BEC Wiley Module 9
Nexco, Inc. is considering factoring its accounts receivable. Factorco, Inc. has offered the following terms for accounts receivable due in 30 days: Value of receivables to be held in reserve for contingencies10%Following costs are deducted at time accounts are factored:Interest rate on amounts provided12%Factor fee on total receivables factored2% If Nexco factors $200,000 of its accounts receivable due in 30 days with Factorco and, during that 30 days, $10,000 of those accounts receivable are reversed because the related goods were return or allowances were granted, which one of the following is the amount that Nexco will receive from Factorco at the end of the 30 day period? a. $ -0- (no amount) b. $ 9,800 c. $10,000 d. $19,600
$10,000 The amount held in reserve was .10 x $200,000, or $20,000. During the 30-day period of the factor agreement, $10,000 of the accounts receivable factored had to be reversed because of sales returns and allowances. Therefore, at the end of the 30-day period, Factorco would pay Nexco the remaining $10,000 ($20,000 reserve - $10,000 reversed = $10,000).
advantages of leasing
1. limited immediate cash outlay 2. possible lower cost than purchasing, resulting primarily from lessor efficiencies, lower interest rates, or tax savings, some of which are "passed on" to the lessee 3. the resulting debt (lease payment) is specific to the amount needed 4. possibility of scheduling payments to coincide with cash flows 5. no (or fewer) restrictive agreements than incurring certain other debt
advantages of factoring accounts receivable
1. commonly available 2. flexible: as new accounts receivable occur, they are available for sale 3. compensating balances are not required 4. provides cash for general use 5. buyer generally assumes billing and collection responsibilities
advantages of using pledge accounts receivable to secure a loan
1. commonly available 2. flexible - as new receivables occur, they are available as security 3. compensating balances are not required 4. provides cash for general use 5. lender may assume billing and collection services
advantages of using inventory to secure short-term financing
1. commonly available for certain inventories 2. flexible- as new inventory are obtained, they are available as security 3. compensating balances are not required 4. provides cash for general use
advantages of short term notes for financing purposes
1. commonly available for creditworthy firms 2. flexible- amounts and periods (within one year) can be varied with needs 3. unsecured- no assets pledged as collateral 4. provides cash 5. short maturity permits refinancing at lower cost if interest rates decline
advantages of line of credit, revolving credit, and letter of credit
1. commonly available for creditworthy firms 2. highly flexible- credit used (debt incurred) only when needed 3. unsecured- no assets pledged as collateral 4. line of credit and revolving credit provide cash for general use
disadvantages of factoring accounts receivable
1. cost may be greater than certain other sources of short-term financing 2. if sold with recourse, firm may have ongoing risk 3. sale of their accounts may alienate customers
advantages of using trade accounts payable for financing
1. ease of use- little legal documentation required 2. flexible- expands and contracts with needs (purchases) 3. interest normally not charged 4. unsecured - no assets pledged as collateral 5. discount often offered for early payment
disadvantages of leasing
1. not all assets are commonly available for lease 2. lease financing is asset specific - funds are not available for general use 3. lease terms may prove different than the period of asset usefulness 4. often chosen for reasons other than economic justification
disadvantages of using commercial paper for financing
1. only available to most creditworthy firms 2. requires satisfaction in the short-term usually of a large amount 3. lacks flexibility of extension or other accommodation available in bank loans
disadvantages of using long-term notes
1. poor credit rating result in higher interest rates, greater security requirements, and more restrictive covenants 2. violation of restrictive covenants triggers serious consequences, including technical default
degree of financial leverage (DFL)
% change in EPS/% change in EBIT EPS = earnings per share EBIT= Earnings before interest and taxes
degree of operating leverage (DOL)
% change in operating income/ & change in unit volume
advantages of using bonds for financing purposes
1. a source of large sums of capital 2. does not dilute ownership or earnings per share 3. interest payments are tax deductible
advantages of using long-term notes
1. commonly available for creditworthy firms 2. provides long-term financing, often with periodic repayment
advantages of using accrued accounts payable for financing
1. ease of use- occurs in the normal course of business 2. flexible- expands and contracts with activity 3. unsecured- no assets pledged (though taxing authorities have a specific legal claim)
disadvantages of using common stock for financing
1. generally a higher cost of capital than other sources 2. dividends paid are not tax deductible 3. additional shares issued dilute ownership and earnings
advantages of using commercial paper for financing
1. interest rate is generally lower than other short-term sources 2. larger amount of funds can be obtained through multiple commercial paper notes than would be available through a single financial institution 3. compensating balances are not required 4. unsecured- no assets are pledged as collateral 5. provides cash for general use
disadvantages of using inventory to secure short-term financing
1. pledged inventory may not be available when needed 2. cost can be greater than certain other sources of short-term financing 3. requires repayment in the short-term 4. not available for certain inventory
secured bonds
Have specific assets (e.g., machinery and equipment) designated as collateral for the bonds.
retained earnings and common stock
In addition, since common stockholders have a residual claim to income, and retained earnings are largely residual income, the expected rate of return on common stock also reflects the implicit cost of internal financing—that is, the cost of using retained earnings rather than distributing them in the form of dividends. The cost of capital for retained earnings (for which there are no flotation costs) would be less than the cost of capital for issuing new common stock due to the flotation costs of issuing such new securities.
mortgage bonds
Secured by a lien on real property (e.g., land and building).
outstanding preferred stock
Since the annual dividend is "fixed" and the market price will change to reflect changes in market perceptions of the stock, the expected rate of return (computed above) reflects the rate investors currently require to invest in the stock. That rate is a measure of the firm's current cost of outstanding preferred stock capital.
new preferred stock
The cost of newly issued preferred stock is determined by dividing the annual dividend by the issue price, including any premium or discount.
current yield
The ratio of annual interest payments to the current market price of the bond. Assuming a $1,000, 6% bond currently selling for $900, the current yield (CY) would be computed as: CY = Annual coupon interest / Current market price
Which of the following formulas should be used to calculate the historic economic rate of return on common stock? a. (Dividends + change in price) divided by beginning price. b. (Net income - preferred dividend) divided by common shares outstanding. c. Market price per share divided by earnings per share. d. Dividends per share divided by market price per share.
a. (Dividends + change in price) divided by beginning price.
PSV =
annual dividend/ required rate of return
Larson Corp. issued $20 million of long-term debt in the current year. What is a major advantage to Larson with the debt issuance? a. The reduced earnings per share possible through financial leverage. b. The relatively low after-tax cost due to the interest deduction. c. The increased financial risk resulting from the use of the debt. d. The reduction of Larson's control over the company.
b. The relatively low after-tax cost due to the interest deduction. The issuance of debt results in interest expense, which is deductible for tax purposes. Therefore, the effective cost of debt is less than its stated interest rate by the amount of taxes saved by that interest deduction. The effective cost of debt is its interest cost x (1 - tax rate).
If a firm purchases raw materials from its supplier on a 2/10, net 40, cash discount basis, the equivalent annual interest rate (using a 360-day year) of forgoing the cash discount and making payment on the 40th day is: a. 2% b. 18.36% c. 24.49% d. 36.72%
c. 24.49% The annual interest rate of forgoing the cash discount is calculated as: [Discount %/(1.00 - Discount %)] × [360/(40 - 10)] For the facts given, the calculation would be: [.02/(1.00 - .02)] × [360/30] = .02041 × 12 = .2449 (or 24.49%)
Which one of the following would not be considered a means of long-term financing? a. Financial lease. b. Common stock. c. Trade accounts payable. d. Bonds payable.
c. trade accounts payable The use of trade accounts payable (a current liability) is a means of short-term financing, not long-term financing.
