FIN 323 : Study Guides for Final EXam
FIN 323 : Study Guides for Final EXam FIN 323
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Date Created: 04/27/16
FIN 323 : Study Guides for Final Exam Answer for the Questions in the textbook CHAPTER 2 :WORKING WITH FINANCIAL STATEMENTs 1.Liquidity measures how quickly and easily an asset can be converted to cash without significant loss in value. It’s desirable for firms to have high liquidity so that they can more safely meetshort-term creditor demands. However, liquidity also has an opportunity cost. Firms generally reap higher returns by investing in illiquid, productive assets. It’s up to the firm’s financial management staff to find a reasonable compromise between these opposing needs. 2.The recognition and matching principles in financial accounting call for revenues, and the costs associated with producing those revenues, to be “booked” when the revenue process is essentially complete, not necessarily when the cash is collected or bills are paid. Note that this way is not necessarily correct; it’s the way accountants have chosen to do it. 3.Historical costs can be objectively and precisely measured, whereas market values can be difficult to estimate, and different analysts would come up with different numbers. Thus, there is a tradeoff between relevance (market values) and objectivity (book values). 4.Depreciation is a non-cash deduction that reflects adjustments made in asset book values in accordance with the matching principle in financial accounting. Interest expense is a cash outlay, but it’s a financing cost, not an operating cost. 5.Market values can never be negative. Imagine a share of stock selling for – $20. This would mean that if you placed an order for 100 shares, you would get the stock along with a check for $2,000. How many shares do you want to buy? More generally, because of corporate and individual bankruptcy laws, net worth for a person or a corporation cannot be negative, implying that liabilities cannot exceed assets in market value. 6.For a successful company that is rapidly expanding, capital outlays would typically be large, possibly leading to negative cash flow from assets. In general, what matters is whether the money is spent wisely, not whether cash flow from assets is positive or negative. 7.It’s probably not a good sign for an established company, but it would be fairly ordinary for a start- up, so it depends. 8.For example, if a company were to become more efficient in inventory management, the amount of inventory needed would decline. The same might be true if it becomes better at collecting its receivables. In general, anything that leads to a decline in ending NWC relative to beginning NWC would have this effect. Negative net capital spending would mean more long-lived assets were liquidated than purchased. CHAPTER 3 :WORKING WITH FINANCIAL STATEMENTS 1.a. If inventory is purchased with cash, then there is no change in the current ratio. If inventory is purchased on credit, then there is a decrease in the current ratio if it was initially greater than 1.0. bReducing accounts payable with cash increases the current ratio if it was initially greater than 1.0. c.Reducing short-term debt with cash increases the current ratio if it was initially greater than 1.0. d.As long-term debt approaches maturity, the principal repayment and the remaining interest expense become current liabilities. Thus, if debt is paid off with cash, the current ratio increases if it was initially greater than 1.0. If the debt has not yet become a current liability, then paying it off will reduce the current ratio since current liabilities are not affected. e.Reduction of accounts receivables and an increase in cash leaves the current ratio unchanged. fInventory sold at cost reduces inventory and raises cash, so the current ratio is unchanged. g.Inventory sold for a profit raises cash in excess of the inventory recorded at cost, so the current ratio increases. 2.The firm has increased inventory relative to other current assets; therefore, assuming current liability levels remain mostly unchanged, liquidity has potentially decreased. 3.A current ratio of 0.50 means that the firm has twice as much in current liabilities as it does in current assets; the firm potentially has poor liquidity. If pressed by its short-term creditors and suppliers for immediate payment, the firm might have a difficult time meeting its obligations. A current ratio of 1.50 means the firm has 50% more current assets than it does current liabilities. This probably represents an improvement in liquidity; short-term obligations can generally be met com- pletely with a safety factor built in. A current ratio of 15.0, however, might be excessive. Any excess funds sitting in current assets generally earn little or no return. These excess funds might be put to better use by investing in productive long-term assets or distributing the funds to shareholders. 4.a. Quick ratio provides a measure of the short-term liquidity of the firm, after removing the effects of inventory, generally the least liquid of the firm’s current assets. bCash ratio represents the ability of the firm to completely pay off its current liabilities balance with its most liquid asset (cash). CHAPTER 4 : INTRODUCTION TO VALUATION: THE TIME VALUE OF MONEY 1.Compounding refers to the growth of a dollar amount through time via reinvestment of interest earned. It is also the process of determining the future value of an investment. Discounting is the process of determining the value today of an amount to be received in the future. 2.Future values grow (assuming a positive rate of return); present values shrink. 3.The future value rises (assuming a positive rate of return); the present value falls. 