Study Guide. Financial Management. By Sarah M. Burke, Ph.D. Contributing Reviewer Sandra L. Pinick

Transcription

1 Study Guide Financial Management By Sarah M. Burke, Ph.D. Contributing Reviewer Sandra L. Pinick

2 About the Author Sarah M. Burke, Ph.D., is an assistant professor in the Department of Finance at Goldey-Beacom College in Wilmington, Delaware. She earned her doctorate in business and economics from Lehigh University. Her areas of specialization are corporate finance and public economies. About the Contributing Reviewer Sandra L. Pinick has a BBA in finance and an MBA from Washburn University in Topeka, Kansas. She owns and operates her own information technology business, and she has taught classes in finance, marketing, and information technology at Washburn University and Baker University in Baldwin City, Kansas.

3 INSTRUCTIONS TO STUDENTS 1 LESSON ASSIGNMENTS 5 LESSON 1: KEY FINANCIAL CONCEPTS 7 EXAMINATION LESSON 1 27 LESSON 2: FINANCIAL INSTITUTIONS 31 EXAMINATION LESSON 2 47 LESSON 3: INVESTMENTS 51 EXAMINATION LESSON 3 73 LESSON 4: CORPORATE FINANCE, PART 1 77 EXAMINATION LESSON 4 93 LESSON 5: CORPORATE FINANCE, PART 2 97 EXAMINATION LESSON SELF-CHECK ANSWERS 121 Contents iii

4 YOUR STUDY GUIDE 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 you ll 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, you ll complete a multiple-choice examination. As you work through your study guide and textbook, you ll learn about important principles of financial management. This course provides a basic introduction to the study of finance, including financial institutions, investments, and corporate finance. First, you ll learn about the essential concepts and analytical tools of finance, as they re used in all three areas of study. These areas are then explored individually and as interrelated components. Note that this study guide isn t meant to take the place of your textbook. Rather, it s designed to complement the text material by highlighting essential concepts and clarifying the more difficult content. In addition, the study guide provides examples and problems intended to reinforce the book readings, as well as assignments and self-checks that will help you evaluate your understanding of the material before you complete the examinations. KNOW YOUR TEXTBOOK Your textbook, Basic Finance: An Introduction to Financial Institutions, Investments, and Management, Ninth Edition, is the heart of this course. It contains the study material on which your examinations are based. Each time we mention your text in this study guide, we re referring to this book. This textbook provides the material you need to know to successfully complete your Financial Management course. It s very important that you read the material in the text and study it until you re completely familiar with it. This is the material that your examinations will be based on. Before you actually begin reading your assignments, however, it s 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 1

5 Start your survey of the textbook on the page titled Brief Contents. Note that the textbook is organized into five parts. The pages titled Contents expand the Brief Contents by presenting itemized topics listed under each of the five parts of the textbook. Skim these topics to see what to expect in each chapter. Turn to the Preface on page xix and read about the various learning tools that are employed throughout the book. The Prologue, beginning on page 1, describes the role of finance and the concepts that serve as its foundation. Students who have never taken a course in finance are strongly encouraged to study the Prologue. As you use your textbook, take time to study exhibits, figures, equations, and other graphic and tabular inserts. These illustrations supplement or amplify the discussion in fact, many of them are integral parts of the discussion. You ll 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 A F, 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, you ll 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 2 Instructions to Students

6 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 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 you ve finished reading all of the assigned textbook pages for each lesson and you re sure that you re 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 there s no time limit. You may go back to your textbook to review material at any time when you re working on the examination. When you re 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. Don t wait until another examination is ready to be sent. 5. Repeat these steps until all five lessons have been completed. Instructions to Students 3

7 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 instructor s 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! 4 Instructions to Students

8 Lesson 1: Key Financial Concepts For: Read in this Read in study guide: the textbook: Assignment 1 Pages 8 18 Pages 3 8, Assignment 2 Pages Pages , Examination Material in Lesson 1 Lesson 2: Financial Institutions For: Read in this Read in study guide: the textbook: Assignment 3 Pages Pages and Assignment 4 Pages Pages Assignment 5 Pages Pages Examination Material in Lesson 2 Lesson 3: Investments For: Read in this Read in study guide: the textbook: Assignment 6 Pages Pages Assignment 7 Pages Pages , Assignment 8 Pages Pages Examination Material in Lesson 3 Lesson 4: Corporate Finance, Part 1 For: Read in this Read in study guide: the textbook: Assignment 9 Pages Pages , Assignment 10 Pages Pages Examination Material in Lesson 4 Assignments 5

9 Lesson 5: Corporate Finance, Part 2 For: Read in this Read in study guide: the textbook: Assignment 11 Pages Pages Assignment 12 Pages Pages Examination Material in Lesson 5 6 Lesson Assignments

10 Key Financial Concepts INTRODUCTION Welcome to Financial Management! One of the most important components of every business operation is financial decision making. Business decisions at all levels have some underlying financial implications, either direct or indirect. Also, financial concepts arise in the everyday management of your personal resources. It s 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. It s essential that you take the time to master these concepts. As you work your way through this course, you ll learn the importance of finance to the success of every entity, both personal and professional. In Lesson 1, you ll 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, you ll 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 that s 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. You ll 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 7

11 OBJECTIVES When you complete this lesson, you ll 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 3 8 and in your textbook. Be sure to complete the self-check to gauge your progress. The Time Value of Money One of the most important concepts in the study of finance is the time value of money. As this phrase implies, this concept covers how time impacts the value of money. One dollar today isn t equal in value to one dollar 10 years from now. The difference in the value of these two dollars can be explained by the time value of money. The Future Value of a Dollar The future value of one dollar is the amount that one dollar will grow to at some point in the future. The process of compounding takes into account the earning of interest on interest, and is the process of finding the future value of some initial amount. 8 Financial Management

12 Let s look at an example problem. Example: Suppose you begin with $100 today and deposit it in an account that pays 10 percent annually. How much will you have in the account after 1 year? Solution: The calculation is relatively simple. In this example, you ve 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 ( percent) 1 FV = $100 ( ) 1 FV = $100 (1.10) 1 FV = $ FV = $110 Thus, the value of the $100 investment after 1 year will be $110. Now, let s 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, you re 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 9

13 Substitute the known values of PV, I, and N into the formula and solve. FV = $100 ( percent) 5 FV = $100 ( ) 5 FV = $100 (1.10) 5 FV = $100 (1.6105) FV = $ Thus, the value of the $100 investment after 5 years will be $ In this example problem, note that the compounding process (the process of earning interest on interest) has produced total interest of $61.05, which is greater than the total simple interest of $50. The Present Value of a Dollar Finding the present value of a dollar is the opposite of calculating its future value. The present value of a dollar is the amount that a future dollar is worth today. You would calculate the present value when you need to determine how much money to invest today to obtain some future goal. Discounting is the process of finding the present value of some future amount. Let s 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. You ve 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

14 The missing variable that you need to calculate is the present value (PV), which is the amount of money you ll 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 [( percent) 1 ] PV = $100 [( ) 1 ] PV = $100 [1.101] PV = $ PV = $90.91 Thus, you ll 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, you re 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

15 Substitute the known values of PV, I, and N into the formula and solve. PV = FV [( percent) 5 ] PV = $100 [( ) 5 ] PV = $100 [(1.10) 5 ] PV = $100 [1.6105] PV = $62.09 Thus, the process of discounting tells you that you ll need to invest $62.09 today. After 5 years of earning 10 percent interest annually, your investment will have a value of $100. The Future Value of an Annuity An annuity is a series of equal payments made at equal time intervals (for example, annually). An annuity that s paid annually is called an ordinary annuity. Let s 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 you ll 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, you re 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

16 You would use the following formula to calculate the future value of the investment (FV). FV = PMT [(1 + I.) N 1] I Substitute the known values of PMT, I, and N into the formula and solve. FV = $100 [( percent) 3 1] 10 percent FV = $100 [( ) 3 1] 0.10 FV = $100 [(1.10) 3 1] 0.10 FV = $100 [ ] 0.10 FV = $ FV = FV = $ Thus, the value of the annuity after 3 years will be $ The Present Value of an Annuity Now let s examine how to calculate the present value of an annuity, which is the amount of money you ll 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, you re 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