Which of the following statements concerning short-term financing is/are correct? I. Accounts payable can provide short-term financing. II. Accounts receivable can provide short-term financing. III. Inventory can provide short-term financing. a. I only. b. I and II, only. c. I and III, only. d. I, II, and III.
d. I, II, and III.
the market price of a bond issued at a premium is equal to the present value of its principal amount a. only, at the stated interest rate b. and the present value of all future interest payments, at the stated interest rate c. only, at the market (effective) interest rate d. and the present value of all future interest payments, at the market (effective) interest rate
d. and the present value of all future interest payments, at the market (effective) interest rate
maturity face value
discounted as the present value of a single amount
revolving credit agreement
like a line of credit, but it is in the context of a legal agreement between the borrower and the financial institution
intermediate-term financing
taken as sources of financing that mature in more than one year but less than ten years
indenture
the bond contract
Long-term capital financing
the sources of funds used by a firm that do not mature within one year. - beyond ten years.
maturity
the time at which the issuer repays the par value to the bondholders
Financial leases
when leasing is an option for acquiring assets in a capital budgeting project, evaluation of the project has to take into account the different costs associated with each alternative for financing the project assets buying and leasing. Therefore, the analysis would need to determine: 1. whether the proposed project is economically feasible if assets are purchased; and 2. whether the proposed project is economically feasible if assets are leased
disadvantages of short term notes for financing purposes
1. poor credit rating results in high interest (and possibility of security required) 2. requires satisfaction in the short-term 3. a required compensating balance increases cost and reduces effective funds available 4. refinancing at higher rates may be necessary if interest rates increase
debenture bonds
Unsecured; no specific asset is designated as collateral. These bonds are considered to have more risk and, therefore, must provide a greater return than secured bonds.
accrued accounts payable
results from benefits or cash received for the related unpaid obligation. Examples: 1. salaries and wages payable 2. taxes payable 3. unearned revenue (collected in advance) To the extent that there is a timing difference between when the benefit (or cash) is received and when the related obligation is satisfied, the cost or funds involved provide temporary (short-term) financing to the entity.
private market
includes loans from financial institutions or through private placement using unregistered interments, typically through insurance companies or pension funds
management changes
requiring lender approval before certain changes in key personal are made
additional incurrence of debt
requiring lender approval before taking on additional long-term debt, including such s might arise through financial leases
frequency and nature of financial information
requiring the borrower to provide periodic financial statements and related disclosures, perhaps with an audit report
common stock expected return
(dividend in next year/ market price) + growth rate
disadvantages of using pledge accounts receivable to secure a loan
1. accounts are committed to lender 2. cost may be greater than certain other sources of short-term financing 3. requires repayment in the short term
Types of long term financings
1. long-term notes 2. financial (capital) leases 3. bonds 4. preferred stock 5. common stock
preferred stock
A class of ownership in a corporation that has a priority claim on its assets and earnings before common stock, generally with a dividend that must be paid out before dividends to common shareholders are paid. grants ownership interest in a corporation that has preference claims not held by common stock shareholders. given a priority claim to income distribution and to assets upon liquidation of the firm dividend amount is expected and limited in amount and generally does not include voting rights it does grant ownership interest, has no maturity date, does not require dividends be paid, provides that dividends paid are not an expense and are not tax deductible, has liability that is limited to the amount of the investment, different classes, cumulative/noncumulative feature to distinguish whether dividends not paid in any year accumulate and require payment before payment of common dividends, protective provisions, convertible/nonconvertible to common stock, call provisions
bonds
Long-term promissory notes wherein the borrower, in return for buyers'/lenders' funds, promises to pay the bondholders a fixed amount of interest each year and to repay the face value of the note at maturity.
relative level of debt financing for cost of capital
Recognizes that at some level of debt financing increasing financing sought through debt will increase the cost of marginal debt and result in increasing the cost of capital.
debt security for cost of capital
Recognizes that the greater the value of collateral relative to the amount of debt, the lower the interest rate, or cost of capital.
amount of financing for cost of capital
Recognizes that the larger the absolute amount of financing sought, the higher the cost of capital.
debt maturity for cost of capital
Recognizes that the longer the maturity of debt, the higher the cost of capital. The longer the debt, the greater the risk of interest rate changes, thus, lenders charge a maturity premium for that risk.
Which one of the following forms of short-term financing is least likely to be restricted as to use of proceeds? a. Trade accounts payable. b. Accrued taxes payable. c. Accrued salaries payable. d. Short-term notes payable.
d. Short-term notes payable As a form of short-term financing, short-term notes usually provide cash which often may be used for various asset and expense purposes.
disadvantages of using preferred stock for financing
1. dividend expectations are high 2. dividend payments are not tax deductible 3. if trigged, protective provisions may be onerous 4. generally, a higher cost of capital than bonds
advantages of using common stock for financing
1. no legally required periodic payments. default cannot result from failure to pay dividends 2. no maturity date 3. no security required
advantages of using preferred stock for financing
1. no legally required periodic payments; default cannot result from failure to pay dividends 2. generally a lower cost of capital than common stock 3. generally does not bestow voting rights 4. no maturity date 5. no security required
disadvantages of using bonds for financing purposes
1. required periodic interest payments - default can result in bankruptcy 2. required principal repayment at maturity - default can result in bankruptcy 3. may require security and/or have restrictive covenants.
Eurobonds
Debt security (bond) payable in the borrower's currency but sold outside the borrower's country. For example, a U.S. firm (issuer) might issue bonds payable in dollars but sold in another country. Because the registration and disclosure requirements are less than in the U.S., the bond can be issued at lower costs than in the U.S.
macroeconomic conditions for cost of capital
Includes market conditions and expectations concerning economic factors such as interest rates, tax rates, and inflation/deflation rates. Increasing interest rates, tax rates and inflation, or expectation thereof, will result in a higher cost of capital.
investor related crowdfunding regulations
Limit the amount an individual investor may invest in offerings to: If the investor's annual income or net worth is less than $107,000, the greater of: > $2,200, or> 5% of the lesser of their annual income or net worthIf both the investor's annual income and net worth are equal to or greater than $107,000, 10% of the lesser of their annual income or net worth, not to exceed $107,000 Limit the maximum amount an investor may invest in all crowdfunding equity offerings during a 12-month period to $107,000 Generally imposes a one-year holding requirement before the securities may be resold (Source: SEC, Updated Investor Bulletin: Crowdfunding for Investors, May 10, 2017)
preferred stock rate of return
PSER= annual dividend/market price
company-related crowdfunding requirements
Preclude the use of crowdfunding by certain entities, including non-U.S. companies, companies that must report under the Exchange Act, companies that have no specific business plan, companies that plan to merge with or acquire another unspecified company, certain investment companies, and companies that fail to comply with SEC reporting requirements Require all crowdfunding transactions take place through an SEC-registered broker-dealer or funding portal Limit the amount a company may raise through crowdfunding during any 12-month period to a maximum of $1 million Require certain reporting by the company, including information about the business, the intended use of funds raised, the security price and the total offering amount; a discussion of the company's financial condition and disclosure of its financial statements; information about officers, directors, owners of 20% or more of the company and certain related party transactions
past performance of the firm for cost of capital
Reflects management's operating and financial decisions and the riskiness associated with those decisions. The greater the inferred risk inherent in past performance, the higher the risk premium required and, therefore, the cost of capital.
