ECON 135 - Corporate Finance (Concepts)

Which of the following bond ratings are considered investment grade?

1) A 2) AAA 3) BBB 4) AA Bonds with a rating of AAA, AA, A or BBB are considered investment grade, while lower rated bonds are considered speculative grade or junk bonds.

Which examples involve only implicit opportunity costs (not explicit costs)?

1) A company using a spare machine for a new project 2) A real estate company using a rental apartment as its own office 3) A firm withholding licensing rights from others to gain a competitive advantage The cost of buying an asset, e.g., Treasury bills, is an explicit cost. An opportunity cost is the cost of a forgone opportunity, such as no longer being able to sell an asset if it is used for a new project. Opportunity costs must be included in capital budgeting.

Which statements are true?

1) A sole proprietorship is easy to set up. 2) It is impossible to sell a part of your ownership stake in a sole proprietorship. 3) All profits from a sole proprietorship are passed through to the owner for paying taxes. 4) A sole proprietorship is subject to few government regulations. As a sole proprietor, you have unlimited liability for the debt of the business.

Which are examples of current liabilities?

1) Accrued wages 2) Accounts payable 3) Current portion of long-term debt Paid-in capital is a component of equity.

Which statements are true?

1) C-corporations are subject to double taxation. 2) A general partnership can have many owners. 3) Corporations and LLCs limit the owners' liability. Companies that want to take investments from many shareholders are best organized as corporations.

Which are examples of current assets?

1) Cash 2) Accounts receivable 3) Inventory Accrued expenses are a current liability: a cost incurred that hasn't been paid yet.

Which statements are true?

1) Corporations have to hold regular elections for the board of directors. 2) Normally, each share of stock has one vote. 3) Shareholders can transfer their right to vote to someone else. Shareholders can vote in person at the annual meeting, but don't have to. It is more common to vote by mail or transfer one's right to vote to someone else, by means of a proxy (a permission to vote on someone else's behalf).

Which are elements of the indenture?

1) Description of protective covenants 2) Repayment arrangements 3) Description of collateral 4) Basic terms of the bonds, such as coupon rate and maturity date The indenture will specify the par or face value of the bond, but not its price, since prices fluctuate over time and in line with market interest rates.

What are advantages of a corporation over a partnership?

1) Easier fundraising 2) Unlimited life 3) Limited liability Most corporate earnings are subject to double taxation: the corporation has to pay corporate income taxes on its taxable income and then shareholders have to pay taxes again on the remaining cash that is distributed to shareholders in the form of dividends.

Which of these problems does corporate finance deal with?

1) How to finance long-term investments 2) How to manage short-term finances 3) Which long-term investments to make Compensation is primarily a strategic or human resources decision. Deciding how to finance long-term investments is a capital structure decision, how to manage short-term finances is working capital management, and deciding which long-term investments to make is a capital budgeting decision.

Which are valid reasons for using the IRR?

1) IRR is the easiest way to summarize a project's merit. 2) A rate of return seems more intuitive to many people. 3) The IRR calculation doesn't require a discount rate. IRR and NPV can give contradictory recommendations if a project's cash flows are non-conventional or if projects are mutually exclusive.

Which are problems of the payback criterion?

1) It doesn't show the value created by a project. 2) It uses an arbitrary cutoff value. 3) It ignores cash flows after the cutoff date. 4) It doesn't fully reflect the risk of a project. 5) It ignores the time value of money. The payback period is the easiest criterion to calculate. However, that is also its only redeeming feature: - It doesn't fully reflect the risk of a project: Projects with very volatile cash flows can have the same payback period as projects with certain cash flows (unlike NPV, which uses a higher discount rate for riskier projects). - It ignores the time value of money: Cash flows get added up without discounting. - It uses an arbitrary cutoff value: There is no good justification for the use of any particular cutoff value.

What are examples of a possible result of the conflict of interest between shareholders and corporate managers?

