MGT Financial Management Final Exam

Distinguish between debt and equity financing
Equity financing often means issuing additional shares of common stock to an investor. With more shares of common stock issued and outstanding, the previous stockholders’ percentage of ownership decreases.

Debt financing means borrowing money and not giving up ownership. Debt financing often comes with strict conditions or covenants in addition to having to pay interest and principal at specified dates.

Reasons why common stock is more difficult to value than a bond
PV of stock is equal to the PV of all future dividends… but how many will there be? this means that we still can’t compute a value for the stock because we would have to forecast an infinite number of dividends and then discount them all
zero growth, constant growth, and non constant growth
1. zero growth – dividend is always the same, stock can be viewed as an ordinary perpetuity with a cash flow equal to D every period
2. constant growth – grows at a steady rate, growing perpetuity, steady/constant growth is a goal of many companies
3. non constant growth – supernormal growth for a finite amount of time, growth rate cannot exceed the required return indefinitely but it could for some number of years
dividend yield and capital gains yield

dividend yield + capital gains yield = discount rate

dividend yield – a stock’s expected cash dividend divided by its current price
capital gains yield – dividend growth rate, or the rate at which the value of an investment grows
cumulative voting and straight voting
cumulative voting – a shareholder may cast all votes for one member of the board of directors, to permit minority participation
straight voting – directors are elected one at a time, a procedure in which a shareholder may cast all votes for each member of the board of directors
proxy voting
a grant of authority by a shareholder allowing another individual to vote that shareholder’s shares
preemptive right (for common stock)
the right to share proportionally in any new stock sold… means that a company that wishes to sell stock must first offer it to the existing stockholders before offering it to the general public to protect their proportionate ownership in the company
payments by a corporation to shareholders, made in either cash or stock
1. not a liability, cannot become bankrupt bc of nonpayment of dividends
2. payment of dividends is not a business expense, not deductible for tax purposes, aka they are paid out of the corporation’s aftertax profits
3. dividends received by individual shareholders are taxable
common stock
– equity without priority for dividends or in bankruptcy
– shareholders elect directors who hire management to carry out their directives
– classes of stock vary
preferred stock
– stock with dividend priority over common stock, normally with a fixed dividend rate, sometimes without voting rights
– have a stated liquidating value
– can be considered a debt in disguise, a kind of equity bond
cumulative and noncumulative dividends (for preferred stock)
1. cumulative dividends – if preferred dividends are cumulative and are not paid in a particular year, they will be carried forward as an arrearage; usually both accumulated preferred and current preferred
2. noncumulative dividends – may be paid to or withheld from shareholders at the company’s discretion
primary market and secondary market
primary market – market in which new securities are originally sold to investors to raise money
secondary market – market in which previously issued securities are traded among investors
dealers and brokers
dealers – agent who buys and sells securities from inventory (cars)
broker – agent who arranges security transactions among investors, does not maintain inventory (real estate)
The Nasdaq is a dealer’s market, wherein market participants are not buying from and selling to one another directly but through a dealer, who, in the case of the Nasdaq, is a market maker.
The NYSE is an auction market, wherein individuals are typically buying and selling between one another and there is an auction occurring; that is, the highest bidding price will be matched with the lowest asking price.
net present value (NPV)
– the difference between an investment’s market value and its cost
– how much value is created or added today by undertaking an investment
– net present value rule: reject if NPV negative, accept if positive
payback period
– the amount of time required for an investment to generate cash flows sufficient to recover its initial cost
– packback rule: investment is acceptable if its calculated payback period is less than some respecified number of years
– advantages: easy to understand, adjusts for uncertainty of later cash flows, biased toward liquidity
– disadvantages: TVM not taken into account, cutoff period isn’t exact, ignores cash flows beyond cutoff date, biased against LT projects
average accounting return (AAR)
– an investment’s average net income divided by its average book value
– avg net income/avg book value
– AAR rule: a project is acceptable if its AAR return exceeds a target AAR
