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Study Guide

Financial Management
By
Sarah M. Burke, Ph.D.

Contributing Reviewer
Sandra L. Pinick

About the Author


Sarah M. Burke, Ph.D., is an assistant professor in the Department
of Finance at Goldey-Beacom College in Wilmington, Delaware. She
earned her doctorate in business and economics from Lehigh
University. Her areas of specialization are corporate finance and
public economies.

About the Contributing Reviewer


Sandra L. Pinick has a BBA in finance and an MBA from Washburn
University in Topeka, Kansas. She owns and operates her own information technology business, and she has taught classes in finance,
marketing, and information technology at Washburn University and
Baker University in Baldwin City, Kansas.

All terms mentioned in this text that are known to be trademarks or service marks
have been appropriately capitalized. Use of a term in this text should not be
regarded as affecting the validity of any trademark or service mark.
Copyright 2009 by Penn Foster, Inc.
All rights reserved. No part of the material protected by this copyright may be
reproduced or utilized in any form or by any means, electronic or mechanical,
including photocopying, recording, or by any information storage and retrieval system, without permission in writing from the copyright owner.
Requests for permission to make copies of any part of the work should
be mailed to Copyright Permissions, Penn Foster, 925 Oak Street, Scranton,
Pennsylvania 18515.
Printed in the United States of America

LESSON ASSIGNMENTS

LESSON 1: KEY FINANCIAL CONCEPTS

EXAMINATIONLESSON 1

27

LESSON 2: FINANCIAL INSTITUTIONS

31

EXAMINATIONLESSON 2

47

LESSON 3: INVESTMENTS

51

EXAMINATIONLESSON 3

73

LESSON 4: CORPORATE FINANCE, PART 1

77

EXAMINATIONLESSON 4

93

LESSON 5: CORPORATE FINANCE, PART 2

97

EXAMINATIONLESSON 5

115

SELF-CHECK ANSWERS

121

Contents

INSTRUCTIONS TO STUDENTS

iii

YOUR STUDY GUIDE

This course provides a basic introduction to the study of


finance, including financial institutions, investments, and
corporate finance. First, youll learn about the essential concepts and analytical tools of finance, as theyre used in all
three areas of study. These areas are then explored individually
and as interrelated components.
Note that this study guide isnt meant to take the place of
your textbook. Rather, its designed to complement the text
material by highlighting essential concepts and clarifying the
more difficult content. In addition, the study guide provides
examples and problems intended to reinforce the book readings, as well as assignments and self-checks that will help
you evaluate your understanding of the material before you
complete the examinations.

KNOW YOUR TEXTBOOK


Your textbook, Basic Finance: An Introduction to Financial
Institutions, Investments, and Management, Ninth Edition,
is the heart of this course. It contains the study material on
which your examinations are based. Each time we mention
your text in this study guide, were referring to this book. This
textbook provides the material you need to know to successfully complete your Financial Management course. Its very
important that you read the material in the text and study it
until youre completely familiar with it. This is the material
that your examinations will be based on. Before you actually
begin reading your assignments, however, its important to
become thoroughly familiar with the textbook itself. Get
your textbook out now and refer to it as you read through
the following information.

Instructions

This study guide is designed to help you make the most of your
textbook, Basic Finance: An Introduction to Financial Institutions,
Investments, and Management. Here youll find a study plan
that includes a useful introduction and a listing of your reading assignments. When you finish each lesson in the study
guide, youll complete a multiple-choice examination. As you
work through your study guide and textbook, youll learn
about important principles of financial management.

Start your survey of the textbook on the page titled Brief


Contents. Note that the textbook is organized into five parts.
The pages titled Contents expand the Brief Contents by
presenting itemized topics listed under each of the five parts
of the textbook. Skim these topics to see what to expect in
each chapter.
Turn to the Preface on page xix and read about the various
learning tools that are employed throughout the book. The
Prologue, beginning on page 1, describes the role of finance
and the concepts that serve as its foundation. Students who
have never taken a course in finance are strongly encouraged
to study the Prologue.
As you use your textbook, take time to study exhibits, figures,
equations, and other graphic and tabular inserts. These
illustrations supplement or amplify the discussionin fact,
many of them are integral parts of the discussion. Youll also
notice that the author uses the margins to provide definitions
and present calculator solutions to problems solved in the text.
Be sure to preview the material at the back of your text.
There are six appendices, labeled AF, that contain some
very useful interest tables, instruction on use of Microsoft
Excel (a widely used electronic spreadsheet), and answers
to selected problems. Finally, the Index refers you to page
numbers on topics you may need to review. Before beginning
your educational journey, spend some time familiarizing
yourself with your text.

OBJECTIVES
When you complete this course, youll be able to
Solve problems that involve the time value of money
Perform a basic analysis of financial statements
Describe the components of financial assets
Explain the role of a financial intermediary
Describe the role of security markets
Value debt and equity instruments
List the components of financial decision making

Instructions to Students

A STUDY PLAN
This study guide will guide you through your assignments,
and provide the best approach to building your knowledge
base in these lessons. The information, instructions, and
advice in this book will help you make the most of your
textbook. You must read this study guide and your textbook
carefully, and follow the instructions for each assignment.
The assignments in this study guide are numbered 112.
Complete all work related to Assignment 1 before moving
on to the next assignment. To complete these lessons:
1. Read the short introduction to each assignment in
the study guide.
2. Read the required sections in the textbook, and
work through the practice problems contained in
the assignment.
3. Complete the self-check in the study guide for each
assignment, and check your answers against those
provided at the back of the study guide.
4. When youve finished reading all of the assigned
textbook pages for each lesson and youre sure that
youre comfortable with the material, complete the
examination for that lesson. The lesson examinations
are contained in this study guide.
Each examination contains 20 multiple-choice questions.
Take your time as you complete each examination
theres no time limit. You may go back to your textbook
to review material at any time when youre working
on the examination. When youre finished with each
examination, submit only your answers to the school for
grading, using one of the examination answer options
provided to you. Submit your answers as soon as you
complete the examination. Dont wait until another
examination is ready to be sent.
5. Repeat these steps until all five lessons have
been completed.

Instructions to Students

Remember, you may ask your instructor for help whenever you
need it. Your instructor can answer your questions, provide
additional information, and provide further explanation of your
study materials. Contact your instructor, and he or she will
make sure you receive the needed information. Your instructors guidance and suggestions will be very helpful as you
progress through your course.
Now, look over the lesson assignments. Then, begin your
study of financial management with Lesson 1.
Good luck with your course!

Instructions to Students

Lesson 1: Key Financial Concepts


Read in this
study guide:

Read in
the textbook:

Assignment 1

Pages 818

Pages 38, 106129

Assignment 2

Pages 2025

Pages 167176, 187206

Examination 08171700

Material in Lesson 1

Lesson 2: Financial Institutions


For:

Read in this
study guide:

Read in
the textbook:

Assignment 3

Pages 3134

Pages 1033 and 5165

Assignment 4

Pages 3640

Pages 3448

Assignment 5

Pages 4244

Pages 90101

Examination 08171800

Material in Lesson 2

Lesson 3: Investments
For:

Read in this
study guide:

Read in
the textbook:

Assignment 6

Pages 5160

Pages 254280

Assignment 7

Pages 6167

Pages 283290, 214243

Assignment 8

Pages 6970

Pages 316334

Examination 08171900

Material in Lesson 3

Lesson 4: Corporate Finance, Part 1


For:

Read in this
study guide:

Read in
the textbook:

Assignment 9

Pages 7786

Pages 176187, 338372

Assignment 10

Pages 8892

Pages 436469

Examination 08172000

Material in Lesson 4

Assignments

For:

Lesson 5: Corporate Finance, Part 2


For:

Read in this
study guide:

Read in
the textbook:

Assignment 11

Pages 97105

Pages 374395

Assignment 12

Pages 107113

Pages 399429

Examination 08172100

Material in Lesson 5

Lesson Assignments

Key Financial Concepts

Welcome to Financial Management! One of the most important


components of every business operation is financial decision
making. Business decisions at all levels have some underlying
financial implications, either direct or indirect. Also, financial
concepts arise in the everyday management of your personal
resources. Its important, therefore, to understand the basics of
finance. For example, the time value of money and the analysis
of financial statements are basic components of finance that
will be used throughout the remainder of this course and in
future finance classes. Its essential that you take the time to
master these concepts. As you work your way through this
course, youll learn the importance of finance to the success
of every entity, both personal and professional.
In Lesson 1, youll learn some important fundamentals of
finance. Some of this material is analytical in nature, requiring
you to understand some mathematical calculations. Example
problems in both your textbook and study guide will help
you to master these calculations. Some of the problems can
be completed manually or with the help of tables; however,
youll find that some calculations are much easier to perform
with the aid of a financial calculator. A financial calculator is a
special type of calculator thats designed to perform specific
financial functions. A financial calculator is a useful professional tool that can be used throughout this course and in
future finance classes. If you prefer, use an electronic spreadsheet such as Microsoft Excel to perform financial calculations.
Professionals in finance generally use electronic spreadsheets
more than calculators, although they require more time to
learn. Your textbook provides instructions for both financial
calculators and spreadsheets. Youll find financial calculator
instructions starting on pages 111; Appendix E, starting on
page 587, provides instructions for using Excel. Either a
financial calculator or an electronic spreadsheet is required
to complete this course.

Lesson 1

INTRODUCTION

OBJECTIVES
When you complete this lesson, youll be able to
Explain the importance of financial decision making to
the business community
Describe the importance of financial statement analysis
Explain the concepts of compounding and future value
Discuss the concepts of discounting and present value
Calculate the present value and future value of
an annuity
Read and understand the principal components of a
balance sheet
Perform ratio calculations to determine liquidity, activity,
and profitability

ASSIGNMENT 1
Read the following assignment. Then read pages 38
and 106129 in your textbook. Be sure to complete
the self-check to gauge your progress.

The Time Value of Money


One of the most important concepts in the study of finance is
the time value of money. As this phrase implies, this concept
covers how time impacts the value of money. One dollar
today isnt equal in value to one dollar 10 years from now.
The difference in the value of these two dollars can be
explained by the time value of money.

The Future Value of a Dollar


The future value of one dollar is the amount that one dollar
will grow to at some point in the future. The process of
compounding takes into account the earning of interest on
interest, and is the process of finding the future value of
some initial amount.

Financial Management

Lets look at an example problem.


Example: Suppose you begin with $100 today and deposit it
in an account that pays 10 percent annually. How much will
you have in the account after 1 year?
Solution: The calculation is relatively simple. In this example,
youve been given three variables. The present value (PV) is
the amount you begin with, which is $100. The number of
time periods (N) is 1 year. The interest rate (I) is 10 percent
annually. The missing variable that you need to calculate is
the future value (FV), which is the value of the investment at
the end of 1 year.
You would use the following formula to calculate the future
value of the investment.
FV = PV (1 + I.)N
Substitute the known values of PV, I, and N into the formula
and solve.
FV = $100 (1 + 10 percent)1
FV = $100 (1 + 0.10)1
FV = $100 (1.10)1
FV = $100 1.1
FV = $110
Thus, the value of the $100 investment after 1 year
will be $110.
Now, lets consider the same problem over a 5-year period.
Example: Today, suppose that you deposit $100 into an
account that pays 10 percent annually. How much will you
have in the account after 5 years?
Solution: In this problem, youre given the following variables:
PV = $100
N = 5 years
I = 10 percent annually
You would again use the following formula to calculate the
future value of the investment (FV).
FV = PV (1 + I.)N
Lesson 1

Substitute the known values of PV, I, and N into the formula


and solve.
FV = $100 (1 + 10 percent)5
FV = $100 (1 + 0.10)5
FV = $100 (1.10)5
FV = $100 (1.6105)
FV = $161.05
Thus, the value of the $100 investment after 5 years will
be $161.05.
In this example problem, note that the compounding process
(the process of earning interest on interest) has produced
total interest of $61.05, which is greater than the total
simple interest of $50.

The Present Value of a Dollar


Finding the present value of a dollar is the opposite of calculating
its future value. The present value of a dollar is the amount that
a future dollar is worth today. You would calculate the present
value when you need to determine how much money to invest
today to obtain some future goal. Discounting is the process of
finding the present value of some future amount.
Lets look at another example problem.
Example: Suppose you want to know how much money to
invest today to reach a future goal of $100. You want to invest
the money for 1 year in an account that pays 10 percent interest
annually.
Solution: This calculation is relatively simple. Youve been
given the following three variables:
future value (FV) = $100
number of time periods (N) = 1 year
interest rate (I) = 10 percent annually

10

Financial Management

The missing variable that you need to calculate is the


present value (PV), which is the amount of money youll
need to invest today to reach your future goal.
You would use the following formula to calculate the present
value of the investment.
PV = FV  [(1 + I.)N.]
Next, substitute the known values of FV, I, and N into the
formula and solve.
PV = $100  [(1 + 10 percent)1]
PV = $100  [(1 + 0.10)1]
PV = $100  [1.101]
PV = $100  1.10
PV = $90.91
Thus, youll need to invest $90.91 today to have $100 after
one year.
Now, consider the same problem over a five-year period.
Example: Suppose you want to know how much money to
invest today in order to reach a future goal of $100. You
want to invest the money for 5 years in an account that
pays 10 percent interest annually.
Solution: In this problem, youre given the following
three variables.
FV = $100
N = 5 years
I = 10 percent annually
You would again use the following formula to calculate the
present value of the investment (PV).
PV = FV  [(1 + I.)N ]

Lesson 1

11

Substitute the known values of PV, I, and N into the formula


and solve.
PV = FV  [(1 + 10 percent)5]
PV = $100  [(1 + 0.10)5]
PV = $100  [(1.10)5]
PV = $100  [1.6105]
PV = $62.09
Thus, the process of discounting tells you that youll need
to invest $62.09 today. After 5 years of earning 10 percent
interest annually, your investment will have a value of $100.

The Future Value of an Annuity


An annuity is a series of equal payments made at equal time
intervals (for example, annually). An annuity thats paid
annually is called an ordinary annuity. Lets look at some
example problems that demonstrate how to calculate the
value of an annuity.
Note: The equations we provide in the study guide for
calculating the time value of annuities take a different form
than the equations in the textbook. We think youll find that
the study guide equations are simpler.
Example: What will be the future value of an ordinary
annuity after 3 years, if $100 is deposited annually and the
account earns an interest rate of 10 percent annually?
Solution: In this problem, youre given the following
three variables.
value of each payment (PMT) = $100
number of annuity payments (N) = 3 annual payments
interest rate (I) = 10 percent annually
The missing variable that you need to calculate is the future
value of the annuity (FV), which is the value of the investment
after 3 years.

12

Financial Management

You would use the following formula to calculate the future


value of the investment (FV).
FV = PMT [(1 + I.)N 1]  I
Substitute the known values of PMT, I, and N into the formula
and solve.
FV = $100 [(1 + 10 percent)3 1]  10 percent
FV = $100 [(1 + 0.10)3 1]  0.10
FV = $100 [(1.10)3 1]  0.10
FV = $100 [1.331 1]  0.10
FV = $100 0.331  0.10
FV = 33.1  0.10
FV = $331.00
Thus, the value of the annuity after 3 years will be $331.00.

The Present Value of an Annuity


Now lets examine how to calculate the present value of an
annuity, which is the amount of money youll need to invest
today to reach a future goal.
Example: What is the present value of an annuity that will
pay $100 a year, at the end of each of the next 3 years, at an
interest rate of 10 percent annually?
Solution: In this problem, youre given the following
three variables.
PMT = $100
N = 3 yearly payments
I = 10 percent annually
The missing variable that you need to calculate is the present value of the annuity (PV). You would use the following
formula to calculate PV.
PV = PMT {1 [1  (1 + I )N ] }  I

Lesson 1

13

Substitute the known values of PMT, I, and N into the formula


and solve.
PV = $100 {[1 [1  (1 + 10 percent)3]}  10 percent
PV = $100 {[1 [1  (1 + 0.10)3]}  0.10
PV = $100 {[1 [1  (1.10)3]}  0.10
PV = $100 {[1 [1  1.331]}  0.10
PV = $100 {1 0.7513}  0.10
PV = $100 0.2487  0.10
PV = 24.87  0.10
PV = $248.70
Thus, youll need to invest $248.70 today to receive payments
of $100 per year for 3 years.

Practice Problems
Now, in this section, well examine some more practice problems. Work through each of the practice problems to make
sure you understand the calculations that are represented.
Example: At 5 percent interest compounded annually, how
many years will be needed for an investment of $200 to grow
to $255?
Solution: In this problem, youre given the following
three variables.
FV = $255
PV = $200
I = 5 percent annually
The missing variable that you need to calculate is the number
of time periods (N). You would use the following formula to
calculate N.
FV = PV (1 + I )N

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Financial Management

Substitute the known values into the formula and solve for N.
$255 = $200 (1 + 5 percent)N
$255 = $200 (1 + 0.05)N
$255 = $200 (1.05)N
$255  $200 = (1.05)N
1.275 = (1.05)N
log 1.275 = N (log 1.05)
0.1055 = N (0.021189)
0.1055  0.021189 = N
4.97 = N
N = 5 years (rounded)
Example: A widow currently has a $75,000 investment
that yields 7 percent annually. Can she withdraw $15,000 a
year for the next 10 years?
Solution: This problem requires you to find the amount of
money that can be withdrawn from her account annually.
In other words, youre looking for the annuity payment for
this investment. In this problem, youre given the following
three variables.
PV = $75,000
N = 10 yearly payments
I = 7 percent annually
The missing variable that you need to calculate is the value
of each payment (PMT). You would use the following formula
to calculate PMT.
PV = PMT {1 [1  (1 + I ) N ] }  I

Lesson 1

15

Substitute the known values into the formula and solve


for PMT.
$75,000 = PMT {1 [1  (1 + 7 percent)10]}  7 percent
$75,000 = PMT {1 [1  (1 + 0.07)10]}  0.07
$75,000 = PMT {1 [1  (1.07)10]}  0.07
$75,000 = PMT {1 [1  1.9672]}  0.07
$75,000 = PMT {1 0.5083}  0.07
$75,000 = PMT 0.4917  0.07
$75,000 = PMT 7.024
$75,000  7.024 = PMT
$10,677.67 = PMT
No, she can withdraw only $10,677.67 per year for the next
10 years.
Example: Imagine that youre 30 years old and inherit
$75,000 from your grandfather. You want to invest your
inheritance and increase the total amount to $100,000
after 4 years. What compound annual interest rate of
return must you earn to achieve your goal?
Solution: This problem requires you to find the interest
rate that will produce a certain future value. Youre given
the following three variables:
FV = $100,000
PV = $75,000
N=4
You would use the following formula to calculate the interest
rate ( I ) .
FV = PV (1 + I )N

16

Financial Management

Substitute the known values into the formula and solve for I.
$100,000 = 75,000 (1 + I.)4
$100,000  75,000 = (1 + I.)4
1.3333 = (1 + I.)4
log 1.3333 = 4 log (1 + I.)
0.1248 = 4 log (1 + I.)
0.0312 = log (1 + I.)
1.075 = 1 + I
0.075 = I
I = 7.5 percent (rounded)
An interest rate of 6 percent will increase the amount of your
inheritance to $100,000 after 4 years.
Example: Suppose that you want an investment of $1,000
to double within a period of 3 years. At what annual rate of
growth must your investment increase to achieve your goal?
Solution: You need to find the interest rate that will cause
your investment of $1,000 to double to $2,000 within 3
years. Youre given the following three variables:
FV = $2,000
PV = $1,000
N=3
You would use the following formula to calculate the interest
rate ( I ).
FV = PV (1 + I )N

Lesson 1

17

Substitute the known values into the formula and solve for I.
$2,000 = $1,000 (1 + I.)3
$2,000  $1,000 = (1 + I.)3
2 = (1 + I.)3
log 2 = 3 log (1 + I.)
0.3010 = 3 log (1 + I.)
0.3010  3 = [3 log (1 + I.)]  3
0.1003 = log (1 + I.)
1.26 = 1 + I
0.26 = I
I = 26 percent
An interest rate of 26 percent will cause an investment of
$1,000 to double within 3 years.
Note that this answer will be the same no matter what
value you choose for your present value. You can prove
this to yourself if you wish by resolving the problem with a
different present value. For example, try PV = $10,000 and
FV = $20,000.

18

Financial Management

Self-Check 1
At the end of each section of Financial Management, youll be asked to pause and
check your understanding of what youve just read by completing a Self-Check.
Writing the answers to these questions will help you review what youve studied
so far. Please complete Self-Check 1 now.
Indicate whether each of the following statements is True or False.
______

1. Compounding is the process of determining the amount of simple interest on


an investment.

______

2. At an annual interest rate of 7 percent, it will take 16.2 years for an investment
of $100 to triple to $300.

______

3. The future value of one dollar increases with lower interest rates.

______

4. The future value of one dollar increases with longer periods of time.

______

5. An ordinary annuity is a series of equal payments made at the beginning of


each time period.

Complete Problems 1, 2, 4, 5, 6, 7, 9, 12, 13, 14, 15, 18, and 19 on pages 131132 in
the textbook.

Check your answers with those on page 121.

Lesson 1

19

ASSIGNMENT 2
Read the following assignment. Then read pages 167176
and 187206 in your textbook. Be sure to complete the
self-check to gauge your progress.