APR
[(Discount lost/principal)X1]/Time Fraction of Year principal is the amount that would have been paid if the discount were taken
letter of credit
a conditional commitment by a bank to pay a third party in accordance with specified terms and commitments use of a letter of credit provides assurance of funding to the third party without the borrowing firm having to pay in advance of shipment of goods. letters of credit are frequently used in connection with foreign transactions
inventory secured loans
a firm pledges all or part of its inventory as collateral for a short-term loan. the amount that can be borrowed depends on the value and marketability of the inventory. Different arrangements for inventory secured loans provide different treatment of the inventory and different levels of security for the lender: 1. floating lien agreement 2. chattel mortgage agreement 3. field warehouse agreement 4. terminal warehouse agreement
Which of the following corporate characteristics would favor debt financing versus equity financing? a. A high tax rate. b. A high debt-to-equity ratio. c. Low aversion to risk. d. Below-average stock issuing costs.
a. A high tax rate Other things being equal, the higher the tax rate of a firm, the greater the benefit from debt financing because the cost of debt (interest expense) is tax deductible and therefore generates a tax savings. That tax savings offsets the nominal cost of the debt. Since interest is not paid on dividends to equity holders and since dividends are not tax deductible, there is no comparable savings related to equity financing.
Sen Corp., a publicly traded, mid-cap company, wanted to obtain $30 million in new capital to expand its Iowa plant. Cost of capital was a factor in making the decision. Sen Corp. could either issue new preferred stock or new debentures. Sen Corp.'s underwriter estimated that preferred stock should have an annual dividend payout of $6 and an issue price of $103 per share. The debentures should have a coupon interest rate of 9% and an issue price of $101. Sen Corp.'s marginal income tax rate was 40%. Which of the following approaches describes Sen Corp.'s best strategy? a. Sen Corp. should issue the debentures since the after-tax cost of debt (5.347%) would be less than the cost of equity (5.825%). b. Sen Corp. should issue the debentures since the after-tax cost of debt (5.347%) would be less than the cost of equity (6%). c. Sen Corp. should issue the preferred stock because the cost of equity (6%) is less than the cost of debt (9%). d. Sen Corp. should issue the preferred stock because the cost of equity (5.825%) is less than the cost of debt (9%).
a. Sen Corp. should issue the debentures since the after-tax cost of debt (5.347%) would be less than the cost of equity (5.825%). Sen Corp.'s best strategy would be the one that results in the lower cost of obtaining the $30 million in new capital. The cost of debentures is determined as the annual interest payment divided by proceeds received per bond issued, reduced by the tax savings resulting from the deductibility of the bond interest expense. The annual interest payment per bond is: .09 × $100 = $9.00. The proceeds from each bond are $101.00. Thus, the computed pretax cost of the bonds is: $9.00 / $101.00 = .0891. With a tax rate of 40%, the net of tax cost is: .0891 × (1 - .40) = .0891 × .60 = .053465, or 5.347%. The cost of preferred stock is the annual dividend divided by the proceeds received per share issued. Since dividends are not deductible for tax purposes, there is no adjustment for tax savings. The annual dividend per share is $6. The proceeds from issue of the stock is $103. Thus, the computed cost of the preferred stock is $6.00 / $103.00 = .05825, or 5.825%. Therefore, the cost of issuing bonds (5.347%) is less than the cost of issuing preferred stock (5.825%), and Sen should issue bonds to obtain its new capital.
Term structure of interest rates
also called the yield curve- shows the current yield to maturity (rate of return) on bonds of similar quality that have different lengths of time until maturity. The term structure is commonly plotted with interest rate so the veritable axis and time to maturity on the horizontal axis
A start-up company plans to offer shares of its common stock through a SEC-registered online funding portal. Assuming the company meets the requirements for crowdfunding, which one of the following is the maximum amount, if any, it may raise through crowdfunding during its first year? a. $100,000. b. $1,000,000. c. $10,000,000. d. There is no limit.
b. $1,000,000
Whipco has determined that its pre-tax cost of preferred stock is 12%. If its tax rate is 30%, which one of the following is its after-tax cost of preferred stock? a. 15.6% b. 12.0% c. 8.4% d. 3.6%
b. 12.0% Since dividends on preferred stock are not tax deductible, no adjustment to the pre-tax cost needs to be made. Therefore, the after-tax cost of preferred stock is the same as the pre-tax cost, 12%.
Bander Co. is determining how to finance some long-term projects. Bander has decided it prefers the benefits of no fixed charges, no fixed maturity date, and an increase in the credit-worthiness of the company. Which of the following would best meet Bander's financing requirements? a. Bonds. b. Common stock. c. Long-term debt. d. Short-term debt.
b. Common stock Issuing common stock to finance its projects would best meet Bander's financing strategy. Specifically, issuing common stock would (1) not result in fixed charges, since dividends are at the discretion of the Board of Directors, (2) not result in a fixed maturity date, since common stock does not mature, and (3) would likely increase the credit-worthiness of the company because the issuance of additional common stock would reduce its debt to equity ratio by increasing equity.
Which of the following types of bonds is most likely to maintain a constant market value? a. Zero-coupon. b. Floating-rate. c. Callable. d. Convertible.
b. Floating-rate Floating-rate bonds are most likely to maintain a constant market value. The rate of interest paid on floating-rate bonds (also called variable-rate bonds/debt) varies with the changes in some underlying benchmark, usually a market interest rate benchmark (e.g., LIBOR or the Fed Funds Rate). Because the interest rate changes with changes in the market rate of interest, they maintain a relatively stable (constant) market value.
Which of the following statements concerning the use of short-term financing by an entity is/are correct? I. Short-term financing generally offers greater financial flexibility than long-term financing. II. Short-term financing generally has a lower interest rate than long-term financing. III. Short-term financing generally has a lower risk of illiquidity than long-term financing. a. I only is correct. b. I and II are correct. c. II and III are correct. d. I, II and III are correct
b. I and II are correct In general, short-term financing offers a firm greater financial flexibility than does long-term financing. With short-term financing, the level of borrowing can be more readily expanded or contracted with changes in the need for funds. With long-term financing, the level of borrowing cannot be readily adjusted with changes in needs, especially when there is a contraction in the need for debt. Short-term financing is generally cheaper than long-term financing. For a given borrower at a particular point in time, interest rates on short-term borrowings, in general, are lower than interest rates on long-term borrowings. Finally, III is not correct because short-term financing generally has a higher (not lower) risk of illiquidity than does long-term financing. By its nature, short-term borrowing must be repaid or refinanced in the near term and, on an on-going basis, more often than long-term debt. Changes in the economic environment or within the entity, may make it impossible for the firm to either repay or refinance the debt. In that case, the firm would be technically insolvent.
Which of the following statements concerning preferred stock is/are generally correct? I. Requires dividends be paid.II. Grants ownership interest.III. Grants voting rights. a. I only. b. II only. c. I and II only. d. I, II and III.
b. II only
The best reason corporations issue Eurobonds rather than domestic bonds is that a. These bonds are denominated in the currency of the country in which they are issued. b. These bonds are normally a less expensive form of financing because of the absence of government regulation. c. Foreign buyers more readily accept the issues of both large and small US corporations than do domestic investors. d. Eurobonds carry no foreign exchange risk.
b. These bonds are normally a less expensive form of financing because of the absence of government regulation. Eurobonds are issued in a currency other than the currency of the country in which they are issued. For example, U.S dollar-denominated bonds issued in an EEU country would be Eurobonds. Because they are not issued in the country of the currency in which they are denominated, these bonds are not subject to the government regulations of the country of the currency and, thus, avoid expense and disclosure requirements of that country.