– advantages: easy to calculate, needed info will usually be available
– disadvantages: not a true rate of return, TVM ignored, arbitrary benchmark cutoff rate, based on avg net income and book values not cash flows and market values
internal rate of return (IRR)
– the discount rate that makes the NPV of an investment zero
– IRR rule: an investment is acceptable if the IRR exceeds the required return, it should be rejected otherwise
– advantages: closely related to NPV, easy to understand and communicate
– disadvantages: may result in multiple answers with nonconventional cash flows, may lead to incorrect decisions in comparisons of mutually exclusive investments
profitability index
– PV of an investment’s future cash flows divided by its initial cost, also benefit-cost ratio
– advantages: closely related to NPV, easy to understand, useful when available investment funds are limited
– disadvantages: may lead to incorrect decisions in comparisons of mutually exclusive investments
the practice of capital budgeting
true NPV is unknown, companies use multiple criteria for evaluating a proposal, need to take everything into account to make a sound decision
stand alone principle
the assumption that evaluation of a project may be based on the project’s incremental cash flows
incremental cash flows
the difference between a firm’s future cash flows with a project and those without the project
sunk costs
a cost that has already been incurred and cannot be recouped and therefore should not be considered in an investment
opportunity cost
the most valuable alternative that is given up if a particular investment is undertaken
the cash flows of a new project that come at the expense of a firm’s existing projects
net working capital
normally a project will require that a firm invest in NWC in addition to LT assets… firm supplies NWC at the beginning and recovers it towards the end (similar to a loan)
role of financing costs in analyzing a proposed investment
in analyzing a proposed investment, we will not include interest paid or any other financing costs such as dividends or principal repaid, because we are interested in the cash flow generated by the assets of the project
understand cash flows used are actual (accrued amounts are not used) and they represent aftertax amounts
only interested in measuring cash flow when it actually occurs, after tax… but thats not the same as net income/accounting profit
project cash flow
= project operating cash flow – project change to NWC – project capital spending
operating cash flow
= earnings before interest and taxes + depreciation – taxes
depreciation = a non cash expense
depreciation tax shield – the tax saving that results from the depreciation deduction, calculated as depreciation multiplied by the corporate tax rate… reduces taxes
accelerated cost recovery system (ACRS)
depreciation method under US tax law allowing for the accelerated write-off of property under various classifications
modified ACRS (MACRS) depreciation
every asset is assigned to a particular class… class establishes its life for tax purposes… once tax life is determined, we compute the depreciation for each year by multiplying the cost of the asset by a fixed percentage
scenario analysis and sensitivity analysis
– scenario analysis – determination of what happens to NPV estimates when we ask what-if questions
– sensitivity analysis – investigation of what happens to NPV when only one variable is changed
managerial options
opportunities that managers can exploit in certain things happen in the future; also known as “real” options
contingency planning
taking into account the managerial options implicit in a project, ex: the option to expand, abandon, wait
strategic options
options for future, related business products or strategies, ex: research and development
capital rationing
the situation that exists if a firm has positive NPV projects but cannot obtain the necessary financing
soft rationing
the situation the occurs when units in a business are allocated a certain amount of financing for capital budgeting
hard rationing
the situation that occurs when a business cannot raise financing for a project under any circumstances
risk and return
the required return depends on the risk of the investment… risk premium
portfolio and portfolio weights
portfolio – group of assets such as stocks and bonds held by an investor
portfolio weights – percentage composition of a particular holding in a portfolio
expected and unexpected returns
expected return – return on a risky asset expected in the future
unexpected – uncertain, or risky part
systematic and unsystematic risks
systematic risk – a risk that influences a large number of assets; market risk
unsystematic risk – affects at most a small number of assets; unique or asset-specific risk
principle of diversification
spreading an investment across a number of assets will eliminate some, but not all, of the risk

unsystematic risk is essentially eliminated by diversification, so a relatively large portfolio has almost no unsystematic risk

