D076
You are calculating the present value of an annuity due of $5,000 a year for 20 years. The discount rate is 3%. What should be the "type" input variable of the PV function?
1 - The type is the cash flow type in the PV function. 1 = BEGIN, or an indication of an annuity due.
How far into the future do cash budgets usually forecast?
Between one month and one year -Cash budgets are not useful if they forecast less than one month, and it is not necessary for cash budgets to extend beyond one year in the future.
How do bond payments to investors differ from stock payments to investors?
Bond payments are fixed, and stock payments are variable.
Why would bondholders set bond contracts that are very strict to deter the company from taking on risky projects?
Bondholders are primarily interested in making sure they will be paid back. - If a company takes on a riskier project, there is a higher probability of the project being unsuccessful, which means that the bondholders may put themselves at a higher risk of not receiving their loan back.
Why might a firm prefer to raise debt capital through bonds instead of stocks?
Bonds do not require a firm to give up any ownership.- This is attractive to a firm that needs funds for a project but wishes to maintain control.
Why is it appropriate to calculate the value of a bond in the same way that the present value of an annuity is calculated?
Bonds pay a coupon every six months, pay a constant coupon amount, and have a maturity date. - Bond cash flows are an annuity, a constant amount paid every period.
Why would a company or individual want to retain risk?
Both companies and individuals retain risk when they believe that the cost of pursuing an activity is less than the alternative.
What tool can you use to understand your overall personal cash flows?
Budgeting helps you to understand your income and expenses and to analyze your cash flows.
How can having more debt benefit a company?
Interest expense on debts is paid before taxes are calculated. - This describes the tax shield advantage of debt.
What is the term for the percentage of the principal that a lender charges a borrower for the use of assets?
Interest rate - This is the definition of interest rate.
You are calculating the lump sum of money needed now in order to withdraw $10,000 a year over the next 5 years from an account that earns a 3% interest rate. Which Excel function should you use?
PV function- Since you are looking for a relative past value of future cash flows, you should use the PV function in Excel.
What role does financial forecasting play in the future success and growth of a firm?
Financial forecasting supplements historical data with proposed investments or changes to allow for more accurate foresight. - While understanding the past is key to moving forward, accounting for any proposals in your forecasts highlights where funding may be needed or where you might actually have more room to spend.
Omar is about to purchase a new car for $30,000. He knows he wants to buy the car, but he is still trying to decide how to pay for it. He has barely over $30,000 in his bank account. He can either take out an auto loan from a bank or use a mix of cash and an auto loan.
Financing a goal
What type of ratio is used to consider how a firm is financed and to assess a firm's ability to pay interest and pay back long-term obligations?
Financing ratios - Financing ratios consider how a firm is financed.
You are considering purchasing a house for $250,000. You have two options to finance it. One is a 20-year mortgage with an interest rate of 3.5%, and the other is a 30-year mortgage with an interest rate of 3.5%. Which mortgage option requires you to pay more in total interest?
A 30-year mortgage - Even though the interest rate is the same, the longer the loan is, the more interest you pay for the mortgage.
Which statement below is an example of how ratios are used in the field of finance?
A firm's ratios are compared with those of a benchmark peer group to determine the firm's relative strength and performance. - This is called cross-sectional analysis and is common in financial analysis.
What is default risk?
A firm-specific risk that comes from the probability of a loss resulting from a borrower's failure to repay a contractual obligation
Why is it important to consider the time value of money in an ideal evaluation method for capital investment?
Because the value of a cash flow today is different from the value of a cash flow of the same dollar amount in 10 years - You cannot directly compare dollar amounts received at different times.
Why are ratios considered flexible?
Because they are not regulated and can be changed or invented according to a firm's needs - Because financial ratios are an internal management tool, they are not subject to external rules and regulations.
Why are activity ratios also called efficiency ratios or asset use efficiency ratios?
Because they measure how well a company uses its assets to generate sales or cash.
What is the process of analyzing financial data with ratios to compare a firm's performance to competitors?
Benchmarking
The firm Betsy's Books conducts a financial analysis using ratios to know how it is performing in comparison to other similar firms. What is this process called?
Benchmarking - Benchmarking allows management to see how firms differ from one another and evaluate their performance relative to each other.
A company called Bobby's Books is considering purchasing a new bookbinding machine. The company calculates the hurdle rate of the project to be 9% and the IRR to be 11%. Should the company purchase the bookbinding machine?
Yes, because the IRR exceeds the cost of capital. - When the IRR of a project is greater than the hurdle rate (the required rate of return, or cost of capital), it indicates that the company should accept the project.
BigDog and SmallDog are two companies that have an identical return on equity. One difference between the two companies is that BigDog has 40% of assets financed by debt while SmallDog has 100% of assets financed by equity. What can you conclude about BigDog and SmallDog?
SmallDog has a higher ROA than BigDog. - Since SmallDog has no debt, the leverage multiplier of SmallDog is smaller than that of BigDog. Since both companies have the same ROE, SmallDog must have a higher ROA.
Maria and Mateo are setting financial goals. They decide that they need to save $200 each month to reach their goal of taking their children to visit their grandparents in Spain next summer. What is the objective of setting such a goal?
To maximize individual utility Correct! While everyone has different personal financial goals, the objectives of such goals is to maximize individual utility.
What is the primary goal of the financial manager of a firm?
To maximize owner wealth
What is the main goal of a firm?
To maximize owner wealth - The main goal of a firm is to maximize owner wealth, and the financial manager should make decisions based on this goal.
What is the primary aim of personal finance goals?
To maximize satisfaction from products purchased and services obtained
Which responsibility is a focus of the U.S. Securities and Exchange Commission?
To protect investors - The responsibilities of SEC are to protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation.
What are the purposes of financial markets?
To provide liquidity and determine prices - The purposes of financial markets are to provide liquidity and to determine prices.
Why might a firm seek capital investment?
To purchase long-term assets for future growth - Firms need funding for projects that will increase shareholder wealth in the future.
The Federal Reserve sometimes adjusts the interest rate at which commercial banks can borrow from it. What is the purpose of adjusting the interest rate?
To regulate inflation and unemployment - Regulating inflation and unemployment is the main objective of the Federal Reserve and central banks, and it is accomplished by adjusting the interest rate.
What is the main question that both individuals and companies must consider when making financial decisions to reach a goal?
Will the benefits of the action outweigh the costs?
Why is it important to consider all relevant cash flows in an ideal evaluation method for capital investment?
Without considering every cash flow of a potential project, you do not know how the project will enhance the value of a firm. - You need to include all the cash flows coming from a potential project to understand how much value they will add to the firm.
Why is built-in inflation linked to adaptive expectations?
Workers want higher wages to keep their standard of living as prices increase, which pushes the prices even higher. - When the prices of goods and services go up, employees expect and even demand higher wages to maintain their living standard, which will lead to further increases in prices.
What are incremental cash flows?
Any additional cash flows, whether in or out of the firm, that are created as a result of accepting a project - This is the correct definition of incremental cash flows.
How is the interest rate expressed?
As a percentage - Interest is the percentage of the principal that a lender receives or that a borrower pays to use the money.
An investor just purchased a bond for $973 that has a par value of $1,000. What type of bond is this?
A discount bond - When the market price is less than the par price of a bond, you know that the YTM is currently higher than the coupon rate of that particular bond, so it is being sold at a discount.
Freedom Rock Bicycles has a sales capacity of $10 million. When sales exceed this capacity, the company must invest $200,000 in new equipment. Freedom Rock Bicycles had sales of $9 million in one year, and it projects a sales growth of 10%. The net fixed assets in the year were $500,000. By how much will the company's discretionary financing need increase?
$0
Which NPV value indicates that the IRR has been reached?
$0.00 - The IRR is the rate of return that makes the NPV of a project equal to zero.
Which cash flow of a particular project would be a sunk cost?
$50,000 marketing study conducted three months ago for the project
In 1980, the inflation rate was 5% and a particular investment gave a return of 15%. In 2010, the inflation rate was 5% and the same investment gave a return of 12%. In which year did stockholders gain greater purchasing power and why?