1) Managers using company resources for personal benefit. 2) Managers paying themselves excessive salaries. 3) Managers faking earnings to temporarily boost the stock price. Nearly all worthwhile investment projects carry the risk of losing money. Nevertheless, it is in the interest of shareholders to fund risky projects if the expected outcome is beneficial for shareholders.

Which are reasons for considering NPV the best decision criterion?

1) NPV correctly chooses between mutually exclusive projects. 2) NPV shows the value added to the firm. 3) NPV adjusts for the riskiness of a project. 4) NPV considers all cash flows. 5) NPV takes into account the time value of money. NPV shows the value created by the project (in dollars), not the return generated. The IRR shows the return generated by the project.

Which statements are true about partnerships?

1) Partners have unlimited liability. 2) All profits from a partnership are passed through to the partners for paying taxes. 3) A partnership is easy to set up. Partnerships cannot easily raise large amounts of capital since ownership stakes are not easily tradable (unlike the shares of a corporation).

Which statements are true about common stock?

1) Stockholders have limited liability: the most they can lose in the event of failure of the corporation is their original investment. 2) Common stock is an ownership share in a corporation. 3) Stockholders are the last in line of all those who have a claim on the assets or income of the corporation (residual claim). Dividend payments are the discretion of the board of directors and can be suspended temporarily or indefinitely.

The executive board comprises the top managers of a company: CEO, CFO, COO, CMO, etc. Which statements are true?

1) The board of directors appoints and monitors the executive board. 2) Shareholders elect the board of directors. 3) The board of directors has a fiduciary duty to shareholders. There are too many shareholders to effectively supervise the executive board. That is why shareholders elect a board of directors to supervise the top managers on their behalf.

Which are rights of common stockholders?

1) The right to a share of dividends paid 2) The right to vote for members of the board of directors 3) The right to vote on major decisions at the annual general meeting Common shareholders are not entitled to regular dividends. Dividend payments are at the discretion of the board of directors.

Which of these corporate units do typically report to the Chief Financial Officer (CFO)?

1) Treasury 2) Credit 3) Accounting 4) Capital Budgeting The CFO typically oversees all aspects of financial planning and controlling.

The Weighted Average Cost of Capital (WACC) is the appropriate discount rate for _____.

1) all cash flows for the firm as a whole 2) projects that are as risky as the firm as a whole The WACC is the appropriate discount rate for the company as a whole, and for individual projects that have the same level of risk as the company overall, e.g., extension projects that increase the scale of existing business operations.

Bonds are _____.

1) loans from investors to issuers 2) less costly than bank loans for the borrower 3) issued by governments or corporations Stocks are riskier than bonds, since stock prices are more volatile than bond prices and bondholders have precedence over stockholders in the case of bankruptcy.

Given similar maturities, the (before-tax) cost of debt is also the _____.

1) yield to maturity on new bonds 2) coupon rate on new bonds 3) yield to maturity on already outstanding bonds The cost of debt is the coupon rate on new bonds, which equals the yield to maturity on already outstanding bonds if the maturity dates are the same. Since bonds are typically issued at par, the coupon rate is usually the same as the yield to maturity on the issue date.

Which bond has the highest risk of default?

A bond with a B rating AAA is the highest (most secure) bond rating, followed by AA, A, BBB, BB, B, C and D.

You just logged into your online brokerage account and bought 100 shares of Apple stock. This is an example of _____.

A secondary market transaction. One investor buying shares from another investor is a secondary market transaction.

Which of the following is a primary market transaction?

Apple issues one million shares of new stock and sells them to the public with the help of an investment bank. In a primary market transaction, a company issues (creates) new securities by selling them to investors for the first time.

If interest is compounded quarterly, the ________ expresses the interest rate as if it were compounded annually.

EAR If interest is compounded quarterly, the EAR expresses the interest rate as if it were compounded annually.

Companies High Debt (HD) and Low Debt (LD) have the same sales, assets and net income, but HD has more debt. Which of the following statements is correct?

HD has a higher ROE than LD. Since assets are the same, HD must have less equity than LD. With the same net income, HD must have a higher ROE. Assets = Debt + Equity ROE = Net income / Equity

Which statement is correct about the payback method?