The maximum period for which commercial paper may be used for financing purposes is a. 30 days. b. 180 days. c. 270 days. d. 365 days.
c. 270 days
Which one of the following bond issues, with different terms and stated rates of interest, would have the highest interest rate risk, all other things being equal? a. 10-year, 4% bonds. b. 10-year, 6% bonds. c. 30-year, 4% bonds. d. 20-year, 4% bonds.
c. 30-year, 4% bonds You Answered Correctly! This issue has the longest maturity (with the lowest stated interest rate). Therefore, it will have the highest interest rate risk.
A company issued common stock and preferred stock. Projected growth rate of the common stock is 5%. The current quarterly dividend on preferred stock is $1.60. The current market price of the preferred stock is $80, and the current market price of the common stock is $95. What is the expected rate of return on the preferred stock? a. 2% b. 7% c. 8% d. 13%
c. 8% The expected rate of return on the preferred stock (P/S) is determined as the annual dividend on the stock divided by the market price of the stock. This correct answer is computed as: Annual Dividend on P/S $6.40 / Market Price of P/S $80 = .08 (or 8%).
Apollo Inc.'s common stock is currently selling for $100 per share and will pay a $4.00 per share dividend. If Apollo's dividend is expected to grow indefinitely at 5%, what is the market's required rate of return on a prospective investment in Apollo's stock? a. 4% b. 5% c. 9% d. 20%
c. 9% The market's required rate of return on a prospective investment in Apollo's stock is 9%. The answer is computed as: (Current dividend/Current market price) + Growth rate, or ($4/$100) + 5% = 4% + 5% = 9%.
Which of the following statements concerning the sale of equity securities through crowdfunding are correct? Crowdfunding must take place through a SEC-registered broker-dealer or funding portal. Any company registered with the SEC may use crowdfunding. An investor is limited in the amount that can be invested through crowdfunding during a 12-month period. a. I only. b. I and II only. c. I and III only. d. I, II, and III.
c. I an III only
Which of the following statements concerning common stock is/are generally correct? I. Requires dividends be paid.II. Grants ownership interest.III. Grants voting rights. a. I only. b. II only. c. II and III only. d. I, II and III.
c. II and III only
Which of the following statements concerning debenture bonds and secured bonds is/are correct? I. Debenture bonds are likely to have a greater par value than comparable secured bonds. II. Debenture bonds are likely to be of longer duration than comparable secured bonds. III. Debenture bonds are more likely to have a higher coupon rate than comparable secured bonds. a. I only. b. II only. c. III only. d. I, II, and III.
c. III only Debenture bonds are unsecured bonds. Because they are unsecured, they are likely to have a higher coupon rate (interest rate) than comparable secured bonds.
Which of the following scenarios would encourage a company to use short-term loans to retire its 10-year fixed-rate callable bonds that have five years until maturity? a. The company expects interest rates to increase over the next five years. b. Interest rates have increased over the last five years. c. Interest rates have declined over the last five years. d. The company is experiencing cash flow problems.
c. Interest rates have declined over the last five years. If interest rates have declined over the last five years, a company can currently borrow at a lower interest rate than that on the older, fixed-rate debt. Thus, a company would be encouraged to replace the outstanding fixed-rate bonds with short-term borrowings that have a lower interest cost.
A company has $650,000 of 10% debt outstanding and $500,000 of equity financing. The required return of current equity holders is 15%, and there are no retained earnings currently available for investment purposes. If new outside equity is raised, it will cost the firm 16%. New debt would have before-tax cost of 9%, and the corporate tax rate is 50%. When calculating the marginal cost of capital, what cost should the company assign to equity capital and to the after-tax cost of debt financing? a. cost of equity 15%; after-tax cost of debt 4.5% b. cost of equity 15%; after-tax cost of debt 5.0% c. cost of equity 16%; after-tax cost of debt 4.5% d. cost of equity 16%; after-tax cost of debt 5.0%
c. cost of equity 16%; after-tax cost of debt 4.5% The cost of new (marginal) equity is 16%, which would include the cost associated with flotation of the new issue. The after-tax cost of new debt would be the before-tax cost of 9% less the tax savings resulting from the deductibility of interest on the debt, which would be computed as 9%× (1.00 - .50) = .09× .50 = .045 (or 4.5%).
flotation costs
causes the issuance of new common stock to be higher (the costs associated with issuing the new securities) reduce the proceeds received, and therefore, increase the cost of financing
raising equity through crowdfunding
crowdfunding is the raising of funds for an undertaking by obtaining many small amounts from a large number of sources, typically accomplished through the internet
A stock priced at $50 per share is expected to pay $5 in dividends and trade for $60 per share in one year. What is the expected return on this stock? a. 10% b. 20% c. 25% d. 30%
d. 30% The dollar return on stock consists of both the dividends received ($5) and the change in stock price ($10). The rate of return on stock is calculated as the dollar return divided by the dollar amount of the investment on which the return was earned. Thus, the correct calculation is: ($5 + $10) / $50 = $15 / $50 = 30%.
The cost of debt most frequently is measured as a. Actual interest rate. b. Actual interest rate adjusted for inflation. c. Actual interest rate plus a risk premium. d. Actual interest rate minus tax savings.
d. Actual interest rate minus tax savings The cost of debt most frequently is measured as the actual interest rate minus the tax savings. The tax savings result because the interest expense is deductible for tax purposes and the resulting tax savings reduce the effective cost (and rate) of debt financing. For example, if the stated (actual) interest rate is 10% and the tax rate is 40%, the effective interest rate (actual interest rate minus tax savings) will be 10% x (1.00 - .40), or 10% x .60 = 6% effective cost of debt.
The market price of a bond issued at a premium is equal to the present value of its principal amount a. Only, at the stated interest rate. b. And the present value of all future interest payments, at the stated interest rate. c. Only, at the market (effective) interest rate. d. And the present value of all future interest payments, at the market (effective) interest rate.
d. And the present value of all future interest payments, at the market (effective) interest rate. The market price of a bond, whether issued at par, at a premium, or at a discount, will be the present value of the principal amount plus the present value of future interest payments, all at the market (effective) rate of interest.
According to the hedging principle (or the principle of self-liquidating debt), in making decisions concerning the maturity structure of an entity's financing, which one of the following guidelines would be most appropriate? a. Fund a project with short-term benefits by issuing common stock. b. Fund a seasonal expansion in inventory by issuing bonds. c. Fund a project that will benefit eight years with a short-term note. d. Fund a permanent expansion in accounts receivable by issuing long-term bonds.
d. Fund a permanent expansion in accounts receivable by issuing long-term bonds. The hedging principle states that the maturity structure of an entity's financing should be consistent with the cash flow produced by the asset being financed. Assets or projects that provide short-term benefits should be financed with short-term financing and assets or projects of long-term duration or benefit should be financed with long-term or permanent financing. Therefore, a permanent expansion in accounts receivable, which will require a permanent increase in financing, should be financed by issuing long-term bonds (or, if the option is provided, common stock issuance).
What would be the primary reason for a company to agree to a debt covenant on new bonds limiting the percentage of the company's long-term debt? a. To cause the price of the company's stock to rise. b. To lower the company's bond rating. c. To reduce the risk for existing bondholders. d. To reduce the interest rate on the bonds being sold.
d. To reduce the interest rate on the bonds being sold The primary reason a company would agree to a debt covenant limiting the percentage of its long-term debt would be to reduce the interest rate on the bonds being sold. A debt covenant limiting the percentage of its long-term debt would give the bondholders greater certainty of repayment and, thus, reduce the risk associated with the new bond issue. The reduced risk would lower the interest rate demanded by investors.