In this assignment, youll learn about essential financial


statements and some of the methods that are used to
analyze them. Your textbook reviews the content of the
balance sheet and the income statement, and then explores
the use of ratio analysis to reveal information about the
financial health of a firm.

Ratio Analysis
The balance sheet provides a summary of a firms assets
and liabilities. On the left-hand side of the balance sheet,
assets are catalogued in order of liquidity (that is, according
to how quickly they can be converted into cash). Liabilities
and equity are catalogued on the right-hand side of the
balance sheet in the order that theyre due.
The income statement indicates the profit or loss that a firm
achieved during the year by tallying revenues and expenses.
The income statement reveals useful information about the
financing of a firm.
In ratio analysis, the balance sheet and income statement
are examined and used to compile information about the
financial health of a firm. Ratio analysis is used both internally and externally by creditors or investors to evaluate a
firms strengths and weaknesses. A ratio analysis thats
considered over time is called a time series analysis, and a
ratio analysis that compares a firm to other firms in the
same industry is called a cross-sectional analysis.
The financial ratios used for comparisons can be grouped
into the following five categories:
1. Liquidity ratios. A liquidity ratio shows a firms ability
to convert assets into cash that can be used to pay
obligations. Liquidity ratios include the current ratio
and the quick ratio.

20

Financial Management

2. Activity ratios. An activity ratio examines the level of a


firms assets relative to their sales. Activity ratios include
inventory turnover, receivables turnover, average collection period, fixed asset turnover, and total asset turnover.
3. Profitability ratios. A profitability ratio looks at the
combined influence of sales, assets, and equity on
performance. Profitability ratios include operating profit
margin, net profit margin, gross profit margin, return on
total assets, return on equity, and basic earning power.
4. Leverage ratios. A leverage ratio communicates information about the level of debt compared to assets. Leverage
ratios include the debt/net worth ratio and the total
debt ratio.
5. Coverage ratios. A coverage ratio reveals the relationship
between operating income and expenses. Coverage ratios
include the times-interest-earned ratio.

Practice Problems
Now, lets look at some example ratio problems.

Cash

$125,000

Accounts receivable

$295,000

Inventory

$398,000

Current liabilities

$415,000

Long-term debt

$595,000

Equity

$577,000

Example: Given the following information, calculate the


current ratio and the quick ratio.
Solution: Use the following formula to calculate the
current ratio.
current ratio = current assets  current liabilities

Lesson 1

21

Substitute the known values into the formula and solve.


current ratio = ($125,000 + $295,000 + $398,000)
 $415,000
current ratio = $818,000  $415,000
current ratio = 1.97
Use the following formula to calculate the quick ratio.
quick ratio = (current assets inventory)  current liabilities
Substitute the known values into the formula and solve.
quick ratio = ($818,000 $398,000)  $415,000
quick ratio = $420,000  $415,000
quick ratio = 1.01
Example: Given the following information about a firm,
calculate the firms sales, total assets, total asset turnover,
and total debt.

Net Income

$300,000

Debt ratio (debt/total assets)

55%

Return on assets

26%

Net profit margin

17%

Solution: Use the following formula to calculate sales.


sales = net income  net profit margin
Substitute the known values into the formula and solve.
sales = $300,000  17 percent
sales = $300,000  0.17
sales = $1,764,706

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Financial Management

Use the following formula to calculate total assets.


total assets = net income  return on assets
Substitute the known values into the formula and solve.
total assets = $300,000  26 percent
total assets = $300,000  0.26
total assets = $1,153,846
Use the following formula to calculate the total asset turnover.
total asset turnover = sales  total assets
Substitute the known values into the formula and solve.
total asset turnover = $1,764,706  $1,153,846
total asset turnover = 1.53
Use the following formula to calculate total debt.
total debt = debt ratio total assets
Substitute the known values into the formula and solve.
total debt = 55 percent $1,153,846
total debt = 0.55 $1,153,846
total debt = $634,615
Example: Two firms each have sales of $1,000,000. Given
the following financial information about the two firms,
calculate the operating profit margins and the net profit
margins for the two firms. Then, calculate the return on
assets and the return on equity for the two firms. Why
are the results different for the two firms, even though they
have the same amount of sales?

Lesson 1

23

Firm 1

Firm 2

EBIT

$155,000

$155,000

Interest expense

$25,000

$80,000

Income tax

$55,000

$35,000

Debt

$425,000

$725,000

Equity

$625,000

$325,000

Solution: Use the following formula to calculate the operating


profit margin.
operating profit margin = EBIT  sales
First, find the operating profit margin for Firm 1. Substitute
the known values into the equation and solve.
operating profit margin = $155,000  $1,000,000
operating profit margin = 15.5 percent
Find the operating profit margin for Firm 2.
operating profit margin = $155,000  $1,000,000
operating profit margin = 15.5 percent
Use the following formula to calculate the net profit margin.
net profit margin = net earnings  sales
Find the net profit margin for Firm 1. Substitute the known
values into the equation and solve.
net profit margin = $75,000  $1,000,000
net profit margin = 7.5 percent
Find the net profit margin for Firm 2.
net profit margin = $40,000  $1,000,000
net profit margin = 4 percent
Both firms have the same operating profit margins15.5
percent. The difference in the net profit margin is the result
of Firm 2 paying more interest than Firm 1.

24

Financial Management

Use the following formula to calculate the return on assets.


return on assets = earnings  assets
Find the return on assets for Firm 1. Substitute the known
values into the equation and solve.
return on assets = $75,000  $1,000,000
return on assets = 7.5 percent
Find the return on assets for Firm 2.
return on assets = $40,000  $1,000,000
return on assets = 4 percent
Use the following formula to calculate the return on equity.
return on equity = earnings  equity
Find the return on equity for Firm 1. Substitute the known
values into the equation and solve.
return on equity = $75,000  $625,000
return on equity = 12 percent
Find the return on equity for Firm 2.
return on equity = $40,000  $325,000
return on equity = 12.3 percent

Lesson 1

25

Self-Check 2
Indicate whether each of the following statements is True or False.
______

1. The larger the debt ratio, the riskier a firm becomes.

______

2. Paid-in capital is considered to be a current asset.

______

3. Liabilities are equal to assets minus equity.

______

4. The more rapidly receivables turn over, the more rapidly the firm is receiving cash.

______

5. The larger the debt ratio, the more equity a firm is using.

______

6. Liabilities are equal to equity minus assets.

Complete Problems 1, 2, 8, 10, and 13 on pages 207209 in the textbook.

Check your answers with those on page 124.

26

Financial Management

EXAMINATION NUMBER:

08171700
Whichever method you use in submitting your exam
answers to the school, you must use the number above.
For the quickest test results, go to
http://www.takeexamsonline.com
When you feel confident that you have mastered the material in
Lesson 1, go to http://www.takeexamsonline.com and submit
your answers online. If you dont have access to the Internet,
you can phone in or mail in your exam. Submit your answers for
this examination as soon as you complete it. Do not wait until
another examination is ready.
Questions 120: Select the one best answer to each question.

1. A current ratio is presently 2 : 1 for a corporation that sells


sporting goods. Which of the following statements about
the ratio is correct?
A. The quick ratio is smaller than the current ratio.
B. The current ratio is unaffected by exchanging bonds
for stock.
C. The current ratio is increased by purchasing a store with
cash, with potential to increase corporate sales.
D. The current ratio is unchanged by using cash to retire
accounts payable.
2. Accountants suggest that assets should be valued at
A.
B.
C.
D.

cost.
the lower of market or cost.
market.
the higher of market or cost.

Examination

Lesson 1
Key Financial Concepts

27

3. If annual interest rates are 10 percent, which of the following values will be the lowest?
A.
B.
C.
D.

The future value of a $100 investment after 3 years


The future value of an investment after 4 years, if $100 is deposited annually
The present value of an investment that will be worth $100 after 2 years
The present value of an annuity that will pay $200 a year, at the end of each of the
next 4 years

4. If $800 is deposited in a savings account that pays an interest rate of 5 percent


annually, how much money will be in the account after 15 years?
A. $1,663
B. $1,609

C. $384
D. $238

5. Profitability ratios are used to measure


A. liquidity.
B. leverage.

C. performance.
D. turnover.

6. If the interest rate on an account is 8 percent annually, what is the present value of
$40,000 to be received 5 years from today?
A. $6,188
B. $10,018

C. $22,073
D. $27,223

7. Which of the following is calculated by adding total liabilities plus equity?


A. Total assets
B. Hidden assets

C. Inventory
D. Operating income

8. What is the future value of an ordinary annuity if you deposit $500 per year for the
next 10 years in an account that earns an interest rate of 13 percent annually?
A. $1,700
B. $5,000

C. $9,210
D. $14,990

9. At an interest rate of 20 percent compounded annually, how many years will it take for
an investment of $6,000 to grow to $10,000?
A. 1 year
B. 3 years

C. 5 years
D. 7 years

10. Which of the following types of ratio is used to measure activity?


A. A leverage ratio
B. A turnover ratio

28

C. A profitability ratio
D. A liquidity ratio

Examination, Lesson 1

11. If you deposit $700 in an account today, and the money grows to $1,800 in 14 years,
what rate of annual interest have you earned?
A. 4 percent
B. 7 percent

C. 10 percent
D. 50 percent

12. Which of the following is considered to be a current liability?


A.
B.
C.
D.

Work-in-process
Raw materials
Accounts payable
Short-term money market instruments

13. Which of the following would be the most likely cause of an increase in
inventory turnover?
A.
B.
C.
D.

The faster collection of accounts receivable


Lowered sales
An increase in the inventory level
A reduction in the price of the product

14. What is the future value of an ordinary annuity if you deposit $1,500 per year for the
next 5 years into an account that earns an interest rate of 5 percent annually?
A. $8,288
B. $7,500

C. $6,322
D. $1,914

15. Which of the following is calculated by subtracting the cost of goods sold and administrative expense from net sales?
A. Operating income
B. Accounts receivable

C. Total liabilities
D. Inventory cost

16. If an account has an annual interest rate of 12 percent, what is the present value of
$1,000,000 to be received 10 years from today?
A. $3,105,848
B. $789,633

C. $321,973
D. $56,984

17. If an account currently has a value of $84,000 and earns an interest rate of 4 percent
annually, for how many years can you withdraw $10,000 from the account?
A. 8
B. 10

C. 12
D. 20

18. If you deposit $10,000 in an investment that yields 6 percent annually, how many
years will it take for your investment to double in value?
A. 12 years
B. 15 years

Examination, Lesson 1

C. 18 years
D. 20 years

29

19. Discounting determines the worth of funds to be received in the future in terms of their
A.
B.
C.
D.

present value.
future value.
cost factor.
time factor.

20. If annual interest rates are 10 percent, which of the following values will be
the greatest?
A.
B.
C.
D.

30

The future value of an annuity after 4 years, if $100 is deposited annually


The future value of a $100 investment after 3 years
The present value of an investment that will be worth $100 after 2 years
The present value of an annuity that will pay $200 a year, at the end of each
of the next 4 years

Examination, Lesson 1

Financial Institutions

In Lesson 2, youll learn about the components of the financial


environment and the role of financial intermediaries within
that environment. Youll also study security markets and the
procedures that are used to trade securities, such as stocks
and bonds.

OBJECTIVES
When you complete this lesson, youll be able to
Explain the role of money in the world economy
List the main components of the money supply
Describe how the term structure of interest rates is
illustrated by yield curves
Explain the role of financial intermediaries in the
transfer of funds
List the main functions of life insurance and
pension plans
Explain how stocks are purchased on margin
Convert currency values by using foreign exchange rates
Describe the role of the International Monetary Fund

ASSIGNMENT 3
Read the following assignment. Then read pages 1033
and 5165 in your textbook. Be sure to complete the selfcheck to gauge your progress.

Lesson 2

INTRODUCTION

31

The Role of Money and Interest Rates


Every day, we use money to buy or transfer goods and services.
At one time, the transfer of goods and services was facilitated
by a barter system, in which two individuals would negotiate
the exchange of one good for another. However, because
each of these transactions involved a negotiation process,
the system was rather inefficient.
Money in the form of coins and paper currency evolved as a
means to reduce this inefficiency. Rather than barter one
good for another, any good could simply be exchanged for
money. Money doesnt have to be in the form of coins or
paper currency; however, these forms are the most widely
accepted means of trade.
Money has the following four general functions.
1. Money acts as a medium of exchange.
2. Money acts as a store of value.
3. Money acts as a unit of account.
4. Money acts as a standard of deferred payment.
The total supply of money in circulation in the United States
(the money supply) is considered to be an indicator of economic conditions and is watched by many groups of people.
The traditional measure of the money supply is called M-1,
and includes the sum of all coins and currency in circulation,
plus checking and savings account deposits, generally called
demand deposits. A broader definition of the money supply is
called M-2, and includes coins, currency, demand deposits,
savings accounts, and certificates of deposit.
You can think of interest as a type of rent thats paid on
borrowed money. In other words, when you deposit money
into an account, the bank pays you rent (interest) for the use
of that money. The higher the interest that the bank pays,
the more likely youll be to deposit your money in an account.
On the other hand, higher borrowing rates reduce the use of
credit, because the rent becomes more expensive.
A persons willingness to lend money to a bank is partially
dependent on the interest rates paid. As a student of finance,
you should also be aware of the relationship between interest
rates and time. Debt instruments are classified in terms of

32

Financial Management

length to maturity, or the time left until the obligation must


be repaid. A short-term debt instrument generally has
a maturity of one year or less, while a long-term debt
instrument has a maturity of more than one year. Some
classifications also include the intermediate-term debt
instrument, which generally has a maturity of between one
and ten years.
Its important to remember that as the years go by, the term
of a debt instrument changes from long-term to short-term.
Therefore, theres a relationship between interest rates and
time. This relationship is classified by the term structure of
interest rates and can be depicted by a yield curve. An upwardsloping yield curve (such as the one shown on page 21 in your
textbook) shows a positive relationship between interest rates
and time. In other words, this relationship indicates that
investors require higher interest to invest in longer-maturity
instruments. While this is the more common relationship, the
yield curve could also be downward sloping, in which longterm interest rates are lower than short-term interest rates.
Businesses, individuals, and governmental units all require
the use of money. Financial markets exist to ease the exchange
of money between lenders and borrowers. The exchange of
money comes in many different forms, such as stocks,
bonds, bank deposits, and government bonds. All of these
instruments transfer money from one party to another.
The primary market is the market for the sale of new securities.
An example of a security sold in the primary market to the
general public would be an initial public offering (IPO), which
is a first issue of common stock. The market for buying and
selling previously issued securities is referred to as the
secondary market.

Financial Intermediaries
Commercial banks (a type of financial intermediary) exist to
facilitate transactions in financial markets. Commercial banks
qualify as financial intermediaries because they mediate the
transfer of resources. This transfer occurs from someone
with funds to lend to someone in need of funds. The bank,
as intermediary, eliminates some of the risk inherent in a

Lesson 2

33

direct transfer of funds between lender and borrower. For


instance, if a lender makes a loan directly to a borrower and
the borrower then fails to pay back the loan, the lender will
suffer a loss. The loss could have been avoided if the lender
had deposited the money with a financial intermediary rather
than making the direct loan. When a loan is deposited with a
financial intermediary and the borrower fails to pay it back,
the intermediary bears the loss. In addition, lenders are generally protected from the financial intermediarys failures,
since most bank deposits are insured by the Federal Deposit
Insurance Corporation (FDIC).
Other companies (such as life insurance companies, pension
plans, and investment companies) also provide services to
investors by creating savings instruments and then lending
the collected funds. Keep in mind that these companies
arent necessarily financial intermediaries. For example, an
investment company is a financial intermediary only if it
buys instruments issued on the primary market.

34

Financial Management

Self-Check 3
Indicate whether each of the following statements is True or False.
______

1. A general decline in prices also decreases the value of money.

______

2. Stocks and bonds are a substitute for money as a store of value.

______

3. A financial intermediary stands between the ultimate borrowers and lenders and
converts a claim on the lender to the one thats acceptable to the borrower.

______

4. The most important financial intermediary is the pension plan.

______

5. By facilitating the transfer of savings into investments, financial intermediaries


increase the level of economic activity.

______

6. Money market mutual funds invest in long-term securities. (Note: Long-term


indicates a period of more than 1 year.)

______

7. An asset is liquid if it can easily be converted into cash without loss.

______

8. Money is considered to have value because it can be used to buy goods


and services.

Answer each of the following questions in one paragraph:


9. How does underwriting shift risk away from the securities issuer and to the
investment banker?
10. What essential function is served by both commercial bankers and investment bankers?
Explain your answer.
11. Identify at least two factors contributing to the slope of the yield curve.
12. Support or refute this statement: Life insurance companies and commercial banks transfer
money from savers to users.
Check your answers with those on page 126.

Lesson 2

35

ASSIGNMENT 4
Read the following assignment. Then read pages 3448 in
your textbook. Be sure to complete the self-check to gauge
your progress.

The Role of Securities Markets


Many investment instruments are bought and sold in securities
markets. Keep in mind that a securities market distributes
securities among investors. However, a securities market isnt
considered to be a financial intermediary, because securities
markets dont facilitate the transfer of funds between savers
and borrowers.
Now, lets take a closer look at some of the important
terminology that relates to the securities market.

Securities Exchanges
Once a security has been issued on the primary market, it
may be sold again in the secondary market on a securities
exchange. Securities may be listed on an organized exchange
or an unorganized exchange. Organized exchanges include
the New York Stock Exchange (NYSE) and the American Stock
Exchange (AMEX) as well as many smaller regional exchanges.
The unorganized exchange is a more informal market and
is called the over-the-counter market (OTC). The National
Association of Security Dealers Automated Quoting system
(NASDAQ) represents an integral part of the OTC.

Market Makers
As professional securities dealers, market makers act as principals, buying and selling securities to achieve a difference
between the cost of buying and the price for selling. In other
words, the market maker will purchase stock at a bid price and
sell the stock at the ask price. When securities dealers enter bid
and/or ask prices, they create markets for securities, because
the highest bid price and the lowest ask price for a given
security is, by definition, the market price of a security.
Thus, market price is a price range. The difference between the

36

Financial Management

two prices is called the spread on the security. OTC market


makers are called dealers, while market makers for securities
that are listed on the NYSE or AMEX are called specialists.

Brokers
Investors typically buy and sell securities through a broker. A
broker acts as an agent to execute buy and sell instructions
from investors, and receives a transaction fee or commission
in payment. Brokers generally encourage investors to buy
and sell stocks in multiples of 100 shares, which is called a
round lot (a lot of less than 100 shares is called an odd lot).
Investors may purchase or sell any quantity of a stock, even
a single share; however, a broker may charge a higher fee
for an odd lot.
When you instruct a broker to make a trade on your behalf,
youre placing an order. The following are four different types
of orders:
1. A market order instructs the broker to trade at the best
available price at the moment.
2. A limit order instructs the broker to buy or sell only
when the price hits a specific level.
3. A day order instructs the broker to terminate the order
at the close of the market if it hasnt been executed.
4. A good-till-canceled order instructs the broker to cancel
the order only when instructed to do so by the investor.

Buying on Margin
Investors can borrow money from the brokerage house to
pay for a security, or buy a security on margin. The Federal
Reserve Board requires that the investor maintain a minimum balance of total equity, or a margin requirement.
Lets look at an example problem that illustrates how margin
requirements work. This is Problem 6 from page 50 in
your textbook.
Example: Barbara buys 100 shares of DEM at $35 a share
and 200 shares of GOP at $40 a share. She buys on margin
and the broker charges interest of 10 percent.

Lesson 2

37

Part A: If the margin requirement is 55 percent, what is the


maximum amount she can borrow?
Solution: Calculate the value of Barbaras total portfolio.
100 shares of DEM at $35 = $3,500
200 shares of GOP at $40 = $8,000
$3,500 + $8,000 = $11,500
Remember that the margin requirement represents the amount
of equity that Barbara must maintain. Therefore, if the margin
requirement is 55 percent, Barbara will maintain a minimum
of 55 percent of the equity in her portfolio.
equity = 55 percent of $11,500
equity = 0.55 $11,500
equity = $6,325
This means that she can borrow $11,500 $6,325,
or $5,175.
Part B: If Barbara buys the stock using the borrowed
money and holds the stock for 1 year, how much interest
must she pay?
Solution: If Barbara borrows the full amount, she will
incur an interest expense of 10 percent of the amount
borrowed. You can calculate this amount as follows:
interest = 10 percent of amount borrowed
interest = 0.10 $5,175
interest = $517.50
Part C: After 1 year, if she sells DEM for $29 a share and GOP
for $32 a share, how much did she lose on her investment?
Solution: First, calculate the total price of the shares sold.
100 shares of DEM at $29 = $2,900
200 shares of GOP at $32 = $6,400

38

Financial Management

To calculate the loss on DEM, subtract the total selling price


from the original cost.
loss on DEM = $3,500 $2,900
loss on DEM = $600
Calculate the loss on GOP in the same way.
loss on GOP = $8,000 $6,400
loss on GOP = $1,600
Add the DEM loss and the GOP loss together to calculate the
total loss.
total loss = $600 + $1,600
total loss = $2,200
Part D: What is the percentage loss on the funds she invested
if the interest payment is included in the calculation?
Solution: Add the total loss to the interest, and divide by
the equity.
percentage loss on margin = ($2,200 + $517.50) 
$6,325
percentage loss on margin = $2,717.50  $6,325
percentage loss on margin = 0.429, or 43 percent

Selling Short
The old adage of buy low and sell high assumes that an
investor is taking the long position (that is, that the investor
believes that a stock price will rise in the future). Another
possibility is to sell high and buy low by taking the short
position. An investor takes a short position on a stock if he or
she thinks that the stock price will fall in the future. To sell
short, you sell first by borrowing shares from your broker. If
the stock price falls, you then buy the stock at a lower price
and give the shares back to your broker at the original price
(with interest). If the stock price rises, youll have to buy the
stock at a price thats higher than what you sold it for in
order to return the shares.