1980 because the real rate was higher than in 2010 - In order to compare purchasing power, you have to find the real rates. The real rate is nominal rate minus inflation. Therefore, the investment gave higher purchasing power in 1980 than in 2010.
Why is it important to consider the cost of capital in an ideal evaluation method of capital investment?
Because cash flows for a project may be uncertain - This is the reason why you should consider the cost of capital.
Beckingham Sports is an American sporting goods company. Based on a $400,000 market study and a $600,000 fee for consulting spent prior to the project, the firm can increase its annual operating cash flow by $3,000,000 by selling overseas. Because the firm was considering the expansion, it spent $2,000,000 to purchase a land for new factory and equipment. However, someone is making an offer to pay the company $3,000,000 for the land it purchased for the new factory. What is relevant to include in the company's capital budgeting decision?
3,000,000 for the offer price of the land - If you do the project, you will miss the opportunity to sell the land for $3,000,000. This is an example of an opportunity cost.
Why would a monthly mortgage payment be considered a fixed expense?
Because the payment is the same amount each month - A mortgage is a fixed expense, meaning that the payment amount is the same each month. Knowing which of your expenses are the same from month to month will help you budget more accurately.
Which Excel function should be input to cell C5 to find the interest rate of the following cash flows? Assume the discount rate is 12%.
=IRR(B3:E3) - This choice uses the IRR function, which is the function needed to find the interest rate. The only reference is to the cash flows, which is what the IRR function asks.
What should you have in cell C7 in order to calculate the future value correctly and to make sure that any changes in inputs reflect automatically when you change any of the variables in cells C2:C6?
=FV(C2,C3,C4,C5,C6) - To find a future value, you need to use the FV function and reference cells in order of rate, nper, pmt, pv, and type to return a correct future value and reflect any changes you may make in the input.
Why is there always a cost for bringing funds into a business?
A business must compensate investors for the risk that they are taking to invest in the business. - Investors need a reason to part with their money.
Which item is an example of a cash receipt in a personal budget?
A graduation gift of $100 from your grandmother - Since this is money, or income, coming into your cash budget, it represents a cash receipt.
What is an expected return?
A hypothesized estimate of future returns under different scenarios based on expectational data -
Which scenario is an example of an agency problem?
A manager purchases a company car and allocates it as a company expense. - This is a luxury that does not improve shareholder value and costs the company money.
You just purchased a bond for $1,000 that has a par value of $1,000. What type of bond is this?
A par bond - The market price of a par bond is the same as the par value.
Which item represents an example of a cash disbursement a business might have this month? -
A rent check paid and cashed for the warehouse the company uses- Since this expense is being paid this month and the cash is being withdrawn from the company's account, this represents an example of a cash disbursement.
Which statement correctly contextualizes what a return is?
A return is the gain or loss on an investment over some period of time.
In which way is accounting different from finance?
Accounting is backward looking, while finance is focused on the future.
Which account is a spontaneous account?
Accounts payable - Accounts payable is a spontaneous account that varies with sales.
What are spontaneous accounts?
Accounts that vary naturally with sales - By definition, when sales increase, the increase must be matched in another account, such as receivables.
When can the discretionary financing needed (DFN) be determined?
After pro-forma financial statements are forecasted using the percent of sales method - Once all the financial statements are projected according to a given set of assumptions, you can determine the financing required to fund the predicted growth in sales.
Which scenario is an example of an opportunity cost that is not associated with cash flows?
Albert decides to stay home and study for his test instead of going to the movies. - The opportunity cost is going to the movies.
Which scenario correctly describes opportunity cost?
Alexandra decides to spend $50 on some new clothes instead of using that money to pay her electric bill. The opportunity cost is having the electricity turned off. - Because she bought new clothes, she did not pay her bills.
How can agency costs be mitigated?
Aligning managers' interests with shareholders' interests - This is most commonly done by compensating management with shares of ownership in the company.
Given the table above, what does the DuPont framework indicate about return on assets?
All returns are based on the firm's profitability and efficiency.
Which action is based upon moral standards?
Although there is no company policy regarding it, a financial manager chooses not to accept gifts from the company's clients to ensure that she does not create a conflict of interest.
What does the term legal describe?
An action that is in accordance with the laws and rules set by an authority. - Legal means to follow the laws and rules set by an authority.
What characterizes an ethical action?
An ethical action is based on accepted standards of conduct. -
Which phrase accurately depicts what interest rate risk is?
An example of market risk where the value of a bond is affected by changes in interest rates
Why is it important to have an accurate, carefully calculated required rate of return as part of the NPV?
An inaccurate required rate estimate could cause a firm to reject good projects or accept bad projects. - While the required rate of return is the most difficult part of the NPV calculation to estimate, it is also the most important.
Why does an increased demand for goods and services cause inflation?
An increase in demand often causes an insufficient supply in the market, which causes prices to go up until the demand is once again equal to the supply. - An increase in demand results in an increase in prices, which is the definition of inflation.
Twenty years ago, Mateo started an investment account with $2,000. He then invested $100 into the account every month at the end of each month. Today, he has $46,528 in the same account. What is the term for the $100 monthly cash flows?
Annuity - The fixed amount of $100 given every month is an annuity.
What is a depository institution?
An institution that accepts and pays interest on deposits of money, as well as extends loans - This is the definition. Examples include banks and credit unions.
What is the name for the interest rate expressed on an annual basis?
Annual percentage rate - The APR is the annual interest rate that is charged for borrowing money or that is earned through investment, and it is calculated on an annual basis.
Why are several different types of ratios used to analyze a firm?
Because different types of ratios are needed to get information about different parts of a firm - Using only one type of ratio in a full financial analysis of a firm would not tell you very much information about the firm. It is through the calculation of many ratios that an analyst will be able to see the bigger picture of the firm.
Why is "put $50 in a savings account each month for Christmas gifts" a better budgeting goal than "save money for Christmas gifts"?
Because it is specific and measurable - Effective financial goals provide a specific and concrete target to focus on.
How does financial forecasting help with financial decision-making?
It helps decision makers understand the impacts of today's actions on the future performance of the firm. - This is the purpose of financial forecasting.
A pharmaceutical company recently spent $2 million developing a new drug. The company then conducts capital budgeting analysis to determine if it should produce the newly developed drug. The net present value (NPV) of the project is $1.5 million. Why should this company produce the drug?
Because the NPV is greater than zero
Why does the time value of money play an important role in financial decision-making?
Because the benefits of investments received at different times are comparable only when you consider the time value of money - With the time value of money, you can find today's value of future cash flows to compare the costs and benefits of different investments.
The lowest rate of return is required by which type of investor or lender?
Bank
Suppose Sophia is considering a new stock investment for her retirement account. This stock has significant risk, but is quite popular in the market. Inflation for the next few years is expected to be 2-3% per year, and the current U.S. Treasury rates are about 2%. How should she use this information to decide what type of return she can expect from the stock?
Based on the inflation rate, she should expect this stock to provide a return higher than this for the associated risk. - Since the inflation of 2-3% will reduce any nominal returns she receives by this amount, she would want a higher return to accommodate for the opportunity costs and risks associated with the investment.
What allows an investor to determine which financial activities are contributing to changes in the return on equity?
DuPont framework - Decomposing the DuPont framework enables analysis of fundamental performance to determine which financial activities are contributing to changes in the return on equity.
Which area of finance deals with sources of funding and the capital structure of corporations and seeks to increase the value of a firm to its owners?
Business finance - Business finance is the area of finance that deals with uses and sources of funding to increase the value of the firm.
You just inherited $25,000 from a long-lost relative. You decide to put the money in a savings account for the time being. What would be considered an opportunity cost of putting the money in savings?
Buying a brand new car worth $25,000 - Buying a new car would be considered an opportunity cost because it is something you are giving up by keeping the money in your savings account.
Which situation is a real-life example of risk transfer?
Buying home insurance—risk is transferred from the policyholder to the insurer
How does an investment institution, such as a mutual fund, facilitate the circulation of money in the economy?
By providing individuals and firms access to financial markets to buy or sell financial securities
What are the three main uses of cash budgets?