What would be the primary reason for a company to agree to a debt covenant limiting the percentage of its long-term debt? a. To cause the price of the company's stock to rise. b. To lower the company's credit rating. c. To reduce the risk of existing debt holders. d. To reduce the interest rate on the debt being issued.
d. To reduce the interest rate on the debt being issued. The primary reason for a company to agree to a debt covenant limiting the percentage of its long-term debt would be to reduce the risk, and therefore the interest rate, on debt being issued. Debt covenants place contractual limitations on activities of the borrower to help protect the lender. As such, they reduce the default risk associated with a debt issue and, therefore, reduce the interest rate on that debt.
In which one of the following areas is preferred stock most likely to differ from common stock? a. Ownership status. b. Maturity date. c. Tax deductibility of dividends paid. d. Voting rights.
d. Voting rights
What impact will the issuing of new preferred stock have on the following for the issuing entity? a. increase long-term debt and increase debt-to-equity ratio b. increase long-term debt and decrease debt-to-equity ratio c. no change in long-term debt but increase debt-to-equity ratio d. no change in long-term debt but decrease debt-to-equity ratio
d. no change in long-term debt but decrease debt-to-equity ratio Since preferred stock is not debt, there will be no effect on long-term debt; however, since preferred stock is equity, the debt-to-equity ratio will decrease.
periodic interest
discounted as the present value of an annuity
yield to maturity
he rate of return required by investors as implied by the current market price of the bonds is the yield to maturity. determining the yield to maturity is done by determining the discount rate that equates the present value of future cash flows from the bond issue with the current price of the bonds. That rate is the rate of return currently expected by bondholders. the process of determining that rate is identical to the process of determining the internal rate of return on a capital project.
hedging principle of financing
holds that long-term or permanent investments in assets should be financed with long-term or permanent sources of capital and short-term needs should be financed with short-term sources of financing. The objective of this principle is to match cash flows from assets with the cast requirements need to satisfy the related financing
inverted yield curve
if the plotted term structure curve shows that short-term interest rates are higher than long-term rates
operating leverage
measure the degree to which a firm incurs fixed cost in its operations if fixed cost are high, a significant decrease in sales can dramatically affect operating results, thereofre, all other things equal, the greater a firm's fixed cost, the greater the business risk if sales increase for a firm with a high degree of operating leverage, there will be a larger increase in return on equity
financial leverage
measures the extent to which a firm uses debt financing generally, debt is a less costly form of financing than equity; therefore, a firm would like to use as much debt financing as is reasonable so as to produce higher return to shareholder as more and more debt is issued, the risk associated with it increase, this increases the cost (interest rate) on additional debt to compensate lenders for the increased risk. It also increases the risk to shareholder that the interest payment and/or principal repayment cannot be met
structured bonds
provide that either the periodic interest payments or the value at maturity varies with change in one or more underlying, which might include specified stock or bond market indexes, commodity prices, currency exchange rates or other factors. derivative instruments
Business risk constraint
recognizes that firms with higher variability in its operating results should limit the extent to which it uses debt financing. firms with a higher level of business risk have an increased chance that operating results may cause defat on fixed obligations and, therefore, should use less debt financing than a firm with steady operating results
tax rate benefit effect
recognizes that, other things being equal, the higher the tax rate of a firm, the greater the benefit of debt financing. Because the cost of debt is tax deductible, it generates a tax benefit. Therefore, the higher the tac rate faced by a firm, the greater the amount of tax saved from the use of debt financing compared to using equity financing.
Common stock characteristics
represents the basic ownership interest in a corporation 1. limited liability - common shareholders' liability is limited to their investment 2. residual claim to income and assets - common shareholders' claim to income and assets on liquidation comes after the claims of creditors and preferred shareholders 3. right to vote - for directors, auditors and changes to the corporate charter. a temporary power of attorney, called a proxy, can be used to delegate that right 4. preemptive right - the right of first refusal to acquire a proportionate share of any new common stock issued residual claim adds on an element of risk called financial risk, as a result, the cost of common stock capital is usually higher than that of either bonds or preferred stock
optimum capital structure objective
seeks to minimize a firm's aggregate cost of permanent (long-term) capital financing by using an optimum (or satisfying) mix of debt and equity components. Basic long-term debt financing is less costly than common stock financing. Therefore, firms will be motivated to use increasing amounts of long-term debt for financing; this is the concept of financial leverage. However, at some level of relative debt the increased risk of default associated with the debt will result in debt investors demanding such a high return (default premium) that the cost of debt may be greater than the cost of common stock. The objective in structuring the firm's capital mix is to determine the set or sets of capital sources that result in the lowest composite cost of capital for the firm.
cost of bond financing
the cost of financing with bonds (and other debt) is the interest rate less the tax savings from the tax deductibility of interest expense cost of debt = interest rate X (1.0 - marginal tax rate) when bonds are issued at par value, the coupon or state rate of interest is the effective rate of interest and is the basis for determining the cost of debt (bonds) when bonds are issued at a discount or premium, the coupon rate of interest is not the effective rate of interest, and the effective rate has to the determined and used in determining the cost of debt (bonds)
cost of financing with common stock
the expected return is the current cost of financing through the use of existing (outstanding) common stock can also use 1. Capital asset pricing model (CAPM) 2. arbitrage pricing model 3. bond-yield-plus approach
common stock value
the present value of expected cash flows including expected dividends and stock price appreciation csv= dividend in 1st year/ (required rate of return - growth rate)
preferred stock values
the present value of expected future cash flows, the only primary stream of future cash flows for preferred stocks and may be outstanding indefinitely elements used to estimate the value of preferred stock: 1. estimated future annual dividends 2. discount rate in the form of investors' required rate of return 3. an assumption that the dividend stream will exist in perpetuity
public market
the sale of SEC registers instruments in the market
expected return vs. historic return
the total historic rate of return on common stock is the total dollar return earned since acquisition divided by original cost of the investment. for common stock, the total dollar return would consist of both dividends received and the change in the market price of the stock since it was acquired The historic or expected return on a portfolio of common stocks (or other investment) is the weighted average of the historic/expected return on the investments in the portfolio.
as market rates of interest go up,
the value of bonds goes down inversely related
the term structure yield curve is normally
upward sloping showing that the rate of return increases as the term of the debt increases
bonds issued at premium
when the bonds have a coupon rate of interest more than the market rate of interest at the date of issue the effective rate of interest (which is the market rate at issue) will be less than the coupon rate
bonds issued at discount
when the bonds have a coupon rate of interest rate less than the market rate of interest at the date of issue the effective rate of interest (which is the market rate at issue) will be greater than the coupon rate
disadvantages of line of credit, revolving credit, and letter of credit
1. poor credit rating results in high interest (and possibly security) 2. typically involve a fee 3. requires satisfaction in the short-term 4. a required compensating balance increases costs and reduces effective funds available 5. line of credit does not legally obligate the financial institution
disadvantages of using trade accounts payable for financing
1. requires payment in the short-term 2. higher effective cost if discounts not taken 3. use-specific - finances only assets acquired through trade accounts
disadvantages of using accrued accounts payable for financing
1. requires satisfaction in the short term 2. certain sources are use specific- only finances benefits acquired through accrued account (e.g., salaries)
compensating balance
A compensating balance is an amount that the borrower maintains in a demand deposit account with the lender as a condition of the loan (or for other bank services). The amount required is usually expressed as a percentage of the loan (or other factor) and increases the effective cost of the loan.
structured note
A structured short-term note (or other short-term or long-term structured security) is one whose cash flows (borrower's/issuer's payment obligation and lender's/investor's return) are contingent on changes in the value of an underlying interest rate, stock index, commodity price or other factor.
zero coupon bonds
Debt security (bond) that does not pay interest during its life; there are no (zero) coupons to submit for interest payments. These bonds provide a profit to investors by selling at a deep discount (i.e., amount less than maturity value) and paying full face value when redeemed at maturity. Because they provide payment only at maturity, the market price tends to fluctuate more than that of coupon bonds.