It is easy to use. While payback period is easy to use, it suffers from several shortcomings: - It ignores cash flows beyond the payback year. - The maximum acceptable payback period is arbitrary. - It ignores the time value of money.

Which of the following statements is true about the sensitivity of a bond's price to a change in market interest rates?

Long-term bonds are more sensitive than short-term bonds. Bonds with more time to maturity are more sensitive to changes in interest rates than bonds with a shorter time to maturity.

The goal of financial management is to _____.

Maximize the market value of equity (shareholder wealth). The goal of financial management is to maximize the market value of the existing owners' equity. For public companies, this is the same as maximizing the stock price, or shareholder wealth maximization.

Which decision criterion leads most consistently to the correct decision?

Net present value NPV is the best decision criterion. IRR can be misleading when projects are mutually exclusive or cash flows are non-conventional. The other two criteria are generally inferior.

What is the name for an infinite stream of constant payments occurring at regular time intervals?

Perpetuity A perpetuity is an infinite stream of constant payments occurring at regular time intervals.

Which of the following statements is correct for a given company?

The cost of equity is greater than the cost of debt. The cost of equity is always greater than the cost of debt since stocks are riskier than bonds, both in terms of price volatility and the risk of default.

What is the value of a dollar received now compared to a dollar received in the future?

The current dollar is worth more, because it can be invested now. A current dollar is worth more than a future dollar because inflation erodes the purchasing power of the future dollar, and the current dollar can be invested and earn interest between now and the future date.

What happens to the price of a bond with a 5% coupon rate if interest rates for similar bonds go up to 8%?

The price decreases because the present value of future payments falls. Higher interest rates (bond yields) mean a higher discount rate, so that the present values of future coupons and of the face value are reduced.

What is a bond's yield to maturity (YTM)?

The return you'll earn if you hold the bond to maturity and yields stay the same The YTM equals the return for an investor who buys the bond today, holds it until maturity and is able to reinvest all coupons at the current yield. In an efficient market, expected returns must be the same for similar securities. Therefore, the YTM can also be interpreted as the market interest rate for similar bonds.

_____ have maturities up to one year.

Treasury bills Treasury bills have maturities up to one year.

_____ have maturities greater than 10 years.

Treasury bonds Treasury bonds have maturities greater than 10 years.

Given a fixed APR, compounding more frequently leads to

a higher EAR Compounding more frequently leads to a higher EAR, since interest on interest is added more frequently. The APR, on the other hand, is unaffected by the frequency of compounding (which makes it a bad interest rate measure).

The problems stemming from a conflict of interest between shareholders and executives are called _____ problems.

agency Agency problems are due to a conflict of interest in a principal-agent relationship. The agents (executives) have an incentive to make decisions that are in their own best interest, but not necessarily in the best interest of the principals (shareholders) who hired them.

The balance sheet shows a company's _____ _____.

assets and liabilities; at one point in time The balance sheet shows a company's assets, liabilities and equity at one point in time, typically the last day of the quarter or financial year.

Calculating a present value uses _______, while calculating a future value uses ______.

discounting, compounding Calculating a present value uses discounting, while calculating a future value uses compounding.

The dividend growth model is based on the assumption that _____.

dividends grow at a constant rate every period It assumes that dividends grow at some constant rate g every period, such that Dt = Dt-1 (1+g).

The stand-alone principle means that _____.

each project can be evaluated by itself Each project can be evaluated by focusing on the incremental cash flows generated by the project, ignoring the rest of the company.

Based on the IRR criterion, we should accept a project if the IRR is _____.

greater than the required return We should accept a project if the IRR ≥ the required return.

Sunk costs are costs that _____.

have been incurred in the past and cannot be recouped fully Sunk costs are sunk in the sense that they cannot be (fully) recovered.

When capital is limited, we should generally accept the project with a profitability index that is _____.

highest We should accept the project with the highest profitability index.