Lesson 2

39

For example, suppose Leonard sells short 100 shares of MBI


at $100 per share. He borrows 100 shares from his broker
and sells them for $10,000 (100 $100). If the price of MBI
drops to $80 per share, Leonard can buy 100 shares for
$8,000 (100 $80) and return them to his broker. Leonard
has made a profit of $2,000. Of course Leonard will have to
pay interest for borrowing the shares.

40

Financial Management

Self-Check 4
Indicate whether each of the following statements is True or False.
______

1. The American Stock Exchange is an example of a secondary market.

______

2. A purchase of 50 shares is an example of an even lot.

______

3. The use of margin increases the potential return on an investment in stock.

______

4. If an individual establishes a short position and security prices rise, the


investor sustains a loss.

______

5. Over-the-counter stock quotes are obtained through the SEC.

______

6. The larger the margin requirement, the larger the level of equity in the account.

Complete Problems 3, 4, and 5 on pages 4950 in your textbook.

Check your answers with those on page 127.

Lesson 2

41

ASSIGNMENT 5
Read the following assignment. Then read pages 90101 in
your textbook. Be sure to complete the self-check to gauge
your progress.

In Assignment 3, you learned how important money is to the


efficient exchange of goods and services. Money can take the
form of many different currencies. Realize that whenever you
purchase something that was produced in another country,
the currency of that country is used at some point to make
the transaction. This requires an exchange of currencies.
In this assignment, youll learn about the foreign exchange
marketthe markets in which different types of currency are
bought and sold.

Exchange Rates
The value of one currency, relative to the value of another
currency, is called an exchange rate. For example, if one
U.S. dollar can buy 100 Japanese yen, then the exchange
rate is 100 yen per dollar. The exchange rate could also be
expressed in terms of dollars per yen by calculating the
reciprocal. So, 100 yen per dollar is equivalent to $0.01
per yen (or 1 cent per yen).
You can think of the exchange rate as the price of the U.S.
dollar in terms of another currency. That price is determined
by supply and demand for the U.S. dollar (just as any other
price is determined). The greater the demand for dollars, the
higher the price will be. If the value of the dollar rises in
terms of another currency, it will be revalued. Foreign goods
will be cheaper as the dollar can be exchanged for more
units of the foreign currency. If the dollar buys less of a foreign currency (making foreign goods more expensive), it will
be devalued.
Exchange rate movements and currency flows are monitored by
the International Monetary Fund (IMF). Countries are able to
borrow currency from the IMF to reduce a currency imbalance.

42

Financial Management

Many firms conduct business in both their home country and


in foreign countries. These businesses are called multinational
firms. Foreign investment can have both a positive and negative
impact on a companys riskiness. Diversifying business to
foreign countries can lessen the impact of the economic turmoil
in a firms home country. On the other hand, political factors,
regulation, foreign economic fluctuations, and exchange rate
changes may all increase a firms risk exposure.

Practice Problems
Now, lets look at some practice problems involving
exchange rates.
Example: If the price of a British pound is $1.50, then
$1.50 will buy one British pound. What is the price of the
dollar in terms of the pound?
Solution: To find the price of a dollar in terms of the
pound, calculate the reciprocal.
price of the dollar = 1 dollar  price of the pound
price of the dollar = 1  1.50
price of the dollar = 0.667
Therefore, 0.667 pounds are necessary to buy one dollar.
Example: If the value of a French euro is $1.43, then $1.43
will buy one French euro. What is the price of the dollar in
terms of the euro?
Solution: To find the price of a dollar in terms of the euro,
calculate the reciprocal.
price of the dollar = 1 dollar  price of the euro
price of the dollar = 1  1.43
price of the dollar = 0.6992
Therefore, 0.6944 euros are necessary to buy one dollar.

Lesson 2

43

Example: Last year, a U.S. firm had inventory in London


valued at 600,000 pounds. At the time, one pound had a
value of $1.50. If the value of the pound were to strengthen
against the U.S. dollar from $1.50 per pound to $1.75 per
pound and the inventory continued to be worth 600,000
pounds, what would be the gain or loss in U.S. dollars as
a result of the change in the exchange rate?
Solution: In this example, the pound has revalued, or its
value has risen in terms of the dollar. First, calculate the
value of the inventory in U.S. dollars at the previous
exchange rate.
inventory value = 600,000 pounds $1.50 per pound
inventory value = $900,000
Next, calculate the value of the inventory in dollars at the
revised exchange rate.
inventory value = 600,000 pounds $1.75 per pound
inventory value = $1,050,000
To calculate the change in the inventory value, subtract the
old value from the new value.
change in inventory value = $1,050,000 $900,000
change in inventory value = $150,000
Therefore, at the revised exchange rate, the inventory gained
a value of $150,000 in U.S. dollars.

44

Financial Management

Self-Check 5
Indicate whether each of the following statements is True or False.
______ 1. The demand for foreign goods implies supplying the domestic currency.
______ 2. If a nations currency rises in value, foreigners can purchase more of that
nations output.
______ 3. The devaluation of one currency implies a revaluation of other currencies.
______ 4. If the American dollar is devalued, American goods are more expensive to people
holding dollars.
______ 5. The International Monetary Fund may lend currency reserves to a nation with a deficit
in its merchandise trade balance.
______ 6. The political climate abroad will affect the risk associated with foreign investments.
Complete Problems 1, 2, and 3 on page 102 in your textbook.

Check your answers with those on page 128.

Lesson 2

45

NOTES

46

Financial Management

EXAMINATION NUMBER:

08171800
Whichever method you use in submitting your exam
answers to the school, you must use the number above.
For the quickest test results, go to
http://www.takeexamsonline.com

When you feel confident that you have mastered the material in
Lesson 2, go to http://www.takeexamsonline.com and submit
your answers online. If you dont have access to the Internet,
you can phone in or mail in your exam. Submit your answers for
this examination as soon as you complete it. Do not wait until
another examination is ready.
Questions 120: Select the one best answer to each question.

1. A financial intermediary transfers


A.
B.
C.
D.

savings to households.
savings to borrowers.
stocks to brokers.
new stock issues to buyers.

2. If an individual buys stock on margin and its price rises,


the investor
A.
B.
C.
D.

must put up additional collateral.


must pay tax on the unrealized gain.
must pay interest on the borrowed funds.
may take delivery of the stock.

Examination

Lesson 2
Financial Institutions

47

3. Which of the following best explains why commercial banks assume significant liabilities?
A.
B.
C.
D.

All commercial bank deposits are liabilities.


The loans commercial banks write can be risky.
Banks may pay too much interest on their deposits.
Banks may not charge enough interest on their loans to fund
operations and loan default risk.

4. Which of the following best explains a potential disadvantage of leaving securities in


street name?
A. Securities held in street name become the property of the custodian and the
customer is only beneficiary of the securities.
B. Correspondence sent by securities issuers may not be forwarded to brokerage
clients who own securities held in street name.
C. Securities held in street name cant be quickly purchased or sold.
D. In the event of class action suits against securities issuers, the custodian, not the
beneficial owner (customer), is the only party that may benefit from court orders.
5. Which of the following assets is the most liquid?
A.
B.
C.
D.

Money and antiques


Bonds and real estate
Savings accounts and checking accounts
Stocks and bonds

6. When investing in securities, an investor may place a limit order that


A.
B.
C.
D.

limits the amount of commissions.


specifies when the stock will be purchased.
establishes the exchange on which the security is to be bought or sold.
states a price at which the investor seeks to buy or sell the stock.

7. Terry buys 100 shares of XYZ stock on margin at $20 per share. If the margin requirement is 45 percent, the interest rate is 10 percent, and he holds the security for 1
year, how much interest must he pay?
A. $2,000
B. $200

C. $110
D. $90

8. The reserves of commercial banks must be held against


A. the bank as equity.
B. losses.

C. savings deposits.
D. commercial loans.

9. Which of the following statements about specialists is correct?


A.
B.
C.
D.

48

A
A
A
A

specialist
specialist
specialist
specialist

stresses one type of investment.


buys only stock.
analyzes corporate securities.
makes a market in securities.

Examination, Lesson 2

10. The term structure of interest rates involves the relationship between
A. risk and yields.
B. yields and bond ratings.

C. term and yields.


D. stock and bond yields.

11. A stock is currently selling for $36 a share. What is your gain/loss if you sell the stock
short and the price rises to $62?
A. You would lose $26 per share.
B. You would gain $26 per share.

C. You would gain $13 per share.


D. You would lose $6 per share.

12. Which of the following is indicated by an upward-sloping yield curve?


A.
B.
C.
D.

Lower prices for short-term maturity


Higher prices for long-term maturity
Lower interest rates for long-term maturity
Higher interest rates for long-term maturity

13. Which of these statements best describes the function of a preliminary prospectus?
A. A preliminary prospectus is the document that registers a new security issue with
the Securities and Exchange Commission (SEC) and on which the SEC bases its
approval or disapproval of the issue for the general investing public.
B. A preliminary prospectus informs the investing public about many of the terms of a
proposed new security offering.
C. A preliminary prospectus announces to the SEC and the investing public the terms
of a new public issue, including the issuers planned use of the proceeds of the sale
and the proposed price of the issue.
D. A preliminary prospectus, or red herring, serves to provide both valid information
about the proposed issue and conflicting information designed to confuse potential
purchasers of the issue.
14. Which of the following statements about pension plans is correct?
A. A pension plan that grants mortgage loans is an example of a
financial intermediary.
B. A pension plan that grants mortgage loans cant suffer losses.
C. A pension plan that grants mortgage loans is called a savings and loan association.
D. A pension plan that grants mortgage loans isnt an example of a
financial intermediary.
15. Money market mutual funds invest in
A.
B.
C.
D.

corporate bonds.
corporate stock.
federal government treasury bills.
federal government bonds.

Examination, Lesson 2

49

16. Entering an order to sell stock at $17 when the bid is $18$19 is an example of a
A. market order.
B. short sale.

C. margin payment.
D. limit order.

17. Which of the following statements about organized security markets is correct?
A.
B.
C.
D.

Organized
Organized
Organized
Organized

security
security
security
security

markets
markets
markets
markets

are examples of financial intermediaries.


transfer resources from savers to borrowers.
provide secondary markets.
arent subject to regulation.

18. The minimum margin requirement is established by


A. brokerage firms.
B. Congress.

C. the SEC.
D. the Federal Reserve.

19. If an investor sells short, then he or she


A. buys an odd lot of a security.
B. sells securities from his or her portfolio.

C. anticipates a price increase.


D. anticipates a price decrease.

20. Which of the following is a federally insured investment?


A.
B.
C.
D.

50

A savings account in a national commercial bank


A certificate of deposit in excess of $100,000
A life insurance policy
Commercial bank assets

Examination, Lesson 2

Investments
As you work through Lesson 3, youll learn about the basic
types of marketable securities, stocks, and bonds. Youll
study the institutional characteristics of these securities,
as well as valuation techniques.

OBJECTIVES
When you complete this lesson, youll be able to
List the features of several different types of bonds
Calculate the price of a bond
Compare and contrast preferred stocks with bonds
Calculate the value of a preferred stock
Determine whether a stock is undervalued or overvalued
List some of the costs and benefits associated with
investing in mutual fund companies

ASSIGNMENT 6
Read the following assignment. Then read pages 254280 in
your textbook. Be sure to complete the self-check to gauge
your progress.

Bonds
Bonds represent a significant portion of the total value of
traded securities. Issuers of bonds are called borrowers,
while investors are called lenders. Bonds are issued by
many different entities, including the federal government,
local governments, and corporations.
A bond has the following general features:
A principal or par value

Lesson 3

INTRODUCTION

A coupon rate
A maturity date
An indenture
51

Lets take a closer look at these features.


First, a bonds principal or par value is the value to be
paid at maturity. Corporate bonds generally have a par
value of $1,000.
Investors who buy bonds receive interest payments called
coupon payments. The interest or coupon rate is the
percentage of par that the issuer pays on an annual basis.
While the coupon rate is based on the annual interest paid,
coupon payments are generally made on a semiannual basis
(twice a year).
The maturity date is the date when the principal is to be paid
to the investor. Bonds generally have an original maturity of
between 10 years and 30 years. Bonds with a maturity of
more than one year are considered to be long-term debt
instruments.
The legal contract in which the terms of a bond are stated
is called the indenture. The indenture serves a number of
important purposes. First, the indenture defines the par
value, coupon rate, and maturity of a bond. Second, the
indenture specifies information about acceptable methods
for bond retirement.

Types of Bonds
Many different types of corporate bonds exist, with varying
levels of risk assigned to them by third-party bond-rating
agencies. Risk is an important consideration in any investment
opportunity. All bonds are subject to some type of risk. For
example, theres the risk that the issuer will default, or not
pay the coupon payments. Theres also the risk that the issuer
wont be able to repay the principal. Because the value of a
bond is dependent on economic conditions (such as prevailing
interest rates), interest rate risk is an important consideration.
Different types of bonds impose varying risk exposure.
Lets take a closer look at some common types of bonds.
A mortgage bond is a bond whose payments are backed
by real assets; thus, a mortgage bond offers some
risk protection.
A debenture is a bond that isnt backed by any collateral.

52

Financial Management

A subordinated debenture is a bond that, in the event of


bankruptcy, is paid off only after other obligations have
been paid.
An equipment trust certificate is a bond issued to fund
equipment, and is subsequently backed by that equipment.
An income bond is a bond whose coupon payments are
made only if the issuers earnings reach a designated level.
A zero-coupon bond is a bond that pays principal back at
maturity; however, no interest is paid during the time
leading up to maturity. These bonds generally sell at a
discount, or at a value thats less than the principal.
A variable rate bond is a bond whose coupon payments
periodically adjust with changes in current interest rates.
A convertible bond offers investors the option of
exchanging the bond for the companys common stock.
A Eurobond is a bond denominated in a firms home
currency, but issued in a foreign country.
A government bond is issued by a federal, state, or local
government. Treasury bills (T-bills) are obligations of the
U.S. Treasury that mature in one year or less. Treasury
bonds (T-bonds) are issued by the federal government,
mature in 10 years or more, and are generally considered
default risk-free. This is because the federal government
is likely to have the funds available to pay interest and
return principal.
State and local governments can issue municipal or
tax-exempt bonds. These bonds have the advantage of
paying interest thats exempt from federal income tax.
A junk bond is a bond thats below investment grade.
Several rating agencies evaluate corporate bonds, including Moody and Standard and Poor. These ratings provide
information about a junk bonds level of default risk, and
rate them on a quality scale.

Lesson 3

53

The Price (Value) of a Bond


The value of any security is the present value of all expected
future cash flows. With a bond, there are two types of future
cash flows to consider: the coupon payments and the repayment of principal. Earlier in this course, you learned that an
annuity is a series of equal payments. With a bond, the coupon
payments can be considered to be a type of annuity. The
repayment of the principal is a one-time event at maturity,
and thus is considered to be a lump-sum payment.
The value of a bond can be calculated by using the manual
formula on page 272 of your textbook. However, since many
bonds have a maturity of 30 years, the manual calculation
can be a very lengthy process. The calculation is much easier
with the aid of a financial calculator.
Lets look at an example problem.
Example: A 30-year, $1,000 bond has a 10 percent coupon
rate. Find the value or price of the bond if the coupon is paid
annually and competitive bonds yield 8 percent.
Solution: The following values are provided in the problem.
FV = the principal or par value = $1,000
N = number of annual coupon payments = 30
I = the yield = 8 percent
PMT = coupon payment = $100 ($1,000 0.10)
PV = value or price of the bond (the missing variable)
Using a financial calculator to solve the problem, the value of
PV is found to be $1,225.16. Notice that the answer is a
negative value. Its important that the coupon payment (PMT)
and the principal (FV) have the same sign when you enter
them into your calculator. In this case, both the coupon and
the principal values are expected to be received in the future,
so the values are positive. The value (PV) is the price of the
bond and is negative.
Now, consider the same problem with semiannual
coupon payments.

54

Financial Management

Example: A 30-year, $1,000 bond has a 10 percent coupon


rate. Find the value or price of the bond if the coupon is paid
semiannually and competitive bonds yield 8 percent.
Solution: As you did when you solved the time value of
money problems earlier in the course, you must adjust the
number of payments (N), the interest rate (I), and the payment
(PMT) to reflect the semiannual coupon. The following values
are the result.
FV = the principal or par value = $1,000
N = number of semiannual coupon payments = 60
(30 years 2 payments per year)
I = the yield = 4 percent (8 percent  2)
PMT = $50 ($100  2)
PV = price of the bond (the missing variable)
Using a financial calculator to solve the problem, the value
of PV is found to be $1,226.23. Notice that the values for
annual and semiannual compounding arent equal.

Practice Problems
Lets look at some example problems that illustrate some
bond calculations. The first example is Problem 4 from
page 281 in your textbook.
Example: Blackstone, Inc. has a five-year bond outstanding
that pays $60 annually. The face value of each bond is
$1,000, and the bond sells for $890.
Part A: What is the bonds coupon rate?
Solution: The coupon rate is defined by the interest the
issuer pays on an annual basis. Here, the issuer pays $60
annually, so the coupon is $60.
coupon rate = coupon  par value
coupon rate = $60  $1,000
coupon rate = 0.06, or 6 percent

Lesson 3

55

Part B: What is the current yield?


Solution: To find the current yield, divide the coupon by
the price.
current yield = coupon  price
current yield = $60  $890
current yield = 6.74 percent
Part C: What is the yield to maturity?
Solution: Without a financial calculator, trial and error
would be used to find the YTM. However, the calculation
is simpler with the aid of a financial calculator. You would
use the following values to make the calculation.
PV = $890
FV = $1,000
PMT = $60
N=5
I=?
Using these values, the value of I is found to be 8.81 percent.
The next example is Problem 8 from page 282 in your textbook.
Example: Bond A has the following terms:
Coupon rate: 10 percent
Principal: $1,000
Term to maturity: 8 years
Bond B has the following terms:
Coupon rate: 5 percent
Principal: $1,000
Term to maturity: 8 years

56

Financial Management

Part A: What should be the price of each bond if interest


rates are 10 percent?
Solution: Use a financial calculator and the following values
to calculate the price of Bond A.
FV = $1,000
PMT = $100 (PMT = coupon = annual interest)
N=8
I = 10 percent
PV = ?
Using these values, the value of PV is found to be $1,000.
Use a financial calculator and the following values to calculate
the price of Bond B.
FV = $1,000
PMT = $50 (PMT = coupon = annual interest)
N=8
I = 10 percent
PV = ?
Using these values, the value of PV is found to be $1,000.*
Part B: What will be the price of each bond if, after 5 years
have elapsed, interest rates are 10 percent?
Solution: Use a financial calculator and the following values
to calculate the price of Bond A after 5 years.
FV = $1,000
PMT = $90 (PMT = coupon = annual interest)
N=3
I = 10 percent
PV = ?
Using these values, the value of PV is found to be $733.25.*
*Some calculators will show outflow as a negative number.

Lesson 3

57

Use a financial calculator and the following values to calculate


the price of Bond B after 5 years.
FV = $1,000
PMT = $50 (PMT = coupon = annual interest)
N=3
I = 9 percent
PV = ?
Using these values, the value of PV is found to be $899.
Part C: What will be the price of each bond if, after 8 years
have elapsed, interest rates are 8 percent?
Solution: Use a financial calculator and the following values
to calculate the price of Bond A.
FV = $1,000
PMT = $90 (PMT = coupon = annual interest)
N=0
I = 10 percent
PV = ?
Using these values, the value of PV is found to be $1,000.
Use a financial calculator and the following values to calculate
the price of Bond B.
FV = $1,000
PMT = $50 (PMT = coupon = annual interest)
N=0
I = 9 percent
PV = ?
Using these values, the value of PV is found to be $1,000.

58

Financial Management

Bond Yields
Yield is the term bond investors use to express the investment
return available by purchasing a bond and to compare the
investment return of different bonds with similar properties,
such as risk level and maturity.
There are essentially two kinds of yields: current yield and
yield to maturity. Current yield is the annual coupon payment
divided by the price an investor pays for the bond. If a bond
costs $1,100 and it annually pays $55 in coupons, then the
current yield is ($55 / $1,100 =) 5.00%. Current yield is a
useful and simple measure of a bonds investment return.