17 Substitute the known values of PMT, I, and N into the formula and solve. PV = $100 {[1 [1 ( percent) 3 ]} 10 percent PV = $100 {[1 [1 ( ) 3 ]} 0.10 PV = $100 {[1 [1 (1.10) 3 ]} 0.10 PV = $100 {[1 [ ]} 0.10 PV = $100 { } 0.10 PV = $ PV = PV = $ Thus, you ll need to invest $ today to receive payments of $100 per year for 3 years. Practice Problems Now, in this section, we ll 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, you re 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

18 Substitute the known values into the formula and solve for N. $255 = $200 (1 + 5 percent) N $255 = $200 ( ) N $255 = $200 (1.05) N $255 $200 = (1.05) N = (1.05) N log = N (log 1.05) = N ( ) = 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, you re looking for the annuity payment for this investment. In this problem, you re 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

19 Substitute the known values into the formula and solve for PMT. $75,000 = PMT {1 [1 (1 + 7 percent) 10 ]} 7 percent $75,000 = PMT {1 [1 ( ) 10 ]} 0.07 $75,000 = PMT {1 [1 (1.07) 10 ]} 0.07 $75,000 = PMT {1 [ ]} 0.07 $75,000 = PMT { } 0.07 $75,000 = PMT $75,000 = PMT $75, = PMT $10, = PMT No, she can withdraw only $10, per year for the next 10 years. Example: Imagine that you re 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. You re 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

20 Substitute the known values into the formula and solve for I. $100,000 = 75,000 (1 + I.) 4 $100,000 75,000 = (1 + I.) = (1 + I.) 4 log = 4 log (1 + I.) = 4 log (1 + I.) = log (1 + I.) = 1 + I = 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. You re 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

21 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.) = 3 log (1 + I.) = [3 log (1 + I.)] = 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, Financial Management

22 Self-Check 1 At the end of each section of Financial Management, you ll be asked to pause and check your understanding of what you ve just read by completing a Self-Check. Writing the answers to these questions will help you review what you ve studied so far. Please complete Self-Check 1 now. Indicate whether each of the following statements is True or False. 1. Compounding is the process of determining the amount of simple interest on an investment. 2. At an annual interest rate of 7 percent, it will take 16.2 years for an investment of $100 to triple to $ The future value of one dollar increases with lower interest rates. 4. The future value of one dollar increases with longer periods of time. 5. An ordinary annuity is a series of equal payments made at the beginning of each time period. Complete Problems 1, 2, 4, 5, 6, 7, 9, 12, 13, 14, 15, 18, and 19 on pages in the textbook. Check your answers with those on page 121. Lesson 1 19

23 ASSIGNMENT 2 Read the following assignment. Then read pages and in your textbook. Be sure to complete the self-check to gauge your progress. In this assignment, you ll learn about essential financial statements and some of the methods that are used to analyze them. Your textbook reviews the content of the balance sheet and the income statement, and then explores the use of ratio analysis to reveal information about the financial health of a firm. Ratio Analysis The balance sheet provides a summary of a firm s 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 they re 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 firm s strengths and weaknesses. A ratio analysis that s 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 firm s 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

24 2. Activity ratios. An activity ratio examines the level of a firm s 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, let s look at some example ratio problems. Cash $125,000 Accounts receivable $295,000 Inventory $398,000 Current liabilities $415,000 Long-term debt $595,000 Equity $577,000 Example: Given the following information, calculate the current ratio and the quick ratio. Solution: Use the following formula to calculate the current ratio. current ratio = current assets current liabilities Lesson 1 21

25 Substitute the known values into the formula and solve. current ratio = ($125,000 + $295,000 + $398,000) $415,000 current ratio = $818,000 $415,000 current ratio = 1.97 Use the following formula to calculate the quick ratio. quick ratio = (current assets inventory) current liabilities Substitute the known values into the formula and solve. quick ratio = ($818,000 $398,000) $415,000 quick ratio = $420,000 $415,000 quick ratio = 1.01 Example: Given the following information about a firm, calculate the firm s sales, total assets, total asset turnover, and total debt. Net Income $300,000 D ebt ratio (debt/total assets) 55% R eturn on assets 26% N et profit margin 17% Solution: Use the following formula to calculate sales. sales = net income net profit margin Substitute the known values into the formula and solve. sales = $300, percent sales = $300, sales = $1,764, Financial Management

26 Use the following formula to calculate total assets. total assets = net income return on assets Substitute the known values into the formula and solve. total assets = $300, percent total assets = $300, 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

27 Firm 1 Firm 2 EBIT $ 155,000 $155,000 Interest expense $ 25,000 $80,000 Income tax $ 55,000 $35,000 Debt $ 425,000 $725,000 Equity $ 625,000 $325,000 Solution: Use the following formula to calculate the operating profit margin. operating profit margin = EBIT sales First, find the operating profit margin for Firm 1. Substitute the known values into the equation and solve. operating profit margin = $155,000 $1,000,000 operating profit margin = 15.5 percent Find the operating profit margin for Firm 2. operating profit margin = $155,000 $1,000,000 operating profit margin = 15.5 percent Use the following formula to calculate the net profit margin. net profit margin = net earnings sales Find the net profit margin for Firm 1. Substitute the known values into the equation and solve. net profit margin = $75,000 $1,000,000 net profit margin = 7.5 percent Find the net profit margin for Firm 2. net profit margin = $40,000 $1,000,000 net profit margin = 4 percent Both firms have the same operating profit margins 15.5 percent. The difference in the net profit margin is the result of Firm 2 paying more interest than Firm Financial Management

28 Use the following formula to calculate the return on assets. return on assets = earnings assets Find the return on assets for Firm 1. Substitute the known values into the equation and solve. return on assets = $75,000 $1,000,000 return on assets = 7.5 percent Find the return on assets for Firm 2. return on assets = $40,000 $1,000,000 return on assets = 4 percent Use the following formula to calculate the return on equity. return on equity = earnings equity Find the return on equity for Firm 1. Substitute the known values into the equation and solve. return on equity = $75,000 $625,000 return on equity = 12 percent Find the return on equity for Firm 2. return on equity = $40,000 $325,000 return on equity = 12.3 percent Lesson 1 25

29 Self-Check 2 Indicate whether each of the following statements is True or False. 1. The larger the debt ratio, the riskier a firm becomes. 2. Paid-in capital is considered to be a current asset. 3. Liabilities are equal to assets minus equity. 4. The more rapidly receivables turn over, the more rapidly the firm is receiving cash. 5. The larger the debt ratio, the more equity a firm is using. 6. Liabilities are equal to equity minus assets. Complete Problems 1, 2, 8, 10, and 13 on pages in the textbook. Check your answers with those on page Financial Management

30 Lesson 1 Key Financial Concepts EXAMINATION NUMBER: 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 When you feel confident that you have mastered the material in Lesson 1, go to and submit your answers online. If you don t 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 1 20: Select the one best answer to each question. 1. A current ratio is presently 2 : 1 for a corporation that sells sporting goods. Which of the following statements about the ratio is correct? A. The quick ratio is smaller than the current ratio. B. The current ratio is unaffected by exchanging bonds for stock. C. The current ratio is increased by purchasing a store with cash, with potential to increase corporate sales. D. The current ratio is unchanged by using cash to retire accounts payable. 2. Accountants suggest that assets should be valued at A. cost. B. the lower of market or cost. C. market. D. the higher of market or cost. Examination 27

31 3. If annual interest rates are 10 percent, which of the following values will be the lowest? A. The future value of a $100 investment after 3 years B. The future value of an investment after 4 years, if $100 is deposited annually C. The present value of an investment that will be worth $100 after 2 years D. The present value of an annuity that will pay $200 a year, at the end of each of the next 4 years 4. If $800 is deposited in a savings account that pays an interest rate of 5 percent annually, how much money will be in the account after 15 years? A. $1,663 C. $384 B. $1,609 D. $ Profitability ratios are used to measure A. liquidity. C. performance. B. leverage. 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 C. $22,073 B. $10,018 D. $27, Which of the following is calculated by adding total liabilities plus equity? A. Total assets C. Inventory B. Hidden assets 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 C. $9,210 B. $5,000 D. $14, 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 C. 5 years B. 3 years D. 7 years 10. Which of the following types of ratio is used to measure activity? A. A leverage ratio C. A profitability ratio B. A turnover ratio D. A liquidity ratio 28 Examination, Lesson 1

