D076 Test + Quizzes

Which question is answered by financial forecasting? Which product will produce the most in sales over the next year? How much financing will the firm need in the future?

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 are the 2 leading indicators?

Yield curve and stock market return

What area of finance involves deciding which assets to invest in to create wealth in the future? Investments Organizational finance Financial institutions Investment banking

Investments are an area of finance that involves deciding which assets to invest in to create wealth in the future.

A commercial bank

A commercial bank accepts deposits; offers checking and savings accounts and other basic financial products; and extends various loans, such as auto loans and home mortgages. Banks make money by charging a higher interest rate on extended loans than the interest rate they pay out on deposits. These firms play a vital role in the economy, and without them many people would not be able to afford homes or pay for college.

A dealer market (type of secondary market)

A dealer market does not require a physical location. Securities are bought and sold through a network of dealers who trade for themselves. For example, a dealer might hold inventory in a particular stock and be willing to sell to buyers who demand the stock and buy from sellers who will supply the stock. NASDAQ is an example of a dealer market. Most stocks that are listed on NASDAQ have multiple dealers for each stock. The dealers must compete with one another, thus lowering the cost of transacting and improving liquidity in the market.

Which scenario is an example of an agency problem? The owners of the company offer shares of the company to management. A manager purchases a company car and allocates it as a company expense. An employee takes a potential client to dinner and pays for it using the company credit card. The management team works overtime without pay to complete financial reports.

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.

Required Rate of Return (ROE)

A more precise word for interest rate. Composed of opportunity cost, risk, and inflation. It is the compensation that an investor or a lender will accept for investments such as stocks, bonds, or loans. Also known as the hurdle rate in corporate finance. When a financial manager decides whether to invest in a certain project or not, the project return needs to meet the minimum rate of return or else the firm must "hurdle" the rate in order to accept the project.

A mutual fund

A mutual fund is an investment company that continually offers investments and buys financial securities and instruments (usually stocks or bonds) on behalf of investors. Mutual fund companies often have their own products or portfolios composed of multiple stocks and bonds. The performance of the funds determines the company's value. Even though the funds are a pool of financial securities, investors normally do not have the same rights that individual stockholders have.

Perpetuity

A perpetuity is a constant stream of identical cash flows that continues forever. In other words, it is an ordinary annuity that has no end. A good example of a perpetuity is preferred stock, which pays a fixed dividend every consecutive period of time forever.

Yield curve (leading indicator)

A yield curve is a graph that plots the interest rates of bonds with different maturity dates, oftentimes U.S. Treasury bonds. The curve is often used as a benchmark for an interest rate of an auto loan, mortgage, and so on. A normal yield curve results when longer maturity bonds have higher interest rates than shorter ones. It reflects the expectation that the economy will grow in the future along with rising inflation. When longer-term bonds have a lower interest rate than shorter-term bonds, you will see an inverted yield curve. This may indicate an economic downturn. Finally, a flat yield curve results when both short-term and long-term bonds have the same interest rate, indicating that the economy is in a transitional state.

What are the main services offered by financial institutions?

Accepting a wide variety of deposits, offering investment products, providing loans, and brokering financial transactions

A company's officers and board of directors are selling their stocks in the firm at higher prices due to false accounting reports that made the stock seem more valuable than it truly was. Which ethical issue is occurring in this situation? Pursuing individual interest over client interests Conflict between work and personal affairs Agency problem due to conflicting interests

Agency problem due to conflicting interests! Accounting manipulation by management in pursuit of higher stock-related compensation is an example of an agency problem.

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.

Annuity due

An annuity due is paid at the beginning of consecutive periods. Expressed as a 1 in excel. Example is a rent payment—a monthly, equal payment for the term of the contract starting when you sign the contract

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.

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 of a depository institution. Examples include banks and credit unions.

What is the name for the interest rate expressed on an annual basis? Annual percentage rate Real interest rate Compound interest Simple interest

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.

How is the interest rate expressed? As a fractional probability As a dollar amount As a percentage As a ratio

As a percentage. Interest is the percentage of the principal that a lender receives or that a borrower pays to use the money.

Auction market (type of secondary market)

Auction market has a physical location, and prices are determined by the highest price an investor is willing to pay. The New York Stock Exchange (NYSE) is an example of an auction market.

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.

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.

What tool can you use to understand your overall personal cash flows? Setting financial goals Budgeting Investing Saving

Budgeting helps you to understand your income and expenses and to analyze your cash flows.

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? Financial institutions Business finance Investments Real estate

Business finance is the area of finance that deals with uses and sources of funding to increase the value of the firm.

Which type of economic indicator is the consumer price index? Lagging indicator Leading indicator Coincident indicator

CPI usually changes after the economy as a whole changes. (CPI) measures changes in the inflation rate. It examines the average prices of a basket of consumer goods and services and the changes associated with the cost of living. When the CPI decreases, it indicates deflation; when it increases, it indicates inflation.

Capital markets

Capital markets are more often used for long-term assets that are held for greater than one year. Examples include to stock markets and bond markets.

Which financial institution ensures that a nation's economy remains healthy by controlling the amount of money circulating in the economy? Commercial bank Central bank Mutual fund Credit union

Central banks control the supply of money in the economy.

Insurance companies

Charge premiums to invest in bonds and stocks to pay claims

What is the third step in finding a solution to an ethical dilemma? Move forward with the course of action you have chosen Identify and define the problem Consider alternative courses of action Consider all stakeholders involved

Consider all stakeholders involved. First, you should identify and define the problem. Second, consider alternative courses of action. Third, consider all stakeholders involved. Then move forward with the course of action you have chosen

What type of financial institution is an insurance company? Investment Circulatory Contractual Depository

Contractual. Insurance companies are contractual savings institutions. Contractual firms raise capital for long-term contractual agreements. Examples include an insurance company or a private pension fund.

What should be the main question a firm asks when considering any investment decision?

Do the benefits of this investment outweigh the costs? For any investment, you should expect to receive a benefit worth at least as much as the initial cost.

How can agency problems be reduced through corporate control? Accounting manipulations Acquisition of a foreign subsidiary Setting strict goals Executive compensation

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.

Depository institutions

Financial institution that accepts monetary deposits and provides loans. Includes savings banks, commercial banks, savings and loan associations, and credit unions. Bankrate reports that the largest banks in America were JP Morgan Chase and Bank of America as of May 2019.1

Which professional works with individuals to help them achieve their financial goals? Commercial banker Corporate financial analyst Private equity manager Financial planner

Financial planner. Professional financial planners work with individuals to help them achieve their financial goals.

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. In this scenario, what is Omar doing? Budgeting Investing to achieve a goal Financing a goal Assessing a financial goal

Financing a goal. He has already made a decision to purchase the car and is now deciding on financing options.

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? Analyzing data Financing Assessing Investing

Financing. Part of the personal finance process is figuring out how to finance your goals in a way that is within your means.

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? Annuity Future value Perpetuity Present 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.

What are the 2 coincident indicators?

Gross domestic product and personal income

What does the risk-free rate indicate? Inflation and risk Opportunity cost and risk Risk Inflation and opportunity cost

Inflation and opportunity cost. The risk-free rate includes inflation and opportunity cost.

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? Interest rate Risk Inflation Opportunity cost

Inflation. The price of the car simply went up by $1,562 due to inflation.