Cash budgets are used to forecast future financial need, aid in performance evaluation, and show when corrective action is needed.-A good cash budget is used in these ways to help a firm operate more effectively and efficiently.
Why would creating a cash budget be useful for W&H if the firm needs a loan from the bank or another short-term lender?
Cash budgets increase the lender's trust in a firm by demonstrating the firm's ability to make profits and repay loans.-Cash budgets are detailed plans that show creditors that a firm will have enough cash from month to month to support its operations while staying within acceptable borrowing limits. A good cash budget allows creditors to feel secure in lending money to the firm.
W&H Company wants to create a cash budget to better manage its cash flows. The financial manager knows that the firm's labor costs and materials costs are too high for the level of sales each month. The firm also needs to keep better track of its cash flows to assess its need for additional financing through short-term loans. W&H Inc.'s labor costs each month are an example of which item in a cash budget?
Cash disbursement-This is a cash disbursement for the firm because it represents cash going out during the month to pay employees.
What is the name for the process of evaluating and planning for purchases of long-term assets?
Capital budgeting - Capital budgeting is the process of evaluating and planning for purchases of long-term assets.
Which term refers to the metrics and calculations that use tools such as net present value (NPV), internal rate of return (IRR), and profitability index (PI) to evaluate investments?
Capital budgeting criteria
Which term describes the reduction in sales of a company's own products due to the introduction of another similar product?
Cost of cannibalization - The cost of cannibalization is the reduction in sales of a company's own products due to the introduction of another similar product.
What is the name for a forecast of short-term events that helps a company understand if it has sufficient cash?
Cash budget - A cash budget is a short-term forecast of future events that helps a company understand whether it has sufficient cash for regular operations.
Which tool is forward-looking and thus helps decision makers understand how actions taken today can affect their firm's future performance?
Financial forecasting
What three things should be included in a cash budget for a business?
Cash receipts, cash disbursements, and borrowing
Which financial institution ensures that a nation's economy remains healthy by controlling the amount of money circulating in the economy?
Central bank - Central banks control the supply of money in the economy.
If a company expects sales to grow by 10% next year, which account might also increase by 10%?
Cost of goods sold - Cost of goods sold is a spontaneous account, so if sales go up, you would expect the cost of goods sold to increase by a similar percentage. Otherwise, the company would not be able to sell products.
You want to buy a house, so you obtain a mortgage for which you can afford the monthly payments. What process have you engaged in as part of your financial decision-making?
Financing - Part of the personal finance process is figuring out how to finance your goals in a way that is within your means.
Personal income is which type of economic indicator?
Coincident - change as the economy changes.
An investor really cares about having voting rights in a firm. Which type of financial security should this investor purchase?
Common stock
In what way is preferred stock different from bonds?
Companies are allowed to skip payments to preferred stockholders but not to bondholders. - If companies skipped bond payments, they would go into default. Companies can skip payments for preferred stock. However, by skipping these payments, companies are not able to pay common stockholders and must pay dividends in arrears at some point.
An investor is reviewing the bonds of four different companies: Company A issues AA-rated bonds. Company B issues A-rated bonds. Company C issues BB-rated bonds. Company D issues C-rated bonds. Which company is likely to provide the lowest rate of return to the investor?
Company A
Which action would help you make your budget more efficient?
Compare your budgeted cash flows to your actual cash flows, and then revise the budget if necessary. - This would allow you to keep your budget updated and effective so you can make the best use of your money.
Why can compounding interest be a good tool but also a significant detriment?
Compounding interest can be a good tool because it allows a lender to gain interest on interest, but it is a detriment because it causes a borrower to pay interest on interest.
What is the third step in finding a solution to an ethical dilemma?
Consider all stakeholders involved - First, you should identify and define the problem. Second, consider alternative courses of action. Third, consider all stakeholders involved.
What is the second step in finding a solution to an ethical dilemma?
Consider alternative courses of action - First, identify and define the problem. Then, consider alternative courses of action.
What type of financial institution is an insurance company?
Contractual - Insurance companies are contractual savings institutions.
Which ratio helps an analyst evaluate whether a company can cover its short-term obligations?
Current ratio
What is the disadvantage of debt financing?
Debt financing does not actually achieve an optimal capital structure for a company. - Debt creates a tax shield, but there should be a mixture of debt and equity in an optimal capital structure.
What is the effect of debt financing on a firm's income?
Debt interest payments reduce taxable income.
Which action increases a company's sustainable growth rate (SGR)?
Decreasing dividend payout - Decreasing dividend payout increases earnings retention and thus increases the SGR.
Which actions, taken together, will certainly increase a firm's ROE?
Decreasing equity financing and increasing net margin -Decreasing equity financing increases the leverage multiplier, therefore increasing ROE, and increasing net margin also increases ROE.
What is the correct order of the three steps necessary to create a cash budget?
Determine cash receipts, estimate cash disbursements, create the cash budget - Doing these three things in this order can help you understand your business, understand the timing of cash flows, and keep track of borrowing requirements.
What would profitability index (PI) be useful for?
Determining whether a firm should invest in projects with different initial outlays
You are a financial manager of a company. The marketing department has informed you that the projected sales growth for the upcoming year is 10%. As you conduct financial forecasting, you keep the long-term liabilities the same amount as the previous year and will discuss this account with the other managers later. What type of account is long-term liabilities?
Discretionary account - Discretionary accounts do not vary automatically with sales but are left to the discretion of management. In this scenario, you kept the long-term liabilities account the same.
What is the name for the process of "spreading" money over many different assets?
Diversification
What should be the main question a firm asks when considering any investment decision?
Do the benefits of this investment outweigh the costs?
Which term refers to something that conforms with accepted standards of conduct that guide a person's behavior?
Ethical - refers to the accepted standards of conduct that guide a person's behavior
How can agency problems be reduced through corporate control?
Executive compensation - By compensating the management team with stocks and stock options, management may be willing to take on riskier projects. This creates more value for the owners because riskier projects will increase the value of financial securities.
What is the primary difference between finance and accounting?
Finance focuses on the future, while accounting is generally backward-looking.- Finance is the management and allocation of capital with the objectives of investing, forecasting, budgeting, saving, lending, and borrowing.
Which professional works with individuals to help them achieve their financial goals?
Financial planner
A company is developing a financial forecast for the next year. The company plans to implement a new factory that will increase production and resulting sales by 20%. Since the company's assets are increasing significantly, what else must increase?
Financing
You are comparing the return on equity of Firm 1 and Firm 2. Both firms have an identical profit margin and asset turnover, but Firm 1 has an overall higher return on equity. What must be true?
Firm 1 is using a higher proportion of debt to finance its operations. - The third component of return on equity is the leverage multiplier. Since the firms' profit margins and asset turnovers are the same, it must be the leverage multiplier that is different. Using a higher amount of debt would result in a larger leverage multiplier and an overall higher return on equity.
Knowing that you are taking this finance class, a friend asks you about two investment opportunities he is considering. He wants to know which of the firms is using its assets more efficiently to generate sales. Which set of information could help you determine this?
Firm A has an asset turnover of 4, and Firm B has an asset turnover of 2.5. - Asset turnover is an indicator of how well a firm uses its assets to generate sales. Since Firm A generates $4 of sales for every $1 of assets, it is using its assets more efficiently.
Which type of risk can be reduced by adding a variety of different assets into a portfolio?
Firm-specific risk - Firm-specific risk can be diversified away.
Which statement accurately describes firm-specific risk?
Firm-specific risk is the risk associated with problems that companies may face because of lawsuits, labor problems, or management decisions, among other factors.
Which account should be looked at first when examining capacity constraints to determine whether the discretionary financing needed (DFN) can be reduced?
Fixed assets - You can recheck capacity analyses to verify whether the firm really needs as large of an increase in fixed assets as projected in the forecast.
You are analyzing fixed assets to create pro forma financial statements for your company. You realize that, since sales will increase next year, you will also need your manufacturing capacity to increase by the same amount. Currently, you are operating at maximum capacity. You buy an entire new factory and multiple pieces of equipment that increase capacity to much more than you need to meet the sales growth. Which concept describes why such a large purchase was necessary?