Floating rate bonds
Debt security (bond) that pays a rate of interest that fluctuates over the life of the instrument. Typically, the rate of interest paid is tied to a macroeconomic benchmark rate such as the prime rate, the U.S. Treasury Bill rate, LIBOR (London Interbank Offered Rate), the federal funds rate or similar rate, plus a spread (which is a constant amount). For example, the rate might be quoted as "prime rate (which varies) + .50% (which remains constant)." Because the rate of interest paid "floats" (increase or decrease) with changes in a macroeconomic benchmark, the bonds tend to maintain their market value as the market rate of interest changes.
Short-term Notes payable
Short-term notes payable result from borrowing, usually from a commercial bank, with repayment due in one year or less. typically for a designated purpose, require a promissory note be given, and carry a rate of interest determined by the credit rating of the borrower. generally are unsecured, unless the borrower's credit rating dictates the lender require security. The interest rate usually will be expressed as a rate (or points) above the prime rate (or a similar benchmark). For example, the rate may be expressed as "1.00% over prime."
Which one of the following most likely would not be considered when computing the weighted average cost of capital? a. Short-term debt. b. Long-term debt. c. Common stock. d. Preferred stock.
a. Short-term debt short-term debt likely would not considered when computing the weighted average cost of capital. Short-term debt is not considered part of the capital structure of an entity
Component of long-term financing would be part of a. capital structure and financial structure b. capital structure only c. financial structure only d. neither capital nor financial structure
a. capital structure and financial structure
Bonds Payable, which mature in 10 years, would be included as part of a firm's a. financial structure: yes capital structure: yes b. financial structure: yes capital structure: no c. financial structure: no capital structure: yes d. financial structure: no capital structure: no
a. financial structure: yes capital structure: yes
Under which of the following described lease terms would the lessee be responsible during the term of the lease for executory costs associated with the leased asset? a. net lease and net-net lease b. net lease only c. net-net lease only d. neither net lease nor net-net lease
a. net lease and net-net lease Under a net lease, the lessee assumes the executory costs associated with the asset during the lease, including such elements as maintenance, taxes and insurance. In a net-net lease, the lessee assumes responsibility for the executory costs during the life of the lease, as well as for a residual value at the end of the lease.
Which of the following uses of accounts receivable, if either, would be considered short-term financing? a. pledging accounts receivable and factoring accounts receivable b. pledging accounts receivable only c. factoring accounts receivable only d. neither pledging accounts receivable nor factoring accounts receivable
a. pledging accounts receivable and factoring accounts receivable Both pledging of accounts receivable and factoring accounts receivable are considered means of short-term financing. In pledging of accounts receivable, the receivables are used as collateral in a financing agreement with a lender. In factoring of accounts receivable, the receivables are sold at a discount for cash to a factor.
line of credit
an informal agreement between a borrower and a financial institution whereby the financial institution agrees to a maximum amount of credit that it will extend to the borrower at any one time generally, the agreement is good only for the prospective borrower's fiscal year and although the agreement is not legally binding on the financial institution, provides the firm reasonable assurance that the agreed upon financing will be available. unsecured and may require a compensating balance
Short-term financing (current liabilities)
applies to obligations that will become due within one year. current assets which can be used to secure financing would be forms of short-term financing. trade accounts payable, accrued accounts payable, short-term notes payable, Line of credit, revolving credit, and letter of creditCommercial paperPledging accounts receivableFactoring accounts receivable Inventory secured loans
Nexco, Inc. is considering factoring its accounts receivable. Factorco, Inc. has offered the following terms for accounts receivable due in 30 days: Value of receivables to be held in reserve for contingencies10%Following costs are deducted at time accounts are factored:Interest rate on amounts provided before deducting interest (annual rate)12%Factor fee on total receivables factored2% If Nexco plans to factor $200,000 of accounts receivable due in 30 days, which one of the following is the amount it will receive from Factorco at the time the accounts are factored? a. $154,880 b. $174,240 c. $176,000 d. $196,000
b. $174,240 The amount provided would be $200,000 accounts receivable - $20,000 reserve - $4,000 factor fee = $176,000, for which interest would be charged for 30 days, or 1% (i.e., 1/12 of 12%). Therefore, the correct amount received would be $176,000 - ($176,000 x .01) = $176,000 - $1,760 = $174,2
A company purchased $10,000 of merchandise inventory on May 1. The terms of the purchase were 2/10, net 30. The company would pay what amount on May 9? a. $7,000 b. $9,800 c. $9,980 d. $10,000
b. $9,980 If the company pays on May 9, it would pay $9,800. The terms offered of 2/10, n/30 offer a 2% discount if the payment is made within 10 days of the purchase. Since the purchase was on May 1, May 9 would be within the 10 day period. Therefore, the company would take a 2% discount on the purchase amount, or .02 × $10,000 = $200 discount, leaving a balance due of $9,800.
A company wants to approximate the 12% annual interest rate based on a 365-day year it pays on its working capital loan. Which of the following terms should the company offer its customers? a. 2.00%, 15, net 45. b. 1.00%, 15, net 45. c. 0.75%, 10, net 30. d. 0.50%, 10, net 30.
b. 1.00%, 15, net 45. These terms would provide the desired 12% annual interest rate. The interest rate associated with discount terms is computed as: [Discount Rate/Principal] × [1/(Length of discount period/365)]; where: Principal = Amount after discount Length of discount period = Difference between discount date and net date Using the facts in this question: [.01/.99] × [1/(30/365)] = .0101 × (365/30) = .0101 × 12.16 = 12.28 (or 12% rounded) annual interest rate, the correct answer. (NOTE: An easier and quicker approximation can be made by dividing the discount period into the days in a year, or 45 - 15 = 30 days; 365/30 = 12.1, and multiplying that by the discount amount = 12.1 × .01 = .121 (or 12% rounded), the correct answer.)
Zebra Company, Inc., will require $1,000,000 of new external financing for two projects it is undertaking. Those projects are: (1) acquisition of a new long-term asset with a cost of $500,000, and (2) a permanent increase in its level of inventory of $500,000. The firm is considering two options for financing the two projects. The first option is to execute a 5-year loan for the full $1,000,000. The second option is to execute a 6-month, $1,000,000 loan with the need to renew the loan at the end of each 6-month period for 5 years. A restrictive covenant on existing debt requires that the firm maintain a minimum current ratio of 2.00 or be in default on that loan. The firm currently has current liabilities of $5,000,000 and a current ratio of 2.10, calculated as current assets/current liabilities. Which of the alternative financing options for the $1,000,000, if any, will permit the firm to meet the obligation of its existing loan covenant to maintain a current ratio of at least 2.00? a. 5-year term loan and 6-month loans b. 5-year term loan only c. 6-month loans only d. neither 5-year term loan nor 6-month loans
b. 5-year term loan only The 5-year loan would maintain a current ratio of at least 2.00, but the 6-month loan option would not result in a current ratio of at least 2.00. Currently, with $5,000,000 in current liabilities and a 2.10 current ratio, Zebra has current assets of $10,500,000, calculated as:Current ratio (CR)=Current Assets(CA)/Current Liabilities(CL)CR2.10=CA unknown/CL$5,000,000CA=CL$5,000,000×CR2.10CA=$10,500,000 For the current ratio calculation, the 5-year term loan would result in an increase in the current asset Inventory by $500,000, an increase in long-term assets by $500,000, but would not change current liabilities. The note payable would be recorded as a long-term obligation that does not affect current liabilities and the $500,000 for the acquisition of the long-term asset would not affect current assets. Therefore, neither the increase in long-term assets nor the 5-year loan would affect the current ratio. Consequently, under the 5-year term loan arrangement current asset would be $11,000,000 ($10,500,000 + $500,000), current liabilities would be unchanged at $5,000,000, and the new current ratio would be:CR=CA$11,000,000/CL$5,000,000=2.20 (greater than2.00) Under the 6-month loan option the current ratio would be less than the required 2.00. For the current ratio calculation, the 6-month loan option would result in an increase in the current asset Inventory by $500,000, an increase in long-term assets by $500,000 and an increase in the current liability Short-Term Note Payable of $1,000,000. The $500,000 for the acquisition of the long-term asset would not affect current assets and, therefore, would not affect the current ratio. Therefore, under the 6-month loan arrangement current assets would be $11,000,000 ($10,500,000 + $500,000), current liabilities would be $6,000,000 ($5,000,000 + $1,000,000), and the new current ratio would be:CR=CA$11,000,000/CL$6,000,000=1.83 (less than2.00)
A financial instrument used for short-term financing that is unsecured and available only to the most creditworthy firms is most likely a a. Convertible bond b. Commercial paper c. Letter of credit d. Convertible preferred stock
b. Commercial paper Commercial paper is a short-term unsecured promissory note which is sold by large, highly creditworthy firms as a form of short-term financing.