32 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 C. 10 percent B. 7 percent D. 50 percent 12. Which of the following is considered to be a current liability? A. Work-in-process B. Raw materials C. Accounts payable D. Short-term money market instruments 13. Which of the following would be the most likely cause of an increase in inventory turnover? A. The faster collection of accounts receivable B. Lowered sales C. An increase in the inventory level D. 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 C. $6,322 B. $7,500 D. $1, Which of the following is calculated by subtracting the cost of goods sold and administrative expense from net sales? A. Operating income C. Total liabilities B. Accounts receivable 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 C. $321,973 B. $789,633 D. $56, 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 C. 12 B. 10 D 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 C. 18 years B. 15 years D. 20 years Examination, Lesson 1 29

33 19. Discounting determines the worth of funds to be received in the future in terms of their A. present value. B. future value. C. cost factor. D. time factor. 20. If annual interest rates are 10 percent, which of the following values will be the greatest? A. The future value of an annuity after 4 years, if $100 is deposited annually B. The future value of a $100 investment after 3 years C. The present value of an investment that will be worth $100 after 2 years D. The present value of an annuity that will pay $200 a year, at the end of each of the next 4 years 30 Examination, Lesson 1

34 Financial Institutions INTRODUCTION In Lesson 2, you ll learn about the components of the financial environment and the role of financial intermediaries within that environment. You ll also study security markets and the procedures that are used to trade securities, such as stocks and bonds. OBJECTIVES When you complete this lesson, you ll 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 and in your textbook. Be sure to complete the selfcheck to gauge your progress. Lesson 2 31

35 The Role of Money and Interest Rates Every day, we use money to buy or transfer goods and services. At one time, the transfer of goods and services was facilitated by a barter system, in which two individuals would negotiate the exchange of one good for another. However, because each of these transactions involved a negotiation process, the system was rather inefficient. Money in the form of coins and paper currency evolved as a means to reduce this inefficiency. Rather than barter one good for another, any good could simply be exchanged for money. Money doesn t 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 that s 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 you ll 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 person s 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

36 length to maturity, or the time left until the obligation must be repaid. A short-term debt instrument generally has a maturity of one year or less, while a long-term debt instrument has a maturity of more than one year. Some classifications also include the intermediate-term debt instrument, which generally has a maturity of between one and ten years. It s important to remember that as the years go by, the term of a debt instrument changes from long-term to short-term. Therefore, there s 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

37 direct transfer of funds between lender and borrower. For instance, if a lender makes a loan directly to a borrower and the borrower then fails to pay back the loan, the lender will suffer a loss. The loss could have been avoided if the lender had deposited the money with a financial intermediary rather than making the direct loan. When a loan is deposited with a financial intermediary and the borrower fails to pay it back, the intermediary bears the loss. In addition, lenders are generally protected from the financial intermediary s 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 aren t 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

38 Self-Check 3 Indicate whether each of the following statements is True or False. 1. A general decline in prices also decreases the value of money. 2. Stocks and bonds are a substitute for money as a store of value. 3. A financial intermediary stands between the ultimate borrowers and lenders and converts a claim on the lender to the one that s acceptable to the borrower. 4. The most important financial intermediary is the pension plan. 5. By facilitating the transfer of savings into investments, financial intermediaries increase the level of economic activity. 6. Money market mutual funds invest in long-term securities. (Note: Long-term indicates a period of more than 1 year.) 7. An asset is liquid if it can easily be converted into cash without loss. 8. Money is considered to have value because it can be used to buy goods and services. Answer each of the following questions in one paragraph: 9. How does underwriting shift risk away from the securities issuer and to the investment banker? 10. What essential function is served by both commercial bankers and investment bankers? Explain your answer. 11. Identify at least two factors contributing to the slope of the yield curve. 12. Support or refute this statement: Life insurance companies and commercial banks transfer money from savers to users. Check your answers with those on page 126. Lesson 2 35

39 ASSIGNMENT 4 Read the following assignment. Then read pages in your textbook. Be sure to complete the self-check to gauge your progress. The Role of Securities Markets Many investment instruments are bought and sold in securities markets. Keep in mind that a securities market distributes securities among investors. However, a securities market isn t considered to be a financial intermediary, because securities markets don t facilitate the transfer of funds between savers and borrowers. Now, let s 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

40 two prices is called the spread on the security. OTC market makers are called dealers, while market makers for securities that are listed on the NYSE or AMEX are called specialists. Brokers Investors typically buy and sell securities through a broker. A broker acts as an agent to execute buy and sell instructions from investors, and receives a transaction fee or commission in payment. Brokers generally encourage investors to buy and sell stocks in multiples of 100 shares, which is called a round lot (a lot of less than 100 shares is called an odd lot). Investors may purchase or sell any quantity of a stock, even a single share; however, a broker may charge a higher fee for an odd lot. When you instruct a broker to make a trade on your behalf, you re 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 hasn t 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. Let s 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

41 Part A: If the margin requirement is 55 percent, what is the maximum amount she can borrow? Solution: Calculate the value of Barbara s total portfolio. 100 shares of DEM at $35 = $3, 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 = $ 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, shares of GOP at $32 = $6, Financial Management

42 To calculate the loss on DEM, subtract the total selling price from the original cost. loss on DEM = $3,500 $2,900 loss on DEM = $600 Calculate the loss on GOP in the same way. loss on GOP = $8,000 $6,400 loss on GOP = $1,600 Add the DEM loss and the GOP loss together to calculate the total loss. total loss = $600 + $1,600 total loss = $2,200 Part D: What is the percentage loss on the funds she invested if the interest payment is included in the calculation? Solution: Add the total loss to the interest, and divide by the equity. percentage loss on margin = ($2,200 + $517.50) $6,325 percentage loss on margin = $2, $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, you ll have to buy the stock at a price that s higher than what you sold it for in order to return the shares. Lesson 2 39

43 For example, suppose Leonard sells short 100 shares of MBI at $100 per share. He borrows 100 shares from his broker and sells them for $10,000 (100 $100). If the price of MBI drops to $80 per share, Leonard can buy 100 shares for $8,000 (100 $80) and return them to his broker. Leonard has made a profit of $2,000. Of course Leonard will have to pay interest for borrowing the shares. 40 Financial Management

44 Self-Check 4 Indicate whether each of the following statements is True or False. 1. The American Stock Exchange is an example of a secondary market. 2. A purchase of 50 shares is an example of an even lot. 3. The use of margin increases the potential return on an investment in stock. 4. If an individual establishes a short position and security prices rise, the investor sustains a loss. 5. Over-the-counter stock quotes are obtained through the SEC. 6. The larger the margin requirement, the larger the level of equity in the account. Complete Problems 3, 4, and 5 on pages in your textbook. Check your answers with those on page 127. Lesson 2 41

45 ASSIGNMENT 5 Read the following assignment. Then read pages in your textbook. Be sure to complete the self-check to gauge your progress. In Assignment 3, you learned how important money is to the efficient exchange of goods and services. Money can take the form of many different currencies. Realize that whenever you purchase something that was produced in another country, the currency of that country is used at some point to make the transaction. This requires an exchange of currencies. In this assignment, you ll learn about the foreign exchange market the 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

46 Many firms conduct business in both their home country and in foreign countries. These businesses are called multinational firms. Foreign investment can have both a positive and negative impact on a company s riskiness. Diversifying business to foreign countries can lessen the impact of the economic turmoil in a firm s home country. On the other hand, political factors, regulation, foreign economic fluctuations, and exchange rate changes may all increase a firm s risk exposure. Practice Problems Now, let s 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 = price of the dollar = Therefore, 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 = price of the dollar = Therefore, euros are necessary to buy one dollar. Lesson 2 43

47 Example: Last year, a U.S. firm had inventory in London valued at 600,000 pounds. At the time, one pound had a value of $1.50. If the value of the pound were to strengthen against the U.S. dollar from $1.50 per pound to $1.75 per pound and the inventory continued to be worth 600,000 pounds, what would be the gain or loss in U.S. dollars as a result of the change in the exchange rate? Solution: In this example, the pound has revalued, or its value has risen in terms of the dollar. First, calculate the value of the inventory in U.S. dollars at the previous exchange rate. inventory value = 600,000 pounds $1.50 per pound inventory value = $900,000 Next, calculate the value of the inventory in dollars at the revised exchange rate. inventory value = 600,000 pounds $1.75 per pound inventory value = $1,050,000 To calculate the change in the inventory value, subtract the old value from the new value. change in inventory value = $1,050,000 $900,000 change in inventory value = $150,000 Therefore, at the revised exchange rate, the inventory gained a value of $150,000 in U.S. dollars. 44 Financial Management

