Module 44: Financial Management

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Overview

This module describes major aspects of financial management. Financial management deals with the various types of monetary decisions that must be made by managers in a company, along with the tools and analyses used to make those decisions.

Financial management includes the following five functions:

1. Financing function—Raising capital to support the firm's operations and investment programs.
2. Capital budgeting function—Selecting the best projects in which to invest firm resources, based on a consideration of risks and return.
3. Financial management function—Managing the firm's internal cash flows and its capital structure (mix of debt and equity financing) to minimize the financing costs and ensure that the firm can pay its obligations when due.
4. Corporate governance function—Developing an ownership and corporate governance system for the firm that will ensure that managers act ethically and in the best interest of stakeholders.
5. Risk-management function—Managing the firm's exposure to all types of risk.

This module focuses primarily on the financing, financial management and financial risk management functions. It is divided into four sections. The first section reviews the concepts of working capital management, the second section deals with the topic of a firm's capital structure, asset and liability valuation is described in the third section, and the final section focuses on business mergers. Before beginning the reading you should review the key terms at the end of the module.

WORKING CAPITAL MANAGEMENT

A. Working capital management involves managing and financing the current assets and current liabilities of the firm. The primary focus of working capital management is managing inventories and receivables.

1. Managing the Firm's Cash Conversion Cycle

   The cash conversion cycle of a firm is the length of time between when the firm makes payments and when it receives cash inflows. This cycle is illustrated below.

   

   To enable more detailed analysis, the cash conversion cycle may be analyzed using the following three periods:

   • Inventory conversion period
   • Receivables collection period
   • Payables deferral period
   1. Inventory conversion period—The average time required to convert materials into finished goods and sell those goods.

      

      EXAMPLE

      Assume that average inventory is $10,000,000 and annual cost of goods sold are $40,000,000; the inventory conversion period is equal to 91 days, as calculated below.

      

   2. Receivables collection period (days sales outstanding)—The average time required to collect accounts receivable.

      

      EXAMPLE

      Assume that the average receivables balance is $3,000,000 and credit sales are $40,000,000; the receivables collection period is equal to 27 days as calculated below.

      

   3. Payables deferral period—The average length of time between the purchase of materials and labor and the payment of cash for them.

      

      EXAMPLE

      Assume that the average payables balance for labor and materials is $2,500,000 and cost of goods sold is $30,000,000; the payables deferral period is 30 days as calculated below.

      

   4. The cash conversion cycle nets the three periods described above and, therefore, measures the time period from the time the firm pays for its materials and labor to the time it collects its cash from sales of goods. The conversion period calculated from the above examples is shown below.

      

   5. Effective working capital management involves shortening the cash conversion cycle as much as possible without harming operations. This strategy improves profitability because the longer the cash conversion cycle, the greater the need for financing. We will now turn our attention to the management of each type of current asset.
2. Cash Management

   A firm should attempt to minimize the amount of cash on hand while maintaining a sufficient amount to (1) take advantage of trade discounts, (2) maintain its credit rating, and (3) meet unexpected needs.

   1. Firms hold cash for two basic purposes
      • Transactions. Cash must be held to conduct business operations.
      • Compensation to financial institution. Financial institutions require minimum balances (1) for certain levels of service or (2) as a requirement of loan agreements. Such minimums are referred to as compensating balances.
   2. Firms prepare cash budgets to make sure that they have adequate cash balances to
      • Take advantage of cash discounts. Suppliers often offer lucrative discounts for early payment of invoices.
      • Assure that the firm maintains its credit rating.
      • Take advantage of favorable business opportunities, such as opportunities for business acquisitions. These amounts are sometimes called speculative balances.
      • Meet emergencies, such as funds for strikes, natural disasters, and cyclical downturns. These amounts are sometimes called precautionary balances.
   3. A key technique for cash management is managing float. Float is the time that elapses relating to mailing, processing, and clearing checks. A float exists for both the firm's payments to suppliers and the firm's receipts from customers. Effective cash management involves extending the float for disbursements and shortening the float for cash receipts.
   4. Zero-balance accounts. This cash management technique involves maintaining a regional bank account to which just enough funds are transferred daily to pay the checks presented. Regional banks typically receive the checks drawn on their customers' accounts in the morning from the Federal Reserve. The customer can then be notified as to the amount of cash needed to cover the checks and arrange to have that amount of cash transferred to the account. This arrangement has two advantages:
      • Checks take longer to clear at a regional bank, providing more float for cash disbursements.
      • Extra cash does not have to be deposited in the account for contingencies.

      A zero-balance account is cost-effective if the amount the firm saves on interest costs from the longer float is adequate to cover any additional fees for account maintenance and cash transfers.

      EXAMPLE

      A firm has an opportunity to establish a zero-balance account system using three different regional banks. The total amount of the maintenance and transfer fees is estimated to be $5,000 per year. The firm believes that it will increase the float on its operating disbursements by an average of three days, and its cost of short-term funds is 4%. Assuming that the firm estimates its average daily operating disbursements to be $50,000, should the firm establish the accounts?

      The solution to this problem is found by comparing the $5,000 cost in fees to the benefit in terms of reduced interest costs. If the float on the average is lengthened by three days, the firm gets the use of $150,000 of additional funds ($50,000 per day × 3 days). The annual value of the use of an extra $150,000 in funds is measured by the interest savings, or $6,000 ($150,000 × 4%). Therefore, the firm would save an estimated $1,000 ($6,000 − $5,000) by establishing the zero-balance accounts.

   5. Lockbox system. In a lockbox system, customer payments are sent to a post office box that is maintained by a bank. Bank personnel retrieve the payments and deposit them into the firm's bank account. This technique has the following advantages:
      • Increases the internal control over cash because firm personnel do not have access to cash receipts.
      • Provides for more timely deposit of receipts which reduces the need for cash for contingencies.

        If management is evaluating the feasibility of establishing a lockbox system solely based on the cash flow benefit, the system is cost effective if the interest costs saved due to obtaining more timely deposits is sufficient to cover the net increase in costs of cash receipt processing (bank fees less internal costs saved from having the bank process receipts). The computation would be similar to the one illustrated above for a zero-balance account.

        EXAMPLE

        Assume that a firm is evaluating whether to establish a lockbox system. The following information is available to make the decision:

        • The bank will charge $25,000 per year for the process and the firm will save approximately $8,000 in internal processing costs. Therefore, the estimated net additional cost of processing the receipts is $17,000 ($25,000 − $8,000).
        • The float for cash receipts will be reduced by an estimated two days. Therefore, the firm will receive use of the cash receipts on the average two days earlier.
        • Average daily cash receipts are equal to $300,000 and short-term interest costs are 4%.

        Should the firm establish the lockbox system?

        Based solely on cash flow considerations, the firm should establish the system if the interest savings is greater than the increased costs. In this case, the amount of interest savings is measured by multiplying the increase in average funds, $600,000 ($300,000 per day × 2 days), by the interest cost, 4%. The firm will save an estimated $24,000 ($600,000 × 4%) in annual interest costs. Therefore, the cost savings for the lockbox system is estimated to be $7,000, the savings in interest cost less the net increase in processing costs ($24,000 − $17,000). The real benefit may be even greater, because of the intangible value of the increase in internal control from having the bank process cash receipts. This reduces the firm's business risk.

   6. Concentration banking. Another way to speed up collection of payments on accounts is concentration banking. Using this technique, customers in an area make payments to a local branch office rather than firm headquarters. The local branch makes deposits in an account at a local bank. Then, surplus funds are periodically transferred to the firm's primary bank. Since these offices and banks are closer to customers, the firm gets the use of the funds more quickly. The float related to cash receipts is shortened. However, transferring funds between accounts can be costly. Wire transfers generally involve a significant fee. A slower but less expensive way of transferring funds is through the use of official bank checks (depository transfer checks) which are preprinted checks used to make transfers.

      EXAMPLE

      Assume that a firm is considering establishing a concentration banking system and has the following information to make the decision:

      • The concentration banking arrangement will allow access to the firm's average $100,000 daily cash receipts from customers two days faster.
      • Bank maintenance and transfer fees are estimated at $4,000 per year.
      • The firm's short-term borrowing cost is 3.5%.

      Should the firm establish the concentration banking system?

      Again, in evaluating the decision, management must compare the interest savings, $7,000 [($100,000 per day × 2 days) × 3.5%] to the additional costs, $4,000. Thus, management would save $3,000 ($7,000 − $4,000) by establishing the concentration banking system.

   7. Electronic funds transfer. Electronic funds transfer is a system in which funds are moved electronically between accounts without the use of a check. As an example, through a terminal at a supermarket a customer's payment is automatically charged with a “debit card” against the customer's bank account before he or she leaves the store. Electronic funds transfer systems actually take the float out of both the receipts and disbursements processes.
   8. International cash management. Multinational firms can use various systems, including electronic systems, to manage the cash accounts they hold in various countries. Carefully managing international accounts may provide management with opportunities to increase earnings. As an example, management may be able to transfer funds to a country in which interest rates are higher, allowing increased returns on investments.
3. Marketable Securities Management

   In most instances firms hold marketable securities for the same reasons they hold cash. Such assets can generally be converted to cash very quickly, and marketable securities have an advantage over cash in that they provide an investment return. There are many securities to choose from for short-term investment. The factors that are considered in making the choice include

   • Minimum investment required—Some investments, such as high-yield certificates of deposit, require larger investments.
   • Safety—The risk to principal.
   • Marketability (liquidity)—Relates to the speed with which the investment can be liquidated.
   • Maturity—The length of time the funds are committed.
   • Yield—Generally, the higher the yield the better. However, additional yield comes with higher risk or longer maturity.

