable income $21,380 Taxes (35%) 7,483 Net income $13.897 Now we can calculate the OCF, which is: OCF = EBIT + Depreciation - Taxes OCF = $23,230 + 2,550 - 7,483 OCF = $18,297

Suppose a company's operating cash flow was 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. As cash balances go down, the company faces insolvency, where it does not have the underlying value to continue operations. A company that has several years of negative cash flow would eventually run out of cash and cease to exist. On the other hand, a start-up would likely face negative cash flow for several years. The negative cash flow would be a sign of growth as the company develops its concepts into a viable product.

Marginal tax rate vs. average income tax rate

Marginal tax rate •The marginal tax rate is adjusted on a marginal basis, meaning that if you earn more, you pay more taxes at a higher tax rate. Average Income Tax Rate •The average income tax rate is the average tax rate you pay on total income. •Average rate= total tax payments/total income

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.

Bear Tracks, Inc. has current assets of $2,030, net fixed assets of $9,780, current liabilities of $1,640, and long-term debt of $4,490. What is the value of the shareholders' equity amount for this firm? How much is net working capital?

Owners' equity = Total liabilities and owners' equity - Current liabilities - Long-term debt Owners' equity = $11,810 - 1,640 - 4,490 Owners' equity = $5,680 NWC = Current assets - Current liabilities NWC = $2,030 - 1,640 NWC = $390

BC Corporation has 1,800 shares outstanding and earned $2,700 last year on assets of $2 million and equity of $1.5 million. What is the PE ratio if the stock is currently selling at $18 per share?

PE ratio= price per share/earnings per share • 18/1.5=12 times Earnings per share= net income/ shares outstanding • 2,700/1,800=1.5

What are the four primary disadvantages to the sole proprietorship and partnership forms of business organization? Advantages?

Proprietorships and partnerships have some disadvantages. 1. Unlimited liability: The owners' wealth is exposed to losses in the business. If the assets of the business are insufficient to meet the claims on the business, creditors will seize the personal assets of the owners. This, as you can, imagine, limits the interest of outsiders to invest in the business. 2. Limited life: Formally the proprietor/partner is the business. They die, the business legally also dies. 3. Difficulty in transferring ownership: A proprietor or partner desiring to exit the business must find someone who would wish to buy them out. This transfer of ownership is a complex, expensive and time-consuming process. It is also made difficult by the lack of an external market price that would help value the business. 4. Hard to raise capital funds: This disadvantage is the result of the other three disadvantages. Proprietorships/partnerships will not attract many outside investors. Anyone wanting to invest, but not be an active manager, faces risk to their entire wealth, would have to invest in a business that would legally die if an owner dies, and would find it difficult to get out of the investment. Advantages 1. Simple to establish: They have a much simpler structure to establish and run. 2. Less regulation: They face less regulation than corporations. 3. No Agency conflict: The owners are the managers, so there is not an inherent agency conflict. 4. Taxes: This is a biggie! Profits are taxed as personal income of the owners

What are the primary disadvantages to the corporate forms of business organization? Advantages?

Their disadvantages include the following. 1. Double taxation. Corporations, as separate legal entities from their owners, are taxed. Any profits distributed to their owners—shareholders—are then taxed as personal income. 2. Agency problems: The corporate structure separates owners from managers, allowing managers to pursue their own interests to the potential harm of shareholders, customers, and society in general. Despite these disadvantages, corporations dominate economic activity because of their substantial advantages. 1. Limited liability: Shareholders face the potential loss of their investment in the company, but to not put all of their assets at risk to poor decisions on the part of the corporation's managers. 2. Unlimited life: The corporation, as a separate legal entity from its owners, is not subject to the requirement to be reorganized upon the death of an owner. 3. Ease of transferability: Ownership interests are valued as shares, which can be easily transferred among investors in the stock market. 4. Ease of raising capital: As you can see, these three advantages of corporations are the mirror image of the disadvantages of the proprietorship/partnership organizational form. Corporations can attract external investors because these investors, do not risk their whole wealth, can depend on a corporation being around for a long time period, and can easily sell their investment. Just about the most important decision on making an investment is having a clear exit available! 4. Specialization: The Key Concepts: The Forms of Business Organizations stressed the separation of ownership and management, which leads to specialization, which leads to increased efficiency.