What is the term for the percentage of the principal that a lender charges a borrower for the use of assets? Simple interest Compound interest Inflation rate Interest rate

Interest rate. This is the definition of interest rate.

What is a reasonable alternative to keeping an emergency stash of cash? Investing in a savings account Investing the money in a nicer car Investing in high-risk growth stocks Investing in long-term bonds

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? Central bank Pension fund Private equity institution Investment bank

Investment banks facilitate complex financial deals, like mergers.

Which type of financial institution is a mutual fund? Contractual institution Federal institution Depository institution Investment institution

Investment institution. Investment institutions provide individuals and firms access to financial markets.

Which type of financial institution provides individuals and firms access to financial markets? Depository institutions Credit institutions Investment institutions Contractual savings institutions

Investment institutions. Investment institutions provide both individuals and firms access to financial markets.

Which subspecialty of finance primarily involves deciding which assets will create more wealth and earn positive returns? Accounting Financial institutions Capital structure Investments

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? Financial management Asset pricing Investments Financial institutions

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.

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 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.

Unemployment rate is which type of economic indicator? Lagging Coincident Concurrent Leading

Lagging indicators change after the economy changes.

Yield curve is which type of economic indicator? Coincident Lagging Leading Concurrent

Leading. Leading indicators change before the economy changes.

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 an investment decision Managing financial investments Managing working capital Making a financing decision

Making a financing decision. Since the project has already been approved, Hannah is trying to find a way to finance the investment and considering its capital structure.

Which task does a financial manager perform when choosing to obtain a loan to purchase a piece of equipment for a new project? Making credit standard decisions Making investment decisions Making inventory control decisions Making financing decisions

Making financing decisions. The manager is deciding where to get the funds to support a new project, which means the manager is making a financing decision.

Which task does a financial manager perform when assessing the costs and benefits of potential projects? Managing working capital Making financing decisions Making investment decisions Implementing financial policies

Making investment decisions. Understanding how benefits weigh up against costs is the first priority before moving forward with financing and managerial decisions.

Which situation is an example of an agency problem? A firm fails to maximize long-term investment. Owners prevent managers from maximizing profits. Managers do not agree with employees on material supply issues. Managers follow their own interests instead of the owners' interest.

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 kind of market primarily allows institutions to borrow and lend in the short term? Futures and options markets Capital market Primary market Money market

Money market. Assets in money markets are typically highly liquid and intended for use within a year or less. A money market is a type of financial market that government and corporate entities use to borrow and lend money in the short term

Which type of interest rate is the rate at which invested money grows for a certain period time? Risk-free rate Real rate Nominal rate Inflation rate

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. The nominal rate includes inflation, so it does not measure the actual purchasing power you will earn in the future. Using the nominal rate results in the amount of money you will have in the future, but not how much you will be able to buy with it.

What is a component of the required rate of return? Simple interest Opportunity cost Hurdle rate Compound interest

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 Perpetuity Single sum Annuity due

Ordinary annuity. This is the definition of an ordinary annuity. The keys are "at the end of each period," "fixed period," and "equal payments." Expressed as a 0 in excel.+

Which financial institution invests funds contributed by a company to provide retirement funds for the company's employees? Insurance Pension fund Mutual fund Central bank

Pension fund

Which type of financial institution deals mainly with providing for retirement through employers? Investment bank Pension fund Credit union Mutual fund

Pension fund. Through employers, individuals can contribute to pension funds, which then invest their money in the market to provide retirement funds.

Which financial institution specializes in managing and administering retirement funds? Pension funds Private equity Investment banks

Pension funds specialize in retirement funds.

Personal income (coincident indicator)

Personal income provides some insight into overall consumer spending in an economy and can be related to changes in overall consumption. When the economy is doing well, personal income generally increases, which leads to an increase in spending. When the economy is not doing so well, personal income decreases and consumer spending will tighten.

What happens to prices in a market in which there is inflation? Prices remain the same Prices fluctuate from day to day Prices rise Prices fall

Prices rise. Prices rise because of increase in demand, increase in cost of goods, and adaptive expectations.

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? Dealer market Futures and options market Secondary market Primary market

Primary market. When a company issues stock for the first time to raise capital, shares must initially be sold through a primary market.

Which financial career focuses on investing capital into firms whose shares are not currently sold on any public stock exchange? Private equity Financial planning Insurance Corporate finance

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 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? Credit union Commercial bank Mutual fund Private equity

Private equity. This is the role of a buyout private equity firm.

What is the compensation for risk given to investors called? Risk-free rate Real rate Risk premium Opportunity cost

Risk premium is the compensation that investors take for the risk they have to bear.

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.

In which financial market are securities such as stocks and bonds are traded after their initial issuance? Secondary market Primary market Initial market Dealer market

Secondary market. Financial securities are first sold in the primary financial market and then traded among investors in the secondary financial market.

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.

Consumer Price Index (lagging indicator)

The consumer price index (CPI) measures changes in the inflation rate. It examines the average prices of a basket of consumer goods and services and the changes associated with the cost of living. When the CPI decreases, it indicates deflation; when it increases, it indicates inflation.

Gross domestic product (GDP) (coincident indicator)

The gross domestic product (GDP) is the monetary value of all the finished goods and services produced within a country's borders in a specific time period. Therefore, when GDP increases, it is a sign that the economy is strong. When GDP decreases, it is a sign that the economy is in recession.

Cost of capital

The interest rate from the borrower's perspective is called the cost of capital. If the lender requires you to pay interest as stated by a required rate, the required rate becomes the cost of borrowing to you.

How does a financial manager manage working capital

The manager needs pay the firm's suppliers and many other day-to-day operations by setting its credit standards for the customers, discussing inventories with the supply chain manager (inventory control)

What is the inflation rate? The rate of return that an investor will accept for investment The rate at which invested money grows for a certain period of time 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.

Which component of an interest rate is an indicator of inflation and opportunity cost? Purchasing power Risk-free rate Risk premium Growth 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 type of financial market is where securities such as stocks and bonds are traded after their initial issuance? The dealer market The secondary financial market The initial public offering The primary financial market

The secondary financial market. Financial securities are first sold in the primary financial market and then traded among investors in the secondary financial market.

Stock market return (leading indicator)

The stock market is often considered a leading indicator as well. A rising market may mean an improving economy, while a declining market may signal a worsening economy. While this interpretation of stock market return as a leading indicator is logical, you should be careful to understand the reason behind such changes. For example, a rising stock market may indicate just monetary inflation rather than economic growth. Monetary inflation is not sustainable; thus, one day inflation will slow down and the stock market will fall.

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.

In what way are coincident indicators useful? They are analyzed during economic shifts to provide information about the current state of the economy.

They 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.

How do insurance companies pay policyholders when a claim is made? They raise premiums for everyone who filed a claim during the year. They use returns from stocks and bonds.

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.

What is the name for the concept that a dollar today is worth more than a dollar in the future? Ordinary annuity Cost of capital Time value of money Perpetuity

Time value of money is the concept that today's dollar is worth more than a dollar in the future.

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.

Why might a manager manipulate accounting procedures? To maximize shareholder wealth To restrict a firm from taking on risky projects To make the company's performance look good

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.