   Because short-term investments must be available to meet the current cash needs of the firm, the most important considerations with respect to these investments are liquidity and safety. Major types of short-term investments include

   1. Treasury bills (T-bills)—Short-term obligations of the federal government. Although treasury bills are initially offered with maturities of from 91 to 182 days, existing T-bills may be purchased on the market with virtually any maturity date up to 182 days. T-bills are popular short-term investments because the active market ensures liquidity.
   2. Treasury notes—Government obligations with maturities from one to ten years. These securities are appropriate for the investment of short- to intermediate-term funds.
   3. Treasury Inflation Protected Securities (TIPS)—Government obligations that pay interest that equates to a real rate of return specified by the US Treasury, plus principal at maturity that is adjusted for inflation. These are useful to a firm that wants to minimize interest rate risk.
   4. Federal agency securities—Offerings of government agencies, such as the Federal Home Loan Bank. These securities offer security, liquidity (active market), and pay slightly higher yields than treasury issues.
   5. Certificates of deposit (CD)—Savings deposits at financial institutions. There is actually a two-tier market for CDs—small CDs ($500 − $10,000) with lower interest rates and large ($100,000 or more) with higher interest rates. There is a secondary market for large CDs, providing some liquidity. Interest yields are higher on CDs than for government securities but CDs are not as liquid or as safe. CDs are normally insured up to $100,000 by the federal government.
   6. Commercial paper—Large unsecured short-term promissory notes issued to the public by large creditworthy corporations. Commercial paper has a two- to nine-month maturity period and is usually held to maturity by the investor because there is no active secondary market.
   7. Banker's acceptance—A draft drawn on a bank for payment when presented to the bank. Banker's acceptances generally arise from payments for goods by corporations in foreign countries. The corporation receiving the banker's acceptance may have to wait 30-90 days to present the acceptance for payment. As a result, a secondary market has developed for the sale of these instruments at a discount. Therefore, management may purchase banker's acceptances as short-term investments. Banker's acceptances involve slightly more risk than government securities but also offer slightly higher yields.
   8. Eurodollar certificate of deposit—Eurodollars are US dollars held on deposit by foreign banks and in turn lent by the banks to anyone seeking dollars. To obtain dollars, foreign banks offer Eurodollar certificates of deposit. As an investment, Eurodollar certificates of deposit pay higher yields than treasury bills or certificate of deposit at large US banks.
   9. Money market funds—Shares in a fund that purchases higher-yielding bank CDs, commercial paper, and other large-denomination, higher-yielding securities. Money market funds allow smaller investors to participate in these markets.
   10. Money market accounts—Similar to savings accounts, individual or business investors deposit idle funds in the accounts and the funds are used to invest in higher-yielding bank CDs, commercial paper, etc.
   11. Equity and debt securities—Management may also decide to invest in the publicly traded stocks and bonds of other corporations. Such investments have greater risk than other short-term investments, but they also offer higher average long-term returns. If management invests in such securities it should purchase a balanced portfolio to diversify away the unsystematic risk (e.g., default risk) of the individual investments.
4. Inventory Management

   Effective inventory management starts with effective forecasting of sales and coordination of purchasing and production. The two goals of inventory management are

   • To ensure adequate inventories to sustain operations, and
   • To minimize inventory costs, including carrying costs, ordering and receiving costs, and cost of running out of stock.
   1. Production pattern. If the firm has seasonal demand for its products, management must decide whether to plan for level or seasonal production. Level production involves working at a consistent level of effort to manufacture the annual forecasted amount of inventory. Level production results in the most efficient use of labor and facilities throughout the year. However, it also results in inventory buildups during slow sales periods. This results in additional inventory holding costs. Seasonal production involves increasing production during periods of peak demand and reducing production during slow sales periods. Seasonal production often has additional operating costs for such things as overtime wages and maintenance.

      EXAMPLE

      A firm has projected the following data for the two alternatives of level production and seasonal production. The firm's short-term interest cost is 7%.

      

      Which alternative is preferable?

      Under the level production alternative, the firm would incur an additional $3,500 (($200,000 − $150,000) × 7%) in inventory holding costs, but it would also save $10,000 ($1,010,000 − $1,000,000) in production costs. Therefore, level production would be the best production alternative. It would save the firm $6,500 ($10,000 − $3,500).

   2. Inventory and Inflation. A firm's inventory policy also might be affected by inflation (deflation). As an example, if a firm uses silver as a raw material, the firm could experience significant gains or losses simply because of price fluctuations that occur in the silver market. Price instability occurs in a number of markets, such as copper, wheat, sugar, etc. The problem may be partially controlled by holding low levels of inventory. Another way would be to hedge the price movement with a futures contract to sell silver at a specified price in the future. In this manner, if the price of the silver falls, reducing the value of the inventory, the value of the future contract would rise to completely or partially offset the inventory loss.
   3. Supply chain. The term supply chain describes a good's production and distribution. It illustrates the flow of goods, services, and information from acquisition of basic raw materials through the manufacturing and distribution process to delivery of the product to the consumer, regardless of whether those activities occur in one or many firms. To manage inventories and their relationships with their suppliers many firms use a process known as supply chain management. A key aspect of supply chain management is the sharing of key information from the point of sale to the final consumer back to the manufacturer, to the manufacturer's suppliers, and to the suppliers' suppliers. As an example, if a manufacturer/distributor shares its sales forecasts with its suppliers and they in turn share their sales forecasts with their suppliers, the need for inventories for all firms is significantly decreased. The manufacturer/distributor, for example, needs far less raw materials inventory than normally would be the case because its suppliers are aware of the manufacturer's projected needs and are prepared to have the materials available when needed. Specialized software facilitates the process of information sharing along the supply chain network.
   4. Economic order quantity

      How much to order? The amount to be ordered is known as the economic order quantity (EOQ). The EOQ minimizes the sum of the ordering and carrying costs. The total inventory cost function includes carrying costs (which increase with order size) and ordering costs (which decrease with order size). The EOQ formula is derived by setting the annual carrying costs equal to annual ordering cost or by differentiating the cost function with respect to order size.

      

      When to reorder? The objective is to order at a point in time so as to avoid stockouts but not so early that an excessive safety stock is maintained. Safety stocks may be used to guard against stockouts; they are maintained by increasing the lead time (the time that elapses from order placement until order arrival). Thus, safety stocks decrease stockout costs but increase carrying costs. Examples of these costs include

      Carrying costs of safety stock (and inventory in general) Stockout costs	Stockout costs
      Storage Interest Spoilage Insurance Property taxes	Profit on lost sales Customer ill will Idle equipment Work stoppages

      The amount of safety stock held should minimize total stockout and carrying costs, as shown below.

      

      The most common approach to setting the optimum safety-stock level is to examine previous lead-time periods to determine the probabilities of running out of stock (a stockout) for different assessed levels of safety stock.

   5. Inventory Management and MRP. Materials requirements planning (MRP) is a computerized system that manufactures finished goods based on demand forecasts. Demand forecasts are used to develop bills of materials that outline the materials, components, and subassemblies that go into the final products. Finally, a master production schedule is developed that specifies the quantity and timing of production of goods, taking into account the lead time required to purchase materials and to manufacture the various components of finished products. A key weakness of MRP is that it is a “push through” system. Once the master schedule is developed goods are pushed through the production process whether they are needed or not. Therefore, inventories may accumulate at various stages, especially if there are production slowdowns or unreliable demand forecasts. MRP II was developed as an extension of MRP and it features an automated closed loop system. That is, production planning drives the master schedule which drives the materials plans which is input to the capacity plan. It uses technology to integrate the functional areas of a manufacturing company.
   6. Just-in-Time (JIT) Purchasing. JIT is a demand-pull inventory system which may be applied to purchasing so that raw material arrives just as it is needed for production. The primary benefit of JIT is reduction of inventories, ideally to zero. Because of its non-value-added nature, inventory is regarded as undesirable. In a JIT system, suppliers inspect their own goods and make frequent deliveries of materials, which are placed into production immediately upon receipt. This process eliminates the need for incoming inspection and the storeroom. Suppliers all along the supply chain are informed through specialized software (e.g., enterprise resource systems) about the forecasted demand for their products allowing them to plan to supply the items when needed.

      Obviously, the most important aspect of a JIT purchasing system is selection of, and relationships with, suppliers. If suppliers do not make timely delivery of defect-free materials, stockouts and customer returns will occur and they will be more pronounced. In addition, if sales forecasts are not reliable, goods ordered will vary from what is expected, causing inventories to build up somewhere along the supply chain.

   7. JIT Production. JIT methodology can also be applied to production. JIT production is a “demand pull” system in which each component of a finished good is produced when needed by the next production stage. The production process is driven by the demand. It begins with an order by the customer triggering the need for a finished good and works its way back through each stage of production to the beginning of the process. A JIT system strives to produce high-quality products that meet the customer's needs on a timely basis and at the lowest possible cost. Obviously, JIT production reduces inventories to a minimal level. To accomplish JIT production, management must
      • Emphasize reducing production cycle time (manufacturing lead time) and setup time. Cycle time is the time required to complete a product from the start of its production until it is finished. Setup time is the time required to get equipment and materials ready to start working on the product. The time for both is cut to a minimum in a JIT system.
      • Emphasize production flexibility. Plant layout is organized around manufacturing cells that produce a product or type of product with the workers being able to operate a number of the different machines. Machinery is purchased that can be used for multiple functions.
      • Emphasize solving production problems immediately. If it is discovered that parts are absent or defective, production is corrected on the spot. This practice contrasts with traditional systems, in which the production of defective products often continues because defective goods are sitting in inventory—awaiting sale and thus ultimate feedback from the customer. In a JIT system, each worker is responsible for the quality of his or her own work. Thus, JIT results in reductions in scrap and rework.
      • Focus on simplifying production activities. The goal of JIT is to identify and eliminate non-value-added activities. Less factory space is used for inventory storage and production activities, and materials handling between workstations is streamlined.

      JIT purchasing and production systems offer many advantages over traditional systems, including the following:

      • Lower investments in inventories and in space to store inventory.
      • Lower inventory carrying and handling costs.
      • Reduced risk of defective and obsolete inventory.
      • Reduced manufacturing costs.
      • The luxury of dealing with a reduced number (when compared with traditional systems) of reliable, quality-oriented suppliers.
      • JIT allows a simplified costing system called backflush costing. The lack of inventories in a JIT system makes choices about cost-flow (such as LIFO and FIFO) unimportant—all manufacturing costs are simply run through cost of goods sold.

      On the other hand, JIT systems can break down with disastrous results if (1) suppliers do not provide timely delivery of quality materials, (2) employers are not well trained or supervised, or (3) technology and equipment are not reliable.

   8. Enterprise Resource Planning (ERP) Systems. ERP systems are enterprise-wide computerized information systems that connect all functional areas within an organization. By sharing information from a common database, marketing, purchasing, production, distribution, and customer relations management can be effectively coordinated. ERP systems also facilitate supply chain management by connecting the firm electronically to its suppliers and customers.
5. Receivables Management

   Effective receivables management involves systems for deciding whether or not to grant credit and for monitoring the receivables. Obviously, management should establish consistent credit evaluation procedures that balance the costs of lost sales with the costs of credit losses (uncollectible accounts). The firm's credit policy consists of the following four variables:

   • Credit period—The length of time buyers are given to pay for their purchases.
   • Discounts—Percentage provided and period allowed for discount for early payment.
   • Credit criteria—Required financial strength of acceptable credit customers. Firms often use a statistical technique called credit scoring to evaluate a potential customer.
   • Collection policy—Diligence used to collect slow-paying accounts.
   1. The credit period and discount policies will be the major determinant of the eventual size of the receivables balance. If a firm has $10,000 in credit sales per day and allows 30 days for payment, the firm will carry an approximate balance of $300,000 ($10,000 × 30). If the firm extends the terms to 45 days, the receivables balance will swell to approximately $450,000 ($10,000 × 45).
   2. In making an individual credit decision, management must determine the level of credit risk of the customer based on prior records of payment, financial stability, current financial position, and other factors. Credit information is available from sources such as Dun & Bradstreet Information Services to make such decisions. Dun & Bradstreet makes available its Business Information Report (BIR) and a number of credit scoring reports.
   3. To provide overall monitoring of receivables, management will often use measures such as the days sales outstanding and aging schedules. The days sales outstanding provides an overall measure of the accumulation of receivables and is calculated as follows:

      

      EXAMPLE

      Assume that a firm's outstanding receivables balance is $2,000,000 and annual sales is $52,000,000; the days sales outstanding is calculated below.

