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Financial Management

By

Sarah M. Burke, Ph.D.

Contributing Reviewer

Sandra L. Pinick

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.

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

EXAMINATIONLESSON 1

27

31

EXAMINATIONLESSON 2

47

LESSON 3: INVESTMENTS

51

EXAMINATIONLESSON 3

73

77

EXAMINATIONLESSON 4

93

97

EXAMINATIONLESSON 5

115

SELF-CHECK ANSWERS

121

Contents

INSTRUCTIONS TO STUDENTS

iii

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.

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.

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

Read in this

study guide:

Read in

the textbook:

Assignment 1

Pages 818

Assignment 2

Pages 2025

Examination 08171700

Material in Lesson 1

For:

Read in this

study guide:

Read in

the textbook:

Assignment 3

Pages 3134

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

Assignment 8

Pages 6970

Pages 316334

Examination 08171900

Material in Lesson 3

For:

Read in this

study guide:

Read in

the textbook:

Assignment 9

Pages 7786

Assignment 10

Pages 8892

Pages 436469

Examination 08172000

Material in Lesson 4

Assignments

For:

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

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.

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 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

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

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.

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

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

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.

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

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.

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

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

14

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

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.

______

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.

______

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.

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.

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

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

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

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

55%

Return on assets

26%

17%

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

22

Financial Management

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

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

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.

______

______

______

______

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.

______

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.

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 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

annually, how much money will be in the account after 15 years?

A. $1,663

B. $1,609

C. $384

D. $238

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

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

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

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.

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 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

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

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

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

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.

______

______

______

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.

______

______

increase the level of economic activity.

______

indicates a period of more than 1 year.)

______

______

and services.

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.

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

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

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

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

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.

______

______

______

______

investor sustains a loss.

______

______

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

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.

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

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

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.

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.

A.

B.

C.

D.

savings to households.

savings to borrowers.

stocks to brokers.

new stock issues to buyers.

the investor

A.

B.

C.

D.

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.

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.

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.

Bonds and real estate

Savings accounts and checking accounts

Stocks and bonds

A.

B.

C.

D.

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

A. the bank as equity.

B. losses.

C. savings deposits.

D. commercial loans.

A.

B.

C.

D.

48

A

A

A

A

specialist

specialist

specialist

specialist

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.

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.

D. You would lose $6 per share.

A.

B.

C.

D.

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

transfer resources from savers to borrowers.

provide secondary markets.

arent subject to regulation.

A. brokerage firms.

B. Congress.

C. the SEC.

D. the Federal Reserve.

A. buys an odd lot of a security.

B. sells securities from his or her portfolio.

D. anticipates a price decrease.

A.

B.

C.

D.

50

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

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.

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Financial Management

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 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.

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Financial Management

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

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55

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

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Financial Management

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

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.

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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

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.

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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.

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

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

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).

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Financial Management

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

common stock.

V=

(1 + K)1

+...+

(1 + K)2

D

(1 + Kp)n

V=

D

K

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)

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 + 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

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.

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Financial Management

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.

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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.

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

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.

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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.

Lesson 3

71

NOTES

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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.

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

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

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

A. Convertible bonds

B. Income bonds

D. Debentures

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.

D. fall from $60 to $50.

A.

B.

C.

D.

74

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

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

A.

B.

C.

D.

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

A.

B.

C.

D.

76

retirement date.

present value of cash flows.

coupon rate.

Examination, Lesson 3

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

sole proprietorship, partnership, and corporation

and regressive tax structures

Identify the assets and liabilities that vary with the level

of sales

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%

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

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

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Financial Management

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

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

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Financial Management

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

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

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.

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.

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

$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

350,000

Total assets

88

350,000

Financial Management

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

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

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

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

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:

of sales method and apply part of it to all or part of

the fixed asset purchase/lease.

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

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.

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.

$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

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

A. financial leverage and risk.

B. total costs and revenues.

D. dividends and retained earnings.

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

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

A.

B.

C.

D.