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 minimize personal expenses To set priorities in personal finances To maximize individual utility To make personal finances predictable

To maximize individual utility. 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 minimize the asset holdings of the firm To minimize the costs of the firm To maximize owner wealth To maximize the manager's utility

To maximize owner wealth. The financial manager should make decisions based on the primary goal of maximizing owner wealth.

What is the main goal of a firm? To make investment decisions To make decisions on how to finance projects To maximize owner wealth To circulate money in the economy

To maximize owner wealth. 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 provide liquidity To regulate inflation To raise interest rates To protect investors

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 To affect the distribution of income for investors To maintain fair, orderly, and efficient markets To willingly take risk and capture returns

To provide liquidity and determine prices. The purposes of financial markets are to provide liquidity and to determine prices.

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 are the 2 lagging indicators?

Unemployment rate and consumer price index (CPI)

Utility

Utility is an economic term referring to the total satisfaction received from consuming goods and services. In other words, utility is the happiness you gain from your decisions as a consumer.

Unemployment rate (lagging indicator)

When the economy is in recession, there are not as many jobs available, and the unemployment rate is expected to rise. When the economy recovers and does well, more jobs are created.

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.

Three main tasks that a financial manager of a firm does in order to achieve the goal of the firm, which is to maximize shareholder wealth.

making investment decisions making financing decisions managing working capital

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? Cash budgeting Internal rate of return (IRR) Net present value (NPV) Debt-to-equity ratio

IRR is easy to interpret, which makes it ideal for communicating the potential of an investment decision.

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? Market risk Idiosyncratic risk Non-diversifiable risk Systematic 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. Note that non-diversifiable risk and systematic risk are just other words for Market risk!

Par Bond

If a bond is selling at par (known as a par bond), the bond's price is exactly equal to its face value. For a par bond, the YTM of the bond and the coupon rate are exactly the same as well.

Premium Bond

If a bond is sold at a premium (known as a premium bond), the bond is selling above its par value (normally $1,000 in the U.S. corporate world). When the bond is traded at premium, the YTM of the bond is lower than its coupon rate.

Leverage Multiplier

If a leverage multiplier is less than the industry average it implies that the firm is more conservatively financed and uses less debt than other companies

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.

Default risk rating system (AAA - D)

Ratings begin at AAA (for the least risky bonds—those from the most financially solid companies) and end at D (for the riskiest bonds).

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 $50,000 $200,000 $900,000

$0

Which NPV value indicates that the IRR has been reached? $99.99 $15.00 -$100.00 $0.00

$0.00. The IRR is the rate of return that makes the NPV of a project equal to zero. This is because it is the rate of return that makes the present value of the cash inflows exactly equal the present value of the cash outflows.

Which cash flow of a particular project would be a sunk cost? $20,000 market value of equipment at the end of the project $35,000 incremental cash flows for the third year of the project $50,000 marketing study conducted three months ago for the project

$50,000 marketing study conducted three months ago for the project

Quick Ratio

(Current Assets - Inventory) / Current Liabilities. Similar to Current Ratio but helpful for companies and industries that have a lot of inventory or that may take a longer time to liquidate inventory. A company with a higher quick ratio is usually viewed as having greater ability to meet short-term obligations taking into account inventory.

You just purchased a bond for $1,000 that has a par value of $1,000. What type of bond is this? A discount bond A par bond A preferred bond A premium bond

A par bond! The market price of a par bond is the same as the par value.

What is the effect of debt financing on a firm's income? Debt interest payments reduce taxable income. Income is taxed at a lower rate when a firm has no debt. Income is taxed at a lower rate when a firm has more debt.

Debt interest payments reduce taxable income.

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 Perpetuity Future value Present value

Annuity. The fixed amount of $100 given every month is an annuity.

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? 0.03 1 20 5000

1. The type is the cash flow type in the PV function. 1 = BEGIN, or an indication of an annuity due.

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? 2010 because the nominal rate was higher than in 1980 1980 because the real rate was higher than in 2010 1980 because the return was higher than in 2010 2010 because the inflation was greater than in 1980

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.

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 $400,000 spent on the market study

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.

The nominal interest rate of an investment is 8%, and the inflation rate is 3%. What is the real interest rate? 8% 3% 13% 5%

5%. Real Rate = Nominal Rate - Inflation, so 8% - 3% = 5%.

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 20-year mortgage Both are the same A 30-year mortgage Cannot be determined

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.

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. A business must compensate investors for the opportunity cost of investing in the 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.

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 A premium bond A par bond A preferred bond

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.

Financial risk (type of Price risk)

A firm's financial risk depends on how much debt the firm has, which affects earnings and stock prices.

Which statement below is an example of how ratios are used in the field of finance? Ratios are helpful only when comparing companies that are the same size and that use the same operational style. A firm's ratios are compared with those of a benchmark peer group to determine the firm's relative strength and performance.

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.

Which item is an example of a cash receipt in a personal budget? A graduation gift of $100 from your grandmother A purchase of $53 for groceries and toiletries for the week A payment of $125 for an annual doctor's visit

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? The cost to a firm to use an investor's capital The annual interest rate that is charged for borrowing money A hypothesized estimate of future returns under different scenarios based on expectational data

A hypothesized estimate of future returns under different scenarios based on expectational data

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 A collection of accounts receivable on sales made last month A purchase of inventory on credit that will be paid off next month Interest earned on bank deposits held by the firm.

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 that one makes on an investment over a period of time. A return is the gain or loss on an investment over some period of time.

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. Accounting is about budgeting, saving, and borrowing, while finance is about investing, forecasting, and lending.

Accounting is backward looking, while finance is focused on the future.

Which account is a spontaneous account? Long-term debt Common stock Notes payable Accounts payable

Accounts payable. Accounts payable is a spontaneous account that varies with sales.

What are spontaneous accounts? Accounts that vary naturally with sales Accounts that do not vary with sales

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 total revenue and expenses are projected After total financing need is determined After pro-forma financial statements are forecasted using the percent of sales method

After pro-forma financial statements are forecasted using the percent of sales method. Rercent of sales forecasting uses (1) a sales forecast and (2) historical relationships between sales and other variables to create pro forma statements (pro forma means "as if"). That is, you use the percent of sales method to estimate financial statements for future periods "as if" sales grew as predicted.

Which scenario is an example of an opportunity cost that is not associated with cash flows? Daisy lost $50 playing poker. Because of this, she decides not to gamble again. Albert decides to stay home and study for his test instead of going to the movies. Charlie stays home all weekend. He did not have any other plans.

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? Caroline makes $25 an hour. Instead of working one night, she goes to a concert that costs $50 and lasts two hours. The opportunity cost of the concert is $50. 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.

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.

What does the DuPont framework indicate about return on assets? Return on assets is based on the amount of the firm's debt and equity. All returns are based on the firm's profitability and efficiency. A firm can still have a high return on assets with low net income.

All returns are based on the firm's profitability and efficiency.

Default risk (firm-specific risk)

Also known as credit risk, default risk is the probability of a loss resulting from a borrower's failure to repay a contractual obligation. This is a firm-specific risk and affects both the bonds and stocks of the firm. The higher probability of default a company has, the higher the default risk is and the higher the required rate of return.

Why is it important to have an accurate, carefully calculated required rate of return as part of the NPV? Lenders will provide a firm with funds to invest in a project only if the required rate of return is extremely accurate. An inaccurate required rate estimate could cause a firm to reject good projects or accept bad projects.