      

      An aging schedule breaks down receivables by age, as shown below.

      

      By monitoring days sales outstanding and the aging schedule, management can detect adverse trends and evaluate the performance of the credit department.

   4. Management of accounts receivable also involves determining the appropriate credit terms and criteria to maximize profit from sales after considering the cost of holding accounts receivable and losses from uncollectible accounts.

      EXAMPLE

      Assume that management believes that if they relax the firm's credit standards, sales will increase by $240,000. The firm's average collection period for these new customers will be 60 days and the payment period for existing customers is not expected to change. Management expects 5% losses from uncollectible accounts for these new customers. If variable costs are 75% of sales, and the cost of financing accounts receivable is 10%, should management decide to relax credit standards? The answer to this question involves comparing incremental revenues to incremental costs as shown below.

      

      The interest cost is calculated by recognizing that if collection takes approximately 60 days, there will be approximately 60 days sales outstanding during the year. Average outstanding receivables is calculated as

      

6. Financing Current Assets
   1. Because many firms have seasonal fluctuations in the demand for their products or services, current assets tend to vary in amount from month to month. Conventional wisdom would say that such assets should be financed with current liabilities—accounts payable, commercial bank loans, commercial paper, etc. However, a certain amount of current assets are required to operate the business in even the slowest periods of the year. This amount of current assets is called the amount of permanent current assets. Permanent current assets are more appropriately financed with long-term financing, such as stock or bonds. Additional current assets (inventory, accounts receivable, etc.) are accumulated during periods of higher production and sales. These current assets are called temporary current assets, and they may be appropriately financed with short-term financing.
   2. Various strategies are used to finance current assets. Since short-term debt is less expensive than long-term, firms generally attempt to finance current assets with short-term debt. However, use of extensive amounts of short-term debt is aggressive in that firms must pay off the debt or replace it as it comes due. A business recession may render the firm unable to meet these obligations. In addition, the amount of interest expense over time will be more volatile because the firm has not locked in an interest rate on a long-term basis. More conservative strategies involve financing some current assets with long-term debt which involves a more stable interest rate. However, as indicated above long-term debt tends to be more expensive, and the provisions or covenants of long-term debt agreements generally constrain the firm's future actions. Finally, prepayment penalties may make early repayment of long-term debt an expensive proposition.
   3. Illustrated in the graph below is a conservative short-term investment strategy in which permanent current assets are financed with long-term debt.

      

   4. The maturity matching or self-liquidating approach to financing assets involves matching asset and liability maturities. This strategy minimizes the risk that the firm will be unable to pay its maturing obligations. This method is often referred to as a hedging approach.
   5. Generalizations about the cost, riskiness, and flexibility of short-term versus long-term debt depend on the type of short-term debt being used. We will now turn our attention to the different sources of short-term funds.
7. Sources of Short-Term Funds
   1. Accounts payable (trade credit). Firms generally purchase goods and services from other firms on credit. Trade credit, especially for small firms, is a very significant source of short-term funds. A major advantage of trade credit is that it arises in the normal course of conducting business and bears no interest cost, providing it is paid on time.

      Many firms have credit terms that allow a cash discount for early payment of the invoice. For example, a firm might sell on terms of 2/10, net 30, which means that payment is due in thirty days and a 2% discount is allowed for payment within 10 days. Generally, it is a good financial decision to take advantage of such discounts because the rate of interest realized for early payment is significant. The approximated cost of not taking the discount is calculated with the following formula:

      

      With our example of 2/10, net/30, the discount percentage is 2%, the total pay period is 30 days, and the discount period is 10 days. Therefore, the nominal annual cost is equal to 37.2% as calculated below.

      

      The nominal rate does not consider the effects of compounding. Therefore, the effective annual rate is significantly higher than the 37.2%.

   2. Short-term bank loans. Notes payable to commercial banks represents the second most important source of short-term funds. We will now turn our attention to key features of bank loans.

      Maturity—While banks do make long-term loans, the majority of their lending has a maturity date of one year or less. Business loans typically mature every 90 days requiring the firm to pay or renew the loan on a regular basis.

      Promissory note—Notes are executed using a signed promissory note. The note specifies the terms of the agreement.

      Interest—The rate for short-term bank loans fluctuates with changes in short-term interest rates as measured by such indexes as

      • Prime rate—The rate a bank charges its most creditworthy customers. The rate increases for customers with more credit risk. As an example, a customer might have a rate of prime plus 100 basis points, which would be equal to the prime rate plus one percent. One basis point is equal to one hundredth of one percent (0.01%).
      • London Interbank Offered Rate (LIBOR)—This rate is important because of the availability of dollars for loan on the international market. US companies can decide to borrow money in the US financial markets, London, or any other major money market center. LIBOR reflects price of funds in the international market.

        Compensating balances—Loan agreements may require the borrower to maintain an average demand deposit balance equal to some percentage of the face amount of the loan. Such requirements increase the effective interest rate of the loan, because the firm does not get use of the full amount of the loan principal. As an example, if a firm gets a $100,000, 90-day loan at 6% with a 10% compensating balance arrangement, the effective interest rate on the loan would be calculated as follows:

        

        

      Informal line of credit—An informal specification of the maximum amount that the bank will lend the borrower.

      Revolving credit agreements—A line of credit in which the bank is formally committed to lend the firm a specified maximum amount. The bank typically receives a commitment fee as a part of the agreement. Revolving credit arrangements are often used for intermediate-term financing.

      Letter of credit—An instrument that facilitates international trade. A letter of credit, issued by the importer's bank, promises that the bank will pay for the imported merchandise when it is delivered. It is designed to reduce the risk of nonpayment by the importer.

   3. Commercial paper. Commercial paper is a form of unsecured promissory note issued by large, creditworthy firms. It is sold primarily to other firms, insurance companies, pension funds, banks, and mutual funds. Commercial paper typically has maturity dates that vary from one day to nine months. This form of financing is very favorable for corporations with the financial strength to issue it. The rate is often 2 to 3% less than the prime rate and there are no compensating balance requirements. However, the market is less predictable than bank financing.
   4. Accounts receivable financing.
      • (1) Pledging of receivables. Pledging accounts receivable involves committing the receivables as collateral for a loan from a financial institution. The financial institution will evaluate the receivables to see if they are of sufficient quality to serve as collateral. The interest rate will depend on the financial strength of the firm and the quality of the receivables. Typically, the financial institution will lend 60 to 80% of the value of the receivables and the outstanding balance of the loan will fluctuate with the amount of the receivables outstanding. Interest is computed based on the outstanding loan balance and tends to be quite high. However, for small or troubled companies the interest rate will be less than for unsecured loans.
      • (2) Factoring. When accounts receivable are factored, they are sold outright to a finance company. In such situations, the finance company is often directly involved in the credit decisions, and will submit the funds to the firm upon acceptance of the account. For taking the risk, the finance company is generally paid a fee of from 1 to 3% of the invoices accepted. In addition, the finance company receives the interest rate for advancing the funds.

        EXAMPLE

        Assume that a finance company charges a 2% fee and a 12% annual interest rate for factoring the firm's receivables which are payable in 30 days. The effective annual rate of interest on this arrangement would be calculated as follows:

        2% Fee

        1% Interest for 1 month (12% annual/12)

        3% Monthly × 12 = 36% annual rate

        Obviously, with the high rates associated with factoring, it is only considered by firms that have few other options.

      • (3) Asset-backed public offerings. Large firms recently have begun floating public offerings of debt (e.g. bonds) collateralized by the firm's accounts receivables. Because they are collateralized, such securities generally carry a high credit rating, even though the issuing firm may have a lower credit rating. Therefore, this form of accounts receivable financing can be advantageous. The creation of asset-backed securities is also called securitization of assets.
   5. Inventory financing. A firm may also borrow funds using its inventory as collateral. The extent of the feasibility of this strategy depends on the marketability of the inventory. Obviously, widely traded raw materials such as lumber, metals, and grains are easily used as collateral. The methods used by lenders to control the pledged inventories include
      • Blanket Inventory Lien—This is simply a legal document that establishes the inventory as collateral for the loan. No physical control over inventory is involved.
      • Trust Receipt—An instrument that acknowledges that the borrower holds the inventory and that proceeds from sale will be put in trust for the lender. Each item is tagged and controlled by serial number. When the inventory is sold, the funds are transferred to the lender and the trust receipt is cancelled. This form of financing is also referred to as floor planning and is widely used for automobile and industrial equipment dealers.
      • Warehousing—This is the most secure form of inventory financing. The inventory is stored in a public warehouse or under the control of public warehouse personnel. The goods can only be removed with the lender's permission.
   6. Hedging to reduce interest rate risk. Firms that must borrow significant amounts of short-term variable rate funds are exposed to high levels of interest rate risk. If interest rates go up suddenly, the firm could experience a significant increase in interest costs. To mitigate this interest rate risk, management may decide to hedge the risk with derivatives purchased or sold in the financial futures market. Derivatives and hedging strategies are described in Module 43.

CAPITAL STRUCTURE

This section focuses on determining the appropriate capital structure of the firm which involves a combination of debt and equity.

A. Long-Term Debt

The characteristics of the various forms of financing available to the firm help determine the funding sources that are most appropriate.

1. Public and Private Debt

   Debt is increasingly a source of funds for US corporations. In issuing debt, management must first decide whether to issue the debt privately or publicly.

   1. Private debt is of two principal types. The first type is loans from financial institutions (either an individual institution or a syndicated loan from multiple institutions). Such loans almost universally have a floating interest rate that is tied to a base rate, usually LIBOR (the London Interbank Offered Rate) or the US bank prime interest rate. The second type of private debt involves the private placement of unregistered bonds sold directly to accredited investors (often pension funds or insurance companies). Such debt is typically less expensive to issue than public debt.
   2. In the United States, public long-term debt offerings involve selling SEC registered bonds directly to investors. The bond agreement specifies the par value, the coupon rate, and the maturity date of the debt. The par value is the face amount of the bond and most corporate bonds have a $1,000 face amount. The coupon rate is the interest rate paid on the face amount of the bond. Since most bonds pay a fixed rate of interest, the market value of the bond fluctuates with changes in the market interest rate. The maturity date is the final date on which repayment of the bond principal is due.