48 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 nation s currency rises in value, foreigners can purchase more of that nation s output. 3. The devaluation of one currency implies a revaluation of other currencies. 4. If the American dollar is devalued, American goods are more expensive to people holding dollars. 5. The International Monetary Fund may lend currency reserves to a nation with a deficit in its merchandise trade balance. 6. The political climate abroad will affect the risk associated with foreign investments. Complete Problems 1, 2, and 3 on page 102 in your textbook. Check your answers with those on page 128. Lesson 2 45

49 NOTES 46 Financial Management

50 Lesson 2 Financial Institutions EXAMINATION NUMBER: 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 When you feel confident that you have mastered the material in Lesson 2, go to and submit your answers online. If you don t 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 1 20: Select the one best answer to each question. 1. A financial intermediary transfers A. savings to households. B. savings to borrowers. C. stocks to brokers. D. new stock issues to buyers. 2. If an individual buys stock on margin and its price rises, the investor A. must put up additional collateral. B. must pay tax on the unrealized gain. C. must pay interest on the borrowed funds. D. may take delivery of the stock. Examination 47

51 3. Which of the following best explains why commercial banks assume significant liabilities? A. All commercial bank deposits are liabilities. B. The loans commercial banks write can be risky. C. Banks may pay too much interest on their deposits. D. Banks may not charge enough interest on their loans to fund operations and loan default risk. 4. Which of the following best explains a potential disadvantage of leaving securities in street name? A. Securities held in street name become the property of the custodian and the customer is only beneficiary of the securities. B. Correspondence sent by securities issuers may not be forwarded to brokerage clients who own securities held in street name. C. Securities held in street name can t 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. Money and antiques B. Bonds and real estate C. Savings accounts and checking accounts D. Stocks and bonds 6. When investing in securities, an investor may place a limit order that A. limits the amount of commissions. B. specifies when the stock will be purchased. C. establishes the exchange on which the security is to be bought or sold. D. 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 C. $110 B. $200 D. $90 8. The reserves of commercial banks must be held against A. the bank as equity. C. savings deposits. B. losses. D. commercial loans. 9. Which of the following statements about specialists is correct? A. A specialist stresses one type of investment. B. A specialist buys only stock. C. A specialist analyzes corporate securities. D. A specialist makes a market in securities. 48 Examination, Lesson 2

52 10. The term structure of interest rates involves the relationship between A. risk and yields. C. term 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. C. You would gain $13 per share. B. You would gain $26 per share. D. You would lose $6 per share. 12. Which of the following is indicated by an upward-sloping yield curve? A. Lower prices for short-term maturity B. Higher prices for long-term maturity C. Lower interest rates for long-term maturity D. 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 issuer s 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 can t 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 isn t an example of a financial intermediary. 15. Money market mutual funds invest in A. corporate bonds. B. corporate stock. C. federal government treasury bills. D. federal government bonds. Examination, Lesson 2 49

53 16. Entering an order to sell stock at $17 when the bid is $18 $19 is an example of a A. market order. C. margin payment. B. short sale. D. limit order. 17. Which of the following statements about organized security markets is correct? A. Organized security markets are examples of financial intermediaries. B. Organized security markets transfer resources from savers to borrowers. C. Organized security markets provide secondary markets. D. Organized security markets aren t subject to regulation. 18. The minimum margin requirement is established by A. brokerage firms. C. the SEC. B. Congress. D. the Federal Reserve. 19. If an investor sells short, then he or she A. buys an odd lot of a security. C. anticipates a price increase. B. sells securities from his or her portfolio. D. anticipates a price decrease. 20. Which of the following is a federally insured investment? A. A savings account in a national commercial bank B. A certificate of deposit in excess of $100,000 C. A life insurance policy D. Commercial bank assets 50 Examination, Lesson 2

54 Investments INTRODUCTION As you work through Lesson 3, you ll learn about the basic types of marketable securities, stocks, and bonds. You ll study the institutional characteristics of these securities, as well as valuation techniques. OBJECTIVES When you complete this lesson, you ll 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 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 A coupon rate A maturity date An indenture Lesson 3 51

55 Let s take a closer look at these features. First, a bond s 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, there s the risk that the issuer will default, or not pay the coupon payments. There s also the risk that the issuer won t 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. Let s 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 isn t backed by any collateral. 52 Financial Management

56 A subordinated debenture is a bond that, in the event of bankruptcy, is paid off only after other obligations have been paid. An equipment trust certificate is a bond issued to fund equipment, and is subsequently backed by that equipment. An income bond is a bond whose coupon payments are made only if the issuer s 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 that s 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 company s common stock. A Eurobond is a bond denominated in a firm s 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 that s exempt from federal income tax. A junk bond is a bond that s below investment grade. Several rating agencies evaluate corporate bonds, including Moody and Standard and Poor. These ratings provide information about a junk bond s level of default risk, and rate them on a quality scale. Lesson 3 53

57 The Price (Value) of a Bond The value of any security is the present value of all expected future cash flows. With a bond, there are two types of future cash flows to consider: the coupon payments and the repayment of principal. Earlier in this course, you learned that an annuity is a series of equal payments. With a bond, the coupon payments can be considered to be a type of annuity. The repayment of the principal is a one-time event at maturity, and thus is considered to be a lump-sum payment. The value of a bond can be calculated by using the manual formula on page 272 of your textbook. However, since many bonds have a maturity of 30 years, the manual calculation can be a very lengthy process. The calculation is much easier with the aid of a financial calculator. Let s 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, ) 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, Notice that the answer is a negative value. It s important that the coupon payment (PMT) and the principal (FV) have the same sign when you enter them into your calculator. In this case, both the coupon and the principal values are expected to be received in the future, so the values are positive. The value (PV) is the price of the bond and is negative. Now, consider the same problem with semiannual coupon payments. 54 Financial Management

58 Example: A 30-year, $1,000 bond has a 10 percent coupon rate. Find the value or price of the bond if the coupon is paid semiannually and competitive bonds yield 8 percent. Solution: As you did when you solved the time value of money problems earlier in the course, you must adjust the number of payments (N), the interest rate (I), and the payment (PMT) to reflect the semiannual coupon. The following values are the result. FV = the principal or par value = $1,000 N = number of semiannual coupon payments = 60 (30 years 2 payments per year) I = the yield = 4 percent (8 percent 2) PMT = $50 ($100 2) PV = price of the bond (the missing variable) Using a financial calculator to solve the problem, the value of PV is found to be $1, Notice that the values for annual and semiannual compounding aren t equal. Practice Problems Let s 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 bond s coupon rate? Solution: The coupon rate is defined by the interest the issuer pays on an annual basis. Here, the issuer pays $60 annually, so the coupon is $60. coupon rate = coupon par value coupon rate = $60 $1,000 coupon rate = 0.06, or 6 percent Lesson 3 55

59 Part B: What is the current yield? Solution: To find the current yield, divide the coupon by the price. current yield = coupon price current yield = $60 $890 current yield = 6.74 percent Part C: What is the yield to maturity? Solution: Without a financial calculator, trial and error would be used to find the YTM. However, the calculation is simpler with the aid of a financial calculator. You would use the following values to make the calculation. PV = $890 FV = $1,000 PMT = $60 N = 5 I =? Using these values, the value of I is found to be 8.81 percent. The next example is Problem 8 from page 282 in your textbook. Example: Bond A has the following terms: Coupon rate: 10 percent Principal: $1,000 Term to maturity: 8 years Bond B has the following terms: Coupon rate: 5 percent Principal: $1,000 Term to maturity: 8 years 56 Financial Management