total risk = systematic risk + unsystematic risk
systematic risk principle
the expected return on a risky asset depends only on that asset’s systematic risk
Beta coefficient
amount of systematic risk present in a particular risky asset relative to that in an average risky asset
Security Market Line (SML)
positively sloped straight line displaying the relationship between expected return and beta; after NPV, is arguably the most important concept in modern finance
market risk premium
slope of SML, the difference between the expected return on a market portfolio and the risk-free rate
capital asset pricing model (CAPM)
equation of the SML showing the relationship between expected return and beta
1. pure TVM as measured by the risk free rate
2. reward for bearing systematic risk as measured by the market risk premium
3. amount of systematic risk as measured by beta
cost of capital
the minimum required return on a new investment; what the firm must earn on its capital investment in a project just to break even
**** depends primarily on the use of the funds, not the source
sources companies use to raise money
1. ST sources such as accounts payable, bank loans, commercial paper
2. LT sources such as bonds, preferred stock, retained earnings, sale of stock
calculate cost of debt
– return that lenders require on the firm’s debt
– for a firm with publicly held debt, the cost of debt can be measured as the yield to maturity on the outstanding debt. the coupon rate is irrelevant
– if the firm has no publicly traded debt, then the cost of debt can be measured as the yield to maturity on similarly rated bonds
= interest rate * (1 – tax rate)
calculate cost of preferred stock
the rate of return that must be earned on the investment of money raised from the sale of preferred stock in order to keep the common stock price unchanged
= D/P0
= preferred stock dividends/preferred stock – flotation costs
calculate cost of retained earnings
the rate of return that must be earned on the investment of retained earnings in order to keep the common stock price unchanged
= (next years dividend/price of common stock) + future growth rate of dividends = %
calculate cost of common equity
the rate of return that must be earned on the investment of money raised from the sale of new common stock in order to keep the common stock price unchanged
= (next years dividend/(price of common stock*(1 – percentage flotation cost)) + future growth rate of dividends = %
calculate weighted average cost of capital (WACC)
– overall required return on the firm as a whole; appropriate discount rate to use for cash flows similar in risk to the overall firm
= proportion * cost = weighted cost
= (E/V) x Re + (D/V) x Rd x (1-Tc)
distinguish between tax treatment of cost of debt and cost of equity
minimum return required
cost of raising the money, the cost of capital, becomes the minimum desired rate of return for investing money
types of short-type financing decisions and issues
Cash = LT debt + equity + CL – CA (other than cash) – fixed assets
activities that increase, decrease, and do not change cash
increase: increasing LT debt, increasing equity, increasing CL, decreasing CA other than cash, decreasing FA
decrease: decreasing LT debt, decreasing equity, decreasing CL, increasing CA other than cash, increasing FA
calculate and interpret inventory turnover and inventory period
COGS/avg inventory
365/inventory turnover
calculate and interpret receivables turnover and receivables period
credit sales/average accounts receivables
365/receivables turnover
calculate and interpret operating cycle
inventory period + receivable turnover
calculate and interpret payables turnover and payables period
COGS/average payables
365/payables turnover
calculate and interpret cash cycle
operating cycle-accounts payable
flexible and restrictive short-term financial policies
1. the size of the firm’s investment in current assets (flexible vs restrictive, high vs low)
carrying costs and shortage costs
carrying costs = costs that rise with increases in the level of investment in current assets
shortage costs = costs that fall with increases in the level of investment in current assets (can be either trading/order costs, or costs related to lack of safety reserves)
considerations in determining best ST financial policy
1. cash reserves
2. maturity hedging
3. relative interest rates
cash budget
a forecast of cash receipts and disbursements for the next planning period
short term borrowing options
1. unsecured loans –> often arrange a line of credit
2. secured loans –> AR financing, inventory loans
3. other sources –> commercial paper, trade credit
line of credit
a formal (committed) or informal (noncommittal) prearranged, short term bank loan
accounts receivable financing
a secured ST loan that involves either the assignment or factoring of receivables
inventory loans
a secured ST loan to purchase inventory
1. blanket inventory lien
2. trust receipt
3. field warehouse financing
commercial paper
ST notes issued by large and highly rated firms, interest rate can be low
trade credit
increase AP period and can take longer to pay bills, may end up paying a much higher price for what you want to purchase