      EXAMPLE

      Baker Corporation issued $500,000 in 6% bonds, maturing in 20 years. Assuming that the bonds were issued at face value and interest is paid semiannually, the coupon rate of 6% is paid in installments of $30 (3% × $1,000) every six months for each $1,000 bond. Total annual interest for the firm every year is $30,000 ($500,000 × 6%). If the market rate of interest increases to 7% after the bonds are issued, the market value of the bonds will decline to an amount that will allow a new purchaser to realize a 7% yield to maturity. On the other hand, if the market rate of interest decreases to 5%, the market price of the bond will increase to an amount that will allow the new purchaser to earn only a 5% yield to maturity. This example illustrates the interest rate risk that investors assume when they purchase long-term fixed-rate bonds.

   3. A debt market with increasing importance is the market for Eurobonds. A Eurobond is a bond payable in the borrower's currency but sold outside the borrower's country. As an example, the bond of a US firm, payable in US dollars, might be sold in Germany, London, and Japan through an international syndicate of investment bankers. The registration and disclosure requirements for Eurobonds are less stringent than those of the SEC for US-issued bonds. Therefore, the cost of issuance is less.
2. Debt Covenants and Provisions
   1. Debt covenants. Both private and public debt agreements contain restrictions, known as debt covenants. Such covenants allow investors (lenders) to monitor and control the activities of the firm. Otherwise, management could make decisions that would be detrimental to the interests of the debt holders. Negative covenants specify actions the borrower cannot take, such as restrictions on
      • (1) The sale of certain assets.
      • (2) The incurrence of additional debt.
      • (3) The payment of dividends.
      • (4) The compensation of top management.

      Positive covenants specify what the borrower must do and include such requirements as

      • (1) Provide audited financial statements each year.
      • (2) Maintain certain minimum financial ratios.
      • (3) Maintain life insurance on key employees.

      These covenants restrict the action of management and are an important consideration in determining the type of financing to obtain. In addition, major covenants must be disclosed in the footnotes to the firm's financial statements. Now, let's turn our attention to some typical provisions of debt agreements.

   2. Security provisions. Debt may be secured or unsecured. Secured debt is one in which specific assets of the firm are pledged to the bondholders in the event of default. Based on their security provisions debt may be classified as follows:
      • (1) Mortgage bond—A bond secured with the pledge of specific property. The securing property is typically property or plant assets.
      • (2) Collateral trust bond—A bond secured by financial assets of the firm.
      • (3) Debenture—A bond that is not secured by the pledge of specific property. It is a general obligation of the firm. Because of the default risk, such bonds can only be issued by firms with the highest credit rating. Debentures typically have a higher yield than mortgage bonds and other secured debt.
      • (4) Subordinated debenture—A bond with claims subordinated to other general creditors in the event of bankruptcy of the firm. That is, the bondholders receive distributions only after general creditors and senior debt holders have been paid. As you would expect, subordinated debentures have higher yields than senior unsecured debt.
      • (5) Income bond—A bond with interest payments that are contingent on the firm's earnings. Obviously, these bonds also have a high degree of risk and carry even higher yields. These types of bonds are often associated with firms undergoing restructuring.
   3. Methods of payment. Bonds may be paid as a single sum at maturity, or through
      • (1) Serial payments—Serial bonds are paid off in installments over the life of the issue. Serial bonds may be desirable to bondholders because they can choose their maturity date.
      • (2) Sinking fund provisions—The firm makes payments into a sinking fund which is used to retire bonds by purchase.
      • (3) Conversion—The bonds may be convertible into common stock and this may provide the method of payment.
      • (4) Redeemable—A bondholder may have the right to redeem the bonds for cash under certain circumstances (e.g., if the firm is acquired by another firm).
      • (5) A call feature—The bonds may have a call provision allowing the firm to force the bondholders to redeem the bonds before maturity. Call provisions typically call for payment of a 5 to 10% premium over par value to redeem the bonds. Investors generally do not like call features because they may be used to force them to liquidate their investment.
3. Bond Yields
   1. There are three different yields that are relevant to bonds: the coupon rate, the current yield, and yield to maturity.

      EXAMPLE

      Assume that a bond has a par value of $1,000 and pays 12% interest, $120 ($1,000 × 12%) per year for the remaining term of 10 years. The bond is currently selling for $900.

      • The coupon rate (nominal yield) is equal to the 12% stated rate.
      • The current yield is the stated interest payment divided by the current price of the bond.

        

      • The yield to maturity is the interest rate that will equate future interest payments and the maturity payment to the current market price. The future interest payments are $120 per year and the principal payment is $1,000 received at the end of 10 years. The current price of the bond is $900, and the yield to maturity can be estimated with the following formula:

        

   2. The price of a bond is dependent on the current risk-free interest rate and the credit risk of the particular bond. Bond rating agencies have rating systems for bonds to capture credit risk. For example, Moody's Investor Service provides the following nine categories of ranking:

      

      Companies that invest in a significant amount of bonds may decide to share the credit risk by purchasing credit default insurance.

      For additional discussion of the valuation of bonds, review the section on present value in Module 43.

4. Other Types of Bonds
   1. Zero-coupon rate bonds—These types of bonds do not pay interest. Instead they sell at a deep discount from the face or maturity value. The return to the investor is the difference between the cost and the bond's maturity value. The advantage of these bonds is that there are no interest payment requirements until the bonds mature. In addition, the amortization of interest is tax-deductible even though the firm is not making any interest payments.
   2. Floating rate bonds—The rate of interest paid on this type of bond floats with changes in the market rate (usually monthly or quarterly). Therefore the market price of the bond does not fluctuate as widely. Reverse floaters are floating rate bonds that pay a higher rate of interest when other interest rates fall and a lower rate when other rates rise. Reverse floaters are riskier than normal bonds.
   3. Registered bonds—These bonds are registered in the name of the bondholder. Interest payments are sent directly to the registered owners.
   4. Junk bonds—These bonds carry very high-risk premiums. Junk bonds often have resulted from leveraged buyouts or are issued by large firms that are in troubled circumstances. They may appeal to investors who feel they can diversify the risk by purchasing a portfolio of the bonds in different industries.
   5. Foreign bonds—These bonds are international bonds that are denominated in the currency of the nation in which they are sold. Foreign bonds might serve as an effective hedge for a firm that is heavily invested in assets in the foreign country.
   6. Eurobonds—As described above, these bonds are international bonds that are denominated in US dollars.
5. Advantages and Disadvantages of Debt Financing

   In deciding whether debt should be used as a form of financing, management must keep in mind the following advantages and disadvantages. The advantages of debt financing include

   • Interest is tax-deductible.
   • The obligation is generally fixed in terms of interest and principal payments.
   • In periods of inflation, debt is paid back with dollars that are worth less than the ones borrowed.
   • The owners (common stockholders) do not give up control of the firm.
   • Debtors do not participate in excess earnings of the firm.
   • Debt is less costly than equity. Therefore, the use of debt, up to some limit, will lower the firm's cost of capital. Cost of capital is discussed later in this module.

   Disadvantages of debt financing include

   • Interest and principal obligations must be paid regardless of the economic position of the firm.
   • Interest payments are fixed in amount regardless of how poorly the firm performs.
   • Debt agreements contain covenants that place restrictions of the flexibility of the firm.
   • Excessive debt increases the risk of equity holders and therefore depresses share prices.
6. Leasing as a Form of Financing
   1. Another potential source of intermediate or long-term financing involves leasing assets. From a financial statement standpoint, leases may be capital leases or operating leases. Capital leases are those that meet any one of the following four conditions as set forth in SFAS 13:
      • (1) The arrangement transfers ownership of the property to the lessee by the end of the lease.
      • (2) The lease contains a bargain purchase option at the end of the lease. The option price must be sufficiently low so exercise of the option appears reasonably certain.
      • (3) The lease term is equal to 75% or more of the estimated life of the leased property.
      • (4) The present value of the minimum lease payments equals 90% or more of the fair value of the leased property at the inception of the lease.

      If a lease meets one of these conditions, the firm must record the leased asset and related liability on its balance sheet, and account for the asset much like it would a purchased asset. The asset is recorded at the present value of the future lease payments and amortized (depreciated). A liability is recorded at the same amount and each lease payment involves payment of interest and principal on the obligation.

   2. An operating lease is one that does not meet the criteria to be treated as a capital lease. Operating leases are treated as rental agreements; the asset and obligation are not recorded on the firm's balance sheet. The lease payments are expensed as rent as they are incurred.
   3. A sale-leaseback is a transaction in which the owner of the property sells the property to another and simultaneously leases it back. Such arrangements often provide financing and tax advantages.
   4. Leases have a number of advantages over purchasing the asset and financing through other means, including
      • A firm may be able to lease an asset when it does not have the funds or credit capacity to purchase the asset.
      • The provisions of a lease agreement may be less stringent than a bond indenture.
      • There may be no down payment requirement.
      • Creditor claims on certain types of leases, such as real estate, are restricted in bankruptcy.
      • The cost of a lease to the lessee may be reduced because the lease may be structured such that the lessor retains the tax benefits.
      • Operating leases do not require recognition of a liability on the financial statement of the lessor.
   5. On the other hand, the dollar cost of leasing an asset is often higher than the cost of purchasing the asset.

B. Equity

This section describes the use of various forms of equity used for long-term financing.

1. Common Stock

   The ultimate owners of the firm are the common shareholders. They generally have control of the business and are entitled to a residual claim to income of the firm after the creditors and preferred shareholders are paid. Common stock ownership involves a high degree of risk. The investor is the last in line to receive earnings and distributions upon liquidation of the firm. On the other hand, common stockholders have the potential opportunity to receive very high returns. The return of the common stockholder includes dividends and appreciation in the value of the stock.