60 Part A: What should be the price of each bond if interest rates are 10 percent? Solution: Use a financial calculator and the following values to calculate the price of Bond A. FV = $1,000 PMT = $100 (PMT = coupon = annual interest) N = 8 I = 10 percent PV =? Using these values, the value of PV is found to be $1,000. Use a financial calculator and the following values to calculate the price of Bond B. FV = $1,000 PMT = $50 (PMT = coupon = annual interest) N = 8 I = 10 percent PV =? Using these values, the value of PV is found to be $1,000.* Part B: What will be the price of each bond if, after 5 years have elapsed, interest rates are 10 percent? Solution: Use a financial calculator and the following values to calculate the price of Bond A after 5 years. FV = $1,000 PMT = $90 (PMT = coupon = annual interest) N = 3 I = 10 percent PV =? Using these values, the value of PV is found to be $ * *Some calculators will show outflow as a negative number. Lesson 3 57

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

62 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 bond s investment return. P PMT PMT PMT FV = (1 i ) 1 (1 i ) 2 (1 i ) (1 i ) B n n Yield to maturity is a superior measure of bond investment returns, because it incorporates the time value of money. You re already familiar with the equation, but manually calculating yield to maturity requires trial-and-error. Here s 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 (P B ), 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 calculator s 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 (P B ) 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

63 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 you d 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 that s 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 don t fluctuate. 3. If a convertible bond is converted, the firm s use of financial leverage increases. 4. The interest paid by municipal bonds isn t 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 bond s investment return. Complete Problem 1 on page 281 in your textbook. Check your answers with those on page Financial Management

64 ASSIGNMENT 7 Read the following assignment. Then read pages and in your textbook. Be sure to complete the self-check to gauge your progress. In Assignment 6, you learned about some of the features and valuation techniques of long-term debt. In this assignment, you ll 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. Let s 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

65 The following equation is used to calculate the value of preferred stock when it has a finite life. P p = Dp + Dp Dp + S (1 + K p ) 1 (1 + K p ) 2 (1 + K p ) n (1 + K p ) n In this equation, the variable k p stands for the yield on newly issued preferred stock (the required return); the variable D p stands for the fixed yearly dividend; the variable P p 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. Let s 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 P p =? Using these values, the value of P p is found to be $ If the preferred stock doesn t have a termination date, it s perpetual and can be valued as a perpetuity. P p = D p k p In this equation, the variable k p stands for the yield on newly issued preferred stock (the required return); the variable D p stands for the fixed yearly dividend; and the variable P p stands for the value (price) of preferred stock (the present value of expected future cash flows). 62 Financial Management

66 Let s look at an example problem. Example: Find the value of an issue of perpetual preferred stock that pays a 7 percent dividend if the par value is $100 and the required return is 12 percent. Solution: First, find the value of the yearly dividend. D p = 0.07 $100 D p = $7 Substitute the known values into the following formula and solve. P p = D p k p P p = $7 12 percent P p = $ P p = $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 they re 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 aren t necessarily fixed, and the sale of the stock is unknown. Lesson 3 63

67 The following formula is used to calculate the value of a common stock. V = D + D D (1 + K) 1 (1 + K) 2 (1 + K p ) n This formula can be simplified to the following: V = D K In this equation, the variable V stands for the value (price) of the common stock; the variable D stands for the dividend; and the variable k stands for the investor s required rate of return. This valuation process assumes that the common stock s 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 = D 0 (1 + g) (k g) In this equation, the variable V stands for the common stock s value; the variable D 0 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. Let s look at an example problem. Example: Suppose ABC s 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 = D 0 (1 + g) (k g) 64 Financial Management

68 V = [$2(1 + 5 percent)] (10 percent 5 percent) V = [2( )] ( ) V = [2(1.05)] ( ) V = 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 D p is $10. Substitute the knownvalues into the following formula and solve. P p = D p k p P p = $10 7 percent P p = $ P p = $ 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 P p =? The stock price is $ Lesson 3 65

69 Why are the valuations in these two problems different? Well, in the first problem, the stock is perpetual, but in the second problem, the investor anticipates receiving the principal amount (the $100 par) at the end of 20 years. The return of the $100 decreases the value of this preferred stock. Example: TSC, Inc. stock sells for $26 and pays an annual per-share dividend of $1.30, which you expect to grow at 12 percent. What is your expected return on this stock? What would be the expected return if the stock price was $40? Solution: Consider the valuation equation. Since you know the price of the stock, you know its value. You need to find the expected rate of return. First, the following equation can be rearranged to help find the value of k. V = D 0 (1 + g) (k g) V = [D 0 (1 + g)] (k g) V (k g) = D 0 (1 + g) k g = [D 0 (1 + g)] V k = {[D 0 (1 + g)] V } + g Substitute the known values into the equation and solve for k. k = {[D 0 (1 + g)] V } + g k = {[$1.30 ( )] $26} k = {[$1.30 (1.12)] $26} k = {1.456 $26} k = k = 0.176, or 17.6 percent If the price were $40, the expected return would fall. 66 Financial Management

70 Substitute the values into the equation and solve. k = {[D 0 (1 + g)] V } + g k = {[$1.30( )] $40} k = {[$1.30(1.12)] $40} k = {1.456 $40} k = k = , or 15.6 percent Lesson 3 67

71 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 stock s dividend is in arrears, the dividend isn t 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 didn t pay dividends. Complete problems 1, 2, and 3 on page 234; problems 1 and 4 on pages ; and problems 1, 2, and 4 on page 291 in your textbook. Check your answers with those on page Financial Management

72 ASSIGNMENT 8 Read the following assignment. Then read pages in your textbook. Be sure to complete the self-check to gauge your progress. In this assignment, you ll learn about investment companies and mutual funds. Mutual funds represent one of the fastestgrowing investment markets today. Mutual funds offer investors the opportunity to increase their buying power by pooling funds with other investors. In doing so, investors are often able to reduce risk while taking advantage of new investment opportunities. Mutual funds are actually created by investment companies. A mutual fund pools the resources of many investors to buy a portfolio of investment securities (such as stocks and bonds). By pooling funds, a mutual fund can invest in a variety of investments so that their success isn t 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 they re 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

73 Mutual funds themselves come in many different forms. They vary both by fee and objective. With respect to fees, mutual funds can be classified into no-load and load categories. A no-load mutual fund doesn t 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 fund s objective. Index funds are a unique category of mutual funds that attempt to mimic a particular stock or bond index. 70 Financial Management

74 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 can t sell for a discount. 4. Loading fees reduce the investor s return. 5. The loading fee reduces a fund s net asset value. 6. An index fund seeks to outperform a specific stock index like the S&P 500. Complete Problems 1, 2, and 3 on page 335 in your textbook. Check your answers with those on page 133. Lesson 3 71

75 NOTES 72 Financial Management

76 Lesson 3 Investments EXAMINATION NUMBER: 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 When you feel confident that you have mastered the material in Lesson 3, go to and submit your answers online. If you don t 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 1 20: Select the one best answer to each question. 1. What is the value of a common stock if the growth rate is 8 percent, the most recent dividend was $2, and investors require a 15 percent return on similar investments? A. $25.78 C. $28.57 B. $27.34 D. $ Which of the following preferred stock properties would provide the best argument favoring purchase of preferred stock by an investor? A. When long-term bond yields decline, the value of preferred stock can potentially rise. B. Because preferred stock trading volume is lower than common stock trading volume, preferred stock prices are less volatile than common stock prices. C. The yield differential between preferred stock and bonds is smaller than would be expected on the basis of risk differentials. D. Preferred stockholders receive preferential treatment over lower-class, common stockholders when the corporation earns sufficient profit to pay creditors and shareholders. Examination 73

77 3. If a company fails to meet the terms of indenture, the company is A. bankrupt. C. profitable. B. in default. D. in registration. 4. Which of the following is the best conclusion, given only the following information: ZYX Corporation s 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 corporation s outstanding preferred stock shares, which pay dividends at 5% of par. A. ZYX Corporation s net income decline is largely attributable to the expense it incurred to purchase its preferred stock. B. ZYX Corporation s 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 Corporation s purchase of preferred stock had no effect on the firm s asset balance. D. ZYX Corporation s 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 C. $828 B. $895 D. $ 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 C. $40 B. $60 D. $20 7. Which of the following bonds is supported by collateral? A. Convertible bonds C. Equipment trust certificates B. Income bonds D. Debentures 8. If a perpetual preferred stock pays a dividend of $5 a year, and yields rise from 10 percent to 12 percent, the price of the stock will A. rise from $50 to $60. C. rise from $41.67 to $50. B. fall from $50 to $ D. fall from $60 to $ Interest is exempt from federal income taxation on A. equipment trust certificates. B. zero coupon bonds. C. federal bonds such as savings bonds. D. state of Florida bonds. 74 Examination, Lesson 3