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.

Which example below is considered a market risk factor? A company's labor force goes on strike. A company's top management personnel die in a plane crash. An unexpected change in interest rate occurs. An oil tank bursts and floods a company's production area.

An unexpected change in interest rate occurs. This is a factor that affects everyone because it will cause the cost of borrowing and lending to increase. This is a market risk factor.

What are incremental cash flows? The sum of all positive and negative cash flows that create an incremental increase or decrease in revenue Any additional cash flows, whether in or out of the firm, that are created as a result of accepting a project

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. They are included in the analysis.

What is the ratio that tells you on average how long it takes for a firm to collect accounts receivable? Fixed asset turnover Accounts receivable turnover Average collection period Inventory turnover

Average collection period. The ACP tells how long on average it takes for a company to collect accounts receivable from its customers.

The lowest rate of return is required by which type of investor or lender? Preferred stockholder Bank Bondholder Common stockholder

Bank

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 Because it cannot be determined how a potential project enhances the firm's value without considering every cash flow of the project

Because cash flows for a project may be uncertain

Why are several different types of ratios used to analyze a firm? Because ratios are sometimes inaccurate, and firms have a greater chance of calculating an accurate ratio if they calculate multiple ratios Because different types of ratios are needed to get information about different parts of 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.

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 project will provide a total value of $3.5 million to the company Because the NPV is greater than zero Because the development costs are greater than the value of the project

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.

A firm had sales of $100,000 this month. However, the firm received only $90,000 in cash from sales. Why would the firm receive $10,000 less cash than its monthly sales? Because the firm purchased inventory on credit this month Because the firm did not make all sales on cash

Because the firm did not make all sales on cash! Some sales are made on credit rather than cash, and a portion of credit sales are collected in the following months after the sales.

Why would a monthly mortgage payment be considered a fixed expense? Because the payment is the same amount each month Because the payments vary based upon the cost of the house

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.

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 Because without considering every cash flow of a potential project, you do not know how the project would enhance the firm's value

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 they are based on estimates and thus do not have to be exact

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 would a company or individual want to retain risk?

Because they believe that the cost of pursuing an activity is less than the alternative.

What is the process of analyzing financial data with ratios to compare a firm's performance to competitors? Evaluating Auditing Valuing Benchmarking

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? Auditing Maximization Equity valuation Benchmarking

Benchmarking allows management to see how firms differ from one another and evaluate their performance relative to each other. It is often used for equity valuation.

How far into the future do cash budgets usually forecast? Between one and three years Between one month and one year

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? Stock payments have a shorter duration than bond payments. Bond payments are larger than stock payments. Bond payments are fixed, and stock payments are variable.

Bond payments are fixed, and stock payments are variable.

Why might a firm prefer to raise debt capital through bonds instead of stocks? Bonds do not require the firm to pay back its loan. Bonds do not require a firm to give up any ownership. Bonds have no expiration date.

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. The cash flows that come from owning a bond grow at a constant rate every year, and the payments continue forever.

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.

Which situation is a real-life example of risk transfer? Changing investment vehicles—risk is transferred from one asset to another Buying home insurance—risk is transferred from the policyholder to the insurer Purchasing U.S. Treasury bonds—risk is transferred from the holder of the bond to the government

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 raising capital on a contractual basis, such as an insurance contract By providing individuals and firms access to financial markets to buy or sell financial securities

By providing individuals and firms access to financial markets to buy or sell financial securities

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 Projected financing criteria Security analysis criteria

Capital budgeting criteria

What is the name for the process of evaluating and planning for purchases of long-term assets? Capital budgeting The time value of money

Capital budgeting. Capital budgeting is the process of evaluating and planning for purchases of long-term assets.

What is the name for a forecast of short-term events that helps a company understand if it has sufficient cash? Percent of sales forecast Sustainable growth rate Time value of money Cash budget

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.

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. Cash budgets help companies know how much to invest in capital, aid in expense tracking, and predict when additional financing is needed.

Cash budgets are used to forecast future financial need, aid in performance evaluation, and show when corrective action is needed. This helps 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 include a detailed credit report of the business's operations, which proves that the company can use borrowed funds responsibly. Cash budgets increase the lender's trust in a firm by demonstrating the firm's ability to make profits and repay loans.

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 Inc.'s labor costs each month are an example of which item in a cash budget? Net cash for the month Minimum cash need Cash disbursement Cash receipt

Cash disbursement. This is a cash disbursement for the firm because it represents cash going out during the month to pay employees.

What three things should be included in a cash budget for a business? Cash receipts, cash disbursements, and savings Cash receipts, cash disbursements, and borrowing Income, expenses, and savings Sales, expenses, and borrowing

Cash receipts, cash disbursements, and borrowing. All three of these things affect cash flows in a business and should be included in a cash budget.

An investor really cares about having voting rights in a firm. Which type of financial security should this investor purchase? Common stock Secured bonds Preferred stock Zero-coupon bonds

Common stock

In what way is preferred stock different from bonds? Companies must pay preferred stockholders but not bondholders before common stockholders. Companies are allowed to skip payments to preferred stockholders but not to bondholders.

Companies are allowed to skip payments to preferred stockholders but not to bondholders. If companies skipped bond payments, they would go into default which means that it has failed to meet its debt obligation. 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 Company B Company C Company D

Company A

Which action would help you make your budget more efficient? Reduce your payments toward savings so you have enough for monthly expenses. Compare your budgeted cash flows to your actual cash flows, and then revise the budget if necessary.

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.

What is operating margin useful for? Comparing the profitability of firms with different capital structures Understanding production cost efficiency

Comparing the profitability of firms with different capital structures. Operating margin is calculated pre-interest, so you can frequently use it to compare firms with different capital structures.

Why can compounding interest be a good tool but also a significant detriment? Compounding interest can be a good tool to understand the time value of money, but it is a detriment because it does not take inflation into account. 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.

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.

Which term describes the reduction in sales of a company's own products due to the introduction of another similar product? Interest cost Cost of cannibalization Opportunity cost Sunk costs

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.

If a company expects sales to grow by 10% next year, which account might also increase by 10%? Cost of goods sold Headquarters utilities

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 are a financial analyst of an investment bank, and you are doing research on equity. You are looking at a book publisher's financial ratios in comparison to its competitors and the industry average. What is this an example of? Trend analysis Performance evaluation Progress measurement Cross-sectional analysis

Cross-sectional analysis compares a firm's financial ratios with those of a peer group.

Current Ratio

Current assets / Current liabilities. Current liabilities are obligations that will require cash within the next year. Current assets are items that will generate cash within the next year. The current ratio is a direct comparison between these variables. A higher current ratio means a better likelihood that the firm will be able to meet its short-term obligations.

Which ratio helps an analyst evaluate whether a company can cover its short-term obligations? Current ratio Net margin Return on equity Market-to-book ratio

Current ratio

Discretionary financing needed (DFN) equation

DFN=Projected Total Assets−Projected Total Liabilities−Projected Owner's Equity

What is the disadvantage of debt financing? Debt financing does not actually achieve an optimal capital structure for a company. The more debt a company takes on, the less equity it can raise.

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.