Use the following tax table to answer this question: 0-50,000 (15%) 50,001-75000(25%) 75,001-100,000 (34%) 100,001-335,000 (39%) 335,001-10,000,000 (34%) Comfy Inn earned $218,310 in taxable income for the year. How much tax does the company owe?

Total tax = .15($50,000) + .25($25,000) + .34($25,000) + .39($218,310-100,000) Total tax = $68,390.90

In preparing a balance sheet, why do you think standard accounting practices focuses on historic costs rather than market values?

Uses and Guiding Principles of Accounting, we defined the cost principle to record the purchase price of assets. Accounting uses historical costs, which can be measured and reflect market values at the time the asset is obtained. Historical costs are thus considered more objective and not subject to estimation errors, or inflated by managers to make them look better. On the other hand, estimated market values for many assets are uncertain

The quick ratio provides a more reliable measure of liquidity than the current ratio especially when the company's inventory takes ______ to sell.

a long time because inventory that is held for a long time is not very liquid

Current assets

assets= resources short term assets have a life of one year or less 1. Cash 2. Marketable securities (Businesses may store some of their liquid purchasing power in short-term investments called marketable securities. These assets earn interest, but can be quickly liquidated—turned back into cash--when cash is needed. Treasury bills, commercial paper, certificates of deposits and bankers' acceptances are examples of marketable securities.) 3. Inventory (Materials and products in the manufacturing process are assets of the company and recorded as inventory. Inventory changes forms, from raw materials to work-in-progress, to finished goods ready for sale. Inventory is the least-liquid of current assets: there is no assurance that an item in inventory will actually be sold!) 4. Accounts Receivable (Many companies extend short-term credit to their customers called trade credit. The customer receives the product, and agrees to pay for it within a certain period of time. This is not as liquid as cash, as a customer may delay paying, or even default.)

General partnership 1. pass through? (for purposes of paying taxes who is responsible to pay taxes over those profits. does company or owner pay for income tax? yes or no) 2. extent of liability 3. potential for agency problem (inherent conflict of interest between stockholders and owners) 4. access to capital (limited or unlimited needs) 5. access to capital (limited or unlimited life)

at least 2 people 1. yes (taxes fall on general partners) 2. unlimited liability (partners are jointly liable for the partnership) 3. no 4. limited needs (While partnerships may need more capital than proprietorships they face the same basic limitation: the amount of capital raised depends on the creditworthiness of the partners.) 5. Limited life (When a partner dies, the partnership also ends legally. The partnership agreement can be structured to have partners joining or leaving the partnership in case of death or other issues that may arise).

Probably the least effective means of aligning management goals with shareholder interests is: the threat of a takeover of the firm. the potential for a proxy fight by an unhappy segment of shareholders. holding management salaries steady while increasing stock option grants. basing all management bonuses on performance goals. automatically increasing management salaries on an annual basis.

automatically increasing management salaries on an annual basis

Jenna has been promoted and is now in charge of all external financing. In other words, she is in charge of: asset allocation. capital budgeting. working capital management. risk management. capital structure management.

capital structure management

Cash flow to stockholders is defined as: cash flow from assets plus cash flow to creditors. net income minus the addition to retained earnings. dividends paid plus the change in retained earnings. operating cash flow minus cash flow to creditors. dividends paid minus net new equity raised.

dividends paid minus net new equity raised.

Bear Tracks, Inc., has current assets of $2,330, net fixed assets of $10,900, current liabilities of $1,430, and long-term debt of $4,140. What is the value of the shareholders' equity account for this firm? How much is the company's net working capital?

equity: 7660 net working capital: 900

The Sarbanes-Oxley Act of 2002 has: decreased the number of U.S. firms going public on foreign exchanges. decreased senior management's involvement in the corporate annual report. greatly increased the number of U.S. firms that are going public for the first time. essentially made officers of publicly traded firms personally responsible for the firm's financial statements. reduced the annual compliance costs of all publicly traded firms in the U.S.

essentially made officers of publicly traded firms personally responsible for the firm's financial statements