Fixed assets are lumpy. - You cannot purchase only part of a factory and equipment to meet the sales growth. Instead, you must purchase the entire factory along with all the equipment to meet the sales growth. We call the increase of fixed assets as the firm approaches its full capacity "lumpy assets" because it requires a lump sum purchase.
Which principle of ratio analysis means that ratios are open for analyst interpretation, are not governed by rules, and allow creativity to work according to a particular company or asset?
Flexibility
You are the financial manager of a firm. The firm is small and is struggling to collect cash from accounts receivable. Also, due to the nature of industry, inventories are illiquid. To make sure that the firm has enough cash holdings for short-term obligations, you decide to create a new ratio of cash to short-term obligations. What is this scenario an example of?
Flexibility - Ratio analysis is flexible, so you can create a new ratio given the need of the firm.
Why is it appropriate to calculate the value of a preferred stock in the same way that you would find the present value of a perpetuity?
For a preferred stock, a fixed amount is paid forever to compensate the investors. - This is the case for preferred stocks, which are a type of perpetuity.
What does a net margin of 7% indicate?
For every dollar of revenue, 7 cents remain for the equity holders after all other costs are covered. - Net margin tells us the percentage of sales that will become net income, which is the amount remaining for the equity holders.
How do you factor sunk costs into capital investment analysis?
For the purposes of analysis, sunk costs are irrelevant. - Sunk costs are costs that have already been incurred whether you choose to do a project or not.
You are conducting financial forecasting for your firm given the projected sales. What are you doing if you are estimating changes in the balance sheet based on the predicted change in sales?
Forecasting spontaneous accounts -Spontaneous accounts change in proportion to sales growth.
If you invest $10,000 today and then $5,000 each year for the next 5 years into an investment with an interest rate of 4%, you can withdraw $39,248.14 in 5 years. What does $39,248.14 represent?
Future value - Future value measures the worth of relative past cash flows. The $39,248.14 is relative future to other cash flows.
Jack is a personal financial advisor. He is with a new client, and the client is asking him what he recommends for her portfolio. Jack knows that his firm's investment product performed well last year, but its performance changes from year to year—some years it is better than the market, and some years it is not. Also, the fee to invest in the product is higher than the fee to invest in a market index fund. If Jack sells his company's investment product, the customer's loyalty to the company is doubled. Which actions should Jack take?
Give a personal recommendation of the company's product while explaining its performance relative to the market over the past several years. - Giving a recommendation to sell a product is fine, but you should never hide other information. Sharing information about index funds and comparing your product to others is a fair action to take for the client.
You are considering starting a new business to sell Widgets in your hometown. You can import the Widgets at a low cost, and you hope to be able to sell them for significantly more. Which ratio can help you calculate how much profit you will earn from the sale of each Widget? (Assume you are only considering the cost of the Widget, not any other operating costs.)
Gross margin - Gross margin tells you the percent of sales that become gross profit. The rest of the money earned from sales is used for the production of goods.
Which example demonstrates a financing decision in a firm?
How a company will fund its assets and operations—namely, what proportions of debt and equity the business will use - This correctly characterizes a finance decision.
Which question is answered by financial forecasting?
How much financing will the firm need in the future? -Finance forecasting helps us determine how much financing is needed in the future given today's business decisions and growth.
What does the sales capacity equation tell you?
How much room a firm has to grow without additional investment in fixed assets- By using the ratio of actual sales to percent of capacity, you can determine how much sales growth the firm can support without needing to invest in further fixed assets.
A company that produces soap, shampoo, lotion, and other personal care products has recently taken a hit due to a competitor's new product line. The company decides to reduce wages for its labor force to save money while the company focuses on building up its reputation again, but the company's labor force goes on strike to protest the pay cuts. What type of risk does the strike represent?
Idiosyncratic risk - Idiosyncratic risk is the same as firm-specific risk. Since the strike will most likely affect only this firm, it is a firm-specific risk.
How does cannibalization factor into capital investment decisions?
If your company is planning on launching a product, and that product is going to steal some of the sales of another of the company's products, that loss of sales could be an incidental cost or revenue caused by the new product. - This is the correct definition of cannibalization.
How are non-incremental cash flows different from incidental cash flows?
Incidental cash flows are indirect cash flows that are not explicitly revenues or costs. Nevertheless, they must be included in the analysis. - Incidental cash flows are included in analysis and non-incremental cash flows are not.
Which factor contributes to the inflation of the prices of goods and services over time?
Increase in demand for goods and services
How can a company reduce its discretionary financing needed (DFN)?
Increase the net margin. - Increasing net margin increases the projected owners' equity, thus reducing the DFN.
Which action increases the return on equity of a firm if all else remains constant?
Increasing debt financing - Increasing debt financing increases the leverage multiplier, which means that the ROE increases.
Which action will increase the return on equity of a firm?
Increasing the asset usage efficiency of the firm
Which action decreases the discretionary financing needed (DFN)?
Increasing the plowback ratio-Increasing the plowback ratio increases projected owners' equity and thus decreases DFN.
Five years ago, Ahmed decided he was going to save up to purchase a car with cash. The car he wants is priced at $15,000. He saved $245 a month in an account that gave him enough interest to have $15,000 in five years. Today, he pulled out $15,000 from his account to buy the car, but the price of the car is now $16,562. Which component of the required rate of return did Ahmed forget to consider?
Inflation - The price of the car simply went up by $1,562 due to inflation.
What does the risk-free rate indicate?
Inflation and opportunity cost - The risk-free rate includes inflation and opportunity cost.
How is inflation calculated?
Inflation is calculated by determining the rate at which the average price level of particular goods and services increases over a period of time in an economy.
Suppose Alice is trying to explain to her friend, who knows nothing about the time value of money, why she should invest in Alice's new company. Which method of valuation should Alice use to convince her friend to invest?
Internal rate of return (IRR) - The IRR is easy to interpret, which makes it ideal for communicating the potential of an investment decision.
What is the difference between the current ratio and the quick ratio?
Inventory is excluded in the calculation of the quick ratio.-Since inventory is the least liquid current asset, inventory is not included in the calculation.
How can a firm grow its fixed assets if it is expecting growth but has reached capacity with its fixed assets?
Invest a substantial amount of money at one time to increase capacity. - Investments in fixed assets are capital-intensive, meaning they require large payments at one point in time.
What is a reasonable alternative to keeping an emergency stash of cash?
Investing in a savings account - Investing in a readily withdrawable account that still earns some interest is a value-preserving alternative.
A large corporation is looking to merge with another large corporation. Which financial institution can help them do this?
Investment bank - Investment banks facilitate complex financial deals, like mergers.
Which type of financial institution provides individuals and firms access to financial markets?
Investment institutions
What area of finance involves deciding which assets to invest in to create wealth in the future?
Investments
Which subspecialty of finance primarily involves deciding which assets will create more wealth and earn positive returns?
Investments - Investments is the area of finance that seeks to create wealth in the future by deciding where to allocate money.
Which area of finance involves deciding which assets to invest in to create wealth in the future?
Investments - This area involves deciding which assets to invest in to create wealth in the future.
What is the main purpose of charging interest?
It allows borrowers to pay to use the assets of another entity to accomplish their own goals. - Because the funds do not belong to borrowers, they must pay to use them. This payment is the interest rate.
How can the DuPont framework help a company assess its return on equity?
It allows the company to determine how its abilities to generate profits, manage assets, and use financing contribute to the return on equity. - The DuPont framework breaks the return on equity into each of these components using the profit margin, total asset turnover, and leverage ratio.
What is an advantage of using the NPV method?
It calculates the dollar value that would be added to the firm by doing the project. - The NPV is expressed as a dollar amount, and the result of the NPV calculation is exactly how much value would be added to the firm from that specific project.
Why is NPV the most reliable method for evaluating investments?
It considers the time value of money, it tells you the dollar value that the investment will add to the firm, and it takes risk into account. - These are the main advantages of the NPV, some of which are not included in other methods of valuation, which makes NPV the most reliable.
How does the PI aid in interpretation of the NPV?