Which action increases a company's sustainable growth rate (SGR)? Decreasing profitability Decreasing the leverage the company uses Decreasing dividend payout Decreasing asset use efficiency

Decreasing dividend payout! Decreasing dividend payout increases earnings retention and thus increases the SGR.

Which actions will increase a firm's ROE? Increasing net margin and decreasing debt financing Decreasing equity financing and increasing net margin Increasing total asset turnover and decreasing debt financing

Decreasing equity financing and increasing net margin. This 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 Evaluate income, create the cash budget, estimate cash disbursements

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? Computing the future value of a project in the future rather than the present value Determining whether a firm should invest in projects with different initial outlays Calculating returns for a project that does not have a definite return rate for IRR or NPV

Determining whether a firm should invest in projects with different initial outlays

What is another name for the cost of capital? Compound interest Discount rate Real rate Inflation rate

Discount rate. Cost of capital, discount rate, required rate, and interest rate are the same thing with different names based on different perspectives.

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? Projected asset account Projected owners' equity account Spontaneous account 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 Minimization Correlation Spreading

Diversification. The question stem is the definition of diversification.

What allows an investor to determine which financial activities are contributing to changes in the return on equity? Flexibility Trend analysis DuPont framework Cross-sectional analysis

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.

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? Profit turnover Accounts receivable turnover Financing Gross margin

Financing

Which tool is forward-looking and thus helps decision makers understand how actions taken today can affect their firm's future performance? Ratio analysis Financial statements Financial forecasting

Financial forecasting

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. Financial forecasting looks backward to provide historical data that informs future operations.

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.

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? Profitability ratios Market ratios Financing ratios

Financing ratios consider how a firm is financed.

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 2 is not using its assets as efficiently as Firm 1 to generate sales. Firm 1 is using a higher proportion of debt to finance its operations.

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. Firm A has a gross margin of 40%, and Firm B has a gross margin of 35%. Firm A has a leverage ratio of 3, and Firm B has a leverage ratio of 1.5. Both firms have a return on assets of 5%, but Firm B has a higher profit margin.

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? Systematic risk Interest rate risk Firm-specific risk No risk

Firm-specific risk can be diversified away.

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.

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 account should be looked at first when examining capacity constraints to determine whether the discretionary financing needed (DFN) can be reduced? Accounts receivable Fixed assets Notes payable Long-term debt

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.

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? Focus Flexibility Standardization Evaluation

Flexibility

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. Preferred stocks pay a coupon every six months, the coupon amount is constant, and the stock has a maturity date.

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 total assets, 7 cents are generated as sales. For every dollar of revenue, 7 cents remain for the equity holders after all other costs are covered.

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? Sunk costs are subtracted from the opportunity cost and attributed to net cash flow. For the purposes of analysis, sunk costs are irrelevant.

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? Determining total financing need Forecasting spontaneous accounts

Forecasting spontaneous accounts. Spontaneous accounts change in proportion to sales growth.

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? Gross margin Accounts receivable turnover Operating margin Fixed asset turnover

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.

What does the sales capacity equation tell you? How much the firm can grow without issuing new equity How much room a firm has to grow without additional investment in fixed assets

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.

M/B Value stock strong or weak?

If the market-to-book ratio is less than 1 and return on assets is 40%, this combination of ratios seems to indicate a strong firm that may be underpriced. On the other hand, if the market-to-book ratio is less than 1 and return on assets is -40%, this combination seems to indicate a firm in dire straits.

How does cannibalization factor into capital investment decisions? If your company is planning on launching a product, and that product is going to diminish some of the company's cash flows generated from another product, it is better not to harm your products' reputations. 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.

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.

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. All incidental cash flows should be excluded. If a company will incur a cost regardless of whether it adopts a specific project, the cost should not be counted as a cost of the project.

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.

What are the three things one must determine before making a personal budget? Income, expenses, and savings Liabilities, income, and expenses

Income, expenses, and savings. Knowing these things allows you to create a statement that accurately reflects your cash flows from month to month.

Which factor contributes to the inflation of the prices of goods and services over time? Increase in demand for goods and services Decrease in costs of production Decrease in employee demand for higher wages

Increase in demand for goods and services

How can a company reduce its discretionary financing needed (DFN)? Reduce prices. Increase the dividend payout. Increase the net margin. Reduce retention of earnings.

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? Decreasing the total asset turnover Decreasing profitability Increasing equity financing Increasing debt financing

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 liquidity of the firm Increasing the asset usage efficiency of the firm Decreasing the debt financing of the firm Decreasing the profitability of the firm

Increasing the asset usage efficiency of the firm

Which action decreases the discretionary financing needed (DFN)? Increasing the payback ratio Increasing the plowback ratio Decreasing the retention ratio Decreasing the net margin

Increasing the plowback ratio. Increasing the plowback/retention ratio increases projected owners' equity and thus decreases DFN.

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. Inflation is calculated by determining the rate at which the demand for particular goods and services has increased over a period of time in an economy.

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.

Compound interest

Interest earned on both the principal amount and any interest already earned

How can having more debt benefit a company? Interest expense on debts is paid before taxes are calculated. Debt is never beneficial for a company due to its increasing costs over time.

Interest expense on debts is paid before taxes are calculated! This describes the tax shield advantage of debt.

How can a firm grow its fixed assets if it is expecting growth but has reached capacity with its fixed assets? Use the percent of sales method to forecast fixed assets. Continue to invest in capital through small increments over time. Invest a substantial amount of money at one time to increase capacity.

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 an advantage of using the NPV method? It calculates the dollar value that would be added to the firm by doing the project. It tells the percent return on an investment.

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. It makes it easy to estimate the cost of capital, it ignores risk, and it is better for tax purposes.

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. It communicates the value that would be lost to the company if it rejected the project.

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. It provides the firm with the necessary growth rate to maintain sales.

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. Plowback/retention ratio is the proportion of earnings that are retained after dividends are paid.

What does a debt ratio of 40% indicate? It indicates that 40% of assets are financed by equity. It indicates that 40% of total debt is long-term liabilities. It indicates that 40% of assets are financed by debt. It indicates that 40% of fixed assets are financed by debt.

It indicates that 40% of assets are financed by debt. A debt ratio tells the portion of assets financed by debt.

What is a disadvantage of using the NPV method? It is not an effective way to compare projects of different sizes. It often underestimates cash flows. It is not an effective way to compare projects with different time spans.

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 requires users to carefully track specific expenses and write down their income and spending for the month. It is simple and helps ensure that users do not spend more than the cash that they have available.

It is simple and helps ensure that users do not spend more than the cash that they have available.

What is opportunity cost as it relates to the time value of money? It is the cost of having more investment options than one. It is the opportunity you forgo to invest in other options due to the time scope of an investment.

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. It is compared to the NPV. It is input into cash flow calculations.

It is used as the discount rate of cash flows.

How does an analyst use the hurdle rate? It is used to calculate the IRR for a project and determine its value. It is used to determine the time frame of a project. It is used to compare with the IRR to determine whether a project should be accepted.

It is used to compare with the IRR to determine whether a project should be accepted.

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. It helps a person understand how money was spent previously in order to reliably predict future expenses.

It provides access to potential revenue or increases in value to help meet goals faster.

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. Change the notes payable account in proportion to sales growth.

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.