Financial ratios are useful _____.

if they can be compared to historical ratios or other companies' ratios Financial ratios are calculated from the financial statements of a company and make it easier to track key metrics over time or compare one company to its competitors.

When determining relevant cash flows for project evaluation, we should _____.

ignore interest and other financing expenses We ignore interest expenses when calculating relevant cash flows, since they are a result of financing decisions, not operating decisions. However, we will capture the tax savings from interest when calculating the appropriate discount rate for the project.

For a firm without long-term debt and preferred stock, its weighted average cost of capital will be equal to _____.

its cost of equity A company without long-term debt has no bonds outstanding, and is purely equity-financed. As such, its cost of capital is equal to the cost of equity.

The yield to maturity (YTM) for a premium bond is _____ its coupon rate.

less than A premium bond trades above par value. The fact that new investors are willing to accept a capital loss as the price converges to par value over time implies that the coupon rate must be larger than the market interest rate (the YTM).

Preferred stock is like long-term debt since both _____, but preferred stock also resembles equity since both _____.

make regular, fixed payments; don't guarantee dividend payments Preferred stock is like long-term debt since both make regular, fixed payments, but preferred stock also resembles equity since both don't guarantee dividend payments (the board of directors can decide not to pay dividends indefinitely) and any dividend payments are not tax-deductible by the firm (unlike interest payments on bonds).

Two projects that require the full use of the same machines and employees are considered _____.

mutually exclusive Projects are mutually exclusive if doing one projects makes it impossible to do the other project as well. Since each project requires the full use of the same machines and employees, they are mutually exclusive.

An ordinary annuity has the first payment occurring _____, while an annuity due has the first payment occurring _____.

one period from now, now An ordinary annuity has the first payment occurring one period from now, while an annuity due has the first payment occurring now. Periods can be weeks, months, quarters, years or any other time interval of equal length.

When calculating incremental cash flows, we should include _____.

opportunity costs We should include opportunity costs, such as no longer being able to sell an asset that is being used for the project.

A limited liability company is taxed like a _____ and its owners have _____ liability.

partnership; limited An LLC is a pass-through entity for tax purposes, just like a partnership: all profits are passed without taxation to the owners, who then pay taxes on the profits as part of their personal income taxes. It's different from a partnership in that its owners have limited liability.

Based on the NPV criterion, we should accept a project if the NPV is _____.

positive We should accept a project if NPV ≥ 0.

Shareholders are ____ and managers are ____ in the shareholder-manager relationship.

principals; agents Shareholders are the principals who hire managers as their agents to act on their behalf.

The income statement shows a company's _____.

revenue and expenses over a period of time The income statement shows a company's revenue, expenses and profit or loss over a period of time, typically a quarter or a year.

The profitability index _____.

s useful when capital is scarce The PI shows the present value of cash flows generated for each dollar invested (in present value terms), or the "bang for the buck." It can be used to determine which project to accept if a firm has many positive NPV projects but cannot fund them all, a situation known as capital rationing.

The IRR is the discount rate that _____.

sets NPV equal to 0 By definition, IRR is that discount rate that results in an NPV of zero.

When calculating incremental cash flows, we should exclude _____.

sunk costs We should ignore sunk costs, as they are sunk and should thus no longer influence our decisions.

Project cash flows are considered conventional or normal if _____.

the first (one or more) cash flows are negative and the rest are positive With conventional cash flows, the sign of cash flows changes only once, i.e., after one or more negative cash flows initially, all the remaining cash flows are positive.

In capital budgeting, we should accept a project if _____.

the internal rate of return is greater than the required return We should accept a project if the internal rate of return is greater than the required return.

A corporation's life is _____.

unlimited, since management and ownership are separate Since management is separate from ownership, it is easy to replace both managers and owners, thus allowing the corporation to live on forever in theory. Ownership can be transferred simply by selling one's shares.

The best way to maximize shareholders' (or owners') wealth is to

work within the confines of the law and ethical conventions The best way to maximize shareholder wealth is to behave ethically and follow the law, while treating employees and customers as valuable assets.