   1. Classes of common stock. Most firms issue only one class of common stock. However, a firm may issue a second class of stock that differs with respect to the stockholders' right to vote or receive dividends. As an example, if the current stockholders do not wish to give up control of the firm, a class B stock might be issued that has limited voting rights. Obviously, the class B stock would sell for less than the class A stock as a result of the restriction.
   2. Stock warrants. Stock warrants are sometimes issued with bonds to increase their marketability. A stock warrant is an option to buy common stock at a fixed price for some period of time. Once the bond is sold, the stock warrants often may be sold separately and are traded on the market.
   3. Advantages of issuing common stock
      • The firm has no firm obligation, which increases financial flexibility.
      • Increased equity reduces the risk to borrowers and, therefore, will reduce the firm's cost of borrowing.
      • Common stock is more attractive to many investors because of the future profit potential.
   4. Disadvantages of common stock
      • Issuance costs are greater than for debt.
      • Ownership and control is given up with respect to the issuance of common stock.
      • Dividends are not tax-deductible by the corporation whereas interest is tax-deductible.
      • Shareholders demand a higher rate of return than lenders.
      • Issuance of too much common stock may increase the firm's cost of capital.
2. Preferred stock is a hybrid security. Preferred shareholders are entitled to receive a stipulated dividend and, generally, must receive the stipulated amount before the payment of dividends to common shareholders. In addition preferred stockholders have a priority over common stockholders in the event of liquidation of the firm. Common features of preferred stock include
   • Cumulative dividends—Most issues are cumulative preferred stock and have a cumulative claim to dividends. That is, if dividends are not declared in a particular year, the amount becomes in arrears and the amount must be paid in addition to current dividends before common shareholders can receive a dividend.
   • Redeemability—Some preferred stock is redeemable at a specified date. This makes the stock very similar to debt. On the firm's balance sheet such stock is often presented between debt and equity (the so-called mezzanine).
   • Conversion—Preferred stock may be convertible into common stock.
   • Call feature—Preferred stock, like debt, may have a call feature.
   • Participation—A small percentage of preferred shares are participating, which means they may share with common shareholders in dividends above the stated amount.
   • Floating rate—A small percentage of preferred shares have a floating rather than fixed dividend rate.
   1. Advantages of issuing preferred stock
      • The firm still has no obligation to pay dividends until they are declared, which increases financial flexibility.
      • Increased equity reduces the risk to borrowers and, therefore, will reduce the firm's cost of borrowing.
      • Common stockholders do not give up control of the firm.
      • Preferred stockholders do not generally participate in superior earnings of the firm.
   2. Disadvantages of preferred stock
      • Issuance costs are greater than for debt.
      • Dividends are not tax-deductible by the corporation whereas interest is tax-deductible.
      • Dividends in arrears accumulated over a number of years may create financial problems for the firm.
3. Convertible Securities

   A convertible security is a bond or share of preferred stock that can be converted, at the option of the holder, into common stock. When the security is initially issued it has a conversion ratio that indicates the number of shares that the security may be converted into.

   The advantage of convertible securities is the fact that investors require a lower yield because of the prospects that conversion may result in a significant gain.

   The major disadvantage is that conversion dilutes the ownership of other common stockholders.

4. Spin-Offs

   A spin-off occurs when a public diversified firm separates one of its subsidiaries, distributing the shares on a pro rata basis to the existing stockholders. Spin-offs are often part of management's strategy to turn its focus to its core businesses.

5. Tracking Stocks

   A tracking stock is a specialized equity offering that is based on the operations and cash flows of a wholly owned subsidiary of a diversified firm. They are hybrid securities, because the subsidiary is not separated from the parent, legally or operationally. The stock simply is entitled to the cash flows of the subsidiary and, therefore, the trading stock trades at a valuation based on the subsidiary's expected future cash flows. Managers that issue trading stock believe that stockholder wealth will be maximized by separate valuation of two or more parts of the consolidated group.

6. Venture Capital

   Venture capital is a pool of funds that is used to make actively managed direct equity investments in rapidly growing private companies. Such funds may be institutionally managed or involve ad hoc investments by wealthy individuals. In addition to capital, professional venture capitalists provide managerial oversight and business advice to the companies. Venture capitalists generally plan to exit the investment within three to seven years by selling the stock to another firm or by initiating a public offering of the stock. Venture capital provides a good source of capital for promising private companies, but it is expensive and management gives up significant control.

7. Going Public

   As a private firm grows, one decision that must be made is whether and when to go public. Going public involves registering the firm's shares with the SEC. From that point on, the firm must comply with the reporting and other requirements of the SEC and the exchange on which the stock trades.

   1. Advantages of going public
      • An initial public offering provides the firm with access to a larger pool of equity capital.
      • Publicly traded stock may be used for acquisitions of other firms. If a private company decides to acquire another company it generally must do so with cash.
      • The firm can offer stock options and other stock-based compensation to attract and retain qualified managers.
      • Going public provides the owners of the private company liquidity for their investments. These individuals can more easily sell portions of their stock in the firm and diversify their portfolio with other investments.
   2. Disadvantages of going public
      • Significant costs and management effort must be put into an initial public offering.
      • There are significant costs of being public related to compliance with the securities laws and SEC and stock exchange regulations. These costs have been significantly increased by the provisions of the Sarbanes-Oxley Act of 2002.
      • Being public necessarily causes management to be focused on maximizing stock price. This may or may not be in the best long-term interest of the firm.
      • Management must provide a great deal of information about the firm to investors.
8. Employee Stock Ownership Plans (ESOPs)

   Firms often reward management and key employees with stock or stock options as part of their compensation. These plans are designed to motivate management to focus on shareholder value. ESOPs are sometimes used as a vehicle for a leveraged buyout. ESOPs have certain tax advantages to the employees, and compensation expense may or may not have to be recognized by the firm.

9. Going Private

   Some public corporations have decided (often to concentrate control) to go private. These transformations are sometimes executed through a leveraged buyout (LBO). In an LBO large amounts of debt are used to buy all or a voting majority of the shares of stock outstanding. Obviously, the firm, after the LBO, is heavily leveraged with much greater risk.

C. Evaluating the Best Source of Financing

To understand completely the considerations involved in making financing decisions, one must understand the concepts of leverage and cost of capital.

1. Leverage

   The finance literature generally discusses two types of leverage: operating leverage and financial leverage.

   1. Operating leverage. Operating leverage measures the degree to which a firm builds fixed costs into its operations. If fixed costs are high a significant decrease in sales can be devastating. Therefore, all other things being equal, the greater a firm's fixed costs the greater its business risk. On the other hand, if sales increase for a firm with a high degree of operating leverage, there will be a larger increase in return on equity. The degree of operating leverage (DOL) may be computed using the following formula:

      

      Highly leveraged firms, such as Ford Motor Company, enjoy substantial increases in income when sales volume increases. Less leveraged firms enjoy only modest increases in income as sales volume increases.

   2. Financial leverage. Financial leverage measures the extent to which the firm uses debt financing. While the use of debt can produce high returns to stockholders, it also increases their risk. Since debt generally is a less costly form of financing, a firm will generally attempt to use as much debt for financing as possible. However, as more and more debt is issued, the firm becomes more leveraged and the risk of its debt increases, causing the interest rate on additional debt to rise. Therefore, the optimal capital structure for a firm involves a mixture of debt and equity. The degree of financial leverage (DFL) for a firm may be computed using the following formula:

      

      EXAMPLE

      Let's examine two different leverage strategies. Under Plan 1 (the leveraged plan) management borrows $400,000 and sells 20,000 shares of common stock at $10 per share. Under Plan 2 (the conservative plan) the firm borrows $100,000 and issues 50,000 shares of stock at $10 per share. The debt bears interest at 10% and the firm has a 40% tax rate. These alternatives are illustrated below.

      

      Now let's examine two sets of financial results. First, assume that the firm loses $200,000 before interest and taxes (EBIT). The financial results under the two different financing scenarios is shown below.

      

      Next, assume that the firm earns $200,000 before interest and taxes. Again, the financial results under the two different financing scenarios are shown below.

      

      As you can see from the tables, the more leveraged strategy results in much higher earnings for common stockholders when the firm performs well. However, it results in much larger loss per share when the firm performs poorly. These examples clearly illustrate the major advantages and disadvantages of financial leverage.

2. Cost of Capital

   A firm's cost of capital is an important concept in discussing financing decisions, especially those involving financing capital projects (long-term financing). If a firm can earn a return on an investment that is greater than its cost of capital, it will increase the value of the firm. The cost of capital for a firm is the weighted-average cost of its debt and equity financing components. The cost of the various components are determined as described below.

   1. The cost of debt is equal to the interest rate of the loan adjusted for the fact that interest is deductible. Specifically, the cost is calculated as the interest rate times one minus the marginal tax rate. As an example, if a firm's interest rate on a long-term debt is 6% and its marginal tax rate is 30%, the cost of the debt is 4.2% (0.06 × (1.00 − .30)). Remember in considering the cost of new debt, costs of issuing the debt (floatation costs) must be considered. For example, assume the firm issues at face value $20,000,000 of 6% coupon bonds and floatation costs are equal to $1,000,000. The maturity date of the bonds is in 10 years and interest is payable semiannually. To compute the cost of the debt, management should determine the interest rate (internal rate of return) that equates the future interest and principal payments with the present value of the debt. This is equivalent to the bond issue's yield to maturity. To get an accurate yield one would need to use a computer or programmable calculator. However, the following formula may be used to approximate the yield on bonds.

      

   2. The cost of preferred equity is determined by dividing the preferred dividend amount by the issue price of the stock. For example, if 1,000 shares of $8.00 preferred stock is issued for $102,500, the cost of preferred stock is equal to 7.8% ($8,000/$102,500).
   3. The cost of common equity is greater than that of debt or preferred equity because common shareholders assume more risk. Thus, they demand a higher return for their investment. Common equity is raised in two ways: (1) by retaining earnings, and (2) by issuing new common stock. Equity raised by issuing stock has a somewhat higher cost due to the flotation costs involved with new stock issues.
3. The Cost of Existing Common Equity

   Firms use a number of techniques to estimate the cost of existing common equity including the Capital Asset Pricing Model, the Arbitrage Pricing Model, the Bond-Yield-Plus approach, and the Dividend-Yield-Plus-Growth-Rate approach.

   1. The Capital Asset Pricing Model (CAPM) Method. One method of estimating the cost of common equity is by using the CAPM. The steps involved in estimating CAPM are
      • (1) Estimate the risk-free rate of interest, k_RF. Generally, firms use the either the US Treasury bond rate or the short-term Treasury bill rate.
      • (2) Estimate the stock's beta coefficient, b_i for use as an index of the stock's risk. The beta coefficient measures the correlation between the price volatility of the stock market and the price volatility of an individual firm's stock. If the stock price consistently rises and falls to the same extent as the overall market, the stock's beta would be equal to 1.00. Higher betas indicate more volatility and more risk. Betas are computed and reported by financial reporting services.
      • (3) Estimate the expected rate of return on the market, k_M. This is the expected rate of return on stock investments with similar risk. This factor is designed to capture systematic risk of the stock investment.
      • (4) Use the following equation to calculate the CAPM which can be used as an estimate of the cost of equity capital.

        k_s (CAPM) = k_RF + (k_M − k_RF)b_i

      EXAMPLE

      Assume the risk-free interest rate (k_RF) is equal to 5%, the expected market rate of interest (k_M) is equal to 10%, and the stock's beta coefficient (b_i) is equal to 0.9 for a given stock; CAPM is calculated as follows:

      

      Thus, an estimate of the cost of existing common equity is 9.5%

   2. Arbitrage pricing model. As indicated previously, investors face two different types of risk for an investment.
      • Systematic risk—Market risk that cannot be diversified away.
      • Unsystematic risk—The risk of the specific investment that can be eliminated through diversification.

      CAPM uses only one variable to capture systematic risk, the market rate of return or km. The arbitrage pricing model uses a series of systematic risk factors to develop a value that reflects the multiple dimensions of systematic risk. For example, systematic risk may be affected by future oil prices, exchange rates, interest rates, economic growth, etc. The formulation of the arbitrage pricing model is as follows:

      

      As you can see, the amounts in the parentheses are equal to the risk premium associated with each of the factors, (i.e., the market rate for each factor minus the risk-free rate).