78 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 C. 5.6 percent B. 6 percent D. 5 percent 11. Dividends come at the expense of A. interest. C. liabilities. B. retained earnings. 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 C. $1,000 B. $1,159 D. $ An increase in investors required return will cause the value of a common stock to A. rise. C. remain unchanged. B. fall. 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 C. $32 B. $25 D. $ 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 C. 20 years B. 10 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 C. 10 percent B. 8 percent D. 12 percent 17. Preferred stock and bonds are similar because A. they both have voting power. B. interest and dividend payments are legal obligations. C. neither interest nor dividends are tax deductible. D. both may be subject to a call option. Examination, Lesson 3 75

79 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 C. $110 B. $100 D. $ A perpetual preferred stock pays a fixed dividend of $9 and sells for $100. What is the stock s rate of return? A. 6.5 percent C. 11 percent B. 9 percent D percent 20. The value of common stock depends on the A. price of the stock. B. retirement date. C. present value of cash flows. D. coupon rate. 76 Examination, Lesson 3

80 Corporate Finance, Part 1 INTRODUCTION As you work through this lesson, you ll 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, you ll be able to List the characteristics of the various business forms sole proprietorship, partnership, and corporation Explain the importance of taxes to financial planning Describe the characteristics of progressive, proportional, and regressive tax structures Calculate the break-even level of output for a business Calculate the degree of operating leverage for a business Identify the assets and liabilities that vary with the level of sales Describe how the percent of sales method of forecasting is used ASSIGNMENT 9 Read the following assignment. Then read pages in your textbook. Be sure to complete the self-check to gauge your progress. Lesson 4 77

81 Business Forms In this assignment, you ll 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 owner s liability isn t 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 firm s debts. One or more of the partners still maintain full legal liability and control over the business operations. A corporation is a legal entity that s 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 they ve invested in the firm. 78 Financial Management

82 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, let s 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 Marginal Tax Rate $0 50,000 15% $50,001 75,000 25% $75, ,000 34% $100, ,000 39% $335,001 10,000,000 34% $10,000,001 15,000,000 35% $15,000,001 18,300,000 38% Over $18,300,000 35% Solution: The above table shows an example of the structure of the federal corporate income tax. Notice that everyone pays 15 percent on the first $50,000 in earnings. On the next $25,000 in earnings, everyone pays 25 percent, and so on. The total tax owed will be the sum of the tax for the first three income levels. To solve this problem, start by calculating the tax owed for each of the three income levels. Lesson 4 79

83 The company earned a total of $125,000. For income between $0 and $50,000, the tax rate is So, to find the tax owed on the first $50,000 of income, multiply the tax rate by $50, $50,000 = $7,500 For income between $50,001 and $75,000, the tax rate is To calculate the tax owed on the next $25,000 of income, multiply the tax rate by $25, $25,000 = $6,250 For income between $75,001 and $100,000, the tax rate is To calculate the tax owed on the remaining $15,000 of company income, multiply the tax rate by $15, $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 firm s 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 To calculate the tax owed on the first $50,000 of income, multiply the tax rate by $50, $50,000 = $7,500 For income between $50,001 and $75,000, the tax rate is To calculate the tax owed on the next $25,000 of income, multiply the tax rate by $25, $25,000 = $6, Financial Management

84 For income between $75,001 and $100,000, the tax rate is To calculate the tax owed on the next $25,000 of income, multiply the tax rate by $25, $25,000 = $8,500 For income between $100,001 and $335,000, the tax rate is 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, $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, you ll 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 that s 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 firm s sales. You can use the following formula to calculate total revenues: TR = P Q Lesson 4 81

85 In this formula, the variable TR stands for the total revenue, the variable P stands for the price per unit, and the variable Q stands for the quantity of units sold. The firm also must consider the cost of production. The total cost of production (TC) is the cost of making a product. When conducting a break-even analysis, it s 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 don t change as output changes. (For example, if the GMB Company can change its output of products without altering the amount that it spends on promotion, then promotion is a fixed cost.) Variable costs (VC), in contrast, are dependent on the level of production. (In order for the GMB Company to produce more products, it must hire more labor; therefore, labor is a variable cost.) The following formula can be used to calculate the total cost of production: TC = FC + VC Variable cost (VC) can also be calculated separately by multiplying variable costs per unit times quantity of output. This relationship is represented by the following formula: VC = V Q In this formula, the variable V stands for the variable cost per unit of output, and the variable Q stands for the quantity of output. Break-even analysis considers the point where total revenue (TR) exactly offsets total costs (TC). Therefore, you want to find the quantity of production where TR equals TC. Keeping this fact in mind, we can rearrange some of the formulas presented in this section to create a new total revenue formula. We start with the original total cost of production formula: TC = FC + VC You want to find the quantity of production where TR = TC. So, substitute TR for TC in the formula. TR = FC + VC 82 Financial Management

86 Next, you can substitute P Q for TR. P Q = FC + VC Finally, substitute V Q for VC. P Q = FC + (V Q) In break-even analysis, your objective is to find the quantity of production where total revenues exactly offset the total costs of production. Therefore, you need to find the quantity of production (Q). You can therefore rearrange the previous formula to help find Q as follows: Q = FC (P V) In conducting break-even analysis, you learned that total costs are the sum of fixed and variable costs. It s 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, let s 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

87 P Q = FC + (V Q) 3Q = 2, Q 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 = Keep in mind that DOL measures the relationship between the level of operating income and the level of production. A DOL of tells you that at a production level of 5,000 units, a 10 percent increase in sales (500 units) will increase operating income by 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 = Financial Management

88 A DOL of 1.25 tells you that at a production level of 10,000 units, a 10 percent increase in sales (1,000 units) will increase operating income by 12.5 percent. Part D: If the firm changes its costs so that the new cost schedule is TC = $4, Q, 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, Q 3Q 1.5Q = 4, Q = 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 = Lesson 4 85

89 Compare this answer to the answer you computed in Part B. The DOL has increased from to 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 = Financial Management

90 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 one s 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 isn t 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 firm s 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 1 3 on pages , and Problem 1 on page 372 in your textbook. Check your answers with those on page 134. Lesson 4 87

91 ASSIGNMENT 10 Read the following assignment. Then read pages in your textbook. Be sure to complete the self-check to gauge your progress. Forecasting and Budgeting In Assignment 9, you learned some of the economic and business components that influence financial decision making. In addition, you learned some of the methods that are available to aid in the decision-making process. When managers are making financial decisions, they re generally determining the future course of a firm. Good planning and forecasting, therefore, are essential to sound financial decisions. Later, in Lesson 5, you ll learn the significance of the cost of capital and capital budgeting to strategic financial decisions. First, however, you ll 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. Let s 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 Liabilities and Equity Cash $25,000 Accounts receivable 50,000 Inventory 75,000 Current assets 150,000 Fixed assets 200,000 Accounts payable $15,000 Accruals 20,000 Notes payable 50,000 Current liabilities 85,000 Common stock 100,000 Retained earnings 165,000 Total assets 350,000 Total liabilities and equity 350, Financial Management

92 The firm earns 15 percent on sales and distributes 25 percent of its earnings to shareholders in the form of dividends. Part A: Using the percent of sales method, forecast the new balance sheet for sales of $600,000 assuming that cash changes with sales and that the firm isn t 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) don t 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 = 5 percent accounts receivable sales = 50, ,000 = 10 percent inventory sales = 75, ,000 = 15 percent accounts payable sales = 15, ,000 = 3 percent accruals sales = 20, ,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

93 The following are the projections: cash: 5 percent of $600,000 = 0.05 $600,000 = $30,000 accounts receivable: 10 percent of $600,000 = 0.10 $600,000 = $60,000 inventory: 15 percent of $600,000 = 0.15 $600,000 = $90,000 accounts payable: 3 percent of $600,000 = 0.03 $600,000 = $18,000 accruals: 4 percent of $600,000 = 0.04 $600,000 = $24,000 You can now update the company balance sheet as shown here. Assets Liabilities and Equity Old Projected Old Projected Cash $25,000 $30,000 Accounts receivable 50,000 60,000 Inventory 75,000 90,000 Projected change in assets $30,000 Accounts payable $15,000 $18,000 Accruals 20,000 24,000 Projected change in liabilities $7,000 Thus, by proportion calculations, there s a $23,000 need for financing ($30,000 $7,000 = $23,000). Part B: Will the firm need external funds? Solution: We know that the firm distributes 25 percent of its earnings. This means that they retain 75 percent of earnings for reinvestment in the firm (retained earnings). We also know that the firm earns 15 percent on sales. You can calculate the amount that the firm has available for investment as follows: amount available for investment = $600, percent 75 percent amount available for investment = $90, percent amount available for investment = $67, Financial Management