Po Co. plans to use its inventory as collateral for a short-term loan. Which one of the following types of loan agreements with its lender would provide Po Co. the most flexibility in the use of the inventory it pledges as collateral? a. Field warehouse agreement. b. Floating lien agreement. c. Chattel mortgage agreement. d. Terminal warehouse agreement.
b. Floating lien agreement. Under a floating lien agreement the borrower gives the lender a lien against its inventory, but retains control of the inventory and can continuously sell and replace the inventory.
Which of the following statements concerning the leasing of an asset is/are correct? If the net present value of purchasing an asset is not positive, then leasing the asset should not be considered as an alternative. In a net-net lease, the lessee is responsible for executory costs and residual value of the leased asset. a. I only is correct. b. II only is correct. c. I and II are correct. d. Neither I nor II is correct.
b. II only is correct. Statement I is not correct. If the net present value of purchasing an asset is not positive, which shows that it is not economically feasible to purchase the asset and earn a positive return, it still may be economically feasible to lease the asset. In fact, in the final analysis, the basic reason for leasing, rather than buying, is that leasing an asset costs less than purchasing it. Therefore, while the cost of purchasing an asset may result in a negative net present value, the cost savings associated with leasing the asset may be such that leasing the asset is economically feasible. Statement II is correct. In a net-net lease agreement, the lessee assumes responsibility for both executory costs (i.e., insurance, taxes, maintenance, etc.) of the asset and for the asset having a preestablished residual value at the end of the lease.
Which one of the following is a formal legal commitment to extend credit up to some maximum amount to a borrower over a stated period? a. Letter of credit. b. Revolving credit agreement. c. Line of credit. d. Trade credit.
b. Revolving credit agreement A revolving credit agreement is a formal legal commitment, usually by a bank, to extend credit up to some maximum amount to a borrower over a stated period.
Blue J Co. needs cash for a one-time inventory purchase opportunity. To obtain that cash, it is considering factoring its accounts receivable. Blue J would factor $200,000 of its accounts receivable with a 30- day collection period. Blue J has contacted Big Fact Co., a major factoring firm, and has been offered the following factoring terms: Big Fact will advance 75% of the face value of the accounts receivable. Big Fact will collect and process the factored receivables for a fee of 1% of the face value of accounts factored payable in advance. Big Fact will charge a factoring fee of 4% on the face value of the accounts receivable due at the end of the 30-day period covered by the factoring contract. All credits given on the accounts by Blue J for returns and allowances during the period of the contract will be deducted from the terminal payment. Assume Blue J accepts Big Fact's terms. If $10,000 in return and allowance credits are issued by Blue during the 30-day period, how much cash will Blue J receive at the initiation of the contract and at the end of the 30-day period? a. cash received at initiation of contract: $150,000; cash received at termination of contract: $42,000 b. cash received at initiation of contract $148,000; cash received at termination of contract $32,000 c. cash received at initiation of contract $148,000; cash received at termination of contract $42,000 d. c. cash received at initiation of contract $148,000; cash received at termination of contract $40,000
b. cash received at initiation of contract $148,000; cash received at termination of contract $32,000 Blue J will receive $148,000 at initiation of the contract and $32,000 at termination of the contract. Those amounts are computed as follows: Face value of receivables$200,000 Advance percentage.75 Advance amount$150,000 Less: 1% processing fee 2,000 Payment at initiation$148,000 Face value of receivables$200,000 Balance due percentage.25 Balance amount$50,000 Less: A/R credits issued10,000 Less: 4% factor fee8,000 Payment at termination$32,000
Which one of the following would an importer of goods from a new foreign supplier most likely use to assure the supplier of payment? a. Line of credit. b. Letter of credit. c. Trade account application. d. Commercial paper.
b. letter of credit A letter of credit would be used to assure a foreign supplier of payment. A letter of credit is a conditional commitment to pay a third party in accordance with specified terms.
Sole Company entered into a lease contract with BLD Company effective January 1, 2019 to lease a building that cost BLD $1,750,000 to construct and has a market value of $2,000,000. The building has an expected life of 20 years with an estimated residual value of $200,000. The lease is for 10 years with annual payments of $162,745.40 beginning December 31, 2019, and is not renewable. Sole's borrowing rate is 10% and its marginal tax rate is 20%. Present value table factors for 10 years and 20 years are: 10 Years20 YearsPresent value of $1 @ 10%0.385540.14864Present value of ordinary annuity @ 10%6.144578.51356Present value of annuity due @ 10%6.759029.36492 In a financial analysis of the lease, which of the following amounts is closest to the after-tax present value of Sole's lease cost? a. $1,100,000 b. $880,000 c. $800,000 d. 771,080
c. $800,000 The after-tax present value of Sole's lease cost is closest to $800,000. The correct calculation would be to discount the annual lease payments ($162,745.40) at 10% for 10 years, and to deduct from that the annual tax savings (shield) provided by the deductibility of lease payments for tax purposes ($162,745.40 × .20 tax rate), discounted at 10% for 10 years, both using the present value of an ordinary annuity (since payments are at the end of each year). Thus, the correct answer is calculated as: Annual lease payments$162,745.40 PV factor ordinary annuity 10 years @ 10% 6.14457 PV of lease payments$ 1,000,000 Annual lease payments$162,745.40 Tax rate .20 Annual tax savings$ 32,549.08 PV factor ordinary annuity 10 years @ 10% 6.14457 PV of tax saving (shield)$ 200,000 PV of lease payments$ 1,000,000 Less: PV of tax saving 200,000 Present value of after-tax lease cost$ 800,000
Alpha Company borrowed $20,000 from High Bank, giving a one-year note. The terms of the note provided for 6% interest and required a 10% compensating balance. Which one of the following is the effective rate of interest on the loan? a. 4.0% b. 6.0% c. 6.7% d. 10.0%
c. 6.7% The effective rate of interest on the loan is 6.7% and is computed as the net proceeds from the loan divided into the cost of the loan. The cost of the loan is $1,200 ($20,000 × .06 = $1,200) and the net proceeds is $18,000 ($20,000 − [.10 × $20,000] = $18,000); the remaining $2,000 must be maintained as a compensating balance. Thus, the effective interest is: $1,200/$18,000 = 6.666%.
The term "financial structure" refers to which one of the following? a. All debt. b. All equity. c. All debt and equity. d. All long-term debt and equity.
c. All debt and equity.
