Corporate Finance Test 2

22 multiple choice questions (9 conceptual, 13 multiple choice) 6 questions each from Ch. 4 & 610 questions from Ch. 5
Chapter 4 Computations* 2 conceptual current ratioquick ratiodays’ sales outstandinginventory turnover
Chapter 5 Computations* 3 conceptual future value of single suminterest ratenumber of periodspresent value of annuityamount of paymentpresent value of uneven cash flowseffective interest rate
Chapter 6 Computations* 4 conceptual real risk free interest raterisk premium
CHAPTER 4
Liquidity Ratios Show the relationship of a firm’s cash and other current assets to its current liabilities.Give an idea of the firm’s ability to pay off debts that are maturing within a year. Satisfactory liquidity ratios are necessary if the firm is to continue operating.Answers the question: “Will the firm be able to pay off its debts as they come due and thus remain a viable organization?”
Asset Management Ratio Give an idea of how efficiently the firm is using its assets. Good asset management ratios are necessary for the firm to keep its costs low and thus its net income highAnswer the question: “Does the amount of each type of asset seem reasonable, too high, or too low in view of current and projected sales?”These ratios are important because when company’s acquire assets, they must obtain capital from banks or other sources and capital is expensive. Therefore, if a company has too many assets, its cost of capital will be too high, which will depress its profits. On the other hand, if its assets are too low, profitable sales will be lost.
Debt Management Ratios Give an idea of how the firm has financed its assets as well as the firm’s ability to repay its long term debt. Indicate how risky the firm is and how much of its operating income must be paid to bondholders rather than stockholders.The use of debt will increase a firm’s ROE if the firm earns more on its assets than the interest it pays on debt. However, debt exposes the firm to more risk than if it financed only with equity.Un-leveraged = no debtLeveraged = has debtFirms with relatively high debt ratios typically have higher expected returns when the economy is normal, but lower returns and possibly bankruptcy if the economy goes into recessions.Interest on debt is a tax deductible expense, which means that it can reduce a firm’s taxable income and tax obligation.The US tax structure influences a firm’s willingness to finance with debt. The tax structure encourages more debt.
Profitability Ratios Give an idea of how profitably the firm is operating and utilizing its assets. Reflect the net results of all of the firm’s financing policies and operating decisionsA higher operating margin than the industry average indicates either lower operating costs, higher product pricing, or both. If a company’s operating margin increases but its profit margin decreases, it could mean that the company paid more in interest or taxes
Market Value Ratio Give an idea of what investors think about the firm and its future prospects. Tell us what investors think about the company and its prospects.Relate the stock price to earnings and book value priceUsed by investors when they are deciding to buy or sell a stock, by investment bankers when they are setting the share price for a new stock issue, and by firms when they are deciding how much to offer for another firm in a potential merger.
Liquid Asset one that trades in an active market and thus can be quickly converted to cash at the going market price
* Current Ratio Indicates the extent to which current liabilities are covered by those assets expected to be converted to cash in the near future. Current Ratio = Current Assets / Current Liabilities(want number to be higher than industry average)Current assets include cash, marketable securities, accounts receivable, and inventoriesCurrent Liabilities consist of accounts payable, accrued wages and taxes, and short term notes payableA high current ratio generally indicates a very strong, safe liquidity position; it might also indicate that the firm has too much old inventory that will have to be written off and too many old accounts receivable that may turn into bad debts. Or the high current ratio might indicate that the firm has too much cash, receivables, and inventory relative to its sales, in which case these assets are not being managed efficiently.
* Quick (acid) Test Ratio Measures the firm’s ability to pay off short term obligations without relying on the sale of inventoriesCurrent Assets – Inventories / Current Liabilities(you want it to be higher than industry average)Inventories are typically the least liquid of a firm’s current assets; and if sales slow down, they might not be converted to cash as quickly as expected. Also, inventories are the assets on which losses are most likely to occur in the event of liquidation.If a company’s average is below industry average, if the accounts receivable can be collected, the company can pay off its current liabilities even if it has trouble disposing of its inventoriesAn increase in the quick ratio over time usually means that the company’s liquidity position is improving and that the company is managing its short term assets well.
* Inventory Turnover Ratio Sales / InventoriesIf a company’s inventory turnover ratio is lower than the industry average, it suggests that it is holding too much inventory. Excess inventory is unproductive and represents an investment with a low or zero rate of return.
* Days Sales Outstanding (average collection period) Receivables / Average sales per day orReceivables / (Annual Sales/365)Represents the average length of time the firm must wait after making a sale before receiving cash(want DSO to be lower than industry average)
Fixed Assets Turnover Ratio Sales / Net Fixed Assets(want this to be higher than industry average)If a company’s average is above the industry’s average, it indicates that it is using its fixed assets at least as intensively as other firms in the industry.
Total Asset Turnover Ratio Sales / Total Assets(want it to be higher than industry average)When ratio is lower than industry average, it indicates that it is not generating enough sales given its total assets.
Total Debt to Total Capital (debt ratio) Total Debt / Total CapitalorTotal Debt / Total Debt + Equity(want it to be lower than industry average)Total Debt includes all short term and long term interest bearing debt, but it does not include operating items such as accounts payable and accruals. Creditors prefer low debt ratios because the lower the ratio, the greater the cushion against creditors’ losses in the event of liquidation. Stockholders, on the other hand, may want more leverage because it can magnify expected earnings.