It gives an idea of the return generated by a project. - The PI scales different-sized projects so that their returns are comparable.
Why is the sustainable growth rate (SGR) useful?
It gives the maximum growth rate that allows a firm to maintain its current financial ratios without issuing new equity. - The SGR is ROE times the plowback ratio, and it demonstrates the level of growth at which those ratios remain constant.
What is a disadvantage of using the NPV method?
It is not an effective way to compare projects of different sizes. - NPV should not be used to compare projects of different sizes.
What are the benefits of using the traditional envelope method to track cash flows?
It is simple and helps ensure that users do not spend more than the cash that they have available.
Why is the required rate of return also known as the hurdle rate?
It is the minimum rate that a firm must surpass to accept a project. - When a financial manager decides whether to invest in a certain project, the projected return needs to meet the minimum rate of return, or else the firm must "hurdle" the rate in order to accept the project.
What is opportunity cost as it relates to the time value of money?
It is the opportunity you forgo to invest in other options due to the time scope of an investment. - Opportunity cost is the cost that you have to give up for something as a result of investing in something else.
How is the cost of capital used in the decision-making process for a capital investment project?
It is used as the discount rate of cash flows.
How does an analyst use the hurdle rate?
It is used to compare with the IRR to determine whether a project should be accepted.
What would an inverted yield curve signal?
It may indicate an economic downturn. - An inverted yield curve reflects the expectation that the economy will have low or negative growth in the future.
About a year ago, the short-term Treasury bill had 1.54% interest and the long-term Treasury note had 2.54% interest. This week, the 1-year Treasury bill has an interest rate of 3.13%, while the 10-year Treasury note has an interest rate of 2.28%. What does this information indicate about the future economy?
It may indicate an economic downturn. - Since the long-term Treasury interest rate is lower than the short-term rate, it has an inverted yield curve, which may indicate an economic downturn.
What are the effects of attempting to maximize shareholder value for a business in an unethical way?
It often leads to decreased shareholder value for the business. - Unethical behavior can lead to very costly results.
How can investing help a person reach personal financial goals?
It provides access to potential revenue or increases in value to help meet goals faster.
Alphabet Co. has $50,000 to spend on capital investment projects for the next year. It will do as many projects as it has cash for. Alphabet Co. calculates the potential incremental cash flows and costs of the projects as well as the NPV, IRR, and PI for each project. How should the company decide which projects to invest in if it wants to maximize the total amount of value created?
It should choose the projects with the highest PIs until all capital has been used. - By choosing the projects with the highest PI, Alphabet Co. will be able to use its limited capital effectively to create the most overall value for the firm.
After W&H Inc. has developed a cash budget, what should the company do in the following months?
It should monitor its actual cash flows and then revise the cash budget if needed - Monitoring and revising the cash budget will allow W&H Inc. to identify and fix any problems that may arise.
Should a firm accept a project that has a PI of 0.8? Why?
No, because the project would be generating cash inflows that are 20% short of the initial investment.- As a rule, firms should accept only projects that have a PI greater than 1.
The YTM of a bond went from 8% to 7%. What can be predicted about the price of the bond?
It will increase. - There is an inverse relationship between YTM and the price of a bond.
A firm has paid off its short-term loans more quickly in the past couple of years. What might this trend indicate about the firm's financial ratios?
Its liquidity ratio is increasing. - Liquidity is a measure of the ability of a firm to convert short-term assets into cash. Paying off short-term loans quickly is an indication that a firm is quite liquid, so the firm's liquidity ratio would be increasing.
What are three principles of budgeting that are important to know before beginning the budgeting process?
Keep records; develop savings, income, and expense strategies; and use a method that meets your needs and objectives - All three of these principles are included in the six principles of budgeting as discussed in the course. The other three principles are know yourself; understand the key areas of savings, income, and expenses; and eliminate consumer debt and minimize long-term debt.
How do the benefits of knowing the cash position for each period differ between businesses and individuals?
Knowing the cash position allows businesses to recognize when short-term loans are needed, while it allows individuals to analyze progress toward their personal financial goals.- individuals do not usually (and should not) need short-term loans.
Unemployment rate is which type of economic indicator?
Lagging - Lagging indicators change after the economy changes.
Which type of economic indicator changes after the economy changes and helps identify trends in the long term?
Lagging indicator
Yield curve is which type of economic indicator?
Leading - Leading indicators change before the economy changes.
Which type of economic indicator is used by governments and policymakers to implement or alter policies in an effort to avoid or minimize the effects of an economic downturn?
Leading indicator
You are a financial manager of a company, and you have projected sales increase for next year of 8%. Which action would you take when you conduct financial forecasting using the percent of sales method?
Leave the notes payable account constant in the projected financial statements.-Notes payable is a discretionary account. Thus, you should leave it constant in the projected financial statements.
Which type of error would result in a set repercussion or penalty given by the government?
Legal - A legal error would result in a predetermined penalty by the government.
Which type of ratios are banks and lenders most concerned about?
Liquidity
What type of ratio is used to assess a firm's ability to meet short-term obligations without raising external capital?
Liquidity ratios - Liquidity ratios measure a firm's ability to meet short-term obligations without raising external capital.
Which type of ratio is a current ratio?
Liquidity- A current ratio is a liquidity ratio because it assesses whether a firm can meet short-term obligations.
Jack works for a company that manufactures televisions and must obtain financing to increase the company's inventory levels. Jack's manager knows that current investment markets are tight, and it may be difficult for the company to obtain additional financing for the next year. The manager asks Jack to propose a way for the firm to reduce its discretionary financing needed (DFN). What should Jack suggest to reduce next year's DFN?
Lower the amount of dividends that are paid out to shareholders next year
Hannah is the financial manager of a firm. A project that she has recommended has been approved and will cost $5 million. Since the company does not have enough cash on reserve, Hannah must figure out how to raise enough money to start the project. She can choose whether to issue new bonds, new stocks, a mortgage loan, or some combination of those options. What task is Hannah performing in this scenario?
Making a financing decision
What are financial managers doing if they evaluate whether it is worth spending money on research and development for a new product?
Making an investment decision - The financial manager assesses the costs and benefits of potential investments in order to wisely use the investors' money.
A financial manager at a company is trying to determine whether to issue new stocks or new bonds to cover the costs of a project the company is doing the next year.
Making financing decisions
Which task does a financial manager perform when choosing to obtain a loan to purchase a piece of equipment for a new project?
Making financing decisions
Which task does a financial manager perform when assessing the costs and benefits of potential projects?
Making investment decisions - Understanding how benefits weigh up against costs is the first priority before moving forward with financing and managerial decisions.
How does management choose between two projects that are seemingly the same?
Management can analyze the different inherent risks that change the cost of capital to the firm. - Each project will have its own inherent risks.
Which situation is an example of an agency problem?
Managers follow their own interests instead of the owners' interest. - An agency problem occurs when the agent (a manager) does not act in the best interest of the owners.
What makes market risk different from firm-specific risk?
Market risk cannot be diversified away, and firm-specific risk can.
Why are financial models helpful in financial forecasting?
Models allow users to see the complex relationships between sales and other aspects of the business.
What kind of market primarily allows institutions to borrow and lend in the short term?
Money market - Assets in money markets are typically highly liquid and intended for use within a year or less.
What is the purpose of monitoring your cash flows?
Monitoring allows you to evaluate whether your actual cash flows are in line with your goals and to understand when correction or revision is needed. - If a business did not monitor its budget, then tracking cash flows would be useless, and the business would not know if it was on track to reach its goals.
What is the difference between tracking and monitoring cash flows?
Monitoring involves using your tracking record to evaluate cash flows against your target, identify patterns and changes in cash flows, and gauge when correction is needed. - By accessing cash flow records and knowing the remaining balance in the budget throughout the month and year, you will be able to monitor your budget in a way that will help you reach your financial goals.
Which processes help you identify and fix problems in your budget?
Monitoring your budget allows you to identify problems, and then gradual revision and implementation of new processes allow you to fix those problems. - This assures that the budget is as effective as possible at helping you reach your financial goals.