4.It depends. The large deposit will have a larger future value for some period, but after time, the smaller deposit with the larger interest rate will eventually become larger. The length of time for the smaller deposit to overtake the larger deposit depends on the amount deposited in each account and the interest rates. 5.It would appear to be both deceptive and unethical to run such an ad without a disclaimer or explanation. 6.It’s a reflection of the time value of money. TMCC gets to use the $1,163. If TMCC uses it wisely, it will be worth more than $10,000 in thirty years. 7.This will probably make the security less desirable. TMCC will only repurchase the security prior to maturity if it to its advantage, i.e. interest rates decline. Given the drop in interest rates needed to make this viable for TMCC, it is unlikely the company will repurchase the security. This is an example of a “call” feature. Such features are disc ussed at length in a later chapter. 8.The key considerations would be: (1) Is the rate of return implicit in the offer attractive relative to other, similar risk investments? and (2) How risky is the investment; i.e., how certain are we that we will actually get the $10,000? Thus, our answer does depend on who is making the promise to repay. 9.The Treasury security would have a somewhat higher price because the Treasury is the strongest of all borrowers. 10.The price would be higher because, as time passes, the price of the security will tend to rise toward $10,000. This rise is just a reflection of the time value of money. As time passes, the time until receipt of the $10,000 grows shorter, and the present value rises. In 2015, the price will probably be higher for the same reason. We cannot be sure, however, because interest rates could be much higher, or TMCC’s financial position could deteriorate. Either event would tend to depress the security’s price. CHAPTER 6 : INTEREST RATES AND BOND VALUTION 1.No. As interest rates fluctuate, the value of a Treasury security will fluctuate. Long- term Treasury securities have substantial interest rate risk. 2.All else the same, the Treasury security will have lower coupons because of its lower default risk, so it will have greater interest rate risk. 3.No. If the bid were higher than the ask, the implication would be that a dealer was willing to sell a bond and immediately buy it back at a higher price. How many such transactions would you like to do? 4.Prices and yields move in opposite directions. Since the bid price must be lower, the bid yield must be higher. 5.There are two benefits. First, the company can take advantage of interest rate declines by calling in an issue and replacing it with a lower coupon issue. Second, a company might wish to eliminate a covenant for some reason. Calling the issue does this. The cost to the company is a higher coupon. A put provision is desirable from an investor’s standpoint, so it helps the company by reducing the coupon rate on the bond. The cost to the company is that it may have to buy back the bond at an unattractive price. 6.Bond issuers look at outstanding bonds of similar maturity and risk. The yields on such bonds are used to establish the coupon rate necessary for a particular issue to initially sell for par value. Bond issuers also simply ask potential purchasers what coupon rate would be necessary to attract them. The coupon rate is fixed and simply determines what the bond’s coupon payments will be. The required return is what investors actually demand on the issue, and it will fluctuate through time. The coupon rate and required return are equal only if the bond sells for exactly par. 7.Yes. Some investors have obligations that are denominated in dollars; i.e., they are nominal. Their primary concern is that an investment provide the needed nominal dollar amounts. Pension funds, for example, often must plan for pension payments many years in the future. If those payments are fixed in dollar terms, then it is the nominal return on an investment that is important. 8.Companies pay to have their bonds rated simply because unrated bonds can be difficult to sell; many large investors are prohibited from investing in unrated issues. 9.Treasury bonds have no credit risk, so a rating is not necessary. Junk bonds often are not rated because there would no point in an issuer paying a rating agency to assign its bonds a low rating (it’s like paying someone to kick you!). CHAPTER 7 : EQUITY MARKETS AND STOCK VALUATION 1.The value of any investment depends on its cash flows; i.e., what investors will actually receive. The cash flows from a share of stock are the dividends. 2.Investors believe the company will eventually start paying dividends (or be sold to another company). 3.In general, companies that need the cash will often forgo dividends since dividends are a cash expense. Young, growing companies with profitable investment opportunities are one example; another example is a company in financial distress. This question is examined in depth in a later chapter. 4.The general method for valuing a share of stock is to find the present value of all expected future dividends. The dividend growth model presented in the text is only valid (i) if dividends are expected to occur forever; that is, the stock provides dividends in perpetuity, and (ii) if a constant growth rate of dividends occurs forever. A violation of the first assumption might be a company that is expected to cease operations and dissolve itself some finite number of years from now. The stock of such a company would be valued by the methods of this chapter by applying the general method of valuation. A violation of the second assumption might be a start-up firm that isn’t currently paying any dividends, but is expected to eventually start making dividend payments some number of years from now. This stock would also be valued by the general dividend valuation method of this chapter. 