PB =

PMT
PMT
PMT
FV

 

n
1
2
(1i ) (1i )
(1i )
(1i )n

Yield to maturity is a superior measure of bond investment


returns, because it incorporates the time value of money.
Youre already familiar with the equation, but manually calculating yield to maturity requires trial-and-error. Heres the
equation, which is used to find the present value of a bond:
To use this equation, enter the price you would have to pay to
buy the bond ( PB ), the annual coupon payments ( PMT ), and
the principal to be paid at maturity (FV), along with the number
of years in the exponent ( n). You can guess what i is and find
out if the two sides of the equation are equal, or just skip the
trial-and-error process and perform the calculation with a
financial calculator. Even better, do an Internet search for yield
to maturity calculator (without the quotes). Make sure the
Internet source is reliable to ensure the calculators accuracy.
For a given bond, current yield and yield to maturity are
usually different values. So how would you explain a difference between current yield and yield to maturity calculated on
the same bond? The answer lies in the relationship between
the price paid for the bond ( PB ) and its par value, or the principal amount paid at maturity. Unlike current yield, yield to
maturity incorporates the time value impact of buying a bond
at a premium (greater than par) or a discount (less than par).
If you buy a bond for a premium, say $1,100 for a bond with

Lesson 3

59

a par value of $1,000, then the $100 difference has time value
that renders a yield to maturity that is lower than the current
yield. That makes sense because youd expect a premium to
reduce your yield.
Likewise, if a bond trades at a discount, say $900 for a bond
with a par value of $1,000, then the $100 difference has time
value that renders a yield to maturity thats higher than the
current yield. Again, you would expect a discount to increase
your yield.

Self-Check 6
Indicate whether each of the following statements is True or False.
______ 1. If interest rates rise, the prices of existing bonds increase.
______ 2. Since bonds pay a fixed amount of interest, their prices dont fluctuate.
______ 3. If a convertible bond is converted, the firms use of financial leverage increases.
______ 4. The interest paid by municipal bonds isnt subject to federal income taxation.
______ 5. In general, if interest rates rise, the prices of existing bonds rise.
______ 6. If a company defaults on its bonds, interest continues to accrue but may not
be paid.
______ 7. Current yield provides the best measure of a bonds investment return.
Complete Problem 1 on page 281 in your textbook.

Check your answers with those on page 130.

60

Financial Management

ASSIGNMENT 7
Read the following assignment. Then read pages 283290 and
214243 in your textbook. Be sure to complete the self-check
to gauge your progress.

In Assignment 6, you learned about some of the features and


valuation techniques of long-term debt. In this assignment,
youll study some other important sources of financing for
firms, such as preferred stock and common stock.
Several different sources of financing are available to firms,
including debt (bonds) and equity. When a firm issues bonds,
the firm is borrowing money from investors. Equity securities,
on the other hand, represent ownership and provide a residual
claim on returns to investors. This means that equity investors
may receive a distribution of earnings only after all debt
obligations have been paid.
There are two fundamental forms of equity: preferred stock
and common stock. Lets take a closer look at these.

Preferred Stock
Preferred stock, while technically a form of equity, is sometimes called a hybrid security because it has the features
of both bonds and common stock. Preferred stock is similar
to debt in that it typically pays a fixed payment called a
dividend. Preferred stock is, however, a form of equity that
has a priority claim over common stock. In contrast to bonds,
the firm is required to pay the dividend on preferred stock
only if it has enough earnings.
Preferred stock dividends are typically expressed as a percentage of par value. For example, a $25 par, 6 percent issue would
pay a dividend of $1.50 each year (0.06 $25 = $1.50).
Since preferred stock has many of the same features as debt,
it follows a similar valuation procedure. If the preferred stock
has a termination date, the valuation is identical to the bond
valuation you learned about in Assignment 6.

Lesson 3

61

The following equation is used to calculate the value of


preferred stock when it has a finite life.
Pp =

Dp

+
)1

(1 + Kp

Dp

+...+
)2

(1 + Kp

Dp

+
)n

(1 + Kp

S
(1 + Kp)n

In this equation, the variable kp stands for the yield on newly


issued preferred stock (the required return); the variable Dp
stands for the fixed yearly dividend; the variable Pp stands
for the value (price) of preferred stock, or the present value
of expected future cash flows; the variable S stands for the
lump sum repaid when the stock is retired, or the future
value; and the variable n stands for the number of years
until the preferred stock is retired.
Lets look at an example problem.
Example: Suppose that a preferred stock has an annual
dividend of $6. The stock will be retired after 20 years for
$100. What is the price if the appropriate discount rate is 10
percent?
Solution: Use a financial calculator and the following values
to calculate the price of the stock.
FV = $100
PMT = $6
N = 20
I = 10 percent
Pp = ?
Using these values, the value of Pp is found to be $65.95.
If the preferred stock doesnt have a termination date, its
perpetual and can be valued as a perpetuity.
Pp = Dp  kp
In this equation, the variable kp stands for the yield on newly
issued preferred stock (the required return); the variable Dp
stands for the fixed yearly dividend; and the variable Pp
stands for the value (price) of preferred stock (the present
value of expected future cash flows).

62

Financial Management

Lets look at an example problem.


Example: Find the value of an issue of perpetual preferred
stock that pays a 7 percent dividend if the par value is
$100 and the required return is 12 percent.
Solution: First, find the value of the yearly dividend.
Dp = 0.07 $100
Dp = $7
Substitute the known values into the following formula
and solve.
Pp = Dp  kp
Pp = $7  12 percent
Pp = $7  0.12
Pp = $58.33

Common Stock
Each share of common stock designates a piece of ownership
in a firm. Common stock has no maturity date. It represents
a residual claim, meaning that common stockholders may be
paid only after the firm has paid all debt and preferred stock
obligations. It also typically represents the right to vote for the
board of directors. While common stockholders are subject to
losses, an investor can lose no more than 100 percent of his
or her total share. Thus, even though theyre owners, common
stockholders face limited liability.
The value of common stock is the present value of all expected
future cash flows, which is similar to the valuation process
for debt and preferred stock. Expected future cash flows for
common stocks are dividends and proceeds from the sale of
the stock. These cash flows are less certain than those for
bonds and preferred stock, since common stock dividends
arent necessarily fixed, and the sale of the stock is unknown.

Lesson 3

63

The following formula is used to calculate the value of a


common stock.
V=

(1 + K)1

+...+

(1 + K)2

D
(1 + Kp)n

This formula can be simplified to the following:


V=

D
K

In this equation, the variable V stands for the value (price)


of the common stock; the variable D stands for the dividend;
and the variable k stands for the investors required rate
of return.
This valuation process assumes that the common stocks
dividends are fixed and perpetual. This could be an unrealistic
assumption, as common stocks have the potential for growth
in dividends and price.
The dividend growth model accounts for dividend growth. This
model assumes that the dividend will grow at a constant
rate each period for the indefinite future. This model uses
the following equation:
V=

D0 (1 + g)
(k g)

In this equation, the variable V stands for the common stocks


value; the variable D0 stands for the most recent dividend;
the variable k stands for the required rate of return; and the
variable g stands for the expected constant growth rate.
Lets look at an example problem.
Example: Suppose ABCs common stock has just paid a
dividend of $2.00. It has a required rate of return of 10 percent and an expected growth of 5 percent. What is the value
of the stock?
Solution: Substitute the known values into the following
formula and solve.
V=

64

D0 (1 + g )
(k g)

Financial Management

V = [$2(1 + 5 percent)]  (10 percent 5 percent)


V = [2(1 + 0.05)]  (0.10 0.05)
V = [2(1.05)]  (0.10 0.05)
V = 2.1  0.05
V = $42

Practice Problems
Example: What is the price of VH Inc. $10 preferred stock
($200 par) if comparable securities yield 7 percent?
Solution: No retirement date is given, so you can assume
the preferred stock is perpetual (that is, the dividend will be
paid into the indefinite future). The value of Dp is $10.
Substitute the knownvalues into the following formula and
solve.
Pp = Dp  kp
Pp = $10  7 percent
Pp = $10  0.07
Pp = $142.86
Example: What is the price of PR Inc. $8 preferred stock
($100 par), with mandatory retirement after 20 years? Again,
assume that comparable securities yield 7 percent.
Solution: Here, the preferred stock has a termination date,
so it can be valued like a bond. You can use the following
values and a financial calculator to calculate the price of
the stock.
FV = 100
PMT = 8
N = 20
I=7
Pp = ?
The stock price is $110.59.

Lesson 3

65

Why are the valuations in these two problems different? Well,


in the first problem, the stock is perpetual, but in the second
problem, the investor anticipates receiving the principal
amount (the $100 par) at the end of 20 years. The return of
the $100 decreases the value of this preferred stock.
Example: TSC, Inc. stock sells for $26 and pays an annual
per-share dividend of $1.30, which you expect to grow at 12
percent. What is your expected return on this stock? What
would be the expected return if the stock price was $40?
Solution: Consider the valuation equation. Since you know
the price of the stock, you know its value. You need to find
the expected rate of return. First, the following equation can
be rearranged to help find the value of k.

V=

D0 (1 + g)
(k g)

V = [D0 (1 + g)]  (k g)
V (k g) = D0 (1 + g)
k g = [D0 (1 + g)]  V
k = {[D0 (1 + g)]  V } + g
Substitute the known values into the equation and solve for k.
k = {[D0 (1 + g)]  V } + g
k = {[$1.30 (1 + 0.12)]  $26} + 0.12
k = {[$1.30 (1.12)]  $26} + 0.12
k = {1.456  $26} + 0.12
k = 0.056 + 0.12
k = 0.176, or 17.6 percent
If the price were $40, the expected return would fall.

66

Financial Management

Substitute the values into the equation and solve.


k = {[D0 (1 + g)]  V } + g
k = {[$1.30(1 + 0.12)]  $40} + 0.12
k = {[$1.30(1.12)]  $40} + 0.12
k = {1.456  $40} + 0.12
k = 0.0364 + 0.12
k = 0.1564, or 15.6 percent

Lesson 3

67

Self-Check 7
Indicate whether each of the following statements is True or False.
______ 1. Preferred stock dividends are usually fixed.
______ 2. If a cumulative preferred stocks dividend is in arrears, the dividend isnt being paid.
______ 3. Corporations are obligated to pay cash dividends if they generate earnings.
______ 4. The value of a preferred stock rises when interest rates rise.
______ 5. The shorter the term of a preferred stock, the less volatile should be its price.
______ 6. An increase in the required return will tend to increase the value of a stock.
______ 7. Corporations that pay common stock dividends apply less to retained earnings than if
they didnt pay dividends.
Complete problems 1, 2, and 3 on page 234; problems 1 and 4 on pages 251252; and
problems 1, 2, and 4 on page 291 in your textbook.

Check your answers with those on page 131.

68

Financial Management

ASSIGNMENT 8
Read the following assignment. Then read pages 316334 in
your textbook. Be sure to complete the self-check to gauge
your progress.

In this assignment, youll learn about investment companies


and mutual funds. Mutual funds represent one of the fastestgrowing investment markets today. Mutual funds offer investors
the opportunity to increase their buying power by pooling
funds with other investors. In doing so, investors are often
able to reduce risk while taking advantage of new investment
opportunities.
Mutual funds are actually created by investment companies.
A mutual fund pools the resources of many investors to buy a
portfolio of investment securities (such as stocks and bonds).
By pooling funds, a mutual fund can invest in a variety of
investments so that their success isnt limited to the value of
a few individual securities. In addition, mutual funds offer
the individual investor potentially lower costs for professional
management and services.
In the open-end form, the investment company sells shares
directly to investors. If demand for shares rises, the investment company simply creates new shares and applies the
proceeds paid by investors to the purchase of securities. If
demand for shares diminishes, the investment company buys
shares directly from investors with the proceeds earned by
the sale of securities held in the pool.
An open-end investment company transacts purchase and
sale of shares at net asset value (NAV). NAV is the value of
the entire pool of securities in the mutual fund on a pershare basis minus fund liabilities and expenses incurred by
the investment company to manage and market the mutual
fund. For example, if the value of all securities in the fund
is $101 million, fund liabilities and expenses are $1 million
and there are 50 million shares, NAV is $2.
In a closed-end investment company (also called a closed-end
mutual fund ), shares are traded like common stock. The number of shares is fixed, and theyre traded on an exchange. The
price of the fund varies with the supply and demand for the
fund. Thus, closed-end funds can sell at either a discount or
a premium to NAV, depending on investor demand.
Lesson 3

69

Mutual funds themselves come in many different forms. They


vary both by fee and objective. With respect to fees, mutual
funds can be classified into no-load and load categories. A
no-load mutual fund doesnt charge a sales fee when shares
are bought or sold. In contrast, a load fund charges a percentage to purchase fund shares. A back-end load fund charges
a fee to sell shares. These funds are generally sold through
a third party, such as a broker. All mutual funds, both noload and load, also charge management fees to cover the
cost of operating the fund.
The individual objectives of mutual funds vary greatly.
Mutual funds may be classified as stock funds, bond funds,
balanced funds (containing a combination of stocks and
bonds), or money market funds. They can be broken down
further within those categories as growth funds, sector funds,
international funds, municipal funds, and so on. The scope of
a fund may be very focused or very broad, depending on the
individual funds objective. Index funds are a unique category
of mutual funds that attempt to mimic a particular stock or
bond index.

70

Financial Management

Self-Check 8
Indicate whether each of the following statements is True or False.
______ 1. The shares of mutual funds are readily bought and sold in efficient, secondary markets.
______ 2. The shares of closed-end investment companies generally sell for a premium and
rarely sell for a discount.
______ 3. The shares of mutual funds cant sell for a discount.
______ 4. Loading fees reduce the investors return.
______ 5. The loading fee reduces a funds net asset value.
______ 6. An index fund seeks to outperform a specific stock index like the S&P 500.
Complete Problems 1, 2, and 3 on page 335 in your textbook.

Check your answers with those on page 133.

Lesson 3

71

NOTES

72

Financial Management

EXAMINATION NUMBER:

08171900
Whichever method you use in submitting your exam
answers to the school, you must use the number above.
For the quickest test results, go to
http://www.takeexamsonline.com

When you feel confident that you have mastered the material in
Lesson 3, go to http://www.takeexamsonline.com and submit
your answers online. If you dont have access to the Internet, you
can phone in or mail in your exam. Submit your answers for this
examination as soon as you complete it. Do not wait until another
examination is ready.
Questions 120: Select the one best answer to each question.

1. What is the value of a common stock if the growth rate


is 8 percent, the most recent dividend was $2, and investors
require a 15 percent return on similar investments?
A. $25.78
B. $27.34

C. $28.57
D. $30.85

2. Which of the following preferred stock properties would


provide the best argument favoring purchase of preferred
stock by an investor?
A. When long-term bond yields decline, the value of preferred
stock can potentially rise.
B. Because preferred stock trading volume is lower than
common stock trading volume, preferred stock prices are
less volatile than common stock prices.
C. The yield differential between preferred stock and
bonds is smaller than would be expected on the basis
of risk differentials.
D. Preferred stockholders receive preferential treatment over
lower-class, common stockholders when the corporation
earns sufficient profit to pay creditors and shareholders.

Examination

Lesson 3
Investments

73

3. If a company fails to meet the terms of indenture, the company is


A. bankrupt.
B. in default.

C. profitable.
D. in registration.

4. Which of the following is the best conclusion, given only the following information:
ZYX Corporations earnings after taxes have declined by 3.13% from the year earlier.
During the past three months, ZYX purchased from investors (retired) 7.5% of the
corporations outstanding preferred stock shares, which pay dividends at 5% of par.
A. ZYX Corporations net income decline is largely attributable to the expense it
incurred to purchase its preferred stock.
B. ZYX Corporations preferred stock purchase should enhance earnings after taxes next
year because it will earn 5% dividend income from its new preferred stock holdings.
C. ZYX Corporations purchase of preferred stock had no effect on the firms asset balance.
D. ZYX Corporations purchase of preferred stock improved its capacity to pay preferred
stock dividends.
5. A 20-year $1,000 bond has a coupon of 8 percent. What would be the price if the
coupon is paid semiannually and comparable bonds yield 10 percent?
A. $1,000
B. $895

C. $828
D. $624

6. What is the value of a preferred stock that pays an annual dividend of $4 a share if
competitive yields are 5 percent?
A. $80
B. $60

C. $40
D. $20

7. Which of the following bonds is supported by collateral?


A. Convertible bonds
B. Income bonds

C. Equipment trust certificates


D. Debentures

8. If a perpetual preferred stock pays a dividend of $5 a year, and yields rise


from 10 percent to 12 percent, the price of the stock will
A. rise from $50 to $60.
B. fall from $50 to $41.67.

C. rise from $41.67 to $50.


D. fall from $60 to $50.

9. Interest is exempt from federal income taxation on


A.
B.
C.
D.

74

equipment trust certificates.


zero coupon bonds.
federal bonds such as savings bonds.
state of Florida bonds.

Examination, Lesson 3

10. A 30-year $1,000 bond has an annual coupon of 6 percent. What would be the current
yield if the bond sells for $622?
A. 9.6 percent
B. 6 percent

C. 5.6 percent
D. 5 percent

11. Dividends come at the expense of


A. interest.
B. retained earnings.

C. liabilities.
D. stock.

12. A 10-year $1,000 bond has a coupon of 9 percent. What would be the price if the
coupon is paid annually and comparable bonds yield 10 percent?
A. $1,900
B. $1,159

C. $1,000
D. $938

13. An increase in investors required return will cause the value of a common stock to
A. rise.
B. fall.

C. remain unchanged.
D. remain stable or rise slightly.

14. If investors require a rate of return of 8 percent, what is the value of a perpetual
preferred stock that pays a fixed dividend of $2?
A. $16
B. $25

C. $32
D. $50

15. A $1,000 bond has an annual coupon of 5 percent and a price of $692. Find the
number of years to maturity if comparable bonds yield 10 percent.
A. 5 years
B. 10 years

C. 20 years
D. 30 years

16. A common stock costs $40.50, the current dividend is $1.50, and the growth in the
value of the shares and the dividend is 8 percent. What is the annual rate of return
on an investment in this stock?
A. 4.5 percent
B. 8 percent

C. 10 percent
D. 12 percent

17. Preferred stock and bonds are similar because


A.
B.
C.
D.

they both have voting power.


interest and dividend payments are legal obligations.
neither interest nor dividends are tax deductible.
both may be subject to a call option.

Examination, Lesson 3

75

18. What is the value of a $100 par preferred stock that must be retired after 10 years if it
pays a dividend of $5 annually and the investor requires a 6 percent rate of return?
A. $92
B. $100

C. $110
D. $122

19. A perpetual preferred stock pays a fixed dividend of $9 and sells for $100. What is the
stocks rate of return?
A. 6.5 percent
B. 9 percent

C. 11 percent
D. 12.5 percent

20. The value of common stock depends on the


A.
B.
C.
D.

76

price of the stock.


retirement date.
present value of cash flows.
coupon rate.

Examination, Lesson 3

Corporate Finance, Part 1

As you work through this lesson, youll learn about the basics
of corporate finance. Corporations face financial decisions
every day. As a student of finance, you should be familiar
with the economic conditions and firm structures that
influence financial decisions.

OBJECTIVES
When you complete this lesson, youll be able to

List the characteristics of the various business forms


sole proprietorship, partnership, and corporation

Explain the importance of taxes to financial planning

Describe the characteristics of progressive, proportional,


and regressive tax structures

Calculate the break-even level of output for a business

Calculate the degree of operating leverage for a business

Identify the assets and liabilities that vary with the level
of sales

Describe how the percent of sales method of forecasting


is used

ASSIGNMENT 9
Read the following assignment. Then read pages 338372 in
your textbook. Be sure to complete the self-check to gauge
your progress.

Lesson 4

INTRODUCTION

77

Business Forms
In this assignment, youll learn about different business
forms. The form of the business is significant because it
influences many aspects of financial decision making. For
example, there are tax advantages (and disadvantages) to
certain forms of ownership.
The majority of businesses are sole proprietorships, owned by
a single individual. A sole proprietorship is easy to form and
has some tax advantages. However, the primary disadvantage
of the sole proprietorship is that the owner has unlimited
personal liability. Furthermore, the owners liability isnt
limited to their investment in the business, but extends to
all personal assets.
A partnership has many of the same features as a sole proprietorship, although the business has two or more owners.
As with the sole proprietorship, each partner (owner) is legally
liable for the business debts. Thus, the advantages and disadvantages of this form of business are roughly the same as
in the sole proprietorship.
A limited partnership limits the level of liability for some of
the partners. This business arrangement grants one or more
partners limited liability for the operations of the business;
debts can be extended only to their investment. A limited
partnership allows some individuals to invest in the business
without bearing personal liability for the firms debts. One
or more of the partners still maintain full legal liability and
control over the business operations.
A corporation is a legal entity thats established by the state.
The corporation itself is established as an entity and thus
can own assets, collect debt obligations, and pay taxes.
Owners of the corporation maintain limited liability or are
liable only for their investment in the corporation. In other
words, the most that individual owners can lose or be liable
for is the amount that theyve invested in the firm.