Alphabet Co. has $50,000 to spend on capital investment projects for the next year. 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 IRRs until all capital has been used. It should choose the projects with the highest NPVs until all capital has been used. It should choose the projects with the highest PIs until all capital has been used.

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. It should invest any profits in new capital. It should wait until the budgeted months are over and then make a new budget for the months following. It should begin tracking its cash inflows and outflows.

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.

The YTM of a bond went from 8% to 7%. What can be predicted about the price of the bond? It is not possible to predict what will happen to the bond price. It will increase. It will stay the same. It will decrease.

It will increase. There is an inverse relationship between Yield To Maturity 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 leverage ratio is decreasing. Its activity ratio is increasing. Its liquidity ratio is increasing.

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.

Profitability Ratios

Judge how profitable the company is and how well management is doing to maximize owner wealth. One profitability ratio is the gross margin, which is calculated as gross profit over sales. This ratio subtracts the cost of goods or services from sales to calculate the gross profit provided to the firm and then represents this as a percentage of the sales amount. The higher the gross margin ratio is, the lower the cost was to actually produce and sell that good or service (because a greater amount of the sale was retained as profit). This determines if production costs are relatively low.

What are three principles of budgeting that are important to know before beginning the budgeting process? Eliminate debt, evaluate your personal financial performance, and consult a certified financial advisor Keep records; develop savings, income, and expense strategies; and use a method that meets your needs and objectives

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.

Jerry wants to begin budgeting his money. What are three principles that he should know before beginning the budgeting process? Track expenses categorically, use the most updated method of budgeting, and eliminate consumer debt. Keep records; understand the key areas of savings, expenses, and income; and eliminate consumer debt.

Keep records; understand the key areas of savings, expenses, and income; and eliminate consumer debt. These are three of the six principles of budgeting. The other three are know yourself; develop savings, income, and expense strategies; and use a method that meets your needs and objectives.

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. Knowing the cash position allows businesses to evaluate long-term cash accumulation, while it allows individuals to analyze loan balances.

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. The cash position for a period is beginning cash + net cash flow (cash recipients - cash disbursements).

Which type of economic indicator changes after the economy changes and helps identify trends in the long term? Yield curve indicator Leading indicator Coincident indicator Lagging indicator

Lagging indicator

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? Correlated indicator Coincident indicator Lagging indicator Leading indicator

Leading indicator

Which type of ratios are banks and lenders most concerned about? Profitability Activity Liquidity Efficiency

Liquidity

Which type of ratio are suppliers interested in? Financing ratios Profitability ratios Liquidity ratios Market ratios

Liquidity ratios assess a firm's ability to meet short-term obligations to short-term creditors and suppliers.

What type of ratio is used to assess a firm's ability to meet short-term obligations without raising external capital? Activity ratios Profitability ratios Liquidity ratios Market ratios

Liquidity ratios measure a firm's ability to meet short-term obligations without raising external capital.

What are the 5 different types of Ratios?

Liquidity, activity, leverage, profitability, and market.

Which type of ratio is a current ratio? Solvency Liquidity Activity Market

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? Increase sales growth, resulting in a larger amount of revenue coming into the firm Lower the amount of dividends that are paid out to shareholders next year Increase the amount spent on fixed assets to increase production capacity

Lower the amount of dividends that are paid out to shareholders next year

What are long-term financial forecasts used for? Developing savings, income, and expense strategies Making investment and financing decisions

Making investment and financing decisions. Whatever growth a firm anticipates must eventually be financed one way or another. Any investment in capital that exceeds what the firm retains from profit generates a discretionary financing need.

How does management choose between two projects that are seemingly the same? If two projects are seemingly the same, it does not matter what choice management makes. Management can analyze the different inherent risks that change the cost of capital to the firm.

Management can analyze the different inherent risks that change the cost of capital to the firm! Each project will have its own inherent risks.

Market Ratios

Market ratios are used to evaluate the current share price of a public firm's stock. These ratios are used by both current and potential investors to determine whether the firm's stock is undervalued or overvalued. The undervaluation or overvaluation of stock shares helps investors decide whether to buy or sell shares of the stock. If the share is underpriced, investors expect the price to rise, so they will purchase the stock to capture the gain. On the other hand, if the share is overpriced, they believe that the price will decline. Therefore, they will sell the stock.

What makes market risk different from firm-specific risk?

Market risk cannot be diversified away, and firm-specific risk can. Market risk is inherent in the economy as a whole and therefore cannot be diversified away.

Market to Book Ratio

Market value of equity / book value of equity. This numerator is also known as the firm's market capitalization or market cap. Determines if the market considers the company in question a growth stock or a value stock. Growth stocks are greater than 1, this means the market values the firm for more than the balance sheet reports the firm is worth. The investors have expectations for future growth. If the market-to-book ratio is less than 1, the firm is considered a value stock. A value stock status may indicate a good investment, or it could indicate a company that is about to go out of business.

Activity Ratios

Measure how well the company uses its assets to generate sales or cash—the firm's operational efficiency and profitability.

Liquidity Ratios

Measures of the short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash.

Why are financial models helpful in financial forecasting? Models allow users to see the complex relationships between sales and other aspects of the business. Models provide credibility to a firm's financial statements for government agencies to review. Models show the future supply schedule for a firm, which allows for negotiation with suppliers.

Models allow users to see the complex relationships between sales and other aspects of the business.

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. Monitoring allows you to implement changes to your budget gradually in such a way that the changes go smoothly and efficiently.

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. Tracking involves using envelopes or computer programs to record cash flows, whereas monitoring involves evaluating cash flows by hand.

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. Revision allows you to identify problems in your budget, and then tracking allows you to fix those problems immediately so that you can then monitor progress.

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. Tracking is simply recording cash flow.

Which Excel function should you use when you are finding a present value of uneven cash flows to find the PV in one step? IRR NPV FV PV

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 Operating margin Current ratio Fixed asset turnover

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? Profitability index (PI) Initial outlay (IO) Internal rate of return (IRR) Net present value (NPV)

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? Profitability index (PI) Net present value (NPV) Internal rate of return (IRR)

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 exceed the firm's sales capacity. Yes, because the increase in sales will exceed the firm's sales capacity. No, because the increase in sales will not exceed the firm's sales capacity.

No, because the increase in sales will not exceed the firm's sales capacity.

Should a firm accept a project that has a PI of 0.8? Why? Yes, because the PI would generate cash flows that are 80% more than the initial investment. No, because the project would be generating cash inflows that are 20% short of the initial investment.

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.

Which type of account does not vary with sales and is left to management's discretion? Accounts receivable accounts Fixed assets accounts Spontaneous accounts Non-spontaneous accounts

Non-spontaneous accounts. Non-spontaneous, or discretionary, accounts do not vary automatically with sales but are left to the discretion of management.

Which account is a discretionary account? Accounts receivable Fixed assets Notes payable Cash

Notes payable does not vary with sales, and it is based on management discretion.

What does an average collection period of 70 tell you? On average, a firm takes 70 days to pay accounts payable. On average, a firm takes 70 days to collect accounts receivable.

On average, a firm takes 70 days to collect accounts receivable. This ratio tells on average how many days it takes for a firm to collect cash from accounts receivable.