   3. Bond-yield-plus approach. The bond-yield-plus approach simply involves adding a risk premium of 3 to 5% to the interest rate on the firm's long-term debt.
   4. Dividend-yield-plus-growth-rate approach. The dividend-yield-plus-growth-rate (dividend valuation) approach estimates the cost of common equity by considering the investors' expected yield on their investment. Specifically, the following formula is used:

      

      EXAMPLE

      Assume that a firm's stock sells for $25, its next annual dividend is estimated to be $1 and its expected growth rate is 6%. The cost of existing common equity would be calculated as follows:

      

4. The Cost of New Common Stock

   If a firm is issuing new common stock, a slightly higher return must be earned. This higher return is necessary to cover the cost of distribution of the new securities (floatation or selling costs). As an example, assume that the cost of capital for existing stockholders is 10% and the current share price of the stock is $25. Also, assume that the cost of floating the new stock issue is $2 per share, the next expected dividend is $1, and the expected growth rate in earnings for the firm is 6%. Using the dividend-yield-plus-growth-rate approach the cost of issuing new stock would be calculated using the following formula:

   

5. Evaluating the Cost of Capital—An Example

   Assume that Café Roma operates a chain of coffee shops located in the Northwest. Management has decided to undertake an aggressive expansion program into California and is considering the following three financing options to obtain the $38,000,000 needed.

   1. Issuance of $40,000,000 bonds with an 8% coupon rate. After floatation costs the firm would receive approximately $39,000,000, and the effective yield would equal 8.5%.
   2. Issuance of $40,000,000 in 6% preferred stock that would yield approximately $38,000,000 after floatation costs.
   3. Issuance of 2,000,000 shares of common stock at $20 per share that would yield approximately $38,000,000 after floatation costs.

   The current market value of Café Roma's common stock is $20 per share, and the common stock dividend for the year is expected to be $1 per share. Investors are expecting a growth rate in earnings and dividends for the firm of 5%. The firm is subject to an effective tax rate of 40%.

   To determine which of the alternatives is least expensive in terms of cost of capital, the cost of each alternative would be calculated as shown below.

   

   Because total floatation costs are $2,000,000 [(2,000,000 × $20) − $38,000,000], flotation costs per share are $1 ($2,000,000/2,000,000).

6. Optimal Capital Structure
   1. The optimal capital structure defines the mix of debt, preferred, and common equity that causes the firm's stock price to be maximized. The optimal or target capital structure involves a trade-off between risk and return. Incurring more debt generally leads to higher returns on equity but it also increases the risk borne by the stockholders of the firm. From a theoretical standpoint a firm's optimal capital structure is the one that minimizes the weighted-average cost of capital as shown in the graph below.

      

      In practice, the following factors generally affect a firm's capital structure strategies:

      • (1) Business risk. The greater the inherent risk of the business the lower the optimal debt to equity ratio.
      • (2) Tax position. A major advantage of debt is the tax deductibility of interest payments. If the firm has a low marginal tax rate, debt becomes less advantageous as a form of financing.
      • (3) Financial flexibility. Financial flexibility is the ability of the firm to raise capital on reasonable terms under adverse conditions. Less debt should be assumed by firms with less financial flexibility.
      • (4) Management conservatism or aggressiveness. A firm's target capital structure will be affected by the risk tolerance of management. More aggressive management may take on more debt.
   2. Weighted-average cost of capital (WACC). In determining the optimum capital structure, management often calculates the firm's weighted-average cost of capital. This process involves taking the cost of the various types of financing (debt, preferred equity, common equity, etc.) and weighting each by the actual or proposed percentage of total capital. A computation of weighted-average cost of capital is presented below.

      WEIGHTED-AVERAGE COST OF CAPITAL

      

      As illustrated, the weighted-average cost of capital for the firm is 7.46%. Management can now use this model to evaluate various forms of proposed financing options in terms of their effects on the firm's average cost of capital.

      EXAMPLE

      Assume that management, with the capital structure described in the table above, is considering calling the preferred stock and issuing 7% debentures. Assume that the costs to call the preferred shares are negligible and the firm's effective tax rate is 30%. What would be the effect on the firm's weighted-average cost of capital?

      The cost of the new debentures is calculated below.

      

      The following table recalculates the weighted-average cost of capital for the firm.

      WEIGHTED-AVERAGE COST OF CAPITAL

      

      By replacing the preferred stock with debt, the firm has reduced its cost of capital to 7.17%

      D. Dividend Policy

      1. The dividend policy of a firm relates to management's propensity to distribute earnings to stockholders. While it is unclear as to whether the distribution of dividends changes the value of the firm's stock, one of the major influences on dividend policy is where the firm is in its life cycle. The life cycle of a firm has the following four stages:
         1. Development stage
         2. Growth stage
         3. Expansion stage
         4. Maturity stage

         In its first two stages the firm needs to retain its profits to finance development and growth. If any dividends are issued, they tend to be stock dividends. When the firm hits the expansion stage, its need for investment declines and management may decide to issue small cash dividends. Finally, if the firm is successful in its maturity stage, it will tend to begin issuing regular and growing cash dividends.

      2. Most people argue that the relevance of dividends is in their information content. Dividends signal to investors that management believes that the firm had a good year. Increases in dividends tend to increase share prices, while reductions tend to depress share prices. As a result, management is hesitant to decrease dividends.
      3. Other factors that affect management's dividend policy include
         • Legal requirements—Most states forbid firms to pay dividends that would impair the initial capital contributions to the firm.
         • Cash position—Cash must be available to pay the dividends.
         • Access to capital markets—If the firm has limited access to capital markets, management is more likely to retain the earnings of the firm.
         • Desire for control—Retaining earnings results in less need for management to seek other forms of financing which might come with restrictions on management's actions.
         • Tax position of shareholders—Stockholders must pay taxes on dividends and wealthier individuals pay higher taxes.
         • Clientele effect—Some firms may have a strategy of attracting investors that require a dividend, such as retired individuals.
         • Investment opportunities—Retained earnings should be reinvested in the firm if the firm can earn a return that exceeds what the investor can earn on another investment with similar risk.
      4. Other Types of Dividends
         1. Stock dividends are payments to existing stockholders of a dividend in the form of the firm's own stock. As an example, a 10% stock dividend would involve the issuance of 10% more shares to each stockholder. Such dividends are designed to signal to investors that the firm is performing well, but it does not require the firm to distribute cash.
         2. Stock splits are similar to stock dividends but they are generally designed to reduce the stock's price to a target level that will attract more investors. As an example, a 2-for-1 stock split doubles the number of shares outstanding and it would be expected that the price of the stock would drop approximately in half.

      E. Share Repurchases

      Firms will often repurchase some of their shares to have them available for executive stock options or acquisitions of other firms. However, management of some firms have undertaken other repurchase programs based on the following rationales:

      • It sends a positive signal to investors that management believes the stock is undervalued.
      • It reduces the number of shares outstanding and thereby increasing earnings per share.
      • It provides a temporary floor for the stock.

      Many analysts question the validity of these rationales. As an example, the impact on earnings per share is uncertain because investing the cash in operations instead of spending it to repurchase stock might actually increase earnings per share to a greater extent.

      F. Financial Markets

      Financial markets are markets in which financial assets are traded. Such markets facilitate borrowing and lending, sale of previously issued securities, and sale of newly issued securities. Primary markets are markets in which newly issued securities are sold, and secondary markets are markets in which previously issued securities are sold. Examples of markets for stocks and debt include the New York Stock Exchange, the US government bond market, and NASDAQ. Futures and option contracts are traded on exchanges such as the Chicago Board of Trade and the Chicago Mercantile Exchange. A rising market is referred to as a bull market, and a declining or lethargic market is referred to as a bear market. The major players in markets include

      1. Brokers—Commissioned agents of buyers or sellers.
      2. Dealers—Similar to brokers in that they match buyers and sellers. However, dealers can and do take positions in the assets and buy and sell their own inventory.
      3. Investment banks—Assist in the initial sale of newly issued securities by providing advice, underwriting, and sales assistance.
      4. Financial intermediaries—Financial institutions that borrow one form of financial asset (e.g., a savings deposit) and distribute the asset in another form (e.g., a commercial loan).

ASSET AND LIABILITY VALUATION

An important aspect of financial management is the valuation of assets and liabilities. Valuations are needed for a number of purposes including investment evaluation, capital budgeting, mergers and acquisitions, financial reporting, tax reporting, and litigation. The major types of valuation models include

1. Market values obtained from active markets for identical assets
2. Market values derived from active markets for similar but not identical assets
3. Valuation models

A. Using Active Markets for Identical Assets

The most straightforward method of valuing a financial instrument is using prices for identical instruments in an active market. The use of such markets is appropriate if they have sufficient volume of transactions to insure that the market price is reliable.

B. Using Markets for Similar Assets

Another method for valuing instruments involves deriving values from (1) the active market prices of similar but not identical instruments or (2) the market prices for identical items in inactive markets. The key to this method of valuation is accurate adjustment for differences that exist between the instrument being valued and the instrument that is traded in the market. For example, the price might need to be adjusted for such factors as restrictions on sales, or differences in maturity dates, exercise dates, block sizes, credit risk, etc. Financial models are often used to adjust the value of the instrument for these differences.

C. Valuation Models

A method that can be used in the absence of an active market is determining estimated fair value based on a valuation model, such as discounted cash flows. Such valuations generally rely on assumptions about future events and conditions that affect income and cash flows. These assumptions could materially affect the fair value estimate. Accordingly, they must be examined to determine whether they are reasonable and consistent with existing market information, the economic environment and past experience. For example, in determining the fair value of a rare asset for which market information is not available, consideration should be given to sales of similar assets, the general economic environment in which the asset is used, and past experiences with similar assets. As another example, discount rates for calculating discounted cash flows must reflect market expectations of future rates and be consistent with the level of risk inherent in the future cash flows.

In determining estimates of fair values it is also important that the model being used is appropriate based on the nature of the asset and current economic conditions.

D. Valuation Under US GAAP

Under US GAAP, accounting fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. This assumes that the asset or liability is exchanged in an orderly transaction between market participants to sell the asset or transfer the liability in the principal market (or, in absence of a principal market, the most advantageous market).

1. Market approach. The market approach uses prices and other relevant information generated by market transactions involving identical or comparable assets or liabilities. This approach is used for such items as publicly traded commodities, stocks, bonds, and derivatives.
2. Income approach. The income approach uses valuation techniques to convert future benefits or sacrifices to a single present value. Examples include discounted cash flows and earnings capitalization models.
3. Cost approach. The cost approach is based on the amount that currently would be required to replace the service capacity of an asset (often referred to as current replacement cost). This approach is particularly appropriate for specialized facilities or equipment.