Fixed

Fixed

Fixed

Fixed

costs

costs

costs

costs

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

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

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

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

D. Dilution of ownership

Examination, Lesson 4

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

optimal capital structure

value, and internal rate of return

and internal rate of return

of mutually exclusive investments

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.

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.

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Financial Management

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

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

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Financial Management

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

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Financial Management

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.

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.

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

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

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

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 + 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) is the value of an investment in

todays dollars. Lets look at an example problem that

illustrates this method.

Lesson 5

109

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

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 1.331

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 = $2,463

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.

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

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

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.

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.

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.

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.

A.

B.

C.

D.

The

The

The

The

cost

cost

cost

cost

of

of

of

of

debt

debt

debt

debt

is

is

is

is

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.

A.

B.

C.

D.

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

dividend = 6 percent

percent

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.

greater than zero.

less than the cost of the investment.

greater than the cost of the investment.

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.

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

D. less than the interest rate.

Examination, Lesson 5

A.

B.

C.

D.

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

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%.)

receives $50 annually and $500 over the lifetime of

the investment.

c.

2. a.

$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.

contribution but doesnt draw on the fund. The

amount grows to:

Answers

3. False

(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

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

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.

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

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

1.

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)

$ 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.

$1,520,000 = 7

Days sales outstanding: $1,520,000 $29,150.68

= 52 days

c.

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

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

3. a.

c.

$54 $45 = $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

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

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

Foreign Investments

32.30

(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

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

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.

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).

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.

$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

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.

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.

dividends required return = $8 0.07 = $114.29

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

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

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

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

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

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

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

$

Total costs = $6,000 + 3.2Q

Variable costs = 3.2Q

Fixed Costs = $6,000

Quantity

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.

$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

TC = $3,000 + $2.80Q, then earnings are

$4(2,000) $3,000 $2.80(2,000) = ($600).

Answers

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.

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.

$4,000/($2 1.50) = 8,000 units

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

b.

$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.

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)

138

$4,000

Answers

d.

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

Page 456

1.

percent of sales, and the forecasted level of these assets

and their liabilities are

Percent of Sales

Forecasted Level

accounts receivable

$200 $1,000

(0.2)$1,500 = $300

inventory

$400 $1,000

(0.4)$1,500 = $600

$200 $1,000

(0.2)$1,500 = $300

Answers

139

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.

for external financing, if any, and to apply any excess

funds to marketable securities.

Heres the current balance sheet:

Assets

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

140

Current sales

$160,000

Projected sales

$200,000

10 percent

60 percent

Answers

Projected Sales

$200,000

(given)

$20,000

profit margin to projected sales)

Dividend Payout

$12,000

dividend payout to net profit margin)

after Dividends

8,000

from net profit margin)

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

4,200

Accounts Receivable

21,413

Inventory

23,975

51,000

100,588

Answers

Accruals

6,125

Notes Payable

7,000

Long-Term Debt

22,000

Common Stock

20,000

95,998

141

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

4,200

Accounts Receivable

21,413

Inventory

23,975

51,000

100,588

Accruals

6,125

Notes Payable

7,000

Long-Term Debt

26,590

Common Stock

20,000

100,588

Page 469

1.

142

budget. The following table illustrates an efficient way

to prepare the cash budget using a spreadsheet.

Answers

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

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

3. a.

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

Debt/Assets

Weight cost of

debt

Plus

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

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

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

Answers

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.

equity with a cost of capital of 7.1%.

Debt/Assets

Weight cost of

debt

Plus

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

firm is substituting cheaper debt financing.

c.

riskier, the cost of debt and equity will rise and

cause the cost of capital to increase.

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

would be higher, increasing the cost of capital.

145

Self-Check 12

1. False

2. True

3. False

4. True

5. False

6. True

1.

$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.

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

$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.

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.

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

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.

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%

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

rate of return selects Investment B. Since the

investments are mutually exclusive, the firm must

resolve the conflict.

Answers

f.

$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.

firms cost of capital. The internal rate of return

of Investment A is still approximately 5%.

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

149

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