94 Our sales projections indicate that the firm needs $23,000, but $67,500 is available from retained earnings. This means that there s an excess of funds of $44,500 ($67,500 $23,000 = $44,500). So the firm doesn t 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 firm s physical plant and other fixed assets could handle increased production. To accommodate a production increase, management might decide to purchase or lease fixed assets. This fixed asset expansion problem complicates the decision making process. We apply the principles of the percent of sales method, then in a second step we superimpose fixed asset funding. Management can choose any one or a combination of the following options: Take the new cash balance created by the percent of sales method and apply part of it to all or part of the fixed asset purchase/lease. Decrease distributions to shareholders. Assume additional debt. Issue shares of stock. Cash Budgeting Cash budgeting addresses the liquidity problem all entities must address if their revenues and expenses vary throughout the fiscal year. It s 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 doesn t 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 doesn t anticipate borrowing, the business may exceed its Lesson 4 91

95 interest-expense budget. During rich cash-flow periods, they may need to find ways for cash to earn more interest than if it were sitting idle in a checking account. The cash budgeting process breaks down the fiscal year into meaningful intervals daily, monthly, quarterly and 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 don t contribute to cash flow. The benefit of cash budgeting is the same benefit earned by forecasting: Cash budgeting enables managers to anticipate and potentially control costs. Self-Check 10 Indicate whether each of the following statements is True or False. 1. Operating leverage is the result of using debt financing. 2. Long-term liabilities vary spontaneously with sales. 3. Plant and equipment spontaneously rises as the firm expands. 4. Underestimation of the level of assets needed may cause a firm to have insufficient finances. 5. If accounts receivable is 15 percent of sales and sales double, the percent of sales method of forecasting says that accounts receivable will become 30 percent of sales. 6. The percent of sales method of forecasting assumes that inventory as a percent of sales is constant. 7. The purpose of cash budgeting is to forecast the year-end cash balance. Complete Problem 1 on page 456, Problem 7 on page 460, and Problem 1 on page 469. Check your answers with those on page Financial Management

96 Lesson 4 Corporate Finance, Part 1 EXAMINATION NUMBER: 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 When you feel confident that you have mastered the material in Lesson 4, go to and submit your answers online. If you don t 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 1 20: Select the one best answer to each question. 1. A firm s sales increase by 50 percent and inventory was $100,000. According to the percent of sales method of forecasting, what will the new inventory be? A. $100,000 C. $150,000 B. $120,000 D. $175, 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 C. $1,025,000 B. $100,250 D. $10,250, If investors want to limit financial risk and maximize their control of the business, which of the following forms of business would they prefer? A. A sole proprietorship C. An S corporation B. A limited partnership D. A corporation Examination 93

97 4. Break-even analysis is concerned with the relationship between A. financial leverage and risk. C. debt and equity. B. total costs and revenues. D. dividends and retained earnings. 5. A union contract suggests that labor costs may be A. variable. C. a noncash expense. B. fixed. 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 C. 1.2 B. 1.0 D 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. You re 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. a large investment in fixed assets. B. small fixed expenses. C. insufficient government regulation. D. a large use of debt financing. 94 Examination, Lesson 4

98 10. Currently, a firm s 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 C. $750 B. $500 D. $1, Which of the following statements about fixed costs is correct? A. Fixed costs don t change with the level of output. B. Fixed costs don t change with the size of the firm. C. Fixed costs are greater than variable costs. D. Fixed costs are paid before variable costs. 12. If ABC, Inc. has $650,000 in sales and $230,000 in expenses, what are the firm s earnings before interest and taxes (EBIT)? A. $850,000 C. $420,000 B. $650,000 D. $325, Which of the following is an advantage of the sole proprietorship? A. Ease of formation C. Limited liability B. Joint ownership 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 C. 100 units B. 150 units D. 50 units 15. Which of the following tends to vary spontaneously with changes in the level of sales? A. Long-term debt C. Plant B. Accounts payable D. Paid-in capital 16. If Sam s Diner has an EBIT of $350,000, what are the diner s net earnings after paying $50,000 in taxes and $34,000 in interest? A. $434,000 C. $311,000 B. $334,000 D. $266, Which of the following is usually a variable expense? A. Salaries C. Wages B. Rent D. Insurance premiums Examination, Lesson 4 95

99 18. If a firm substitutes fixed for variable costs, which of the following will occur? A. The use of financial leverage will be increased. B. The degree of operating leverage will be increased. C. The break-even level of output will be reduced. D. The 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 C. Elimination of double taxation B. Ease of formation D. Dilution of ownership 96 Examination, Lesson 4

100 Corporate Finance, Part 2 INTRODUCTION As you work through this lesson, you ll learn how a firm s use of debt and equity influences financial decision making. You ll study the capital structure of a firm and learn how to calculate the cost of capital. You ll also learn how to use this calculation in making capital budgeting decisions. OBJECTIVES When you complete this lesson, you ll be able to Identify the components of a firm s capital structure Calculate the cost of capital and determine an optimal capital structure Calculate an investment s payback period, net present value, and internal rate of return Describe the differences between net present value and internal rate of return Choose the most profitable investment from a group of mutually exclusive investments List several reasons for mergers and divestitures ASSIGNMENT 11 Read the following assignment. Then read pages and in your textbook. Be sure to complete the selfcheck to gauge your progress. In Assignment 11, you ll learn about the cost of capital and capital structure decisions. A firm s capital structure refers to the breakdown between debt and equity as sources of the firm s 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 97

101 with debt and equity financing. These costs vary with each issue, depending on current economic conditions and the risk of the firm. It s important to realize that the cost of financing is also dependent on the firm s mix of debt and equity instruments. In this assignment, you ll learn how to identify a firm s optimal capital structure, or the best mix of debt and equity financing. To identify the optimal capital structure, you ll 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, there s 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 (k d ), 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. 98 Financial Management

102 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. k d = i (1 t ) In this formula, the variable k d 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 firm s 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. k d = i (1 t ) k d = 8.5 percent (1 30 percent) k d = (1 0.30) k d = (0.70) k d = , or 5.95 percent Part B: What is the cost of preferred stock? Solution: As explained in your textbook, the cost of preferred stock (k p ) 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. k p = D p P p In this formula, the variable D p stands for the dividend paid by preferred stock, and the variable P p 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. k p = D p P p k p = $9 $91 k p = 0.099, or 9.9 percent Lesson 5 99

103 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, k d = i (1 t ) k d = $91 (1 5 percent) k d = $91 (1 0.05) k d = $91 (0.95) k d = $86.45 Thus, 95 percent of the selling price is $ Flotation costs will increase the cost of preferred stock financing, as shown in the following mathematical example. k p = D p P p k p = k p = 0.104, or 10.4 percent In this problem, you weren t 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, we re given information concerning the dividend or interest payment. This translates to a payoff to the investor that s known. 100 Financial Management

104 According to your textbook, the cost of common equity is an opportunity cost: it s 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. Let s 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 doesn t have this advantage. Under the interest rate plus risk premium method, the cost of common stock (k e ) 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: k e = i + risk premium In this formula, the variable k e 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. It s important to recognize that the market risk premium used in the CAPM model isn t equal to the risk premium of the interest rate plus risk premium model.) Lesson 5 101

105 The CAPM model is expressed with the following formula: k e = r f + market risk premium The market risk premium is equal to (r m r f.)beta. Therefore, the formula can be altered as follows: k e = r f + (r m r f.)beta In this formula, the variable k e stands for the cost of equity; the variable r f stands for the risk-free rate of return; the variable r m stands for the return on the market; and beta equals the volatility in the firm s 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: k e = dividend yield + g k e = [D 0 (1 + g)] P + g k e = D 1 P + g In this formula, the variable k e stands for the cost of equity; the variable D 0 stands for the last dividend paid; and the variable g stands for the expected growth rate. In this example problem, you re given only enough information to estimate the expected return model. Substitute the known values into the following formula and solve. k e = [D 0 (1 + g)] P + g k e = [$0.75 (1 + 6 percent)] $ percent k e = [0.75 ( )] k e = [0.75 (1.06)] k e = [0.795] k e = k e = 0.113, or 11.3 percent 102 Financial Management