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Financial Management

Taxes
As with personal financial decision making, taxes play a
significant role in business operations. Taxes come in three
main forms: progressive, regressive, and proportionate.
A progressive tax rate increases with income. In other words,
high-income earners will pay a higher percentage in taxes
than low-income earners. In contrast, in a regressive tax
system, the tax rate decreases with higher income levels.
Here, low-income earners will pay a higher percentage in
taxes than high-income earners. A proportionate tax maintains
a constant percentage rate for all income levels. Both the
federal personal and federal corporate income tax structures
are progressive, although the corporate structure changes
for higher income levels.
Individuals and corporations are also subject to state and
local taxes. The structure of these taxes varies from progressive to regressive to proportionate, depending on the
state or locality and the type of tax. The impact of taxes
plays an important role in financial decision making at
both the personal and corporate levels.
Now, lets review some more example problems.
Example: If a corporation earns $90,000 in pretax income,
what is the amount of federal income tax owed?
Taxable
Income
$050,000
$50,00175,000
$75,001100,000
$100,001335,000
$335,00110,000,000
$10,000,00115,000,000
$15,000,00118,300,000
Over $18,300,000

Marginal
Tax Rate
15%
25%
34%
39%
34%
35%
38%
35%

Solution: The above table shows an example of the structure


of the federal corporate income tax. Notice that everyone
pays 15 percent on the first $50,000 in earnings. On the
next $25,000 in earnings, everyone pays 25 percent, and so
on. The total tax owed will be the sum of the tax for the first
three income levels. To solve this problem, start by calculating the tax owed for each of the three income levels.
Lesson 4

79

The company earned a total of $125,000. For income


between $0 and $50,000, the tax rate is 0.15. So, to find
the tax owed on the first $50,000 of income, multiply the
tax rate by $50,000.
0.15 $50,000 = $7,500
For income between $50,001 and $75,000, the tax rate is
0.25. To calculate the tax owed on the next $25,000 of
income, multiply the tax rate by $25,000.
0.25 $25,000 = $6,250
For income between $75,001 and $100,000, the tax rate is
0.34. To calculate the tax owed on the remaining $15,000 of
company income, multiply the tax rate by $15,000.
0.34 $15,000 = $5,100
Now, add the three tax amounts together to get the total tax
owed on the $90,000 of income.
$7,500 + $6,250 + $5,100 = $18,850
Example: If a corporation earns $160,000 before taxes, how
much is owed the federal government? What are the firms
marginal and average tax rates?
Solution: To calculate the total tax owed, add together the
amounts of tax owed for each of the first four income levels.
For income between $0 and $50,000, the tax rate is 0.15. To
calculate the tax owed on the first $50,000 of income, multiply the tax rate by $50,000.
0.15 $50,000 = $7,500
For income between $50,001 and $75,000, the tax rate is
0.25. To calculate the tax owed on the next $25,000 of
income, multiply the tax rate by $25,000.
0.25 $25,000 = $6,250

80

Financial Management

For income between $75,001 and $100,000, the tax rate is


0.34. To calculate the tax owed on the next $25,000 of
income, multiply the tax rate by $25,000.
0.34 $25,000 = $8,500
For income between $100,001 and $335,000, the tax rate is
0.39. This company earned $60,000 in this tax bracket
($160,000 $100,000 = $60,000). To calculate the tax owed
on the remaining $60,000 of company income, multiply the
tax rate by $60,000.
0.39 $60,000 = $23,400
Now, add the four tax amounts together to get the total tax
owed on the $160,000 of income.
$7,500 + $6,250 + $8,500 + $23,400 = $45,650
The marginal tax rate is the tax rate for the highest income
level achieved. In this case, an income of $160,000 falls in
the fourth income level at 39 percent. To calculate the
average tax rate, divide the total tax by the total income.
$45,650 $160,000 = 0.285, or 28.5 percent

Break-Even Analysis
One of the more significant tasks in financial decision making
is measuring profits for the firm. To project profits, youll need
to measure sales, costs, and taxes, and also analyze the relationships among the three. This information is necessary to
establish required sales levels and estimated sales levels.
One of the tools thats used to establish a minimum required
sales level is the break-even analysis. Break-even analysis is
used to identify the level of sales that will exactly offset the
cost of production, which is the break-even point for the
firm. Break-even analysis is composed of two components
the total cost of production and total revenues. Total
revenues (TR) are a firms sales. You can use the following
formula to calculate total revenues:
TR = P Q

Lesson 4

81

In this formula, the variable TR stands for the total revenue,


the variable P stands for the price per unit, and the variable
Q stands for the quantity of units sold.
The firm also must consider the cost of production. The total
cost of production (TC) is the cost of making a product. When
conducting a break-even analysis, its important to remember
that the total cost of production can be broken down into
fixed costs and variable costs. Fixed costs (FC) are those that
dont change as output changes. (For example, if the GMB
Company can change its output of products without altering
the amount that it spends on promotion, then promotion is a
fixed cost.) Variable costs (VC), in contrast, are dependent on
the level of production. (In order for the GMB Company to
produce more products, it must hire more labor; therefore,
labor is a variable cost.)
The following formula can be used to calculate the total cost
of production:
TC = FC + VC
Variable cost (VC) can also be calculated separately by multiplying variable costs per unit times quantity of output. This
relationship is represented by the following formula:
VC = V Q
In this formula, the variable V stands for the variable cost
per unit of output, and the variable Q stands for the quantity
of output.
Break-even analysis considers the point where total revenue
(TR) exactly offsets total costs (TC). Therefore, you want
to find the quantity of production where TR equals TC.
Keeping this fact in mind, we can rearrange some of the
formulas presented in this section to create a new total
revenue formula.
We start with the original total cost of production formula:
TC = FC + VC
You want to find the quantity of production where TR = TC.
So, substitute TR for TC in the formula.
TR = FC + VC

82

Financial Management

Next, you can substitute P Q for TR.


P Q = FC + VC
Finally, substitute V Q for VC.
P Q = FC + (V Q)
In break-even analysis, your objective is to find the quantity
of production where total revenues exactly offset the total
costs of production. Therefore, you need to find the quantity
of production (Q). You can therefore rearrange the previous
formula to help find Q as follows:
Q = FC (P V)
In conducting break-even analysis, you learned that total
costs are the sum of fixed and variable costs. Its interesting
to consider how the breakdown of these two components
influences sales and production. The degree of operating
leverage measures the relationship between fixed and
variable costs and operating income. As discussed in your
textbook, the degree of operating leverage quantifies the
responsiveness of operating income to changes in the level
of output or sales.
The following formulas can be used to calculate the degree of
operating leverage.
DOL = (TR VC)  (TR VC FC)
DOL = [(P Q) (V Q)]  [(P Q) (V Q) FC]
Now, lets review an example problem.
Example: A firm has the following cost and revenue functions.
TR = PQ = $3Q
TC = FC + VC = $2,000 + $2Q
Part A: Find the break-even level of output.
Solution: You need to calculate the level of production where
revenues will exactly offset costs. In other words, you want
to find the minimum required level of production. You know
that the units are priced at $3, that there are constant or
fixed costs of $2,000, and that there are variable costs per
unit of $2. Substitute the known values into the following
formula and solve.

Lesson 4

83

P Q = FC + (V Q)
3Q = 2,000 + 2Q
3Q 2Q = 2,000
Q = 2,000 units
Part B: If the level of output is 5,000 units, what is the
degree of operating leverage?
Solution: Substitute the known values into the following
equation and solve.
DOL = [(P Q) (V Q)] [(P Q) (V Q) (FC )]
DOL = [(3 5,000) (2 5,000)] [(3 5,000)
(2 5,000) 2,000]
DOL = [15,000 10,000] [15,000 10,000 2,000]
DOL = [5,000] [5,000 2,000]
DOL = 5,000 3,000
DOL = 1.667
Keep in mind that DOL measures the relationship between
the level of operating income and the level of production. A
DOL of 1.667 tells you that at a production level of 5,000
units, a 10 percent increase in sales (500 units) will increase
operating income by 16.67 percent.
Part C: If the output increases to 10,000 units, what
happens to the degree of operating leverage?
Solution: Substitute the known values into the following
equation and solve.
DOL = [(P Q) (V Q)]  [(P Q) (V Q) (FC )]
DOL = [(3 10,000) (2 10,000)]  [(3 10,000)
(2 10,000) 2,000]
DOL = [30,000 20,000]  [30,000 20,000 2,000]
DOL = [10,000]  [10,000 2,000]
DOL = 10,000  8,000
DOL = 1.25

84

Financial Management

A DOL of 1.25 tells you that at a production level of 10,000


units, a 10 percent increase in sales (1,000 units) will
increase operating income by 12.5 percent.
Part D: If the firm changes its costs so that the new cost
schedule is TC = $4,000 + 1.5Q, what will happen to the
break-even level of output and the degree of operating leverage of 5,000 and 10,000 units of output?
Solution: Notice that fixed costs have increased to $4,000
while variable costs per unit have declined to $1.50. To
calculate the break-even level of output for 5,000 units of
output, substitute the known values into the following equation and solve.
P Q = FC + (V Q)
3Q = 4,000 + 1.5Q
3Q 1.5Q = 4,000
1.5Q = 4,000
Q = 2,667 units
The higher level of fixed costs has increased the minimum
required level of sales to 2,667 units.
Now, find the DOL at 5,000 units. Substitute the known
values into the following equation and solve.
DOL = [(P Q) (V Q)]  [(P Q) (V Q) (FC )]
DOL = [(3 5,000) (1.5 5,000)]  [(3 5,000)
(1.5 5,000) 4,000]
DOL = [15,000 7,500]  [15,000 7,500 4,000]
DOL = 7,500  [7,500 4,000]
DOL = 7,500  3,500
DOL = 2.143

Lesson 4

85

Compare this answer to the answer you computed in Part B.


The DOL has increased from 1.667 to 2.143 at 5,000 units of
production. This illustrates the impact of higher fixed costs.
At any given level of production, the DOL will be higher with
higher proportions of fixed costs.
Now, find the DOL for 10,000 units of output. Substitute the
known values into the following equation and solve.
DOL = [(P Q) (V Q)]  [(P Q) (V Q) (FC )]
DOL = [(3 10,000) (1.5 10,000)]  [(3 10,000)
(1.5 10,000) 4,000]
DOL = [30,000 15,000]  [30,000 15,000 4,000]
DOL = 15,000  [15,000 4,000]
DOL = 15,000  11,000
DOL = 1.36

86

Financial Management

Self-Check 9
Indicate whether each of the following statements is True or False.
______ 1. Partnerships constitute the largest number of businesses and generate the
most profits.
______ 2. If ones income tax rate declines as income declines, the tax is regressive.
______ 3. An investor can transfer ownership in a corporation to another individual.
______ 4. It isnt possible to have limited liability in a partnership.
______ 5. If a firm has a high degree of operating leverage, it has few fixed expenses.
______ 6. If a firms degree of operating leverage is 3.0, then a 10 percent reduction in
sales should decrease operating income by 30 percent.
Complete Problem 2 on page 348, Problems 13 on pages 356358, and Problem 1
on page 372 in your textbook.

Check your answers with those on page 134.

Lesson 4

87

ASSIGNMENT 10
Read the following assignment. Then read pages 436469 in
your textbook. Be sure to complete the self-check to gauge
your progress.

Forecasting and Budgeting


In Assignment 9, you learned some of the economic and
business components that influence financial decision making.
In addition, you learned some of the methods that are available to aid in the decision-making process. When managers
are making financial decisions, theyre generally determining
the future course of a firm. Good planning and forecasting,
therefore, are essential to sound financial decisions.
Later, in Lesson 5, youll learn the significance of the cost of
capital and capital budgeting to strategic financial decisions.
First, however, youll examine the methods that are used to
forecast financial requirements. As sales levels fluctuate, the
needs of a firm will fluctuate. The percent of sales method
can be used to project assets and liabilities with changes in
sales. This can help determine the need for external financing.
Lets look at an example problem that illustrates the percent
of sales method. The following is the solution to Problem 3
on page 483 in your textbook.
Example: CDE, Inc., with sales of $500,000, has the following
balance sheet.

Assets
Cash

Liabilities and Equity


$25,000

Accounts payable

$15,000

Accounts receivable

50,000

Accruals

20,000

Inventory

75,000

Notes payable

50,000
85,000

Current assets

150,000

Current liabilities

Fixed assets

200,000

Common stock

100,000

Retained earnings

165,000

Total liabilities and equity

350,000

Total assets

88

350,000

Financial Management

The firm earns 15 percent on sales and distributes 25 percent


of its earnings to shareholders in the form of dividends.
Part A: Using the percent of sales method, forecast the new
balance sheet for sales of $600,000 assuming that cash
changes with sales and that the firm isnt operating at
capacity. Will the firm need external funds? Would your
answer be different if the firm distributed all of its earnings?
Solution: The first step is to identify those assets and liabilities that spontaneously vary with sales. For example, inventory
will mechanically adjust to reflect changes in sales levels.
Other assets (such as fixed assets like property) dont necessarily have to increase to maintain higher levels of sales. For
example, the physical plant may be an adequate size to be
able to continue the increased production.
On the asset side, cash, inventory, and accounts receivable
will all spontaneously adjust. Of the liabilities, only accounts
payable and accruals will adjust.
Now, calculate the spontaneous assets and liabilities as a
percent of sales.
cash  sales = 25,000  500,000 = 5 percent
accounts receivable  sales = 50,000  500,000 =
10 percent
inventory  sales = 75,000  500,000 = 15 percent
accounts payable  sales = 15,000  500,000 =
3 percent
accruals sales = 20,000 500,000 = 4 percent
Next, consider the new forecast for sales of $600,000. You
need to find the level of each spontaneous asset and liability
that will allow the proportion to sales to stay constant.
For example, cash was previously 5 percent of sales, and
you want to maintain the 5 percent ratio. Therefore, if
sales increase to $600,000, cash should adjust to 5 percent
of $600,000.

Lesson 4

89

The following are the projections:


cash: 5 percent of $600,000 = 0.05 $600,000 =
$30,000
accounts receivable: 10 percent of $600,000 =
0.10 $600,000 = $60,000
inventory: 15 percent of $600,000 = 0.15 $600,000 =
$90,000
accounts payable: 3 percent of $600,000 =
0.03 $600,000 = $18,000
accruals: 4 percent of $600,000 = 0.04 $600,000 =
$24,000
You can now update the company balance sheet as shown here.

Assets

Liabilities and Equity


Old

Cash
Accounts receivable
Inventory
Projected change in
assets

Projected

$25,000

$30,000

Accounts payable

50,000

60,000

Accruals

75,000

90,000

Projected change in
liabilities

Old

Projected

$15,000

$18,000

20,000

24,000
$7,000

$30,000

Thus, by proportion calculations, theres a $23,000 need for


financing ($30,000 $7,000 = $23,000).
Part B: Will the firm need external funds?
Solution: We know that the firm distributes 25 percent of its
earnings. This means that they retain 75 percent of earnings
for reinvestment in the firm (retained earnings). We also know
that the firm earns 15 percent on sales. You can calculate the
amount that the firm has available for investment as follows:
amount available for investment = $600,000
15 percent 75 percent
amount available for investment = $90,000
75 percent
amount available for investment = $67,500

90

Financial Management

Our sales projections indicate that the firm needs $23,000,


but $67,500 is available from retained earnings. This means
that theres an excess of funds of $44,500 ($67,500
$23,000 = $44,500). So the firm doesnt have a need for
external financing.
Part C: Would your answer to Part B be different if the firm
distributed all of its earnings?
Solution: In this case, 100 percent of earnings would be
distributed and none would be retained. The full proportion
calculation of $23,000 would then be needed in external
funding.
The illustration above assumed the firms physical plant and
other fixed assets could handle increased production. To
accommodate a production increase, management might
decide to purchase or lease fixed assets. This fixed asset
expansion problem complicates the decision making process.
We apply the principles of the percent of sales method,
then in a second step we superimpose fixed asset funding.
Management can choose any one or a combination of the
following options:

Take the new cash balance created by the percent


of sales method and apply part of it to all or part of
the fixed asset purchase/lease.

Decrease distributions to shareholders.

Assume additional debt.

Issue shares of stock.

Cash Budgeting
Cash budgeting addresses the liquidity problem all entities
must address if their revenues and expenses vary throughout
the fiscal year. Its the same problem you face in a household
budget, especially if your income varies throughout the year.
Your forecast may show ample cash at the end of the fiscal year
or intervening periods, but that doesnt mean the cash balance
will be sufficient throughout the fiscal year.
Cash budgeting is important because during lean cash-flow
periods, businesses may be forced to borrow. If management
doesnt anticipate borrowing, the business may exceed its

Lesson 4

91

interest-expense budget. During rich cash-flow periods, they


may need to find ways for cash to earn more interest than if
it were sitting idle in a checking account.
The cash budgeting process breaks down the fiscal year into
meaningful intervalsdaily, monthly, quarterlyand forecasts cash flows based on projected cash receipts and cash
disbursements for each interval. This is no place for accruals
(depreciation, credit sales) because accruals dont contribute
to cash flow.
The benefit of cash budgeting is the same benefit earned by
forecasting: Cash budgeting enables managers to anticipate
and potentially control costs.

Self-Check 10
Indicate whether each of the following statements is True or False.
______ 1. Operating leverage is the result of using debt financing.
______ 2. Long-term liabilities vary spontaneously with sales.
______ 3. Plant and equipment spontaneously rises as the firm expands.
______ 4. Underestimation of the level of assets needed may cause a firm to have insufficient
finances.
______ 5. If accounts receivable is 15 percent of sales and sales double, the percent of sales
method of forecasting says that accounts receivable will become 30 percent of sales.
______ 6. The percent of sales method of forecasting assumes that inventory as a percent of
sales is constant.
______ 7. The purpose of cash budgeting is to forecast the year-end cash balance.
Complete Problem 1 on page 456, Problem 7 on page 460, and Problem 1 on page 469.

Check your answers with those on page 139.

92

Financial Management

EXAMINATION NUMBER:

08172000
Whichever method you use in submitting your exam
answers to the school, you must use the number above.
For the quickest test results, go to
http://www.takeexamsonline.com
When you feel confident that you have mastered the material in
Lesson 4, go to http://www.takeexamsonline.com and submit
your answers online. If you dont have access to the Internet, you
can phone in or mail in your exam. Submit your answers for this
examination as soon as you complete it. Do not wait until another
examination is ready.
Questions 120: Select the one best answer to each question.

1. A firms sales increase by 50 percent and inventory was


$100,000. According to the percent of sales method of
forecasting, what will the new inventory be?
A. $100,000
B. $120,000

C. $150,000
D. $175,000

2. If a firm produces 50,000 widgets and sells each unit for $20.50,
what is the total revenue generated by this production?
A. $10,250
B. $100,250

C. $1,025,000
D. $10,250,000

3. If investors want to limit financial risk and maximize their


control of the business, which of the following forms of
business would they prefer?
A. A sole proprietorship
B. A limited partnership

C. An S corporation
D. A corporation

Examination

Lesson 4
Corporate Finance, Part 1

93

4. Break-even analysis is concerned with the relationship between


A. financial leverage and risk.
B. total costs and revenues.

C. debt and equity.


D. dividends and retained earnings.

5. A union contract suggests that labor costs may be


A. variable.
B. fixed.

C. a noncash expense.
D. undetermined.

6. A product sells for $5 per unit. If fixed costs are $1,000 and variable costs are $2 per
unit, what is the degree of operating leverage at 2,000 units?
A. 0.83
B. 1.0

C. 1.2
D. 2.0

7. Which of the following situations would provide corporate management with the
strongest rationale to carry forward current-year losses?
A. Management projects taxable income to remain unchanged over the next five years.
B. Early in his first term this year, the President of the United States initiated legislation
and signed into law a significant increase in income tax rates.
C. Management projects pre-tax losses over the next two years, and possibly even
four years into the future.
D. Congress just passed a very popular bill that reduces marginal federal income
tax rates.
8. Which of these situations offers the best rationale for organizing a business as a
limited partnership?
A. Youre an entrepreneur and you want two others expertise, former business
partners, to help execute your business plan.
B. You want your small new business, which is operating out of your garage, to pay
you and your partner (your spouse) dividends for which income tax will only be
paid by you or your business, not both.
C. Management needs to raise money through a stock offering, but does not want to
relinquish control of the business to stockholders.
D. Management rejects the idea of personally assuming liability for the business.
9. Airlines have a high degree of operating leverage because of
A.
B.
C.
D.

94

a large investment in fixed assets.


small fixed expenses.
insufficient government regulation.
a large use of debt financing.

Examination, Lesson 4

10. Currently, a firms accounts payable is 5 percent of sales. If the level of sales is anticipated to increase from $10,000 to $20,000, what is the level of accounts payable
forecasted by the percent of sales method?
A. $250
B. $500

C. $750
D. $1,000

11. Which of the following statements about fixed costs is correct?


A.
B.
C.
D.

Fixed
Fixed
Fixed
Fixed

costs
costs
costs
costs

dont change with the level of output.


dont change with the size of the firm.
are greater than variable costs.
are paid before variable costs.

12. If ABC, Inc. has $650,000 in sales and $230,000 in expenses, what are the firms
earnings before interest and taxes (EBIT)?
A. $850,000
B. $650,000

C. $420,000
D. $325,000

13. Which of the following is an advantage of the sole proprietorship?


A. Ease of formation
B. Joint ownership

C. Limited liability
D. Ease of transfer of ownership

14. A product sells for $2 per unit. If fixed costs are $200 and variable costs are $1 per
unit, what is the break-even level of output?
A. 200 units
B. 150 units

C. 100 units
D. 50 units

15. Which of the following tends to vary spontaneously with changes in the level of sales?
A. Long-term debt
B. Accounts payable

C. Plant
D. Paid-in capital

16. If Sams Diner has an EBIT of $350,000, what are the diners net earnings after paying
$50,000 in taxes and $34,000 in interest?
A. $434,000
B. $334,000

C. $311,000
D. $266,000

17. Which of the following is usually a variable expense?


A. Salaries
B. Rent

Examination, Lesson 4

C. Wages
D. Insurance premiums

95

18. If a firm substitutes fixed for variable costs, which of the following will occur?
A.
B.
C.
D.

The
The
The
The

use of financial leverage will be increased.


degree of operating leverage will be increased.
break-even level of output will be reduced.
profits will always be higher.