Suppose an individual does not eat chocolate because eating chocolate goes against his personal beliefs. Which type of standard is this?
Moral
Which term reflects a person's beliefs about right and wrong, good and bad, or just and unjust?
Moral - Moral reflects one's beliefs about right and wrong, good and bad, or just and unjust.
Lucas is a financial advisor working for Bullzai, Inc. He is faced with a dilemma. Bullzai has started changing its practices in order to increase profit. As a financial advisor, he is now supposed to suggest to clients to invest in portfolios that will not do as well as the portfolios that Bullzai is invested in. This is an accepted practice done by other businesses in the industry, and it complies with all standards set by the government. However, Lucas knows that this practice is not in his clients' best interest. What type of dilemma is Lucas facing?
Moral - This is not a legal issue because the new practice complies with the law, and it is not an ethical issue because it is a commonly accepted practice within the industry. It is a moral issue because it deals with Lucas's own sense of right and wrong.
What is the term for an individual's beliefs concerning what is and is not acceptable to personally do?
Morals
Which Excel function should you use when you are finding a present value of uneven cash flows to find the PV in one step?
NPV - You can use one NPV function to find the present value of uneven cash flows.
Which of these measures is a component of return on equity?
Net margin - Net margin, total asset turnover, and leverage multiplier are the components of return on equity.
If two projects are mutually exclusive, which decision-making criterion will help you make the best decision about which project to accept?
Net present value (NPV) - When only one project can be chosen, the PI is not useful because it does not indicate the dollar value that a project will add to or take away from a firm.
Talia is comparing four mutually exclusive projects. In order to choose the best project to optimize the goal of the firm, which capital budgeting method should Talia use?
Net present value (NPV)- When you compare mutually exclusive projects, you should look at how much value is added by each project, because you can do only one of them. Therefore, you should use the NPV method to choose a project.
A firm is currently operating at 75% capacity with current sales of $34 million. Will the firm need to acquire additional fixed assets if its sales are predicted to increase by $6 million next year?
No, because the increase in sales will not exceed the firm's sales capacity.
Which type of interest rate is the rate at which invested money grows for a certain period time? -
Nominal rate - The nominal rate is the rate at which invested money grows for a certain period of time and is the interest rate most often used in your daily life.
Nora is an investment manager, which means that she is paid to invest other people's money. To meet her goal for the month, she is seeking to invest money from clients in an investment that is risky but potentially has a higher return. What about this situation represents an ethical dilemma?
Nora is considering investing in a risky asset just to meet her monthly goal. - Nora is caught between the obligation to meet her goal and the obligation to keep her clients' money safe. As an investment manager, she is obligated to do what is best for the client.
A potential project to expand the size of an apartment complex will cost $100,000. Its calculated net present value is $5,000. Given this information, which statement is correct?
The project should be accepted because it has a positive NPV.- Because the NPV is positive, the project should be accepted.
Which description below correctly identifies one type of price risk?
Operating risk—depends on the effect of the firm's operating decisions on its operating costs
Which component of the required rate of return takes into account the loss of potential gain from other alternatives?
Opportunity cost
What must be determined in order to compare the values of two projects with differently timed cash flows that does not need to be determined for projects with similarly timed cash flows?
Opportunity cost - Opportunity cost must be determined to analyze two such projects.
What is a component of the required rate of return?
Opportunity cost - The required rate of return is composed of opportunity cost, risk, and inflation.
What is the name for a series of equal payments made at the end of consecutive periods over a fixed length of time?
Ordinary annuity - This is the definition of an ordinary annuity. The keys are "at the end of each period," "fixed period," and "equal payments."
Which financial institution invests funds contributed by a company to provide retirement funds for the company's employees?
Pension fund - This is the role of pension funds.
Which type of financial institution deals mainly with providing for retirement through employers?
Pension fund - Through employers, individuals can contribute to pension funds, which then invest their money in the market to provide retirement funds.
Which method is most commonly used for determining a company's DFN?
Percent of sales
A company calculated variances of a budget and actual cash flows that indicate the firm's strengths and weaknesses in cash flows and its budgeting process. Which major use of cash budgeting is this an example of?
Performance evaluation
What would an analyst predict for a potential investment with an NPV of zero?
The project would earn exactly the rate of return required by the firm. - An NPV of zero indicates that a project will neither add nor take away value from a firm.
Lolo invested $30,000 today in an account that gives 3% interest. Starting one year from today, she will be able to pull out little over $3,500 a year. What does the $30,000 represent?
Present value - The $30,000 is invested before any cash flows, so it is a relative past cash flow. Therefore, this is the present value.
What happens to prices in a market in which there is inflation?
Prices rise. - Prices rise because of increase in demand, increase in cost of goods, and adaptive expectations.
A sign company is planning to have an initial public offering (IPO). In which type of market will its stock first be sold to the public?
Primary market
A local start-up company just hit its five-year anniversary and is planning an initial public offering sometime this year. In order to issue public stock, which market will the company use?
Primary market - When a company issues stock for the first time to raise capital, shares must initially be sold through a primary market.
How should you go about making changes to your budget?
Prioritize the changes you want to make and then implement them gradually one by one to make sure they work. - Revising your budget in this way will help changes go smoothly and help your company or family members become familiar with the changes.
Which financial institution includes entities that receive money from institutional investors and wealthy individuals to buy troubled companies to improve them and earn returns by selling them or going public?
Private equity - This is the role of a buyout private equity firm.
Which financial career focuses on investing capital into firms whose shares are not currently sold on any public stock exchange?
Private equity deals with investments in firms that are privately held and whose ownership is not yet bought or sold on any public stock exchange.
Which type of ratio should be used to examine the cost efficiency of a firm's production?
Profitability
Which capital investment evaluation method is presented as a ratio?
Profitability index (PI) - The PI is the ratio of discounted benefits to discounted costs.
A company is considering five projects that are not mutually exclusive. However, the company does not have enough money to do all of them. In order to prioritize projects that fit within the company's budget, which capital budgeting method should be used?
Profitability index (PI) - The PI should be used first to compare the projects and then to rank them to maximize the value of the firm.
A company currently has a ratio of 1.5 but hopes to improve the ratio to 2 to align more with the industry benchmark. To achieve this goal, costs were cut in production through an investment in efficient equipment, and the company achieved a higher profit margin. If this continues, you are certain that the firm will achieve its goal in two years. What is this an example of?
Progress measurement - you are comparing the company's ratio to the goal and checking how the company is progressing toward the goal.
A company is trying to decide which of four projects to invest in. Project 1 has an IRR of 14% and an NPV of $54,000. Project 2 has an IRR of 11% and an NPV of $67,000. Project 3 has an IRR of 9% and an NPV of $60,000. Project 4 has an IRR of 13% and an NPV of $47,000. If the company can do only one project, which project should it choose to add the greatest value to the firm?
Project 2 - The project with the highest NPV will bring the most value to the company.
The company Betsy's Wigs is considering three potential projects that are not mutually exclusive. The IRR, NPV, and PI for each project are listed in the table below. Use this information to rank the projects in the order in which Betsy's Wigs should accept them to bring the most value to the firm. Project IRR NPV PI Project 1 23% $820 1.02 Project 2 18% $880 1.27 Project 3 21% $790 1.35
Project 3, Project 2, Project 1 - The projects with the highest PIs should be accepted first.
You are considering four projects. The initial cost to start each project is $500,000, and the total cash inflows generated by each project are $600,000. Each project also has the same level of risk. The only difference between these four projects is the cash flow patterns. Year 1 Year 2 Year 3 Project A $200,000 $200,000 $200,000 Project B $300,000 $200,000 $100,000 Project C $100,000 $200,000 $300,000 Project D $600,000 $300,000 -$300,000 Given the information above, which statement is correct about these four projects?
Project D should be chosen first given that the project will receive cash to sum to $600,000 the most quickly. - Project D receives cash flows the most quickly of the four projects. Given the concept of the time value of money, Project D should generate the highest NPV.
An employee was recently hired as a financial analyst and asked to create a cash budget for the employee's division for the next year. Which component should the employee exclude from the budget?