Which description below correctly identifies one type of price risk? Default risk—depends on how much debt the firm has, which affects earnings and stock prices Operating risk—depends on the effect of the firm's operating decisions on its operating costs Financial risk—depends on the firm's ability to pay back its debt payments and dividend payments Business cycle risk—depends on how the firm is performing relative to its industry's leaders

Operating risk—depends on the effect of the firm's operating decisions on its operating costs! This is the correct description of operating risk. NOTE that financial risk and business cycle risk are also Price risks BUT these are not the correct definitions.

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 Future value of the benefits and future value of the costs

Opportunity cost must be determined to analyze two such projects.

Business cycle risk

Oversupply leads to declining margins, which impacts an entire industry for an extended period of time.

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? FV function PV function RATE function NPER function

PV function. Since you are looking for a relative past value of future cash flows, you should use the PV function in Excel.

Which method is most commonly used for determining a company's DFN? Sustainable growth rate Percent of sales Historical regression Company multiples

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? Standardization Assessment of future needs Corrective action Performance evaluation

Performance evaluation

Preferred stock

Preferred stock is a hybrid security that has fixed payments and does not confer voting rights on shareholders.

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? Efficient market Secondary market Money market Primary market

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. Carefully evaluate the changes you want to make and then implement them all simultaneously so that your budget is the most effective it can be as soon as possible.

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 type of ratio should be used to examine the cost efficiency of a firm's production? Liquidity Market Efficiency Profitability

Profitability

Which capital investment evaluation method is presented as a ratio? Net present value (NPV) Profitability index (PI) Internal rate of return (IRR) Quick ratio

Profitability index (PI)! The PI is the ratio of discounted benefits to discounted costs. If PI = 1 it 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. The project has the internal rate of return equal to the cost of capital!

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? Internal rate of return (IRR) Net present value (NPR) Profitability index (PI)

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? Trend analysis Flexibility Progress measurement Cross-sectional analysis

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 2 has an IRR of 11% and an NPV of $67,000. The project with the highest NPV will bring the most value to the company.

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? Payment toward the line of credit that is due next month Purchase of equipment that will be bought in three years Purchase of inventory for sales that the employee will make this year

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. Purchasers of financial securities look at returns as the percentage that they as investors must receive to break even on the money they invested.

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 returns from the viewpoint of investors.

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 Inventory ratio Leverage ratio Current ratio

Quick ratio

DuPont Framework Equation

ROE = Net Profit Margin×Total Asset Turnover×Leverage Multiplier

What is the difference between return on assets (ROA) and return on equity (ROE)? ROE considers the capital structure of a company, while ROA does not. ROE considers the profitability of a firm, while ROA does not.

ROE considers the capital structure of a company, while ROA does not. DuPont framework tells you that ROE is ROA times leverage multiplier. The leverage multiplier represents the capital structure (equity&debt) of the company.

Simplified ROE formula (DuPont)

ROE=ROA×Leverage Multiplier

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? Cross-sectional analysis Trend analysis Flexibility

Ratio analysis is flexible, so you can create a new ratio given the need of the firm.

How might calculating financial ratios help shareholders? Ratios allow shareholders to participate in management decisions. Ratios can be used to determine whether a firm is maximizing shareholder wealth.

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? Dividends, investments, cash sales, and tax liabilities Raw materials, rent, administrative expenses, interest, and selling expenses Rent, accounts receivable, accounts payable, and raw materials

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.

Real rate

Real Rate = Nominal Rate - Inflation

Which action reduces the future value of cash flows? Increase the inflation rate. Receive all cash flows earlier than expected. Receive all cash flows later than expected. Increase the discount rate.

Receive all cash flows later than expected. The later the cash flows are recieved, the lower the future value is.

MiniCo recently spun off of BigCo. Both companies have the same leverage and asset turnover ratios, but MiniCo is underperforming on its return on equity to shareholders. If MiniCo would like to improve its return on equity, which action would help? Reduce costs to improve its overall profitability. Pay off a significant portion of its debt.

Reduce costs to improve its overall profitability. The third component of return on equity is profitability as indicated by the profit margin. By increasing its profit margin, MiniCo would increase its return on equity as well.

What is the name for the minimum rate of return that an investor or lender will accept for investments? Inflation rate Growth rate Simple interest Required rate of return

Required rate of return. This is the rate that investors accept as compensation for risk, opportunity cost, and inflation.

What is a component of the DuPont framework? Current ratio Times interest earned Return on assets Fixed asset turnover

Return on assets. ROE is ROA times leverage multiplier.

How is risk separation different from diversification?

Risk separation involves dispersing assets geographically instead of concentrating them in one location. This is the main difference between the two techniques.

Why are sales not strictly considered to be the same thing as cash receipts? Sales include expenses outside of the cash budget. Sales include both cash sales and credit sales.

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.

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 Separate owners from management so their interests do not conflict

Set strict covenants that the company cannot uphold if it chooses a risky 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 smaller ROA than BigDog. SmallDog has a higher ROE than BigDog.

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.

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? Non-spontaneous accounts Spontaneous accounts Discretionary accounts

Spontaneous accounts vary naturally with sales. Since they increase proportionally with sales growth, they are examples of spontaneous accounts.

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 A. The higher the Standard Deviation the higher the risk.

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 does not affect the level of risk associated with each investment vehicle.

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 provide a steady stream of income to a firm. Stocks do not require the firm to repay the par value to investors.

Stocks do not require the firm to repay the par value (principal) 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 Improving loan relations by ensuring that it meets debt covenants

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? Steady state growth rate Sustainable growth rate Capital growth rate Sales growth rate

Sustainable growth rate

What is the rate at which a firm can grow without issuing new equity? Retention rate Sustainable growth rate Discount rate Internal rate of return

Sustainable growth rate! The sustainable growth rate is the growth rate that allows a firm to maintain its present financial ratios without issuing new equity.

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.

THIS QUESTION WILL GIVE IRR, NPV, AND PI....JUST CHOOSE THE HIGHEST PI (Profitability Index) TO THE LOWEST

What indicates to a firm that a project will increase shareholder wealth? The NPV is positive. The NPV is negative.

The NPV is positive. The Net Present Value 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 The perpetuity model The IRR method The constant growth model

The PV function in Excel.

Account Receivable Turnover

The accounts receivable turnover (AR turnover) ratio helps to identify how quickly accounts receivable turn over during a given year. It is calculated as AR Turnover=Credit Sales / Accounts Receivable The higher the turnover in the shorter the timeframe, the better account receivable is at obtaining credit from customers.

What is discretionary financing needed (DFN)? The total projected assets needed given a firm's expected future growth The additional financing needed given a firm's expected future growth

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 NPV method. The analyst used the IRR method.

The analyst used the IRR method. IRR calculations are represented as percentages because they are rates of return.

Which item is considered a sunk cost? The consulting cost spent three months prior to the start of a project The price of selling old equipment that will be replaced by new equipment

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 (net present value) calculation is very important but difficult to estimate? The cost of capital The life of the project The expected cash flows The initial outlay

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 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 cash flows were underestimated, so the adjusted annual cash flows are higher than the original ones. The cost of capital was underestimated, so you adjust the cost of capital to be higher.

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.

DuPont framework break down

The decomposition of the DuPont framework breaks down the return on equity into the net margin, total asset turnover, and leverage multiplier to show where profitability is coming from.