19. Which of the following events would be most likely to increase the quantity breakeven
point, assuming other factors remain constant?
A. Reduced marketplace competition enables LMN Corporation to raise its selling
price for finance textbooks.
B. The pressure has subsided: The property owner, who rents space to your
small manufacturing plant, has agreed to blacktop the employee and customer
parking lot.
C. The city council has finally been persuaded: Your taxi business will pay lower water
and sewer rates.
D. XYZ Corp agrees to increase its sales-commissions paid to employees by 12 percent.
20. Which of the following is an advantage of a corporation?
A. Permanence
B. Ease of formation

96

C. Elimination of double taxation


D. Dilution of ownership

Examination, Lesson 4

Corporate Finance, Part 2

As you work through this lesson, youll learn how a firms


use of debt and equity influences financial decision making.
Youll study the capital structure of a firm and learn how to
calculate the cost of capital. Youll also learn how to use this
calculation in making capital budgeting decisions.

OBJECTIVES
When you complete this lesson, youll be able to

Identify the components of a firms capital structure

Calculate the cost of capital and determine an


optimal capital structure

Calculate an investments payback period, net present


value, and internal rate of return

Describe the differences between net present value


and internal rate of return

Choose the most profitable investment from a group


of mutually exclusive investments

List several reasons for mergers and divestitures

ASSIGNMENT 11
Read the following assignment. Then read pages 374395
and 106129 in your textbook. Be sure to complete the selfcheck to gauge your progress.

In Assignment 11, youll learn about the cost of capital and


capital structure decisions. A firms capital structure refers to
the breakdown between debt and equity as sources of the
firms external financing. You learned in Lesson 3 that
issuers of debt and equity pay interest and dividends to
investors. These payments contribute to the cost associated

Lesson 5

INTRODUCTION

97

with debt and equity financing. These costs vary with each
issue, depending on current economic conditions and the
risk of the firm. Its important to realize that the cost of
financing is also dependent on the firms mix of debt and
equity instruments. In this assignment, youll learn how to
identify a firms optimal capital structure, or the best mix
of debt and equity financing.
To identify the optimal capital structure, youll have to calculate the weighted average cost of capital, which is the weighted
average cost of each capital component. Capital components
are the sources of external financing for the firm and generally
come in three forms: debt (bonds), preferred stock, and common
stock. As discussed previously, theres a cost associated with
each source of financing.
The method for determining the cost of capital is best illustrated through an example problem. The following example
is Problem 1 from page 396 in your textbook.
Example: HBM, Inc. has the following capital structure:
Assets: $400,000
Debt: $140,000
Preferred stock: $20,000
Common stock: $240,000
The common stock is currently selling for $15 a share, pays
a cash dividend of $0.75 per share, and is growing annually
at 6 percent. The preferred stock pays a $9 cash dividend and
currently sells for $91 a share. The debt pays interest of 8.5
percent annually, and the firm is in the 30 percent marginal
tax bracket.
Part A: What is the after-tax cost of debt?
Solution: The first step in the weighted average cost of capital
calculation is to compute the cost of each capital component.
When calculating the cost of debt ( kd ), you want to consider
the after-tax cost of debt, because there are tax benefits to
the firm in using debt financing. Interest paid on debt is tax
deductible for the firm.

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Financial Management

The real cost of debt is, therefore, the cost after taxes have
been paid. You can use the following formula to calculate the
cost of debt.
kd = i (1 t )
In this formula, the variable kd stands for the after-tax cost
of debt, the variable i stands for the cost (interest paid) on
new bond issues, and the variable t stands for the firms
marginal tax rate.
In this example problem, debt pays interest of 8.5 percent
annually, and the firm is in the 30 percent marginal tax
bracket. Substitute the known values into the formula
and solve.
kd = i (1 t )
kd = 8.5 percent (1 30 percent)
kd = 0.085 (1 0.30)
kd = 0.085 (0.70)
kd = 0.0595, or 5.95 percent
Part B: What is the cost of preferred stock?
Solution: As explained in your textbook, the cost of preferred
stock ( kp ) depends on its dividend and the price that
investors are willing to pay to purchase the preferred stock.
You can use the following formula to calculate the cost of
preferred stock.
kp = Dp  Pp
In this formula, the variable Dp stands for the dividend paid
by preferred stock, and the variable Pp stands for the price of
the preferred stock.
In this example problem, the preferred stock pays a $9 cash
dividend and currently sells for $91 a share. Substitute the
known values into the formula and solve.
kp = Dp  Pp
kp = $9  $91
kp = 0.099, or 9.9 percent

Lesson 5

99

Notice that as with the case of debt, you use the current
price of preferred stock. In addition, you should consider
the impact of flotation costs in the price of the preferred
stock. Flotation costs are expenses associated with selling
the preferred stock (such as underwriting fees). So, for
example, if flotation costs were 5 percent, the firm would
net only 95 percent of the selling price. Substituting the
known values into the following formula,
kd = i (1 t )
kd = $91 (1 5 percent)
kd = $91 (1 0.05)
kd = $91 (0.95)
kd = $86.45
Thus, 95 percent of the selling price is $86.45.
Flotation costs will increase the cost of preferred stock
financing, as shown in the following mathematical example.
kp = Dp Pp
kp = 9 86.45
kp = 0.104, or 10.4 percent
In this problem, you werent given any information about
flotation, so you would use the 9.9 percent for the cost of
preferred stock. Recognize that the cost of preferred stock
(9.9 percent) is greater than the cost of debt (5.95 percent).
In other words, it costs the firm more to issue preferred
stock than it does to issue bonds.
Part C: What is the cost of common stock?
Solution: The cost of common stock is the most difficult
source of financing to value. In the case of bonds and preferred stock, were given information concerning the dividend
or interest payment. This translates to a payoff to the
investor thats known.

100

Financial Management

According to your textbook, the cost of common equity


is an opportunity cost: its the return that investors could
earn on comparable, alternative uses for their money. Since
the cost of common stock is an opportunity cost, there is no
identifiable expense such as interest that the financial
manager may use to determine the cost of these funds.
Financial managers must use judgment in addition to technical analysis to compute the cost of common stock. Three
widely accepted methods are used to compute the cost of
common stock: the interest rate plus risk premium, the
capital asset pricing model (CAPM), and the expected return
model. Lets take a closer look at each of these.
The interest rate plus risk premium model compares the cost
of common stock to the cost of debt. You know that the cost
of common stock will be higher than the cost of debt for
several reasons. First, as you learned in Lesson 3, a higher
level of risk is generally associated with common stock. So,
investors will demand a higher rate of return for common
stock ownership over bonds. Second, the tax deductibility
of bond interest lowers the effective cost of debt for the firm.
Common stock doesnt have this advantage. Under the
interest rate plus risk premium method, the cost of common
stock (ke) is equal to the interest rate on bonds plus a risk
premium to adjust for the additional risk associated with
common stock. This relationship is expressed with the
following formula:
ke = i + risk premium
In this formula, the variable ke stands for the cost of common stock, the variable i stands for the interest rate on new
bond issues, and the risk premium is the compensation to
investors for bearing risk.
The capital asset pricing model (CAPM) also adjusts for risk.
This model, however, relates the cost of common stock to
the risk-free rate (typically the T-bill) plus a market risk
premium. (The market risk premium is the additional return
investors require for investing in securities. Its important to
recognize that the market risk premium used in the CAPM
model isnt equal to the risk premium of the interest rate
plus risk premium model.)

Lesson 5

101

The CAPM model is expressed with the following formula:


ke = rf + market risk premium
The market risk premium is equal to (rm rf.)beta. Therefore,
the formula can be altered as follows:
ke = rf + (rm rf.)beta
In this formula, the variable ke stands for the cost of equity;
the variable rf stands for the risk-free rate of return; the variable rm stands for the return on the market; and beta equals
the volatility in the firms stock.
The third model is the expected return model, which you
studied in Assignment 7. This model assumes that the cost
of equity is equal to the dividend yield on the stock plus the
growth rate. This relationship is expressed with the following
formula:
ke = dividend yield + g
ke = [D0 (1 + g)]  P + g
ke = D1  P + g
In this formula, the variable ke stands for the cost of equity;
the variable D0 stands for the last dividend paid; and the
variable g stands for the expected growth rate.
In this example problem, youre given only enough information to estimate the expected return model. Substitute the
known values into the following formula and solve.
ke = [D0 (1 + g)]  P + g
ke = [$0.75 (1 + 6 percent)]  $15 + 6 percent
ke = [0.75 (1 + 0.06)]  15 + 0.06
ke = [0.75 (1.06)]  15 + 0.06
ke = [0.795]  15 + 0.06
ke = 0.053 + 0.06
ke = 0.113, or 11.3 percent

102

Financial Management

Part D: What is the firms weighted average cost of capital?


Solution: The weighted average cost of capital (also called
cost of capital) takes into account the cost of each of the
sources of financing.
You know that the firm has three sources of funds: debt,
preferred stock, and common stock. A cost is associated
with each of the three sources:
cost of debt = 5.95 percent
cost of preferred stock = 9.9 percent
cost of common stock = 11.3 percent
You know after considering the proportions that these
sources contribute to the total external financing of the firm.
Of the $400,000 in total assets, debt represents 35 percent
($140,000  $400,000), preferred stock represents 5 percent
($20,000  $400,000) and common stock represents a total
of 60 percent ($240,000  $400,000).
debt = 35 percent
preferred stock = 5 percent
common stock = 60 percent
The total of the three components is 100 percent. The cost of
capital is the weighted average of these three components
and can be calculated as follows:
WACC = (percent debt) kd + (percent preferred stock) kp
+ (percent common stock) ke
WACC = (35 percent 5.95 percent) + (5 percent
9.9 percent) + (6 percent 11.33 percent)
WACC = (0.35 0.0595) + (0.05 0.099) + (0.6
0.1133)
WACC = 0.021 + 0.005 + 0.068
WACC = 0.094, or 9.4 percent
The optimal capital structure (the best mix of debt and
equity) is reached at the point where the WACC is minimized.
So, to find the optimal capital structure, you could calculate
the cost of capital for various proportions of debt and equity,
then select the capital structure that minimizes the WACC.

Lesson 5

103

As in the case of preferred stock, flotation costs can be significant with a new issue of common stock. Up to this point, the
cost of equity has been discussed under the assumption that
the firm doesnt have to issue new shares. In other words, the
opportunity cost associated with common stock is the cost of
retained earnings. If the firm uses a new issue of common
stock as a source of capital, the cost of equity will be higher.
To adjust for flotation cost, you need to calculate the net price
(price flotation costs) to use in your computations. The
difference between these two values can be illustrated in
the following example problem, which is Problem 2 from
page 396 in your textbook.
Example: Sun Instruments expects to issue new stock at
$34 a share, with estimated flotation costs of 7 percent of the
market price. The company currently pays a $2.10 cash dividend and has a 6 percent growth rate. What are the costs
of retained earnings and new common stock?
Solution: The cost of retained earnings is the opportunity
cost to investors.
ke = [D0 (1 + g)]  P + g
ke = [$2.10 (1 + 6 percent)]  $34 + 6 percent
ke = [2.10 (1 + 0.06)]  34 + 0.06
ke = [2.10 (1.06)]  34 + 0.06
ke = 2.226  34 + 0.06
ke = 0.065 + 0.06
ke = 0.125, or 12.5 percent

104

Financial Management

The cost of new common stock is calculated as follows:


flotation costs = 0.07 34 = $2.38
ke = [D0 (1 + g)]  P + g
ke = [$2.10 (1 + 6 percent)]  ($34 $2.38) + 6 percent
ke = [2.10 (1 + 0.06)]  (34 2.38) + 0.06
ke = [2.10 (1.06)]  (34 2.38) + 0.06
ke = 2.226  31.62 + 0.06
ke = 0.07 + 0.06
ke = 0.13, or 13 percent
Notice that the cost of issuing new common stock is higher
than the cost of retained earnings.

Lesson 5

105

Self-Check 11
Indicate whether each of the following statements is True or False.
______ 1. The cost of debt exceeds the cost of equity.
______ 2. Because interest is a tax-deductible expense, the effective cost of debt is less than the
stated rate of interest.
______ 3. Preferred stock is infrequently used because its more expensive than debt and offers
no tax savings.
______ 4. The weighted cost of capital includes the cost of all the components of a firms
capital structure.
______ 5. The effective cost of debt is reduced because interest is a tax-deductible expense.
______ 6. The cost of capital is less than the cost of debt and equity.
Complete Problems 3 and 4 on pages 396397 in your textbook.

Check your answers with those on page 144.

106

Financial Management

ASSIGNMENT 12
Read the following assignment. Then read pages 399429 and
106129 in your textbook. Be sure to complete the self-check
to gauge your progress.

In Assignment 11, you learned how to calculate the cost of


capital, or the cost of raising funds. Now, in this assignment,
youll learn about capital budgeting techniques, which are the
procedures used to select investments. Many different capital
budgeting techniques exist. Youll concentrate on mastering
the following three methods: the payback period, the net
present value, and the internal rate of return.

Payback Period
The payback period projects the amount of time that will pass
before te firm recovers its initial investments in a project. Lets
look at an example problem that illustrates this method.
Example: Consider the following two investment opportunities.

Investment A

Investment B

Year 0

$2,000

$2,000

Year 1

$790

$1,500

Year 2

$900

$2,800

Year 3

$1,200

$500

Year 4

$4,000

$600

Solution: To calculate the payback period, you need to find


the cumulative cash flows.

Lesson 5

107

Investment A

Investment B

Cash
Flow

Cumulative
Cash Flow

Cash
Flow

Cumulative
Cash Flow

Year 0

$2,000

$2,000

$2,000

$2,000

Year 1

$790

$1,210

$1,500

$500

Year 2

$900

$310

$2,800

$2,300

Year 3

$1,200

$890

$500

$2,800

Year 4

$4,000

$4,890

$600

$3,400

The payback period is the number of years it takes to get


back your initial outlay. For Investment A, its clear that the
payback occurs somewhere between Year 2 (cumulative CF =
$310) and Year 3 (cumulative CF = $890). Since at Year 2
the firm is still out $310, payback requires $310 of the next
cash flow. The payback is calculated as follows:
payback for Investment A = 2 + ($310  $1,200)
payback for Investment A = 2 + 0.26
payback for Investment A = 2.26 years
payback for Investment B = 1 + ($500  $2,800)
payback for Investment B = 1 + 0.18
payback for Investment B = 1.18 years
The payback period is a quick and easy capital budgeting
method. The calculation techniques are simple, and the theory
is relatively easy to understand. However, there are several
weaknesses to this method.
First, the payback method ignores the time value of money.
As you know from Lesson 1, a consideration of the time
value of money is critical to any sound financial decision.
Second, the payback method ignores cash flows that occur
after the initial outlay has been recouped. In the above problem, for example, the payback method clearly prefers
Investment B.

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Financial Management

Lets consider the same investments over 5 years.

Investment A

Investment B

Year 0

$2,000

$2,000

Year 1

$790

$1,500

Year 2

$900

$2,800

Year 3

$1,200

$500

Year 4

$4,000

$600

Year 5

$125,000

$200

Payback for Investment A = 2 + ($310  $1,200)


Payback for Investment A = 2 + 0.26
Payback for Investment A = 2.26 years
Payback for Investment B = 1 + ($500  $2,800)
Payback for Investment B = 1 + 0.18
Payback for Investment B = 1.18 years
The payback calculations remain the same because the
first few cash flows are unchanged. By the payback criteria,
Investment B is preferred. However, the $125,000 cash
inflow for Investment A in Year 5 has been ignored.
Your textbook states that the most widely used alternatives
to the payback method, net present value (NPV) and internal
rate of return (IRR), are discounted cash flows techniques.
This means that both of these techniques account for the
time value of money, and are generally considered to be
superior methods of capital budgeting.

Net Present Value (NPV)


Net present value (NPV) is the value of an investment in
todays dollars. Lets look at an example problem that
illustrates this method.

Lesson 5

109

Example: Consider two investments, each with an initial


outlay of $2,000 and an expected life of 4 years. Assume that
the firm has a cost of capital of 10 percent. Calculate the net
present value.
Solution: To calculate the net present value, you need to
find the present value of each cash flow. In other words,
you need to find the value of each cash flow in Year 0.

Investment A

Year 0

Investment B

Cash
Flow

Cumulative
Cash Flow

Cash
Flow

Cumulative
Cash Flow

$2,000

$2,000

$2,000

$2,000

Year 1

$790

$718

$1,500

$1,364

Year 2

$900

$744

$2,800

$2,314

Year 3

$1,200

$901

$500

$375

Year 4

$4,000

$2,732

$600

$410

Calculate the net present value of Investment A.


NPV = [$2,000  (1.10)0] + [$790  (1.10)1] +
[$900  (1.10)2] + [$1,200  (1 + 0.10)3] +
[$4,000  (1 + 0.10)4]
PV in Year 0 = $2,000  (1.10)0
PV in Year 0 = $2,000  1
PV in Year 0 = $2,000
PV in Year 1 = $790  (1.10)1
PV in Year 1 = $790  1.10
PV in Year 1 = $718
PV in Year 2 = $900  (1.10)2
PV in Year 2 = $900  1.21
PV in Year 2 = $744

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Financial Management

PV in Year 3 = $1,200  (1.10)3


PV in Year 3 = $1,200  1.331
PV in Year 3 = $901
PV in Year 4 = $4,000  (1.10)4
PV in Year 4 = $4,000  1.4641
PV in Year 4 = $2,732
NPVA = $2,000 + $718 + $744 + $901 + $2,732
NPVA = $3,095
Now, calculate the net present value of Investment B.
NPV = [$2,000  (1.10)0] + [$1,500  (1.10)1] +
[$2,800  (1.10)2] + [$500  (1 + 0.10)3] +
[$600  (1 + 0.10)4]
PV in Year 0 = $2,000  (1.10)0
PV in Year 0 = $2,000  1
PV in Year 0 = $2,000
PV in Year 1 = $1,500  (1.10)1
PV in Year 1 = $1,500  1.10
PV in Year 1 = $1,363
PV in Year 2 = $2,800  (1.10)2
PV in Year 2 = $2,800  1.21
PV in Year 2 = $2,314
PV in Year 3 = $500  (1.10)3
PV in Year 3 = $500  1.331
PV in Year 3 = $376
PV in Year 4 = $600  (1.10)4
PV in Year 4 = $600  1.4641
PV in Year 4 = $410

Lesson 5

111

NPVB = $2,000 + $1,363 + $2,314 + $376 + $410


NPVB = $2,463
The NPV is the sum of the discounted cash flows. Generally,
if the NPV is positive, the project or investment is acceptable.
Negative NPV projects arent acceptable.
In this example problem, both projects have NPVs that are
greater than zero, so both projects are acceptable if the projects are independent. If the projects are independent,the firm
can accept all projects with positive NPVs. However, if the
projects are mutually exclusive (meaning the firm should
accept only one project or the other, not both), then
Investment A (the higher NPV project) is preferable.
Note that NPV calculations are much less time consuming
with the aid of a financial calculator.

Internal Rate of Return


The calculation of internal rate of return (IRR) is similar to the
NPV process. The IRR is the interest rate that sets the NPV of
a project equal to zero, as shown in the following equation:
NPV = 0 at IRR percent
Lets look at an example problem that illustrates this method.
Example: Consider two investments, each with an initial
outlay of $2,000 and an expected life of 4 years. Calculate
the internal rate of return for each investment.

112

Investment A

Investment B

Cash Flow

Cash Flow

Year 0

$2,000

$2,000

Year 1

$790

$1,500

Year 2

$900

$2,800

Year 3

$1,200

$500

Year 4

$4,000

$600

Financial Management

Solution: The following equation can be used to calculate


the IRR for Investment A.
0 = [$2,000  (1 + r ) 0] + [$790  (1 + r ) 1] +
[$900  (1 + r ) 2 ] + [$1,200  (1 + r )3] + [$4,000  (1 + r ) 4]
In this example, note that the present value is set to zero
and the interest rate (r) becomes the missing variable.
Without the aid of a financial calculator, this equation must
be solved by trial and error. This requires making a first
guess at the interest rate and then adjusting the interest
rate until you find an NPV thats equal to zero. With a financial calculator, the calculation is much easier, and produces
the following results:
IRRA = 52 percent
IRRB = 71 percent
The IRR criteria says that an investment is acceptable if the
IRR is greater than k, where k is equal to the cost of capital
(in this problem, 10 percent). Again, if the investments are
independent, both are acceptable. In the case of mutually
exclusive investments, accept the higher IRR investment,
which is Investment B.
Investment A:
Investment B:

NPVA = $3,095
NPVB = $2,463

IRRA = 52 percent
IRRB = 71 percent

So, if the two investments are mutually exclusive, the NPV


criteria selects Investment A while the IRR criteria selects
Investment B. As stated in your textbook, theres a significant
difference in assumptions between the two capital budgeting
methods. NPV assumes that the cash flows are reinvested
at the cost of capital. IRR assumes that the cash flows are
reinvested at IRR. The NPV assumption is generally more
realistic; thus, NPV should be the preferable method if a
conflict does exist. Its important to note, however, that capital
budgeting decisions require significant subjective judgment
on the part of the financial manager.