BUSINESS VALUATION

Business valuations are obtained for a number of purposes, including tax purposes, sales purposes, acquisition purposes, etc. The individual performing the valuation must also consider the premise of the valuation because the methodology used will vary depending on whether the value is for the existing assets in use or it is assumed that the business will be sold. Further, if it is to be sold the value will vary considering whether the business will be sold as a going-concern or in liquidation. Several approaches are used to value firms, including

A. Market Approach

—Determines the value a nonpublic company based on the market value of comparable firms that are publicly traded. The valuation is performed by examining the relationship of the comparable company's stock price and its earnings or revenue (the multiple). This multiple is then adjusted for such factors as lack of marketability, restrictions on sale of the stock, and the portion of the company being acquired (e.g., a premium is provided for control and a discount is provided for a minority interest). The disadvantage of this approach is the difficulty in obtaining comparable companies to perform the valuation.

B. Income Approach

—Determines the value of the firm is by estimating the present value of the future benefit stream (income or cash flow) of the firm. Net present value is determined by applying a discount or capitalization rate that reflects the risk level of the investment firm. Alternative income approaches include

1. Discounted cash flow analysis—Application of capital budgeting techniques to an entire firm rather than a single investment.
   1. Two key items are needed for this valuation method:
      • (1) A set of pro forma financial statements are developed that project the incremental cash flows that are expected to result from the merger.
      • (2) A discount rate, or cost of capital, to apply to the projected cash flows. The appropriate discount rate is the cost of equity rather than an overall cost of capital. The discount rate used must reflect the underlying riskiness of the firm's operations (future cash flows).
   2. A risk analysis should be performed with the cash flows (e.g., sensitivity analysis, scenario analysis, etc.).
2. Capitalization of earnings—Determines the value of the firm by capitalizing future earnings based on the required rate of return. For example, if the firm is expected to earn $1,000,000 per year and the required return is 10%, the firm would be valued at $10,000,000 ($1,000,000/10%). Note this example assumes no income growth or inflation.
3. Multiple of earnings—Determines the value of the firm by applying a multiple to forecasted earnings. This is equivalent to the capitalization approach described above. For example, a 10% capitalization rate is equivalent to an earning multiple of 10.

C. Asset Approach

—Determines the value of the firm by valuing the individual assets of the firm. This method is more applicable to a firm in liquidation rather than a going concern.

MERGERS

A. Business mergers involve many of the considerations involved in the acquisition of any asset or group of assets. However, there are additional considerations.

1. Firms often acquire other firms due to synergies; the two firms can perform more effectively together than separately. Synergies arise from operating or financial economies, as well as managerial efficiency.
2. Management may also acquire a firm for diversification or tax considerations, or to take advantage of a bargain purchase.

B. Types of Mergers

1. Horizontal merger—When a firm combines with another in the same line of business.
2. Vertical merger—When a firm combines with another firm in the same supply chain (e.g., a combination of a manufacturer with one of its suppliers).
3. Congeneric merger—When the merging firms are somewhat related but not enough to make it a vertical or horizontal merger.
4. Conglomerate merger—When the firms are completely unrelated. These types of mergers provide the greatest degree of diversification.

KEY TERMS

Arbitrage pricing model. Uses a series of systematic risk factors to develop a value that reflects the multiple dimensions of systematic risk.

Cash discounts. Discounts for early payment of accounts.

Compensating balance. Required minimum level of deposit based on loan agreement.

Concentration banking. Payments from customers are routed to local branch offices rather than firm headquarters. This reduces collection time.

Cost of capital. The weighted-average cost of a firm's debt and equity financing components.

Debenture. A bond that is not secured by the pledge of specific property.

Economic order quantity. An inventory technique that minimizes the sum of inventory ordering and carrying costs.

Electronic funds transfer. The movement of funds electronically without the use of a check.

Factoring. The sale of receivables to a finance company.

Financial leverage. Measures the extent to which the firm uses debt financing.

Float. The time that elapses relating to mailing, processing, and clearing checks.

Inventory conversion period. The average length of time required to convert materials into finished goods and sell the goods.

Just-in-time production. A demand-pull system in which each component of a finished good is produced when needed by the next stage of production.

Just-in-time purchasing. A demand-pull inventory system in which raw materials arrive just as they are needed for production. It minimizes inventory holding costs.

Lockbox system. A system in which customer payments are sent to a post office box that is maintained by the company's bank. This reduces collection time and improves controls.

Mortgage bond. A bond secured with the pledge of specific property.

Operating leverage. Measures the degree to which a firm builds fixed costs into its operations.

Payables deferral period. The average length of time between the purchase of materials and labor and the payment of cash for them.

Precautionary balances. Cash available for emergencies.

Receivables collection period. The average length of time required to collect accounts receivable.

Speculative balances. Cash available to take advantage of favorable business opportunities.

Subordinated debenture. A bond with claims subordinated to other general creditors.

Supply chain. Describes the processes involved in a good's production and distribution.

Warehousing. Inventory financing in which the inventory is held in a public warehouse under the lender's control.

Multiple-Choice Questions (1–138)

Working Capital Management

1. Which of the following is not a function of financial management?

1. Financing.
2. Risk-management.
3. Internal control.
4. Capital budgeting.

2. The inventory conversion period is calculated as follows:

3. The payables deferral period is calculated as follows:

^**4. All of the following statements in regard to working capital are correct except:

1. Current liabilities are an important source of financing for many small firms.
2. Profitability varies inversely with liquidity.
3. The hedging approach to financing involves matching maturities of debt with specific financing needs.
4. Financing permanent inventory buildup with long-term debt is an example of an aggressive working capital policy.

^**5. Determining the appropriate level of working capital for a firm requires

1. Evaluating the risks associated with various levels of fixed assets and the types of debt used to finance these assets.
2. Changing the capital structure and dividend policy of the firm.
3. Maintaining short-term debt at the lowest possible level because it is generally more expensive than long-term debt.
4. Offsetting the benefit of current assets and current liabilities against the probability of technical insolvency.

6. Which of the following actions is likely to reduce the length of a firm's cash conversion cycle?

1. Adopting a new inventory system that reduces the inventory conversion period.
2. Adopting a new inventory system that increases the inventory conversion period.
3. Increasing the average days sales outstanding on its accounts receivable.
4. Reducing the amount of time the firm takes to pay its suppliers.

7. Eagle Sporting Goods has $2.5 million in inventory and $2 million in accounts receivable. Its average daily sales are $100,000. The firm's payables deferral period is 30 days and average daily cost of sales are $50,000. What is the length of the firm's cash conversion period?

1. 100 days.
2. 60 days.
3. 50 days.
4. 40 days.

8. Jones Company has $5,000,000 of average inventory and cost of sales of $30,000,000. Using a 365-day year, calculate the firm's inventory conversion period.

1. 30.25 days.
2. 60.83 days.
3. 45.00 days.
4. 72.44 days.

9. The length of time between the acquisition of inventory and payment for it is called the

1. Operating cycle.
2. Inventory conversion period.
3. Accounts receivable period.
4. Accounts payable deferral period.

10. If everything else remains constant and a firm increases its cash conversion cycle, its profitability will likely

1. Increase.
2. Increase if earnings are positive.
3. Decrease.
4. Not be affected.

*11. An organization offers its customers credit terms of 5/10 net 20. One-third of the customers take the cash discount and the remaining customers pay on day 20. On average, 20 units are sold per day, priced at $10,000 each. The rate of sales is uniform throughout the year. Using a 360-day year, the organization has days' sales outstanding in accounts receivable, to the nearest full day, of

1. 13 days.
2. 15 days.
3. 17 days.
4. 20 days.

Cash Management

^**12. Troy Toys is a retailer operating in several cities. The individual store managers deposit daily collections at a local bank in a noninterest-bearing checking account. Twice per week, the local bank issues a depository transfer check (DTC) to the central bank at headquarters. The controller of the company is considering using a wire transfer instead. The additional cost of each transfer would be $25; collections would be accelerated by two days; and the annual interest rate paid by the central bank is 7.2% (0.02% per day). At what amount of dollars transferred would it be economically feasible to use a wire transfer instead of the DTC? Assume a 360-day year.

1. It would never be economically feasible.
2. $125,000 or above.
3. Any amount greater than $173.
4. Any amount greater than $62,500.

13. Which of the following is true about electronic funds transfer from a cash flow standpoint?

1. It is always beneficial from a cash flow standpoint.
2. It is never beneficial from a cash flow standpoint.
3. It is beneficial from a cash receipts standpoint but not from a cash disbursements standpoint.
4. It is beneficial from a cash disbursements standpoint but not from a cash receipts standpoint.

14. Management of Radker Corp. is considering a lockbox system. The bank will charge $10,000 annually for the service, which will save the firm approximately $5,000 in processing costs. The lockbox system will reduce the float for cash receipts by three days. Assuming that the average daily receipts are equal to $100,000, and short-term interest costs are 5%, calculate the benefit or loss from adopting the lockbox system.

1. $5,000 loss.
2. $10,000 loss.
3. $10,000 benefit.
4. $5,000 benefit.

15. Which of the following is true about a firm's float?

1. A firm strives to minimize the float for both cash receipts and cash disbursements.
2. A firm strives to maximize the float for both cash receipts and cash disbursements.
3. A firm strives to maximize the float for cash receipts and minimize the float for cash disbursements.
4. A firm strives to maximize the float for cash disbursements and minimize the float for cash receipts.

16. A firm is evaluating whether to establish a concentration banking system. The bank will charge $5,000 per year for maintenance and transfer fees. The firm estimates that the float will be reduced by two days if the concentration banking is put into place. Assuming that average daily receipts are $115,000 and short-term interest rates are 4%, what decision should the firm make regarding the concentration banking system?

1. Do not establish the concentration banking system because the net cost is $5,000.
2. Do not establish the concentration banking system because the net cost is $21,000.
3. Establish the concentration banking system because the net benefit is $115,000.
4. Establish the concentration banking system because the net benefit is $4,200.

17. A firm is evaluating whether to establish a lockbox system. The bank will charge $30,000 per year for the lockbox and the firm will save approximately $8,000 in internal processing costs. The firm estimates that the float will be reduced by three days if the lockbox system is put into place. Assuming that average daily cash receipts are $350,000 and short-term interest rates are 4%, what decision should the firm make regarding the lockbox system?

1. Do not establish the lockbox system because the net cost is $30,000.
2. Do not establish the lockbox system because the net cost is $22,000.
3. Establish the lockbox system because the net benefit is $12,000.
4. Establish the lockbox system because the net benefit is $20,000.

18. An organization has an opportunity to establish a zero balance account system using four different regional banks. The total amount of the maintenance and transfer fees is estimated to be $6,000 per annum. The organization believes that it will increase the float on its operating disbursements by an average of four days, and its cost of short-term funds is 4.5%. Assuming the organization estimates its average daily operating disbursements to be $40,000 what decision should the organization make regarding this opportunity?