5.The common stock probably has a higher price because the dividend can grow, whereas it is fixed on the preferred. However, the preferred is less risky because of the dividend and liquidation preference, so it is possible the preferred could be worth more, depending on the circumstances. 6.The two components are the dividend yield and the capital gains yield. For most companies, the capital gains yield is larger. This is easy to see for companies that pay no dividends. For companies that do pay dividends, the dividend yields are rarely over five percent and are often much less. 7.Yes. If the dividend grows at a steady rate, so does the stock price. In other words, the dividend growth rate and the capital gains yield are the same. 8.In a corporate election, you can buy votes (by buying shares), so money can be used to influence or even determine the outcome. Many would argue the same is true in political elections, but, in principle at least, no one has more than one vote. 9.It wouldn’t seem to be. Investors who don’t like th e voting features of a particular class of stock are under no obligation to buy it. 10.Investors buy such stock because they want it, recognizing that the shares have no voting power. Presumably, investors pay a little less for such shares than they would otherwise. 11.Presumably, the current stock value reflects the risk, timing, and magnitude of all future cash flows, both short-term and long-term. If this is correct, then the statement is false. 12.A reasonable limit for the growth rate is the growth rate of the economy, which in the U.S. has historically been about 3 to 3.5 percent (after accounting for inflation). As we will see in a later chapter, inflation has historically averaged about 3 percent, so 6 to 6.5 percent (after accounting for inflation) would be a reasonable limit. CHAPTER 9 : MAKING CAPITAL INVESTMENT DECISIONS 1.In this context, an opportunity cost refers to the value of an asset or other input that will be used in a project. The relevant cost is what the asset or input is actually worth today, not, for example, what it cost to acquire. 2.For tax purposes, a firm would choose MACRS because it provides for larger depreciation deductions earlier. These larger deductions reduce taxes, but have no other cash consequences. Notice that the choice between MACRS and straight-line is purely a time value issue; the total depreciation is the same, only the timing differs. 3.It’s probably only a mild over-simplification. Current liabilities will all be paid presumably. The cash portion of current assets will be retrieved. Some receivables won’t be collected, and some inventory will not be sold, of course. Counterbalancing these losses is the fact that inventory sold above cost (and not replaced at the end of the project’s life) acts to increase working capital. These effects tend to offset. 4.Management’s discretion to set the firm’s capital structure is applicable at the firm level. Since any one particular project could be financed entirely with equity, another project could be financed with debt, and the firm’s overall capital structure remain unchanged, financing costs are not relevant in the analysis of a project’s incremental cash flows according to the stand-alone principle. 5.Depreciation is a non-cash expense, but it is tax-deductible on the income statement. Thus depreciation causes taxes paid, an actual cash outflow, to be reduced by an amount equal to the depreciation tax shield T CD. A reduction in taxes that would otherwise be paid is the same thing as a cash inflow, so the effects of the depreciation tax shield must be added in to get the total incremental aftertax cash flows. 6.There are two particularly important considerations. The first is erosion. Will the essentialized book simply displace copies of the existing book that would have otherwise been sold? This is of special concern given the lower price. The second consideration is competition. Will other publishers step in and produce such a product? If so, then any erosion is much less relevant. A particular concern to book publishers (and producers of a variety of other product types) is that the publisher only makes money from the sale of new books. Thus, it is important to examine whether the new book would displace sales of used books (good from the publisher’s perspective) or new books (not good). The concern arises any time that there is an active market for used product. 7.Definitely. The damage to Porsche’s reputation is definitely a factor the company needed to consider. If the reputation was damaged, the company would have lost sales of its existing car lines. CHAPTER 10 : SOME LESSONS FROM CAPITAL MARKET HISTORY 1.They all wish they had! Since they didn’t, it must have been the case that the stellar performance was not foreseeable, at least not by most. 2.As in the previous question, it’s easy to see after the fact that the investment was terrible, but it probably wasn’t so easy ahead of time. 3.No, stocks are riskier. Some investors are highly risk averse, and the extra possible return doesn’t attract them relative to the extra risk. 4.On average, the only return that is earned is the required return—investors buy assets with returns i n excess of the required return (positive NPV), bidding up the price and thus causing the return to fall to the required return (zero NPV); investors sell assets with returns less than the required return (negative NPV), driving the price lower and thus the causing the return to rise to the required return (zero NPV). 5.The market is not weak form efficient. 6.Yes, historical information is also public information; weak form efficiency is a subset of semi-strongform efficiency. 