Operating Margin EBIT / Sales(want it to be higher than industry average)
Profit Margin Net Income / Sales(want it to be higher than industry average)If profit margin for company is below industry average, 1) the firms operating costs are too high; 2) negatively impacted by heavy use of debt
Return on Total Assets Net Income / Total Assets(want it to be higher than industry average)
Return on Common Equity Net Income / Common Equity
Return on Invested Capital EBIT (1-T) / Total Invested Capital
Basic Earning Power Ratio EBIT / Total Assets
Price/Earnings Ratio Price per share / earnings per shareHigh for firms with strong growth prospects and little risk but low for slowly growing and risky firms If below industry average, the firm is seen as risky
Market/Book Ratio Companies that are well regarded by investors (which means low risk and high growth) have high market to book ratios. Book value per share = Common Equity / Shares OutstandingMarket/Book Ratio = Market price per share / Book Value per shareCompanies with high research and development expenses tend to have high P/E ratios
DuPont Equation Shows the rate of return on equity can be found as the product of profit margin, total assets turnover, and the equity multiplier. It shows the relationships among asset management, debt management, and profitability ratios. ROE = ROA x Equity Multiplier ROE = Profit Margin x Total Assets Turnover x Equity MultiplierROE = (Net Income / Sales) x (Sales / Total Assets) x (Total Assets / Total Common Equity)
Income Statement Total Sales / Revenues- Cost of Goods Sold=Gross Profit / Gross Margin- Operating Expenses =Operating Income / EBIT- Tax & Internet=Net Income
Chapter 5
The process for converting present values into future values is called compounding
The process of earning compound interest allows a depositor or investor to earn interest on any interest earned in prior periods True
After the end of the second year and all other factors remaining equal, a future value based on compound interest will never exceed the future value based on simple interest False
All other factors being equal, both the simple interest and the compound interest methods will accrue the same amount of earned interest by the end of the first year True
The process of calculating the present value of a cash flow or a series of cash flows to be received in the future Discounting
Other things remaining equal, the present value of a future cash flow: decreases if the investment time period increases
Payments made at the beginning of each month Annuity Due
Payment made at the end of each month Ordinary Annuity
Normal Yield curved upwards
Inverted Yield curved down
Uneven Cash Flows Calculator 1. CF2. Put in #, enter3. CPT, NPV4. Interest, down arrow5. CPT
When equal payments are made at the beginning of each period for a certain time period, they are treated as An annuity due
Annuities are structured to provide fixed payments for a Fixed period of time
An ordinary annuity of equal time earns less interest than an annuity due
Perpetuities Annuities with an extended or unlimited life
The current value of a perpetuity is based on the discounted value of its nearer (time) cash flows and less by the discounted value of its more distant (in the future) cash flows True
The value of a perpetuity is equal to the sum of the present value of its expected future cash flows True
A perpetuity is a stream of regular timed, equal cash flows that continues forever True
The number of compounding periods in one year is called a compounding frequency
Mortgages are examples of amortized loansending balance of an amortized loan contract will be zeroevery payment made toward an amortized loan consists of two parts — interest and repayment of principal
Chapter 6
Market Interest Rate rate at which the supply of capital equals the demand for capital
Real Risk Free Rate (r*) Rate on short term US treasury securities, assuming there is no inflationNot staticChanges depending on economic conditions, especially 1) rate of return that corporations and other borrowers expect to earn on productive assets and 2) people’s time preferences for current versus future consumptionswill say “real rate of return”, “risk-free”, “base interest rate”, “wants at least 5%”
Quoted or Nominal Rate of Interest (R) will say “nominal interest rate”, “quoted”, “final interest rate”, “i charged this person…”
Maturity Risk Premium (MRP) as interest rates rise, bond prices fall, and as interest rates fall, bond prices rise. Because interest rate changes are uncertain, this premium is added as a compensation for this uncertainity
Nominal Risk Free Rate (rRF) calculated by adding the inflation premium to r*is the quoted rate on a risk free security such as US treasury bill
Inflation Premium (IP) Premium added to the risk free rate that reflects the average sustained increase in the general level of prices for goods and services expected over the security’s entire life.
Default Risk Premium (DRP) Difference between the interest rate on a US treasury bond and a corporate bond of the same profile– that is, the same maturity and marketabilityReflects the possibility that the issuer will not pay the promised interest of principal at the stated time
Liquidity Risk Premium (LP) Premium added to the equilibrium interest rate on a security that cannot be brought or sold quickly enough to prevent or minimize loss
Nominal (quoted) Rate Formula R= r* + IP + DRP + LP + MRP
Interest rates on short term maturities are higher than rates on medium and long term maturities
Yield Curve Graphical representation of the relationship between the yields and the maturities of securities issued by a given borrower in a given currency on a given date
Humped Yield Curve Short term rates are relatively low, intermediate term rates are much higher, and long term rates are much lower
Normal Yield Curve Long term rates are greater than short term rates
Inverted Yield Curve The yield curve exhibits a downward sloping curve
Flat Yield Curve Long term rates are equal to short term rates
Factors that affect the treasury yield curve r*, IPt, and MRP
Factors that can affect the shape of the corporate yield curve r*t, IPt, MRPt, DRPt, and LPt
If inflation is expected to decrease in the future and the real rate is expected to remain steady, then the treasury yield curve is downward sloping True
The yield curve for a BBB rated corporate bond is expected to be above the US Treasury bond yield curve True
Yield curves of highly liquid assets will be lower than yield curves of relatively illiquid assets True
Long term interest rates are not as sensitive to booms and recessions as are short term interest rates True
Countries with strong balance sheets and declining budget deficits tend to have lower interest rates True
When the economy is weakening, the Fed is likely to decrease short term interest rates True

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