106 Part D: What is the firm s weighted average cost of capital? Solution: The weighted average cost of capital (also called cost of capital) takes into account the cost of each of the sources of financing. You know that the firm has three sources of funds: debt, preferred stock, and common stock. A cost is associated with each of the three sources: cost of debt = 5.95 percent cost of preferred stock = 9.9 percent cost of common stock = 11.3 percent You know after considering the proportions that these sources contribute to the total external financing of the firm. Of the $400,000 in total assets, debt represents 35 percent ($140,000 $400,000), preferred stock represents 5 percent ($20,000 $400,000) and common stock represents a total of 60 percent ($240,000 $400,000). debt = 35 percent preferred stock = 5 percent common stock = 60 percent The total of the three components is 100 percent. The cost of capital is the weighted average of these three components and can be calculated as follows: WACC = (percent debt) k d + (percent preferred stock) k p + (percent common stock) k e WACC = (35 percent 5.95 percent) + (5 percent 9.9 percent) + (6 percent percent) WACC = ( ) + ( ) + ( ) WACC = 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

107 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 doesn t 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. k e = [D 0 (1 + g)] P + g k e = [$2.10 (1 + 6 percent)] $ percent k e = [2.10 ( )] k e = [2.10 (1.06)] k e = k e = k e = 0.125, or 12.5 percent 104 Financial Management

108 The cost of new common stock is calculated as follows: flotation costs = = $2.38 k e = [D 0 (1 + g)] P + g k e = [$2.10 (1 + 6 percent)] ($34 $2.38) + 6 percent k e = [2.10 ( )] ( ) k e = [2.10 (1.06)] ( ) k e = k e = k e = 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

109 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 it s more expensive than debt and offers no tax savings. 4. The weighted cost of capital includes the cost of all the components of a firm s 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 in your textbook. Check your answers with those on page Financial Management

110 ASSIGNMENT 12 Read the following assignment. Then read pages and in your textbook. Be sure to complete the self-check to gauge your progress. In Assignment 11, you learned how to calculate the cost of capital, or the cost of raising funds. Now, in this assignment, you ll learn about capital budgeting techniques, which are the procedures used to select investments. Many different capital budgeting techniques exist. You ll 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. Let s look at an example problem that illustrates this method. Example: Consider the following two investment opportunities. Investment A Investment B Year 0 $2,000 $2,000 Year 1 $ 790 $1,500 Year 2 $ 900 $2,800 Year 3 $ 1,200 $500 Year 4 $ 4,000 $600 Solution: To calculate the payback period, you need to find the cumulative cash flows. Lesson 5 107

111 Investment A Investment B Cash Flow Cumulative Cash Flow Cash Flow Cumulative Cash Flow Year 0 $2,000 $2,000 $2,000 $2,000 Year 1 $ 790 $1,210 $ 1,500 $500 Year 2 $ 900 $310 $ 2,800 $2,300 Year 3 $ 1,200 $ 890 $ 500 $2,800 Year 4 $ 4,000 $ 4,890 $ 600 $3,400 The payback period is the number of years it takes to get back your initial outlay. For Investment A, it s 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 = payback for Investment A = 2.26 years payback for Investment B = 1 + ($500 $2,800) payback for Investment B = 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. 108 Financial Management

112 Let s consider the same investments over 5 years. Investment A Investment B Year 0 $2,000 $2,000 Year 1 $ 790 $1,500 Year 2 $ 900 $2,800 Year 3 $ 1,200 $500 Year 4 $ 4,000 $600 Year 5 $ 125,000 $200 Payback for Investment A = 2 + ($310 $1,200) Payback for Investment A = Payback for Investment A = 2.26 years Payback for Investment B = 1 + ($500 $2,800) Payback for Investment B = Payback for Investment B = 1.18 years The payback calculations remain the same because the first few cash flows are unchanged. By the payback criteria, Investment B is preferred. However, the $125,000 cash inflow for Investment A in Year 5 has been ignored. Your textbook states that the most widely used alternatives to the payback method, net present value (NPV) and internal rate of return (IRR), are discounted cash flows techniques. This means that both of these techniques account for the time value of money, and are generally considered to be superior methods of capital budgeting. Net Present Value (NPV) Net present value (NPV) is the value of an investment in today s dollars. Let s look at an example problem that illustrates this method. Lesson 5 109

113 Example: Consider two investments, each with an initial outlay of $2,000 and an expected life of 4 years. Assume that the firm has a cost of capital of 10 percent. Calculate the net present value. Solution: To calculate the net present value, you need to find the present value of each cash flow. In other words, you need to find the value of each cash flow in Year 0. Investment A 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 $ 718 $ 1,500 $1,364 Year 2 $ 900 $ 744 $ 2,800 $2,314 Year 3 $ 1,200 $ 901 $ 500 $375 Year 4 $ 4,000 $ 2,732 $ 600 $410 Calculate the net present value of Investment A. NPV = [ $2,000 (1.10) 0 ] + [$790 (1.10) 1 ] + [$900 (1.10) 2 ] + [$1,200 ( ) 3 ] + [$4,000 ( ) 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 = $ PV in Year 1 = $718 PV in Year 2 = $900 (1.10) 2 PV in Year 2 = $ PV in Year 2 = $ Financial Management

114 PV in Year 3 = $1,200 (1.10) 3 PV in Year 3 = $1, PV in Year 3 = $901 PV in Year 4 = $4,000 (1.10) 4 PV in Year 4 = $4, PV in Year 4 = $2,732 NPV A = $2,000 + $718 + $744 + $901 + $2,732 NPV A = $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 ( ) 3 ] + [$600 ( ) 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, PV in Year 1 = $1,363 PV in Year 2 = $2,800 (1.10) 2 PV in Year 2 = $2, PV in Year 2 = $2,314 PV in Year 3 = $500 (1.10) 3 PV in Year 3 = $ PV in Year 3 = $376 PV in Year 4 = $600 (1.10) 4 PV in Year 4 = $ PV in Year 4 = $410 Lesson 5 111

115 NPV B = $2,000 + $1,363 + $2,314 + $376 + $410 NPV B = $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 aren t acceptable. In this example problem, both projects have NPVs that are greater than zero, so both projects are acceptable if the projects are independent. If the projects are independent,the firm can accept all projects with positive NPVs. However, if the projects are mutually exclusive (meaning the firm should accept only one project or the other, not both), then Investment A (the higher NPV project) is preferable. Note that NPV calculations are much less time consuming with the aid of a financial calculator. Internal Rate of Return The calculation of internal rate of return (IRR) is similar to the NPV process. The IRR is the interest rate that sets the NPV of a project equal to zero, as shown in the following equation: NPV = 0 at IRR percent Let s 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. Investment Cash Flow A Investment B 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 $ Financial Management

116 Solution: The following equation can be used to calculate the IRR for Investment A. 0 = [ $2,000 (1 + r ) 0 ] + [$790 (1 + r ) 1 ] + [$900 (1 + r ) 2 ] + [$1,200 (1 + r ) 3 ] + [$4,000 (1 + r ) 4 ] In this example, note that the present value is set to zero and the interest rate (r) becomes the missing variable. Without the aid of a financial calculator, this equation must be solved by trial and error. This requires making a first guess at the interest rate and then adjusting the interest rate until you find an NPV that s equal to zero. With a financial calculator, the calculation is much easier, and produces the following results: IRR A = 52 percent IRR B = 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: NPV A = $3,095 IRR A = 52 percent Investment B: NPV B = $2,463 IRR B = 71 percent So, if the two investments are mutually exclusive, the NPV criteria selects Investment A while the IRR criteria selects Investment B. As stated in your textbook, there s 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. It s important to note, however, that capital budgeting decisions require significant subjective judgment on the part of the financial manager. Lesson 5 113

117 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 can t 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 investment s net present value. Complete Problems 1, 2, and 3 on pages in your textbook. Check your answers with those on page Financial Management