Purchase of equipment that will be bought in three years
How do corporations and purchasers of financial securities view returns?
Purchasers of financial securities look at returns as the amount of money they require in order to lend or give their money to the corporation that issued those securities. - This is a correct description of returns from the viewpoint of investors.
How can you use the envelope method of budgeting to monitor cash flows?
Put the amount of money budgeted for each category of your expenses into labeled envelopes and then spend the money in each envelope on expenses in that category. - This method will help you plan and monitor your cash flows.
An investment analyst is concerned about a construction company's ability to sell its inventory to meet current obligations, because much of the inventory (commercial buildings) it builds and sells takes longer than a year to construct. Which ratio should this analyst use to consider the effect of the firm's inventory on the firm's ability to meet current obligations?
Quick ratio
How might calculating financial ratios help shareholders?
Ratios can be used to determine whether a firm is maximizing shareholder wealth. - Ratios are used to evaluate managerial actions so shareholders can determine how effectively and profitably managers are using their invested capital.
Which items are considered cash disbursements for a business?
Raw materials, rent, administrative expenses, interest, and selling expenses -These are common products or services that a firm pays cash for during a specified period in order to generate sales.
What should a potential bondholder (lender) do to prevent a company (borrower) from taking on risky projects?
Set strict covenants that the company cannot uphold if it chooses a risky project
What is a component of the DuPont framework?
Return on assets - ROE is ROA times leverage multiplier.
How do insurance companies pay policyholders when a claim is made?
They use returns from stocks and bonds. - Insurance companies invest the money that they earn from premiums into stocks and bonds, and then the returns are used to fill claims.
Maya is considering purchasing stock in a certain company. Her financial advisor suggests that she purchase stocks in multiple companies instead of just one. Which risk management technique is this financial advisor suggesting?
Risk diversification
What is the compensation for risk given to investors called?
Risk premium - Risk premium is the compensation that investors take for the risk they have to bear.
An energy company discovers that a new bill has been proposed to change the amount of fuel that can be exported outside the country. If passed, this could have a serious negative effect on the company's revenues. Some of the company's competitors are obtaining insurance policies to compensate for this risk, but since the energy company believes the likelihood of this bill passing is low, it chooses to do nothing—ultimately taking responsibility for this particular risk instead of trying to transfer the risk through an insurance policy. Which risk management technique is this choice an example of?
Risk retention
How is risk separation different from diversification?
Risk separation involves dispersing assets geographically instead of concentrating them in one location.
Which component of an interest rate is an indicator of inflation and opportunity cost?
Risk-free rate - The risk-free rate describes the rate of return on an investment with no risk, so it just measures inflation and opportunity cost.
Which kind of projects are bondholders interested in?
Safe projects with a higher chance of providing sufficient compensation - Bondholders provide money for a company for a certain period of time and want companies to pay them back for their investment.
Why are sales not strictly considered to be the same thing as cash receipts?
Sales include both cash sales and credit sales. - Sales made on credit are not considered a cash receipt until the time period in which they are collected.
Endothon Company has decided to move its production from the United States to a foreign country. Which situation below would constitute an unethical action by the company?
Saving money by paying inadequate wages to workers overseas - Other countries may not have laws that protect workers, such as minimum wage laws.
In which financial market are securities such as stocks and bonds are traded after their initial issuance?
Secondary market - Financial securities are first sold in the primary financial market and then traded among investors in the secondary financial market.
Which condition indicates that an investment will add value to a company?
The present value of the benefits of the investment outweigh the present value of the costs of the investment. - If the project provides more value than it costs, then mathematically it will add value to the company.
A company is trying to finance a project with a mortgage loan from a bank. The company's assessment of the project indicates that the company may experience several years of loss until the project becomes profitable. This means that the company might lose its ability to pay back the loan and the interest on the mortgage. What action might the bank take to protect its interest?
Set a strict covenant that the company cannot easily achieve. - By setting a strict covenant, there is a risk that the company may not meet its obligation, which would deter the company from taking on risky projects.
You are a financial manager of a company. The marketing department has informed you that the projected sales growth for the upcoming year is 15%. As you conduct financial forecasting, you increase cash, accounts receivable, and inventory accounts by 15%—the same as the projected sales growth. What type of accounts are these?
Spontaneous accounts - Spontaneous accounts vary naturally with sales. Since they increase proportionally with sales growth, they are examples of spontaneous accounts.
Which type of account changes with sales growth?
Spontaneous accounts-Spontaneous accounts vary naturally with sales.
Based on the following information about the stocks of several companies, which stock displays the greatest amount of risk? Stock A: Return = 22.22%, Standard Deviation = 9.99% Stock B: Return = 15.05%, Standard Deviation = 7.35% Stock C: Return = 38.83%, Standard Deviation = 4.54% Stock D: Return = 5.69%, Standard Deviation = 5.32%
Stock A
How does the amount of time affect the risk associated with different investment vehicles?
Stock investments are more risky over a shorter period of time than over a longer period of time. - Time diversification refers to the idea that stock investments are more risky over a shorter period of time than over a longer period of time.
Why might a firm prefer to raise debt capital through stocks instead of bonds?
Stocks do not require the firm to repay the par value to investors. - Stocks are shares of ownership in a firm, so the value of the stock is not required to be returned to investors.
What is one way that a firm can improve its return on equity?
Successfully cutting production costs to boost net margin - Increasing net margin increases the ROE.
What is the term for the rate that allows a firm to maintain its present financial ratios without issuing new equity or increasing debt?
Sustainable growth rate
Company ABC would like to continue to grow, but in order to maintain control of all decisions and ownership, it wants to avoid issuing new stock. Which calculation will show the company's leadership the fastest that ABC can grow?
Sustainable growth rate - Sustainable growth rate is defined as the rate at which a firm can grow without issuing new equity. It implies that the firm's growth comes from the return on equity less any dividends.
What indicates to a firm that a project will increase shareholder wealth?
The NPV is positive. - The NPV is an estimate of the dollar amount that would be added to the firm's value as a result of the investment.
Which method should you use to calculate a bond value?
The PV function in Excel- You should use the PV function in Excel given the rate, FV, nper, and rate input variables.
What is discretionary financing needed (DFN)?
The additional financing needed given a firm's expected future growth - DFN is how much additional financing the firm will need given its expectations for future growth.
Suppose you are a manager at a firm. One of your financial analysts places a report on your desk of valuation calculations for some potential investment projects. When you look at the calculations later, you notice that the analyst did not indicate if she used the NPV or IRR method. However, you do notice that the results of the calculations are all percentages. What can you conclude?
The analyst used the IRR method. - IRR calculations are represented as percentages because they are rates of return.
Why might an investor be concerned by how Company A is achieving its higher-than-industry return on equity?
The company's significantly higher use of debt could present a financial risk.
Which item is considered a sunk cost?
The consulting cost spent three months prior to the start of a project - Since the cost was incurred before the start of the project, this is a sunk cost.
What part of the NPV calculation is very important but difficult to estimate?
The cost of capital - The cost of capital is affected by several things, such as different capital structures, timing of cash flows, and investment potential, which makes it difficult to calculate. An inaccurate prediction of the cost of capital may cause a firm to miss out on good projects or accept bad projects.
You are considering a project that has a profitability index of 1. What does this mean?
The project has the internal rate of return equal to the cost of capital. - PI = 1 means that the break-even point is the estimated cost of capital; in other words, the cost of capital and the rate of return should be exactly the same.
You calculate the PI of a project to be 1 but realize that some aspect of your calculation was incorrect and needs to be adjusted. Which adjustment to the PI estimation should cause you to reject the project?
The cost of capital was underestimated, so you adjust the cost of capital to be higher. - Increasing the cost of capital decreases the PI. Therefore, the new PI will be less than 1, and you should reject the project.
What is the main difference between the current ratio and the quick ratio?
The current ratio includes inventory in current assets, and the quick ratio does not. - Inventory is the least liquid of all current assets. By not including inventory, the quick ratio is a more stringent test of a firm's ability to meet short-term obligations. 3
What makes the expected return subjective and different from other types of returns?