7.Ignoring trading costs, on average, such investors merely earn what the market offers; the trades all have zero NPV. If trading costs exist, then these investors lose by the amount of the costs. 8.Unlike gambling, the stock market is a positive sum game; everybody can win. Also, speculators provide liquidity to markets and thus help to promote efficiency. 9.The EMH only says, that within the bounds of increasingly strong assumptions about the information processing of investors, that assets are fairly priced. An implication of this is that, on average, the typical market participant cannot earn excessive profits from a particular trading strategy. However, that does not mean that a few particular investors cannot outperform the market over a particular investment horizon. Certain investors who do well for a period of time get a lot of attention from the financial press, but the scores of investors who do not do well over the same period of time generally get considerably less attention. 10.a. If the market is not weak form efficient, then this information could be acted on and a profit earned from following the price trend. Under (2), (3), and (4), this information is fully impounded in the current price and no abnormal profit opportunity exists. B-190 S OLUTIONS b.Under (2), if the market is not semi-strong form efficient, then this information could be used to buy the stock “cheap” before the rest of the market discovers the financial statement anomaly. Since (2) is stronger than (1), both imply that a profit opportunity exists; under (3) and (4), this information is fully impounded in the current price and no profit opportunity exists. c.Under (3), if the market is not strong form efficient, then this information could be used as a profitable trading strategy, by noting the buying activity of the insiders as a signal that the stock is underpriced or that good news is imminent. Since (1) and (2) are weaker than (3), all three imply that a profit opportunity exists. Note that this assumes the individual who sees the insider trading is the only one who sees the trading. If the information about the trades made by company management is public information, under (3) it will be discounted in the stock price and no profit opportunity exists. Under (4), this information does not signal any profit opportunity for traders; any pertinent information the manager-insiders may have is fully reflected in the current share price. CHAPTER 11 RISK AND RETURN 1. Some of the risk in holding any asset is unique to the asset in question. By investing in a variety of assets, this unsystematic portion of the total risk can be eliminated at little cost. On the other hand, there are systematic risks that affect all investments. This portion of the total risk of an asset cannot be costlessly eliminated. In other words, systematic risk can be controlled, but only by a costly reduction in expected returns. 2. If the market expected the growth rate in the coming year to be 2 percent, then there would be no change in security prices if this expectation had been fully anticipated and priced. However, if the market had been expecting a growth rate different than 2 percent and the expectation was incorporated into security prices, then the government’s announcement would most likely cause security prices in general to change; prices would typically drop if the anticipated growth rate had been more than 2 percent, and prices would typically rise if the anticipated growth rate had been less than 2 percent. 3. a. systematic b. unsystematic c. both; probably mostly systematic d. unsystematic e. unsystematic f. systematic 4. a. This is a systematic risk; market prices in general will most likely decline. b. This is a firm specific risk; the company price will most likely stay constant. c. This is a systematic risk; market prices in general will most likely stay constant. d. This is a firm specific risk; the company price will most likely decline. e. This is a systematic risk; market prices in general will most likely stay constant. 5. No to both questions. The portfolio expected return is a weighted average of the asset returns, so it must be less than the largest asset return and greater than the smallest asset return. 6. False. The variance of the individual assets is a measure of the total risk. The variance and expected return on a well-diversified portfolio are functions of systematic risk only. 7. Yes, the standard deviation can be less than that of every asset in the portfolio. However, b cannot be less than the smallest beta because bP is a weighted average of the individual asset betas. 8. Yes. It is possible, in theory, to construct a zero beta portfolio of risky assets whose return would be equal to the risk-free rate. It is also possible to have a negative beta; the return would be less than the risk-free rate. A negative beta asset would carry a negative risk premium because of its value as a diversification instrument. 9. Such layoffs generally occur in the context of corporate restructurings. To the extent that the market views a restructuring as value-creating, stock prices will rise. So, it’s not the layoffs per se that are being cheered on but the cost savings associated with the layoffs. Nonetheless, Wall Street does encourage corporations to takes actions to create value, even if such actions involve layoffs. 10. Earnings contain information about recent sales and costs. This information is useful for projecting future growth rates and cash flows. Thus, unexpectedly low earnings often lead market participants to reduce estimates of future growth rates and cash flows; lower prices are the result. The reverse is often true for unexpectedly high earnings.
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