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 high inventory turnover relative to the industry and competitors indicate? The firm does not hold enough inventory and is making its customers wait longer to receive their purchased goods. The firm has mastered its asset use efficiency to generate sales.

The firm does not hold enough inventory and is making its customers wait longer to receive their purchased goods. A high inventory turnover ratio indicates that there is not enough inventory available to meet customer needs in a timely manner.

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. The firm should consider getting extra financing by issuing new stocks.

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. Coupon payments are made semiannually. There is a maturity date. Dividends are fixed.

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 external financing needed to meet the projected growth

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 the risk and the rate of return? The higher the risk investors have to take on, the higher return they require. The rate of return describes the inherent risk of a project.

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.

Internal rate of return (IRR)

The internal rate of return (IRR) is the rate of return that a firm earns on its capital projects. It is the percentage return that we are making on the investment. As such, it is easier to interpret and communicate than the NPV: eg) "We are investing $100,000 and will earn 14% on our investment."

What does inventory turnover assess? How well a firm can meet short-term obligations through sales The inventory management of a firm The proportion of inventory financed by equity

The inventory management of a firm. Inventory turnover tells us how well a firm is managing its inventory. Inventory turnover is the number of times the firm turns (sells) its inventory annually.

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 cost that must be incurred to make a profit

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 percent of sales remaining after covering COGS and operating expenses

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.

How is risk defined in finance? The probability that systematic factors in the market will affect an investment The possibility that the realized or actual return will differ from what we expect

The possibility that the realized or actual return will differ from what we expect.

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. The future value of the benefits of the investment outweigh the future value of the costs of the investment.

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.

You are considering a project that has a profitability index of 1. What does this mean? The project has a negative net present value. The project has a positive net present value. The project has the internal rate of return equal to the cost of capital.

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.

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 rejected because it has a negative NPV. The project should be accepted because it has a positive NPV.

The project should be accepted because it has a positive NPV. Because the NPV is positive, the project should be accepted.

What would an analyst predict for a potential investment with an NPV of zero? The project would take away value from the firm, but only a small amount. The project would earn exactly the rate of return required by the firm.

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.

What tends to happen to the risk of an investment that offers a higher return? The risk is lower for an investment with a higher return. The risk is higher for an investment with a higher return. The risk of a well-diversified portfolio with high returns is always higher than the highest-risk stock in the portfolio.

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.

Maria 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 overvalued. The stock's intrinsic value is greater than 1. The stock is undervalued.

The stock is undervalued.

Interest rate risk

The value of a bond is affected by changes in interest rates. Part of market risk.

The yield to maturity (YTM)

The yield to maturity (YTM) is the rate of return that investors receive on a bond if they purchase a bond today at the market price and hold it until it matures.

Why is the IRR a poor valuation method for a project with unconventional cash flows? The IRR method can be used only to calculate projects that add value to a firm, and projects with unconventional cash flows never add value to a firm. There are multiple sign changes in the calculation resulting in multiple IRRs, and it is impossible to tell which IRR is the correct one.

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.

How does allocated overhead affect the selection of capital investment projects? Overhead is allocated to the various projects of the firm, but never 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 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 flexibility. They provide standardization They allow for performance evaluation.

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. This firm gets an 20% return on investment. This firm is about to go out of business. This firm gets a 20% return on its assets.

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? Pay suppliers more slowly. Pay suppliers more quickly. Tighten the credit standards for its customers.

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.

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. Timing of cash flows is related to the sunk costs associated with those cash flows.

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 purpose of a monthly cash budget? To know how much cash you spend on both a monthly and yearly basis so you can determine how much you have left over to invest To control cash inflows and outflows so you can balance income with expenditures and savings

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.

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 To ensure that the future period's sales and costs will not exceed historical numbers

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 assess a firm's ability to meet short-term obligations without raising external capital or To evaluate the current share price of a public firm's stock

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.

Why might a firm seek capital investment? To pay short-term loans To purchase long-term assets for future growth

To purchase long-term assets for future growth. Firms need funding for projects that will increase shareholder wealth in the future.

What is the goal of financial forecasting? To provide a detailed map of a firm's future To understand the implications of today's decisions on tomorrow's performance

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.

What three things should an individual or company be doing so that their budget is effective and so that they are on track to meet their financial goals? Monitor cash flows, reduce variable costs, and track expenses Track cash flows, monitor cash flows, and revise the budget

Track cash flows, monitor cash flows, and revise the budget. Doing these things helps you to use your money in the most efficient and effective way possible.

Which process is Li engaging in if he recently made a personal budget and is now keeping a record of his cash flows? Forecasting Tracking Monitoring Revising

Tracking

What is the main reason why it is important to track and record cash flows? Tracking cash flows is important because it is impossible to refinance a loan without tracking your income and expenses. 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.

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? Progress measurement Trend analysis Cross-sectional analysis Focus analysis

Trend analysis

Which method of ratio analysis looks at a firm's performance over time? Trend analysis Cross-sectional analysis Focus Progress measurement

Trend analysis looks at a firm's financial ratios over time.

Which statement correctly identifies the relationship between systematic risk and different types of firms? Luxury companies have high systematic risk because as the market moves up and down, more people will invest in their stocks and bonds. 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.

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? Growth stock Overvalued Value stock

Value stock. An M/B ratio of less than 1 is considered a value stock.

Which type of expense is a magazine subscription? Fixed expense Monitored expense Asset expense Variable expense

Variable expense

When evaluating a company's performance, what can variances on a company's cash budget indicate? Variances are expected and should never pose a concern for management. Variances show that certain managers or divisions are not meeting targets.

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.

What do Leverage Ratios describe? What return shareholders will earn on their investment in a firm What proportions of equity and debt a firm uses to finance its assets

What proportions of equity and debt a firm uses to finance its assets. They are used to evaluate whether a company can stay financially healthy in the long term, pay interest on its loans, and pay off its long-term debt. Remember that having higher debts relative to assets is not necessarily bad, but it is riskier for debtholders—if the company's performance declines, the chances of getting paid back become very low.

In what situation might the software method of tracking be preferable to the spreadsheet method of tracking? When a person needs cash flow information for tax purposes When a person has a hard time remembering to record their cash flows and when they prefer to use a card to make purchases

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 When the firm's cash receipts are negative

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.

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? Will utility be maximized through this decision?

Will the benefits of the action outweigh the costs?

What is the envelope method of budgeting? Paying all expenses during the month by check through the physical mailing system to ensure that obligations are met in a timely manner Withdrawing cash at the beginning of the period and then allowing only a certain amount to be available for each category of spending

Withdrawing cash at the beginning of the period and then allowing only a certain amount to be available for each category of spending! The envelope method involves putting a specific portion of your budget in cash in each envelope and only spending this amount during the period.

Why is it important to consider all relevant cash flows in an ideal evaluation method for capital investment? If you can receive money earlier, you can reinvest the cash into different projects earlier. Without considering every cash flow of a potential project, you do not know how the project will enhance the value of a firm.

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.

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. No, because the hurdle rate is lower than the IRR.

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.

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 the current ratio and could compare cost of capital rates. Yes, the analyst could use both the NPV and the IRR.

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 cannibalization. No, the land value represents a sunk cost. Yes, the land value represents an opportunity cost.

Yes, the land value represents an opportunity cost.