The expected return is based on expectational data and the probability of different scenarios occurring. - The expected return is calculated from hypothesized or "best-guess" estimates of future prices or returns in different scenarios.
What does it mean when a firm's calculated discretionary financing needed (DFN) is negative?
The firm will have enough financing to fund projected sales. - If total projected liabilities and owners' equity are greater than total projected assets, then no additional financing is needed.
You are evaluating a common stock. What is a key assumption for this evaluation?
The growth rate is assumed to stay the same forever. - Common stock valuation uses the constant growth model under the assumption that the growth rate is constant forever.
What is the sustainable growth rate (SGR)?
The growth rate that allows a firm to maintain its present financial ratios without issuing new equity - The SGR is the growth rate that allows a firm to maintain its present financial ratios without issuing new equity.
What is the relationship between risk and return?
The higher risk an investor takes, the higher return the investor expects to receive.
What is the relationship between the risk and the rate of return?
The higher the risk investors have to take on, the higher return they require. - Investors will take on more risk if there is potential for a higher return.
What does inventory turnover assess?
The inventory management of a firm - tells us how well a firm is managing its inventory.
What is an opportunity cost?
The loss of the ability to use an asset toward the next best project once you have invested it in another project - The concept of opportunity cost is that because you use an asset to invest in one project, you lose the opportunity to use the same asset to do a different project.
What does the net margin measure?
The percent of revenue that is retained as profit for the firm- The net margin is net income divided by sales, which tells us how much a firm actually gets to keep after paying all its expenses.
The word risk is used in many different contexts. How is risk defined in finance?
The possibility that the realized or actual return will differ from the expected return
What is the inflation rate?
The rate at which the average price level of a basket of goods and services in an economy increases - The rate at which the average price level of a basket of goods and services in an economy increases is the inflation rate.
What tends to happen to the risk of an investment that offers a higher return?
The risk is higher for an investment with a higher return. - The higher the risk an investor takes, the higher the reward the investor is compensated with.
Which type of financial market is where securities such as stocks and bonds are traded after their initial issuance?
The secondary financial market - Financial securities are first sold in the primary financial market and then traded among investors in the secondary financial market.
Maria is planning to invest in some company stocks for retirement and is trying to figure out if the stocks are a good buy. She calculates the intrinsic value of one of the stocks, Quiet Flag Industries, to be $35. The stock is currently trading on the market for $30, so she decides to buy it. Why was it a good idea for Maria to buy this stock?
The stock is undervalued.
What does the discretionary financing needed (DFN) tell us?
The total amount of funding that management will need to obtain through discretionary financing sources - DFN is the difference between the projected total assets and the projected total liabilities plus owners' equity. Any discrepancy between the sources and uses of finance is extra financing that management must obtain.
Why is the IRR a poor valuation method for a project with unconventional cash flows?
There are multiple sign changes in the calculation resulting in multiple IRRs, and it is impossible to tell which IRR is the correct one. - Projects with unconventional cash flows must be valued using NPV.
Why would a long-term investment require a higher rate of return?
There is greater risk involved and a higher opportunity cost. - There is greater risk because you cannot ensure the return of your investment for a longer period of time, and there is a higher opportunity cost because you cannot use that money for other things for a longer period of time.
How does allocated overhead affect the selection of capital investment projects?
These cash flows are not a direct result of a specific project but are a general cost to the firm. - These cash flows are irrelevant to your analysis.
Why are ratios useful for analyzing and comparing company performance between firms of different sizes?
They provide standardization. - Ratios standardize financial data to make them comparable across firms, even those of distinctly different sizes.
The firm Betsy's Books has a market-to-book ratio of 1.2. What does this tell you about the firm?
This firm is expected to grow in the future. - The market-to-book ratio measures the growth prospects of a company. If the ratio is greater than 1, then the company is expected to grow.
Firm A has an average collection period of 67 days, and the industry norm is 40 days. What can the firm do in order to be competitive with accounts receivable management in the industry?
Tighten the credit standards for its customers. - The credit standards are too loose, so the customers are not paying Firm A as quickly as they are paying other competitors in the industry. Tightening the credit standards would shorten the average collection period.
What is the name for the concept that a dollar today is worth more than a dollar in the future?
Time value of money - The time value of money is the concept that today's dollar is worth more than a dollar in the future.
Why is the timing of cash flows an important characteristic of capital investment?
Timing of cash flows is related to the opportunity cost associated with those cash flows. - The cash flows of an investment need to be compared to the cash flows of other projects.
What is the primary role of financial institutions?
To conduct financial transactions such as investments, loans, and deposits - Financial institutions conduct transactions to circulate money.
What is the purpose of a monthly cash budget?
To control cash inflows and outflows so you can balance income with expenditures and savings - Controlling cash inflows and outflows allows you to use your money in the most effective way possible.
Why might a manager manipulate accounting procedures?
To make the company's performance look good - A manager might manipulate accounting procedures to inflate the earnings of a company, which would optimize bonuses and stock-price-related benefits for management.
What is one of the fundamental purposes of financial forecasting?
To estimate how changes in cost structures or sales will impact the future cash flows and financing needs of the firm- A solid financial model will allow you to see how changes in cost structures or sales growth will impact the firm's future cash flows, financing needs, and cash budgeting.
For what purpose are market ratios used?
To evaluate the current share price of a public firm's stock - Market ratios are used to evaluate whether the current share of a public firm's stock is correctly priced.
What is the major purpose of financial forecasting?
To inform a company how business decisions will impact future growth - Financial forecasting helps decision makers understand how actions taken today can impact the firm's future performance.
What is the goal of financial forecasting?
To understand the implications of today's decisions on tomorrow's performance - The goal of financial forecasting is to see the big picture of how financial decisions will affect future performance.
Which process is Li engaging in if he recently made a personal budget and is now keeping a record of his cash flows?
Tracking
What is the main reason why it is important to track and record cash flows?
Tracking your cash flows allows you to recognize where and how your money is spent so you can monitor your cash flows and revise your budget as needed. - This is the first step in the budgeting process, and it is necessary in order to have an accurate budget going forward.
As an active investor, Maria is analyzing her portfolio to decide if there are any stocks she should remove from her pool of financial securities. A company she has invested in, Quiet Flag Industries, just released its annual report. Which kind of method should Maria use to see if the company has improved?
Trend analysis
Which statement correctly identifies the relationship between systematic risk and different types of firms?
Utility companies have low systematic risk because as the market moves up and down, their level of risk will also move up and down but in a diminished way.
Which term is used to describe the stock of a firm with market-to-book ratio of less than 1?
Value stock - An M/B ratio of less than 1 is considered a value stock.
What do leverage ratios describe?
What proportions of equity and debt a firm uses to finance its assets- This information gives insight into the financial structure of a firm.
Which type of expense is a magazine subscription?
Variable expense
When evaluating a company's performance, what can variances on a company's cash budget indicate?
Variances show that certain managers or divisions are not meeting targets. - Cash budgets provide a basis for performance evaluation, and significant variance from predicted income, saving, and expense predictions indicates that management has not accurately assessed company operations.
In what situation might the software method of tracking be preferable to the spreadsheet method of tracking?
When a person has a hard time remembering to record their cash flows and when they prefer to use a card to make purchases-The software method is convenient for busy people who do not want to use cash or record cash flows by hand.
In which situation would a firm need to borrow cash?
When the beginning cash balance plus the net cash is less than the minimum cash balance required for the month - This indicates to a firm that additional financing will be needed during the period to operate effectively.
A financial analyst for the company Bobby's Books has been asked to evaluate a potential investment using a method that considers the time value of money. Is there more than one way to do this?
Yes, the analyst could use both the NPV and the IRR. - Both NPV and IRR take into account the time value of money.
Quiet Flag Industries has a large piece of land worth $250,000 that it is considering using for a miniature golf business. When evaluating the cash flows that would result from doing this project, should Quiet Flag consider the land value? Why or why not?
Yes, the land value represents an opportunity cost.
In what way are coincident indicators useful?
hey are analyzed during economic shifts to provide information about the current state of the economy. - Coincident indicators help analysts see the big picture of economic trends.