On January 23, Inco Company received from one of its suppliers a statement with terms of "2/10, n/30." Because the statement was misfiled, it was not located for payment until February 5. On which one of the following dates should the bill be paid? a. February 5. b. February 6. c. February 22. d. February 28.
c. February 22 Since the date for taking the discount has passed, there is no financial benefit from paying the statement until the final due date, February 22. Payment on that date would assure no penalty for late payment.
Short-term financing is normally concerned with financing for which one of the following lengths of time? a. Length of the operating cycle. b. Length of the collection cycle. c. One year or less in length. d. Up to 10 years in length.
c. One year or less in length
Long-term financing is normally concerned with financing for which one of the following lengths of time? a. One-year or less in length. b. One year to 10 years in length. c. One-year or greater in length. d. Ten-years or greater in length.
c. One-year or greater in length
Which one of the following statements concerning the relationship between the concepts and measurement of capital structure and financial structure of a firm is correct? a. Capital structure and financial structure are the same concepts and measurements. b. The concept and measurement of capital structure includes the concept and measurement of financial structure. c. The concept and measurement of financial structure includes the concept and measurement of capital structure. d. The concept and measurement of capital structure are not related to the concept and measurement of financial structure.
c. The concept and measurement of financial structure includes the concept and measurement of capital structure. The financial structure of a firm includes all items of liabilities and equity used to finance the firm's assets. From an accounting perspective, financial structure includes all the accounts shown on the right-hand side of the balance sheet and is measured as the sum of all liabilities and shareholders' equity, which is an amount equal to total assets. The capital structure of a firm includes only long-term liabilities and shareholders' equity. Capital structure, unlike financial structure, does not include current (or short-term) liabilities, including such items as accounts payable, wages and salaries payable, short-term notes, etc. Thus, financial structure includes capital structure, plus current liabilities.
Which one of the following would be considered a form of spontaneous financing? a. Line of credit b. Short-term loan c. Accounts payable d. Accounts receivable
c. accounts payable Accounts payable are a form of spontaneous financing. Spontaneous financing occurs when financing occurs automatically in the carrying out of day-to-day operations, as happens with many general short-term payables, including trade accounts payable and accrued accounts payable (e.g., taxes payable). Spontaneous financing occurs in the normal course of business and tends to expand and contract with activity.
Which one of the following is a form of inventory secured loan in which the inventory is placed under the control of an independent third party? a. Floating lien agreement. b. Chattel mortgage agreement. c. Field warehouse agreement. d. Recourse loan agreement.
c. field warehouse agreement In a field warehouse agreement, the inventory that serves as security for a borrowing remains with the borrower, but is place under the control of an independent third party. (Also, in a terminal warehouse agreement, the inventory is moved to a public warehouse and placed under the control of an independent third party.)
The weighted average cost of capital for a firm is determined by its cost of a. short-term financing and long-term financing b. short term financing only c. long-term financing only d. neither short-term financing nor long-term financing
c. long-term financing only The weighted average cost of capital for a firm is determined by the cost of its long-term financing, not by its short-term financing.
callability
callable bonds provide that the bonds can be redeemed (bought back) by the issuer prior to maturity most commonly used to enable the issuing firm to call in outstanding bonds if the market rate of interest declines significantly below the interest being paid on the outstanding bonds. By calling in high-interest outstanding bonds and issuing new bonds at the current lower interest rate, the firm can reduce its interest expense usually pay a higher rate of interest to compensate the holder for the risk that the bonds will be called before maturity and the investor will be faced with reinvesting at a lower rate of interest callable features may also provide that the issuer pay a premium (over par or face value) at the time it calls the bonds
convertibility
convertible bonds provide that the bond holder has the option of converting the bonds into a specified number of share of equity (stock) off the issuing company. Investors in convertible bonds will exercise the option to convert if the market price of the stock increases usually pay a lower rate of interest as a result of the value of the holder's option to convert the bonds into stock may also contain a call provision, which would permit the issuing company to call the bonds so as to limit the up-side potential recognized by the bond holders
Black, Inc. has negotiated a $300,000 revolving credit agreement with its bank. Under terms of the agreement, Black will pay a commitment fee of 1% on any unused amount of the credit, 10% APR on funds drawn against the credit, and must maintain a 10% compensating balance from the funds borrowed. Normally, Black would not maintain the amount of the compensating balance with its bank. At the time of the agreement, Black borrows $200,000, of the $300,000 credit line, for one year. Which of the following is the closest to the effective annual interest rate incurred on the borrowing? a. 10.00% b. 10.50% c. 11.11% d. 11.66%
d. 11.66% The effective annual interest rate is closest to 11.66%. The effective annual interest rate is determined as the cost of the borrowing arrangement divided by the funds available from the borrowing. The cost of the borrowing consists of the 10% interest rate on the borrowing plus the 1% commitment fee on the unused portion of funds available. The total cost of borrowing is: Borrowed amount = $200,000 × .10=$20,000Unused portion = $100,000 × .01=1,000Total cost$21,000Amount borrowed$200,000Less: Compensating balance, 10%20,000Funds available from borrowing$180,000Effective interest rate = Cost $21,000/Usable funds $180,000=11.66%, the correct answer.
stand by credit
line credit revolving credit letter of credit
maintaining certain working capital conditions
maintaining a minimum dollar amount of working capital or a minimum working capital ratio
Trade Accounts Payable
occurs in the normal course of business as a firm routinely buys goods or services on credit from its suppliers. not secured by collateral but depends on the borrowers ability and willingness to pay the obligation when due. financing through trade is highly flexible- the level of financing goes up concurrent with the purchase of the goods or service.
commercial paper
short-term unsecured promissory notes sold by large, highly creditworthy firms as a form of short-term financing 270 days or less commonly 6 months or less may be sold with interest discounted or pay interest over the short-life of the note or at its maturity may be sold directly to investors or through a dealer. the effective interest rate is typically less than the cost of borrowing through a commercial bank
par value or face value
the "principal" that will be returned at maturity, most commonly $1,000 per bond
coupon rate of interest
the annual interest rate printed on the bond and paid on par value
floating lien agreement
the borrower gives a lien against all of its inventory to the lender, but retains control of its inventory, which it continuously sells and replaces
chattel mortgage agreement
the borrower gives a lien against specifically identified inventory and retains control of the inventory but cannot sell it without the lender's approval
without recourse
the factor bears the risk associated with collectibility (unless fraud is involved)
with recourse
the factor has recourse against the firm for some or all of the risk associated with uncollectibility
Pledging Accounts Receivable
the firm pledges some or all of its accounts receivable as collateral for a short-term loan from a commercial bank or finance company.
terminal warehouse agreement
the inventory used as collateral is moved to a public warehouse where it is held as security
field warehouse agreement
the inventory used as collateral remains at the firm's warehouse, placed under the control of an independent third-party and held as security
capital structure
the long-term sources of funding, long-term debt and owners' equity
financial structure
the mix of liabilities and owners' equity accounts of a firm
factoring accounts receivable
the sale of accounts receivable to a commercial bank or other financial institution. actual payment to the firm for its accounts receivable may occur at various times between the date of sale and collection of the receivables. the funds received can then be used for financing of other assets or used for other purposes the factor charges a fee based on the creditworthiness and length of maturity of the receivables, and the extent to which the factor assumes risk of uncollectibility
Long-term notes
typically used for borrowings normal from one to ten years, but some may be for longer. usually repaid in periodic installments over the life of the loan and usually are secured by a mortgage on equipment or real estate. often contain restrictive convenants that impose restrictions on the borrower so as to reduce the likelihood of default