A sole proprietorship: provides limited financial liability for its owner. has an unlimited life. has its profits taxed as personal income. involves significant legal costs during the formation process. can generally raise significant capital from non-owner sources.

has its profits taxed as personal income

Corporate shareholders: have the ability to change the corporation's bylaws. are protected from all financial losses. have basically no control over the actual corporation. are proportionately liable for the firm's debts. receive tax-free distributions since all profits are taxed at the corporate level.

have the ability to change the corporation's bylaws

If a company has inventory, the quick ratio will always be ______ the current ratio.

less than

Current liabilities

liabilities=debt short term claims claims that must be paid within a year 1. Accounts Payable (In addition to extending trading credit, companies also use it by establishing accounts with their suppliers. These suppliers then allow companies to receive resources and then pay on their account on a regular basis. This short-term credit for resources received is called accounts payable.) 2. Notes Payable (A company may also establish a short-term line of credit with a bank. This line of credit is set up with a given limit, and a company can draw on it as needed. These short-term loans are listed as notes payable.) 3. Accrued Expenses Payable

Which one of the following forms of business organization offers liability protection to some of its owners but not to all of its owners? Corporation Limited partnership Limited liability company Sole proprietorship General partnership

limited partnership

Long-term liabilities

long-term claims 1. Long-term debt (This account records the nominal, or face value, of the bonds that the company has issued to finance its operations. This nominal value may be very different than the debt's market value, an important concept we will examine in future units.) 2. Deferred taxes (Taxes are complex! As we will see, there are several ways that taxes can be computed. Companies may use tax laws to defer taxes to future periods. These taxes are thus obligations of the company, but they are obligations that are not paid during the current period. This is a complex area that we will leave to your accounting courses.) 3. Bonds

The SGS Co. had $243,000 in taxable income. Using the rates from Table 2.3 in the chapter, calculate the company's income taxes What is the average tax rate and marginal tax rate for this problem?

look at #8 unit 4 application Average tax rate = Total tax / Taxable income Average tax rate = $78,020 / $243,000 Average tax rate = .3211, or 32.11% Marginal tax rate 39%

S-Corp 1. pass through 2. extent of liability 3. potential for agency problem

maximum of 100 owners all owners must be persons all owners must be of US 1. yes 2. limited liability (because recognized as separate entity) 3. yes

The corporate tax structure in the U.S. is based on a: minimum tax rate of 10 percent. flat rate of 34 percent for the highest income earners. flat-rate tax. modified flat-rate tax. maximum tax rate of 38 percent.

modified flat tax rate

Long-term assets

non-current assets often called capital assets or fixed assets Not liquid (cannot easily be disposed at full value) 1. Property, plant and equipment (Such assets are tangible, such as a building, a truck, or, in the 19th century, a team of horses and a stagecoach! The accountant records these assets when the company acquires them and—A Very Important Point—records them at the purchase price. This account also reflects the use of the capital asset over time, called depreciation.) 2. Intangibles (Many long-term assets are intangible. Patents, copyrights, and goodwill are all types of intangible assets. The company brand identity is a very important intangible that the company goes to great length to protect. These intangibles may be very difficult to value. And, the value may change abruptly with a shift in technology or a business event such as a merger or major scandal.)

Agency Costs and Types of Agency Costs

oAgency costs are a reduction in the corporation's cash flows created by the existence of the agency conflict. While these costs can take many forms, here you can explore some of the more important sources. Types of Agency Costs 1. Excessive perquisites (People hear the word executive and think of corner offices, executive jets, limousines, penthouses, or three-martini lunches. All of these perks go with the job and are paid for out of company cash flows.) 2. Horizon problem (Managers hold their positions for a limited time and may make decisions that benefit the short term at the expense of the long term. This horizon problem is a part of human nature and affects all decision makers) 3. Focus on size This large size also allows managers to focus more on corporate wealth, which is an accumulation of assets, rather than shareholder wealth, which focuses on profitability.

Depreciation

oDepreciation is a unique type of expense. It is recognized as an accounting expense, and thus is tax-deductible: it lowers taxable income and thus taxes. However, it is not a cash flow. oDepreciation means allocating a capital asset's expense over the projected life of the asset.