Lesson 5

113

Self-Check 12
Indicate whether each of the following statements is True or False.
______ 1. An increase in interest rates increases the net present value of an investment.
______ 2. One weakness in the payback method of capital budgeting is that it fails to
consider the time value of money.
______ 3. The net present value of an investment cant be negative.
______ 4. The internal rate of return method of capital budgeting permits a ranking of
investment proposals.
______ 5. The internal rate of return on an investment will be higher if the cost of capital
is higher.
______ 6. An increase in the cost of capital will decrease an investments net present value.
Complete Problems 1, 2, and 3 on pages 429430 in your textbook.

Check your answers with those on page 146.

114

Financial Management

EXAMINATION NUMBER:

08172100
Whichever method you use in submitting your exam
answers to the school, you must use the number above.
For the quickest test results, go to
http://www.takeexamsonline.com

When you feel confident that you have mastered the material in
Lesson 5, go to http://www.takeexamsonline.com and submit
your answers online. If you dont have access to the Internet,
you can phone in or mail in your exam. Submit your answers for
this examination as soon as you complete it. Do not wait until
another examination is ready.
Questions 120: Select the one best answer to each question.

1. Which of the following statements best explains why a rising


ratio of debt-to-total assets increases the cost of debt?
A. As the ratio increases, creditors require higher interest
rates to compensate them for higher default risk.
B. As total assets decline in relation to a stable debt level,
equity declines.
C. As debt increases, the contribution of more expensive
equity financing decreases.
D. If debt remains constant while the ratio increases,
rising assets must be finance with more expensive
equity financing.
2. The flotation costs of issuing new securities
A.
B.
C.
D.

decrease the cost of capital.


encourage the retention of earnings.
encourage external financing.
dont affect the cost of capital.

Examination

Lesson 5
Corporate Finance, Part 2

115

3. If the net present values of two mutually exclusive investments are positive, a firm
should select
A.
B.
C.
D.

both investments.
neither investment.
the investment with the higher present value.
the investment with the higher net present value.

4. Which of the following statements about the cost of debt is correct?


A.
B.
C.
D.

The
The
The
The

cost
cost
cost
cost

of
of
of
of

debt
debt
debt
debt

is
is
is
is

equal to the firms interest rate.


greater than the cost of equity.
less than the cost of equity.
greater than the cost of preferred stock.

5. The internal rate of return and net present value methods of capital budgeting assume
that the cash flows are reinvested at the
A.
B.
C.
D.

cost of capital.
internal rate of return.
cost of capital for IRR and the internal rate of return for NPV.
cost of capital for NPV and the internal rate of return for IRR.

6. The optimal capital structure involves


A.
B.
C.
D.

minimizing the cost of all funds.


maximizing the cost of all funds.
minimizing the weighted average of the cost of funds.
maximizing the weighted average of the cost of funds.

Use the information in the following table to answer Questions 7, 8, 9, 10, and 11.

116

Coupon rate = 7 percent

Marginal tax rate = 35 percent

Average tax rate = 32 percent

Common stock dividend (D0 ) = $6

Price of common stock = $80

Preferred stock dividend = $4

Price of preferred stock = $50

Growth rate of common stock


dividend = 6 percent

Bond yield risk premium = 7


percent

Risk-free rate of return = 6


percent

Return on the market = 12 percent

Beta = 1.2

Examination, Lesson 5

7. According to the information provided in the table, what is the cost of debt?
A. 2.45 percent
B. 4.55 percent

C. 6.25 percent
D. 7.0 percent

8. According to the information in the table, what is the cost of preferred stock?
A. 8 percent
B. 9 percent

C. 10 percent
D. 12 percent

9. According to the information in the table, what is the cost of equity using the capital
asset pricing model (CAPM)?
A. 12 percent
B. 13.2 percent

C. 13.95 percent
D. 14.4 percent

10. According to the information in the table, what is the cost of equity using the bond
yield plus risk premium method?
A. 12 percent
B. 13.2 percent

C. 13.95 percent
D. 14 percent

11. According to the information in the table, what is the cost of equity using the expected
growth method?
A. 12 percent
B. 13.2 percent

C. 13.95 percent
D. 14.4 percent

12. A firm should make an investment if the present value of the cash inflows on the
investment is
A.
B.
C.
D.

less than zero.


greater than zero.
less than the cost of the investment.
greater than the cost of the investment.

13. Which of the following statements about retained earnings is correct?


A.
B.
C.
D.

Retained
Retained
Retained
Retained

earnings
earnings
earnings
earnings

Examination, Lesson 5

have no cost.
are the firms cheapest source of funds.
have the same cost as new shares of stock.
are cheaper than the cost of new shares.

117

Use the following information to complete Questions 14, 15, 16, and 17.

A firm has two investment opportunities. Each investment costs $2,000, and the firms cost
of capital is 8 percent. The cash flows of each investment are shown in the following table:

Cash Flow of
Investment A

Cash Flow of
Investment B

Year 1

$1,800

$900

Year 2

$600

$900

Year 3

$500

$900

Year 4

$400

$900

14. According to the information in the table, the NPV for Investment A is
A. $871.
B. $1,300.

C. $2,871.
D. $3,300.

15. According to the information in the table, the NPV for Investment B is
A. $980.
B. $1,600.

C. $2,980.
D. $3,600.

16. Based on the information in the table, if the investments are mutually exclusive,
the firm should select
A.
B.
C.
D.

neither investment.
both investments.
the higher-NPV investment.
the higher-payback investment.

17. Based on the information in the table, if the investments are independent, the firm
should select
A.
B.
C.
D.

the higher IRR investment.


all investments with an IRR thats greater than 8 percent.
all investments with an IRR thats less than 8 percent.
only one investment if the IRR is greater than 8 percent.

18. A firm should reject an investment if the internal rate of return (IRR) on the investment is
A. greater than the cost of capital.
B. less than the cost of capital.

118

C. greater than the interest rate.


D. less than the interest rate.

Examination, Lesson 5

19. The net present value of an investment will be higher if


A.
B.
C.
D.

the cost of capital is higher.


theres no salvage value.
the cost of the investment is lower.
a firm uses straight-line depreciation.

20. Which of the following statements about the marginal cost of capital is correct?
A. The marginal cost of capital is a firms cost of debt and equity finance.
B. The marginal cost of capital is constant once the optimal capital structure
is determined.
C. The marginal cost of capital declines as flotation costs alter equity financing.
D. The marginal cost of capital refers to the cost of additional funds.

Examination, Lesson 5

119

NOTES

120

Examination, Lesson 5

Self-Check 1
1. False
2. True
4. True
5. False

Answers to Textbook Problems


1. a.

x = $1,000(1 + 0.05)10
x = $1,000(1.629) = $1,629
$1,000 grows to $1,629 at 5% for ten years, of
which $629 is interest. (The 1.629 is the interest
factor for the future value of $1 for six years at 5%.)

b. If the interest is withdrawn each year, the investor


receives $50 annually and $500 over the lifetime of
the investment.
c.
2. a.

The difference in the amount of interest ($629


$500 = $129) is the result of compounding.
x = $3,000(73.106) = $219,318
(73.106 is the interest factor for the future sum of
an annuity of $1 at 8% for 25 years.)

b. x = $3,000(113.283) = $339,849
(113.283 is the interest factor for the future sum of
an annuity of $1 at 8% for 30 years.)
The additional funds:
$339,849 $219,318 = $120,531
Leaving the funds in the account and continuing
the annual contribution for only five additional
years increases the retirement funds by over
$120,000.
c.

In this question, the individual stops making the


contribution but doesnt draw on the fund. The
amount grows to:

Answers

3. False

$219,318(1 + 0.08)5 = $219,318(1.469) = $322,178


(1.469 is the interest factor for the future value of
$1 at 8% for five years.)
The difference in (b) and (c) is
$339,849 $322,178 = $17,671
121

4. This problem illustrates the benefit of starting an


investment plan earlier rather than later.
You invest $1,500 starting at age 20 and continue to
invest for 10 years:

FV =

$1,500[(1 + 0.07)10 1]
$1,500[1.9672 1]
=
0.07
0.07
$1,500[.9672] $1,450.7270
=
0.07
.07

= $20,724.67

That sum continues to grow for 30 more years:


FV = $20,724.67(1 + 0.07)30 = $20,724.67(7.6123) =
$157,761.49
Your twin sister invests $1,500 for 30 years starting at
age 30:
$1,500[(1 + 0.07)30 1]
FV =

0.07

$1,500[7.6123 1]
=

0.07

$1,500[6.6123]
$9,918.3826
=
= $141,691.18
0.07
.07
You have the larger amount by the time you and your
twin reach age 60.

5. This problem illustrates the future value of a sum of an


annuity. The amount of the annual contribution is the
unknown value and the future sum is known.
x.(41.301) = $100,000
x = $100,000 41.301 = $2,421
(41.301 is the interest factor for the future sum of an
annuity of $1 at 9% for 18 years.)
If the father started saving for college expenses early,
the required annual amount may be modest. However,
few parents start saving when a child is born for its
college education, and college costs continue to rise, so
the $100,000 may be inadequate 18 years from now.

122

Answers

6. To answer this question, determine the amount that


can be withdrawn:
$93,000 = x (PVAIF)
$93,000 = x (6.418)
x = $14,490.50
7. This problem is an introduction to variation. It asks
what is the present value of a series of future payments
(i.e., illustrates discounted cash flow):
x = [$10,000 (1 + 0.10)] + ... + [10,000 (1 + 0.10)25]
x = $10,000(9.077) = $90,770
(9.077 is the interest factor for the present value of an
annuity of $1 at 10% for 25 years.)
If this investment costs $120,000, its overpriced and
shouldnt be purchased, since its only worth $90,770.
9. The solution calculates the future value of $50,000 after
10 years at a 4% growth rate:
FV = $50,000(1.04)10
= $50,000(1.480)
= $74,012.21
12. $65,000(1 + N )5 = $100,000
(FV$IF) = 100,000 65,000 = 1.538
1.538 is the interest factor for the future value of $1 at
x % for five years. The required interest rate is 9%.
13. $10,000(PVAIF) = $33,520
PVAIF = $33,520 $10,000 = 3.352
Look up 3.352 in the interest table for the present value
of an annuity of $1 to determine that the rate of return
is 15%.
14. x (interest factor for the present value of an annuity of
$1 at 10% for 10 years) is 6.145.
x(6.145) = $61,446
x = $61,446 6.145 = $10,000
15. At 6%:
$150(5.637) = $845.55 < $900
(5.637 is the interest factor for the future value of an
annuity of $1 at 6% for five years.)
$150(6.610) = $991.50 > $900
Answers

123

At 14%:
(6.610 is the interest factor for the future value of an
annuity of $1 at 14% for five years.)
The higher interest rate favors early payments that are
assumed to be reinvested at the higher rate. Thus,
in this example, the $150 received in the early years
produce the higher terminal value when they compound
at 14%. (This problem could be solved by taking both
payments out to their future values at the end of the
fifth year.)
18. $1(1 + x )6 = $2
(1 + x )6 = interest factor = 2  1 = 2
x = 12%
Look up 2 in the interest table for the future value of $1
under six years and determine the growth rate to be
approximately 12%.
19. ($2,000) (FVAIF at 10% for x years) = $50,000
interest factor = $50,000 $2,000 = 25
x, the number of years, is slightly more than 13.
Look up 25 in the interest table for the future value of
an annuity of $1 at 10% and determine the number to
be approximately 13 years.

Self-Check 2
1. True
2. False
3. True
4. True
5. False
6. False

124

Answers

Answers to Textbook Problems


1.

Income Statement: Corporation X


Income Statement for the Year Ended
XX/XX/XX
Sales
Cost of goods sold
Other expenses
Earnings before interest and taxes
Interest expense
Earnings before taxes
Taxes
Net earnings
Number of shares outstanding
Earnings per share

$1,000,0000
600,0000
100,0000
$ 300,0000
80,0000
$ 220,0000
100,0000
$ 120,0000
100,0000
$1.200

2.
C orporation X B alance Sheet as of XX/XX/XX
Assets
C ash and cash equi valents
Accounts recei vable
Inventory
Total current assets
Land
Plant and equi pment ($5,800,000
000less accumulated
000depreci ati on of $800,000)

Liabilities and Ow ners' Equity


$ 300,000
4,100,000
006,400,000
$10,800,000
1,000,000
5,000,000

0000000000
$16,800,000

Accounts payable
Taxes due
Accrued wages
C urrent porti on of long-term debt
Total current li abi li ti es
Long-term debt
Preferred stock
C ommon stock
000($10 par
000150,000 shares outstandi ng)
Retai ned earni ngs

$ 2,100,000
100,000
400,000
300,000
$ 2,900,000
4,200,000
500,000

001,500,000
007,700,000
$16,800,000

8. Current ratio:
current assets  current liabilities = ($100,000 +
357,000 + 458,000)  $498,000
= $915,000  $498,000
= 1.84:1
Quick ratio:
(current assets inventory)  current liabilities =
($915,000 458,000)  $498,000
= $457,000  $498,000
= 0.92:1

Answers

125

10. a.

Receivables turnover: $10,640,000 


$1,520,000 = 7

b. Sales per day: $10,640,000  365 = $29,150.68


Days sales outstanding: $1,520,000 $29,150.68
= 52 days
c.

52 days 30 days = 22 days overdue

13. operating profit margin = EBIT  sales


Firm A: $150,000  $1,000,000 = 15%
Firm B: $150,000  $1,000,000 = 15%
net profit margin = net earnings sales
Firm A: $80,000  $1,000,000 = 8%
Firm B: $45,000  $1,000,000 = 4.5%
Both firms have the same operating profit margins; the
difference in the net profit margin is the result of Firm B
paying more interest.
return on equity = earnings  equity
Firm A: $80,000  $600,000 = 13.3%
Firm B: $45,000  $300,000 = 15%

Self-Check 3
1. False
2. True
3. False
4. False
5. True
6. False
7. True
8. True
9. Parties to the sale of securities in initial public offerings
assume the risk that demand for the securities will be low.
In a best-efforts agreement, the issuer (not the investment
banker) assumes most of the risk. In contrast, if the agreement assigns underwriting to the investment banker, the
issuer is guaranteed certain proceeds from the sale. The
underwriters guarantee forces the underwriter to pay the
issuer for securities not sold in the offering.

126

Answers

10. Both commercial bankers and investment bankers transfer


funds from savers to users. Commercial bankers borrow
money (in the form of savings accounts, certificates of
deposit) from savers to fund loans to borrowers (users).
Investments bankers shift money from savers (securities
buyers) to corporations that use the money.
11. One factor is that longer-term interest-bearing securities
generally must pay investors higher interest rates than
shorter-term securities to compensate investors for additional risk associated with waiting a longer period for
payment of principal and interest. This factor effectively
forces an upward-sloping yield curve. Another is that
inflation renders longer-term, interest-bearing securities
less desirable than shorter-term securities, which forces
an upward-sloping yield curve. If deflation applies, it
would force a downward-sloping yield curve. A third factor
is that todays expectation of future interest rates can,
depending on the markets sentiment, influence the
slope of the yield curve. Higher interest rate expectations
force an upward-sloping curve; lower interest rate expectations force a flatter curve. Finally, uncertainty about
the economy and the general creditworthiness of issuers
can force a steeper curve.
12. Life insurance companies offer, in addition to a death
benefit, a saving vehicle when investors buy annuities
and cash value life insurance policies. Savers funds are
then applied to investors who use those funds through
debt and equity. The parties in this transfer are policy
holders (savers) and corporations or governments (users).
Likewise, banks lend money to borrowers (users) using
money provided by depositors (savers).

Self-Check 4
1. True
2. False
3. True
4. True
5. False
6. True

Answers

127

Answers to Textbook Problems


3. a.

$41.50 $45 = ($3.50)

b. $45 $41.50 = $3.50


c.

$54 $45 = $9

d. $45 $54 = ($9)


In each case, the sale price is subtracted from
the purchase price to determine the profit or loss.
4. Unfortunately, investor Graham didnt cover the short
sale after the stock declined but waited until the price
of the stock rose, and thus sustained a loss of $7 per
share for a total loss of $3,500.
5. Cost of the shares: 200 $25.50 = $5,100
Margin: $5,100 40% = $2,040
Funds borrowed: $5,100 $2,040 = $3,060
Interest paid: $3,060 0.09 = $275.40
Profit on the stock: $6,800 $5,100 = $1,700
Return on the investment: ($1,700 $275.40)
$2,040 = 69.8%

Self-Check 5
1. True
2. False
3. True
4. False
5. True
6. True

Answers to Textbook Problems


1. The number of pounds necessary to purchase $1 is
$1.00 1.82 = 0.5495 pounds
2. Value of the inventory:
Before: 500,000 euros  $1.20 = $600,000
After: 500,000 euros  $1.30 = $650,000
Change in Dollars: $650,000 $600,000 = $50,000 (Gain)

128

Answers

Change in euros: The inventory was denominated in


euros before and after the change in the relative value
of euros and dollars. Therefore, theres no change in the
value of the inventory expressed in euros.
3. The balance of current and capital accounts can be
illustrated by the following table using the form of the
table appearing on page 97 of the textbook. Parentheses
indicate negative values, or net debit balances.
Debit (-)

Credit (+)

Balance

Current Account
Imports

211.50

Exports
Government Spending
Abroad

182.10
4.60

Net Income from


Foreign Investments

32.30

Current Account Balance

(1.70)

Capital Account
Foreign investments in U.S.
U.S. Investments Abroad
Foreign Securities Bought
by U.S.

7.70
24.70
4.90

U.S. Securities Bought


by Foreigners
Purchase of Short-Term
Foreign Securities
Foreign Purchase of U.S.
Short-Term Securities
Capital Account Balance

Answers

2.80
6.50
9.10
(16.50)

129

Self-Check 6
1. False
2. False
3. False
4. True
5. False
6. True
7. False

Answers to Textbook Problems


1. a.

PMT
PMT
PMT
FV



1
2
n
(1i )
(1i )
(1i )
(1i )n
60
60
60
60
60
60






1
2
3
4
5
(10.08)
(10.08) (10.08) (10.08) (10.08)6
(10.08)
60
60
60
60
1, 000





7
8
9
10
(10.08)
(10.08)
(10.08) (10.08)
(1
1 0.08)10
60
60
60
60
1, 000
60
60
60
60
60
60











7
1
.
714
1
.
851
1
.
999
2
.
159
2 .159
1. 080 1.166
1.260 1.360 1.469 1.58
 55 .556 51.44047.630 44.10240.83537.81035.00932.46130.015
27.792463.193
PB 

 $865.80
b.
PMT
PMT
PMT
FV



1
2
n
(1i )
(1i )
(1i )
(1i )n
60
60
60
1, 000
60
60






1
2
3
4
5
(10.08)
(10.08) (10.08) (10.08) (10.08)5
(10.08)
60
60
60
60
60
1, 000






1. 080 1.166 1.260 1.360 1.469 1.469
 55 .556 51.44047.630 44.10240.835680.583
PB 

 $920.15

130

Answers

c.

In both cases, the bonds price is less than par


because the current rate of interest is greater than
the rate paid on these bonds (i.e., 9% versus 7%).
However, the amount of price decline is affected by
the term of the bond, and the bond with the longer
term experiences the larger price depreciation
(because the investors will collect the small interest
payment for a longer period of time).

d. Notice that the interest payment plays a larger role


in the price of the bond for the bond with the longer
term. In the case of the bond with twenty years to
maturity, the interest payments constituted 78% of
the bonds value. The interest payments constituted
30% of the bonds value in the case of the bond with
the term of five years.
e.

The current yields are


$70 $817 = 8.57%
$70 $922 = 7.59%
The yields to maturity are 9% in both cases.

Self-Check 7
1. True
2. True
3. False
4. False
5. True
6. False
7. True

Answers to Textbook Problems


Page 234
1. EPS before the split: $6,900,000  5,000,000 = $1.38
EPS after the split: $6,900,000  15,000,000 = $0.46
Price of the stock before the split: $60
Price of the stock after the split: $60  3 = $20
2. Under traditional trading: 1,000 votes per seat
Under cumulative voting: 1,000 4 = 4,000 votes may
be cast for any one seat
Answers

131

3. a.

New price of the stock: $90  2 = $45

b. Payout ratio before the split: $6  $9.50 = 63.2%


Payout ratio after the split and the dividend is
increased to $3 a share: $3  $4.75 = 63.2%
(The increase in the cash dividend may cause the
price of the stock to rise, but its the dividend
increment and not the stock split that increases the
value of the shares.)
Pages 251252
1.
a.

V
V

4.

b.

V

c.

V

d.

V

e.

V

V

D0 (1g )
k g
$2(10.06)
0.10  0.06

$3(10.06)
0.10  0.06

$2(10.06)
0.075  0.06

$2(10.04)
0.10  0.04

2.12
0.04

3.18
0.04

 $53.00

 $79.50

2.12
0.015

2.08
0.06

$2.30(10.04)
0.10  0.04

 $141.33

 $34.67

2.39
0.06

 $39.87

D0 (1g )
k g

$26 

$1.30(10.12)
k  0.12

1.456
k  0.12

$26(k  20.12))1.456
$26 k  3.12)1.456
$26 k  4.576
k  0.176 or 17.6%

132

Answers

Page 291
1. Price of the perpetual preferred stock = preferred
dividends required return
At 13%: $9 0.13 = $69.23
At 11%: $9 0.11 = $81.82
2. a.