Equality of results versus equality of opportunity

oEquality of results means that all members of society should live with an acceptable standard of living including education, health care, housing, and other economic aspects oEquality of opportunity means that all members of society should have opportunities to seek out their well-being but that they must follow their own incentives with success.

BC Toys has total equity of $584,000. There are 35,000 shares outstanding at a market price of $54 per share. What is the market-to-book ratio?

oMarket value per share/book value per share oBook value per share= total equity/number of shares outstanding (this one NOT on formula sheet) 54/(584,000/35,000) =3.24 times

Net working capital

oNet Working Capital (NWC) measures the difference between assets that will turn into cash within a year and claims that must be paid with cash within a year. (current assets-current liabilities) oNet Working Capital= Short-Term Assets minus short term liabilities oNet Working Capital (NWC) is a very important measure of liquidity: the ability of a company's ability to handle its current expenses. It should be a positive number, meaning that more cash is coming in than going out. NWC management is a very important function in a company. The net resources a company has so it can run on a day to day basis

What is the main difference between the cash coverage ratio and the times interest earned ratio?

oNon-cash expenses oCash ratio adds non-cash expenses back to the EBIT to determine its ability to meet its interest obligations

Socialism

•A command economy, uses collective or government control of property rights. (This means the government directs the economy to provide a fair distribution of society's output.) •Government control of property rights reduced economic inequality, leading to greater social cohesion and the protection of the dignity of each member of society.

Capitalism

•A market economy, uses individual control of property rights. •Market participants act on incentives to maximize their welfare. By allowing individuals to pursue their own benefit, scarce resources are allocated based on the cumulative trade of market participants. This maximizes the standard of living for the society as a whole

Property rights

•Are the right to control an asset. •This control includes how the property should be used, how the benefits from this use are distributed, and the ability to dispose of the asset. •The important question is: who controls these property rights? The answer to this question defines the different economic systems. (socialism and capitalism)

External control devices

•External control devices are controls placed on corporate managers by individuals and organizations outside of the corporation o1. Government •Governments provide substantial regulation and oversight of corporate activity. These regulations focus particularly on general and managerial actions. o2. External audits •Security laws require public companies to undergo an annual audit by an outside auditor. This auditor reports to the stockholders. In their current form, external audits are not acting as effective control devices. o3. Lawsuits •Stockholders who feel that managers have violated their fiduciary responsibility can sue managers and directors of a corporation. o4. Large Institutional Investors •Investors with a substantial ownership share in the corporation can place pressure on managers to improve performance. These large institutions may even have a seat on the board, which further increases their influence. o5. Takeover •An outside group may feel that a corporation is being badly managed. In response, the group may offer existing stockholders a premium for their stock, obtain sufficient shares to control the firm, and then replace the board and existing managers in order to reconfigure the corporation's assets.

Internal control devices

•Internal control devices are internal to the firm in that they are created and run by the firm's managers and owners. These internal controls assure the stockholders that the managers will look after the stockholders' interests. o1. Compensation •Carefully designed compensation contracts for managers are a successful control device. While these contracts involve a straight salary, their major component is often extra compensation (such as additional stock options) connected to the performance of the firm. o2. The Board of Directors •The board is elected by stockholders. They are responsible for setting the direction of the firm and hiring managers. The board also oversees managers' performance and sets their compensation. o3. Charter and By-laws o4. Managers

The Accrual Method/Matching Principle

•The accountant matches expenses (outflows) with revenues (inflows). This makes sense because you will only incur an expense if you expect it to benefit you by producing revenues. In many instances, a specific expense and the revenues it generates will occur in different periods. The account will restate these numbers so that they are comparable.

The Realization Principle

•The accountant recognizes revenues when a contractual obligation occurs, such as a formal sales contract where a customer purchases a product from the company. For major business transactions, substantial time may pass between key events: when the contract is entered into, when the product is produced, when the product is shipped, and when the customer actually pays cash to satisfy the price obligation. There is even a possibility that the customer may default on the contract and not pay, resulting in no revenue or cash. Thus, accounting revenue and cash flow are generally not the same.

The Cost Principle

•To be objective, the accountant records the purchase price of an asset and does not adjust this price to reflect changes in its market value (which may likely be quite variable). Thus, the accountant records the assets at cost, which may not reflect the asset's market value