Price of the perpetual preferred stock = preferred


dividends required return = $8 0.07 = $114.29

b. Price of preferred stock that must be retired at a


specified time period:
PPFD = [$8 (1 + 0.07)] + [$8 (1 + 0.07)2] + ... +
[$8 (1 + 0.07)20] + [$100 (1 + 0.07)20]
= $8(10.594) + $100(0.258)
= $110.55
4.
Times-preferred-dividend-earned ratio 

Earnings taxes
Dividends on preferred stock
$12,000,0003,000,0004,000,000
1,000,000
5,000,000

5.0
1,000,00
00

X1 Times-preferred-dividend-earned ratio 

$15,000,0005,900,0005, 400,000
1,000,000
3,700,000

3.7
1,000,000

X2 Times-preferred-dividend-earned ratio 

X3 Times-preferred-dividend-earned ratio  $17,000,00011,000,0004,000,000


1,500,000
Analysis: The past three years financial results indicate progressively less capacity to pay the preferred stock dividend.

Self-Check 8
1. False
2. False
3. True
4. True
5. False
6. False

Answers

133

Answers to Textbook Problems


1. assets liabilities = equity
$10,000,000 $600,000 = $9,400,000
Net asset value per share: $9,400,000 1,200,000 =
$7.83
2. Load fee: $25 $23.40 = $1.60
Load fee as a percent of net asset value: $1.60
$23.40 = 6.8%
3. The investor received $0.58 in distributions plus the
net asset rose $3.41 ($23.41 20) for a total return
of $3.99. On an investment of $20, the percentage
return is $3.99 $20 = 19.95%.

Self-Check 9
1. False
2. False
3. True
4. False
5. False
6. True

Answers to Textbook Problems


Page 348
2.
a. Corporate income taxes for years 15.
Year

Earnings
Tax (25%)

$1,000

3.000

4,300

5,200

4,400

$250

750

1,075

1,300

1,100

b. If the corporation elects to carry back, taxes paid in


years three and four will be refunded in full. Year-five
taxes will be refunded only up to the total losses realized in year six. So for year five, taxes are reduced by
$325, yielding net tax paid of $775.

134

Answers

Year

Earnings

Tax (25% )

Carry-Back
Earnings
Applicable to
Refund

Tax Applicable
to Refund

Tax Paid

$1,000

$250

3,000

750

4,300

1,075

$4,300

$1,075

$0

5,200

1,300

5,200

1,300

4,400

1,100

1,300

325

775

(10,8000)

10,800

Pages 356358
1.

a. The table:

Quantity

Total
R even u e

Variable
Costs

Fixed
Costs

Total
Costs

Profits
(Loss)

$0

$0

$6,000

$6,000

($6,000)

500

4,250

1,600

6,000

7,600

(3,350)

1,000

8,500

3,200

6,000

9,200

(700)

1,500

12,750

4,800

6,000

10,800

1,950

2,000

17,000

6,400

6,000

12,400

4,600

2,500

21,250

8,000

6,000

14,000

7,250

3,000

25,500

9,600

6,000

15,600

9,900

b. The break-even level of output using the above table:

Quantity

Total
R even u e

Variable
Costs

Fixed
Costs

Total
Costs

Profits
(Loss)

$0

$0

$6,000

$6,000

($6,000)

500

4,250

1,600

6,000

7,600

(3,350)

1,000

8,500

3,200

6,000

9,200

(700)

1,132

9,622

3,622

6,000

9,622

1,500

12,750

4,800

6,000

10,800

195

2,000

17,000

6,400

6,000

12,400

4,600

Answers

135

Confirmation of break-even level of output = FC/( P  V )


$6,000/($8.50  3.20) = 1,132 units

$
Total costs = $6,000 + 3.2Q
Variable costs = 3.2Q
Fixed Costs = $6,000

Quantity

c. If fixed costs were $10,000 instead of $6,000, the fixed


costs and total costs schedules increase. There would be
no change in the total revenue schedule. The new
break-even level of output is
Break-even level of output = FC/( P  V )
=$10,000/($8.50  3.20) = 1,887 units.
2. a.

b.

The break-even levels of output:


$3,000/($4  2.80) = 2,500 and $5,000/($4  2.40)
= 3,125
Earnings = total revenues - total costs
Total revenue = $4(5,000) = $20,000
Earnings under the two alternatives:
1. $20,000  $3,000  $2.80 (5,000) = $3,000
2. $20,000  $5,000  $2.40 (5,000) = $3,000
Sales of 5,000 units equates earnings. If output is
less than 5,000 units, then the cost function with
the lower fixed costs and higher variable costs
produces the higher profits (or smaller losses). If
output exceeds 5,000 units, then the scale of
operation with higher fixed costs and lower
per-unit costs will generate the higher earnings.

c.

136

At sales of 2,000 and scale of operation with


TC = $3,000 + $2.80Q, then earnings are
$4(2,000)  $3,000  $2.80(2,000) = ($600).

Answers

However, $1,500 of the expenses is noncash


depreciation, so the cash flow generated by
operations is
earnings
($600)
depreciation
1,500
$900
(Remember that a firm may operate at an accounting
loss but still generate positive cash flow.)
If the second scale of operations is used and TC =
$5,000 + $2.4Q, the earnings would be
earnings =$4(2,000)  $5,000  $2.4(2,000) =
($1,800).
Cash flow would be
earnings
($1,800)
depreciation
2,500
$700
Either scale of operation generates positive
cash flow.

3.

d.

If the firm selects the scale of production with higher


fixed cost, it can expect net income to exceed fixed
and variable costs by $1,400 in year 1 and $3,000
in year 2. This scale of operation can be justified by
its positive contribution to the firms earnings and
ultimately to the value of the corporation for share
holders. However, compared to the lower scale of
operation, projected profits for the first two years
combined are lower for the scale of production with
higher fixed cost.

a.

Break-even level of output:


$4,000/($2  1.50) = 8,000 units
Earnings: $2(9,000)  $4,000  $1.50(9,000) = $500

b.

Break-even level of output:


$6,000/($2  .50) = 4,000 units
Earnings: $2(9,000)  $6,000  $.50(9,000) = $7,500
Generally a substitution of fixed for variable costs
increases the level of output necessary to break
even. However, that need not necessarily always be
the case, as this problem illustrates. The very large
decrease in per unit variable costs more than offsets
the increase in fixed costs with the result that the
break-even level of output declines.

Answers

137

Page 372
1.

The following table illustrates the facts in the case.


Case Facts for Problem 1
Firm A

Firm B

$10,000

$10,000

Equity
Debt
Rate Applicable to Debt

100%

50%
50%
10%

Quantity
Sales per Unit
VC per Unit
Fixed Cost

10,000
$2.50
$1
$12,000

10,000
$2.50
$1
$12,000

Assets
Asset Financing

Sales

a.

b.

c.

Revenue

$25,000

$25,000

Variable Cost

(10,000)

(10,000)

Fixed Cost

(12,000)

(12,000)

Earnings before
$3,000
Interest and Tax (EBIT)

$3,000

Revenue

$25,000

$25,000

Variable Cost

(10,000)

(10,000)

Fixed Cost

(12,000)

(12,000)

Earnings before
$3,000
Interest and Tax (EBIT)

$3,000

Interest

($500)

Earnings after
Interest

$3,000

$2,500

Revenue

$27,500

$27,500

Variable Cost

(11,000)

(11,000)

Fixed Cost

(12,000)

(12,000)

Earnings before
$4,500
Interest and Tax (EBIT)

$4,500

Interest

($500)

Earnings after Interest $4,500

138

$4,000

Answers

d.

The percentage change is different because Firm Bs


interest expense kept Firm Bs earnings after interest
lower than Firm As earnings after interest. The
production and sales increase introduced in 1.c.
increased both firms earnings before interest by
the same amount, and since the interest expense
didnt increase along with the production and sales
increase, the percent change was greater in Firm B.
This problem illustrates the potential benefit of
leverage. If, instead of increasing production and
sales, the problem had introduced a decline in
production and sales, Firm Bs earnings after
interest would have also fallen at a greater rate
than Firm As earnings after interest. Leverage
imposes greater volatility of earnings (loss)
potential, and thus increases business risk.

Self-Check 10
1. False
2. False
3. False
4. True
5. False
6. True
7. False

Answers to Textbook Problems


Page 456
1.

a. The assets and liabilities that vary with sales, their


percent of sales, and the forecasted level of these assets
and their liabilities are

Asset and Liability

Percent of Sales

Forecasted Level

accounts receivable

$200 $1,000

(0.2)$1,500 = $300

inventory

$400 $1,000

(0.4)$1,500 = $600

trade accounts payable

$200 $1,000

(0.2)$1,500 = $300

Answers

139

Notice that plant, long-term debt, and equity arent


affected since they dont spontaneously change
with the level of sales.
b. The spontaneous increase in assets is $300
($900 $600), and the increase in liabilities is
$100. The spontaneous increase in liabilities is
insufficient to meet the expansion in assets. The
firm will need additional financing. Such funds
may come from external sources (e.g., commercial
bank loan) or internal sources (e.g., retained
earnings). In this problem, the firm earns $150
(0.10 $1,500), so the retention of earnings will
be insufficient to cover the expansion in assets.
Page 460
7.

This problem requires forecasting to determine the need


for external financing, if any, and to apply any excess
funds to marketable securities.
Heres the current balance sheet:
Assets

Liabilities and Equity

Cash

3,200

Accruals

Marketable
Securities

2,000

Accounts Payable

Accounts
Receivable

17,130

Notes Payable

Inventory

19,180

Plant and
Equipment
Total Assets

4,900
17,050
7,000

Long-Term Debt

22,000

Common Stock

20,000

41,000

Retained Earnings

11,560

82,510

Total Liabilities
and Equity

82,510

These facts are also provided:

140

Current sales

$160,000

Projected sales

$200,000

Net profit margin

10 percent

Divident distribution rate

60 percent

Answers

The following inputs and calculations help solve the problem:


Projected Sales

$200,000

(given)

Net Profit Margin

$20,000

(result of applying the 10 percent


profit margin to projected sales)

Dividend Payout

$12,000

(result of applying the 60 percent


dividend payout to net profit margin)

Net Profit Margin


after Dividends

8,000

(result of subtracting dividend payout


from net profit margin)

Assume that, within these constraints, accounts receivable,


inventory, accruals, and accounts payable will proportionally
increase with the increase in sales. But cash is constrained
to $1,000 more than the current balance and we must add
$10,000 to Plant and Equipment. Notes payable is short-term
debt that would change as a result of a financing decision, not
business operations. Likewise, Long-Term Debt and Common
Stock balances would be unaffected by a change in production.
We werent given information about Long-Term Debt that would
enable us to reduce it if principal payments were to be made
during the next fiscal year, so well leave this value unchanged.
In real business applications, part of the long-term debt could
be retired, as principal is paid on the debt, and/or some of the
long-term debt would be reduced to short-term debt.
To answer part A of this item, create the pro forma balance
sheet required for part B, because you need these numbers
to answer part A.
Pro Forma
Assets
Cash
Marketable Securities

Liabilities and Equity


4,200

Accounts Receivable

21,413

Inventory

23,975

Plant and Equipment

51,000
100,588

Answers

Accruals

6,125

Accounts Payable 21,313


Notes Payable

7,000

Long-Term Debt

22,000

Common Stock

20,000

Retained Earnings 19,560


95,998

141

The cash balance is prescribed, we liquidated Marketable


Securities; Accounts Receivable and Inventory increased proportionally to the increase in Aales and Plant and Equipment
was prescribed. Accruals and Accounts Payable increased
proportionally and Retained Earnings increased as a result
of net income. We applied the 10 percent net profit margin to
forecast sales and subtracted dividend payments to arrive at
the credit to retained earnings.
The imbalance in the balance sheet leads us to increase Notes
Payable and/or Long-Term Debt by a total of the difference,
(100,588 95,998 = ) 4,590 to arrive at the financing requirement. With that change, our pro forma looks like this if we
use Long-Term debt to finance the expansion:
Pro Forma
Assets
Cash
Marketable Securities

Liabilities and Equity


4,200

Accounts Receivable

21,413

Inventory

23,975

Plant and Equipment

51,000
100,588

Accruals

6,125

Accounts Payable 21,313


Notes Payable

7,000

Long-Term Debt

26,590

Common Stock

20,000

Retained Earnings 19,560


100,588

Page 469
1.

142

This problem requires you to prepare a monthly cash


budget. The following table illustrates an efficient way
to prepare the cash budget using a spreadsheet.

Answers

Cash Budget for Problem 1

Sales

Cash
Receipts

Accounts
Receivable
Liquidation

Wages

Fixed
Disbursements

Other
Cash
Flows

Beginning Cash

Cash
Balance
before
Min. Cash
Rqmt.

Monthly
Short
Term
Financing

150

Jan.

100

40

60

100

30

120

Feb.

300

120

60

180

100

70

220

Mar.

500

200

180

300

100

200

110

40

Apr.

1,000

400

300

600

100

200

90

240

May

500

200

600

300

100

310

160

June

300

120

300

180

100

250

100

200

Given sales by month with 40 percent of sales received in


cash, construct a cash receipts column by multiplying sales
by 0.40. Sixty percent of sales are on credit with cash
received by the end of the next month. No December sales
are given to arrive at December credit sales reduced to cash
in January, so we must assume 0. Create the wages column
by multiplying sales by the given 60 percent cost. The $100
monthly fixed costs and other cash flows are given. The
beginning cash balance is also the minimum permitted by
management. In the Cash Balance before Min. Cash Rqmt.
column we sum values in corresponding rows, so for
January, we start with $150, add January cash receipts,
subtract January wages, subtract fixed disbursements and
arrive at $30. Management requires a minimum $150 cash
balance, so the Monthly Short-term Financing column
reveals the corresponding financing requirement of ($30
150 = ) $120. The same process is repeated for each month.
The conclusion is that we must plan to borrow $120, $220,
$40 and $240 in January, February, March and April,
respectively, to fund our cash obligations and meet the
minimum cash balance set by management.

Answers

143

Self-Check 11
1. False
2. True
3. True
4. True
5. True
6. False

Answers to Textbook Problems


3. a.

The cost of capital is a weighted average:


k = (weight)(cost of debt) + (weight)(cost of equity)

Debt/Assets

Weight cost of
debt

Plus

Weight cost of equity

0%

(0.0)(0.08)

(1.0)(0.12)

0.120

10%

(0.1)(0.08)

(0.9)(0.12)

0.116

20%

(0.2)(0.08)

(0.8)(0.12)

0.112

30%

(0.3)(0.08)

(0.7)(0.13)

0.115

40%

(0.4)(0.09)

(0.6)(0.14)

0.120

50%

(0.5)(0.10)

(0.5)(0.15)

0.125

60%

(0.6)(0.12)

(0.4)(0.16)

0.136

Equals Cost of capital

b. The optimal capital structure is that combination


that minimizes the firms cost of capital. In this
case, that occurs where debt is 20% of capital and
the cost of capital is 11.2%. The balance sheet is
Assets: $100
Debt: $20
Equity: $80
Since the firm is currently using only 10% debt
financing, it isnt at its optimal capital structure
and should substitute some debt for equity.
c.

144

The cost of capital initially declines because the


effective cost of debt is less than the cost of equity.

Answers

d. As the firm continues to substitute debt for equity,


the firm becomes more financially leveraged and
riskier. This causes the interest rate to rise and the
cost of equity to increase. These increases in the
cost of debt and equity cause the cost of capital
(i.e., the weighted average) to increase.
4. a.

The optimal capital structure: 30% debt and 70%


equity with a cost of capital of 7.1%.

Debt/Assets

Weight cost of
debt

Plus

Weight cost of equity

0%

(0.0)(0.04)

(1.0)(0.08)

0.080

1%

(0.1)(0.04)

(0.9)(0.08)

0.076

20%

(0.2)(0.04)

(0.8)(0.08)

0.072

30%

(0.3)(0.05)

(0.7)(0.08)

0.071

40%

(0.4)(0.06)

(0.6)(0.10)

0.084

50%

(0.5)(0.08)

(0.5)(0.12)

0.100

60%

(0.6)(0.10)

(0.4)(0.14)

0.116

70%

(0.7)(0.12)

(0.3)(0.16)

0.132

Equals Cost of capital

b. The cost of capital initially declines because the


firm is substituting cheaper debt financing.
c.

As the firm becomes more financially leveraged and


riskier, the cost of debt and equity will rise and
cause the cost of capital to increase.

d. The cost of debt is less than the cost of preferred


stock because of the tax advantage: the deductibility
of interest. Preferred stock dividends are paid after
taxes, so the cost to the firm of preferred stock
financing always exceeds the cost of debt financing.
e.

Answers

If interest wasnt tax deductible, the cost of debt


would be higher, increasing the cost of capital.

145

Self-Check 12
1. False
2. True
3. False
4. True
5. False
6. True

Answers to Textbook Problems


1.

Determination of the internal rate of return:


$23,958 = [$6,000 (1 + r )] + [$6,000 (1 + r )2] +
[$6,000 (1 + r )3] + [$6,000 (1 + r )4] + [$6,000 (1 + r )5]
$23,958 = $6,000 (PVAIF for 5 years at ? percent)
IF = 3.993
If you locate 3.993 in the interest table for 5 years, youll
find that the internal rate of return is 8%.

2.

a.

Determination of net present value:


NPVA = [$300 (1 + 0.1)] + [$200 (1 + 0.1)2] +
[$100 (1 + 0.1)3] $480
NPVA = $300(0.909) + $200(0.826) + $100(0.751) $480
NPVA = $513 $480 = $33
NPVB = [$200 (1 + 0.1)] + [$200 (1 + 0.1)2] +
[$200 (1 + 0.1)3] $480
NPVB = $200(0.909) + $200(0.826) + $200(0.751) $480
NPVB = $497 $480 = $17
The firm should make both investments because
their net present values are positive.

146

Answers

b. Determination of the internal rate of return for A:


$480 = [$300 (1 + r )] + [$200 (1 + r )2] +
[$100 (1 + r )3]
Since this isnt an annuity, select an interest rate
and attempt to equate both sides of the equation.
For example, use 14%:
$300(0.877) + $200(0.770) + $100(0.675) =
$484.60, which is approximately equal to $480.
The internal rate of return on Investment A is
approximately 14% (14.68% on a financial
calculator).
Determination of the internal rate of return for B:
$480 = [$200 (1 + r )] + [$200 (1 + r )2] + [$200
(1 + r )3]
$480 = $200(PVAIF for 3 years at ? percent)
IF = 2.400
If you locate 2.400 in the interest table for 3 years,
youll find that the internal rate of return is 12%.
Since the internal rate of return exceeds the cost
of capital (10%), the firm should make both
investments. (This is the same answer determined
in part a.)
c.

If the cost of capital were to increase to 14%, the


net present values would be
A: $484.60 $480 = $4.60
B: $464.40 $480 = ($15.60)
The net present values decline in both cases, but
the net present value of A is still positive, so the
firm should make that investment. (You should
point out that the increase in the cost of capital
doesnt change the investments internal rates of
return. However, since Investment Bs internal rate
of return is now less than the cost of capital, that
investment should not be made. This is the same
conclusion derived from using the net present value.)

Answers

147

3. a.

Determination of net present values:


Net present value of Investment A:
$1,100(PVAIF 8% 3y) $3,000 = $1,100(2.577)
$3,000 = ($165)
Net present value of Investment B:
$3,600(1 + 0.08) $3,000 = $3,600(0.926)
$3,000 = $333
Net present value of Investment C:
$4,562(1 + 0.08)3 $3,000 = $4,562(0.794)
$3,000 = $621

b. Investment A isnt acceptable because its net


present value is negative. Since Investment B and
Investment C are mutually exclusive, the firm
selects Investment C since it has the higher net
present value.
c.

Determination of the internal rates of return:


Investment A: $1,100 (1 + rA )t = $3,000
interest factor = $3,000 $1,100 = 2.727
rA = approximately 5%
Investment B: $3,600 (1 + rB ) = $3,000
interest factor = $3,000 $3,600 = 0.833
rB = 20%
Investment C: $4,562 (1 + rC )3 = $3,000
interest factor = $3,000 $4,562 = 0.6575
rC = 15%

d. Investment A isnt acceptable because the internal


rate of return is less than the firms cost of capital.
Since Investment B and Investment C are mutually
exclusive, the firm selects Investment B because it
has the higher internal rate of return.
e.

148

Net present value selects Investment C, but internal


rate of return selects Investment B. Since the
investments are mutually exclusive, the firm must
resolve the conflict.

Answers

f.

At 10% reinvestment rate:


$3,600 (1 + 0.1)2 = x
$3,600(1.210) = $4,356
The terminal value of Investment B is less than
the terminal value of Investment C ($4,356
versus $4,562). The conflict is resolved in favor
of Investment C.
At 14% reinvestment rate:
$3,600(1 + 0.14)2 = x
$3,600(1.300) = $4,679
The terminal value of Investment B is now greater
than the terminal value of Investment C. The
conflict is resolved in favor of Investment B.
(Question f illustrates the importance of the
reinvestment rate when the financial manager
must choose among competing investments that
meet the acceptance criteria specified by the net
present value and internal rate of return methods
of capital budgeting.)

g.

The internal rate of return isnt affected by the


firms cost of capital. The internal rate of return
of Investment A is still approximately 5%.

h. The payback method will select the investment that


returns the cost of the investment the fastest. In
this example, the payback method would select
Investment B, which as part g indicates, may not
be the best choice.

Answers

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