1. Do not establish the zero balance account system because it results in estimated additional net costs of $6,000.
2. Do not establish the zero balance account system because it results in estimated additional net costs of $1,200.
3. Establish the zero balance account system because it results in estimated net savings of $1,200.
4. Establish the zero balance account system because it results in estimated net savings of $7,200.

^**19. A working capital technique that increases the payable float and therefore delays the outflow of cash is

1. Concentration banking.
2. A draft.
3. Electronic Data Interchange (EDI).
4. A lockbox system.

^**20. Newman Products has received proposals from several banks to establish a lockbox system to speed up receipts. Newman receives an average of 700 checks per day averaging $1,800 each, and its cost of short-term funds is 7% per year. Assuming that all proposals will produce equivalent processing results and using a 360-day year, which one of the following proposals is optimal for Newman?

1. A $0.50 fee per check.
2. A flat fee of $125,000 per year.
3. A fee of 0.03% of the amount collected.
4. A compensating balance of $1,750,000.

^**21. A firm has daily cash receipts of $100,000. A bank has offered to reduce the collection time on the firm's deposits by two days for a monthly fee of $500. If money market rates are expected to average 6% during the year, the net annual benefit (loss) from having this service is

1. $3,000
2. $12,000
3. $0
4. $6,000

*22. A minimum checking account balance that a firm must maintain with a commercial bank is a

1. Transaction balance.
2. Compensating balance.
3. Precautionary balance.
4. Speculative balance.

^**23. A firm has daily receipts of $100,000. A bank has offered to reduce the collection time on the firm's deposits by two days for a monthly fee of $500. If money market rates are expected to average 6% during the year, the net annual benefit from having this service is

1. $0
2. $3,000
3. $6,000
4. $12,000

^**24. Cleveland Masks and Costumes Inc. (CMC) has a majority of its customers located in the states of California and Nevada. Keystone National Bank, a major west coast bank, has agreed to provide a lockbox system to CMC at a fixed fee of $50,000 per year and a variable fee of $.50 for each payment processed by the bank. On average, CMC receives 50 payments per day, each averaging $20,000. With the lockbox system, the company's collection float will decrease by 2 days. The annual interest rate on money market securities is 6%. If CMC makes use of the lockbox system, what would be the net benefit to the company? Use 365 days per year.

1. $ 51,750
2. $ 60,875
3. $111,750
4. $120,875

Marketable Securities Management

25. The most important considerations with respect to short-term investments are

1. Return and value.
2. Risk and liquidity.
3. Return and risk.
4. Growth and value.

^**26. All of the following are alternative marketable securities suitable for investment except:

1. US treasury bills.
2. Eurodollars.
3. Commercial paper.
4. Convertible bonds.

27. Which of the following investments generally pay the highest return?

1. Money market accounts.
2. Treasury bills.
3. Treasury notes.
4. Commercial paper.

^**28. Which one of the following is not a characteristic of a negotiable certificate of deposit? Negotiable certificates of deposit

1. Have a secondary market for investors.
2. Are regulated by the Federal Reserve System.
3. Are usually sold in denominations of a minimum of $100,000.
4. Have yields considerably greater that bankers' acceptances and commercial paper.

Inventory Management

29. Which changes in costs are most conducive to switching from a traditional inventory ordering system to a just-in-time ordering system?

30. To determine the inventory reorder point, calculations normally include the

1. Ordering cost.
2. Carrying cost.
3. Average daily usage.
4. Economic order quantity.

^**31. Which of the following is not a correct comparison of a just-in-time system with a traditional system?

32. The benefits of a just-in-time system for raw materials usually include

1. Elimination of non-value-added operations.
2. Increase in the number of suppliers, thereby ensuring competitive bidding.
3. Maximization of the standard delivery quantity, thereby lessening the paperwork for each delivery.
4. Decrease in the number of deliveries required to maintain production.

33. Bell Co. changed from a traditional manufacturing philosophy to a just-in-time philosophy. What are the expected effects of this change on Bell's inventory turnover and inventory as a percentage of total assets reported on Bell's balance sheet?

34. As a consequence of finding a more dependable supplier, Dee Co. reduced its safety stock of raw materials by 80%. What is the effect of this safety stock reduction on Dee's economic order quantity?

1. 80% decrease.
2. 64% decrease.
3. 20% increase.
4. No effect.

35. The economic order quantity formula assumes that

1. Periodic demand for the good is known.
2. Carrying costs per unit vary with quantity ordered.
3. Costs of placing an order vary with quantity ordered.
4. Purchase costs per unit differ due to quantity discounts.

36. Ral Co. sells 20,000 radios evenly throughout the year. The cost of carrying one unit in inventory for one year is $8, and the purchase order cost per order is $32. What is the economic order quantity?

1. 625
2. 400
3. 283
4. 200

37. The following information pertains to material × that is used by Sage Co.:

Units of material × will be required evenly throughout the year. The order point is

1. 800
2. 1,600
3. 2,400
4. 3,200

38. Firms that maintain very low or no inventory levels

1. Have higher ordering costs.
2. Have higher carrying costs.
3. Have higher ordering and carrying costs.
4. Have lower ordering and carrying costs.

^**39. An example of a carrying cost is

1. Disruption of production schedules.
2. Quantity discounts lost.
3. Handling costs.
4. Obsolescence.

*40. Which of the following is a characteristic of just-in-time (JIT) inventory management systems?

1. JIT users determine the optimal level of safety stocks.
2. JIT is applicable only to large companies.
3. JIT does not really increase overall economic efficiency because it merely shifts inventory levels further up the supply chain.
4. JIT relies heavily on good quality materials.

*41. To evaluate the efficiency of purchase transactions, management decides to calculate the economic order quantity for a sample of the company's products. To calculate the economic order quantity, management would need data for all of the following except:

1. The volume of product sales.
2. The purchase prices of the products.
3. The fixed cost of ordering products.
4. The volume of products in inventory.

Items 42 and 43 are based on the following information:

Ethan, Inc. has seasonal demand for its products and management is considering whether level production or seasonal production should be implemented. The firms' short-term interest cost is 8%, and management has developed the following information to make the decision:

42. Which alternative should be accepted and how much is saved over the other alternative?

1. Alternative 1 with $500,000 in savings.
2. Alternative 2 with $50,000 in savings.
3. Alternative 2 with $10,000 in savings.
4. Alternative 1 with $10,000 in savings.

43. At what short-term interest rate would the two alternatives have the same cost?

1. 6%
2. 9%
3. 10%
4. 12%

^**44. The amount of inventory that a company would tend to hold in stock would increase as the

1. Sales level falls to a permanently lower level.
2. Cost of carrying inventory decreases.
3. Variability of sales decreases.
4. Cost of running out of stock decreases.

*45. An appropriate technique for planning and controlling manufacturing inventories, such as raw materials, components, and subassemblies, whose demand depends on the level of production, is

1. Materials requirements planning.
2. Regression analysis.
3. Capital budgeting.
4. Linear programming.

Receivables Management

46. The procedures followed by the firm for ensuring payment of its accounts receivables are called its

1. Discount policy.
2. Credit policy.
3. Collection policy.
4. Payables policy.

Items 47 and 48 are based on the following information:

Effective September 1, a company initiates seasonal dating as a component of its credit policy, allowing wholesale customers to make purchases early but not requiring payment until the retail selling season begins. Sales occur as follows:

• Each unit has a selling price of $10, regardless of the date of sale.
• The terms of sale are 2/10 net 30, January 1 dating.
• All sales are on credit.
• All customers take the discount and abide by the terms of the discount policy.
• All customers take advantage of the new seasonal dating policy.
• The peak selling season for all customers is mid-November to late December.

47. For the selling firm, which of the following is not an expected advantage to initiating seasonal dating?

1. Reduced storage costs.
2. Reduced credit costs.
3. Attractive credit terms for customers.
4. Reduced uncertainty about sales volume.

48. For sales after the initiation of the seasonal dating policy on September 1, total collections on or before January 11 will be

1. $0
2. $6,370
3. $6,860
4. $7,000

49. Which of the following describes the appropriate formula for days' sales outstanding?

50. Which of the following describes a firm's credit criteria?

1. The length of time a buyer is given to pay for his/her purchases.
2. The percentage of discount allowed for early payment.
3. The diligence to collect slow-paying accounts.
4. The required financial strength of acceptable customers.

Items 51 and 52 are based on the following information:

A company plans to tighten its credit policy. The new policy will decrease the average number of days in collection from 75 to 50 days and reduce the ratio of credit sales to total revenue from 70 to 60%. The company estimates that projected sales would be 5% less if the proposed new credit policy were implemented. The firm's short-term interest cost is 10%.

^**51. Projected sales for the coming year are $50 million. Calculate the dollar impact on accounts receivable of this proposed change in credit policy. Assume a 360-day year.

1. $ 3,819,445 decrease.
2. $ 6,500,000 decrease.
3. $ 3,333,334 decrease.
4. $18,749,778 increase.

^**52. What effect would the implementation of this new credit policy have on income before taxes?

1. $2,500,000 decrease.
2. $2,166,667 decrease.
3. $83,334 increase.
4. $33,334 increase.

^**53. The sales manager at Ryan Company feels confident that if the credit policy at Ryan's were changed, sales would increase and consequently, the company would utilize excess capacity. The two credit proposals being considered are as follows:

Currently, payment terms are net 30. The proposed payment terms for Proposal A and Proposal B are net 45 and net 90, respectively. An analysis to compare these two proposals for the change in credit policy would include all of the following factors except the

1. Cost of funds for Ryan.
2. Current bad debt experience.
3. Impact on the current customer base of extending terms to only certain customers.
4. Bank loan covenants on days' sales outstanding.

^**54. A company enters into an agreement with a firm who will factor the company's accounts receivable. The factor agrees to buy the company's receivables, which average $100,000 per month and have an average collection period of 30 days. The factor will advance up to 80% of the face value of receivables at an annual rate of 10% and charge a fee of 2% on all receivables purchased. The controller of the company estimates that the company would save $18,000 in collection expenses over the year. Fees and interest are not deducted in advance. Assuming a 360-day year, what is the annual cost of financing?

1. 10.0%
2. 14.0%
3. 16.0%
4. 17.5%

^**55. A company with $4.8 million in credit sales per year plans to relax its credit standards, projecting that this will increase credit sales by $720,000. The company's average collection period for new customers is expected to be 75 days, and the payment behavior of the existing customers is not expected to change. Variable costs are 80% of sales. The firm's opportunity cost is 20% before taxes. Assuming a 360-day year, what is the company's benefit (loss) from the planned change in credit terms?

1. $0
2. $28,800
3. $144,000
4. $120,000

Financing Current Assets

56. Gild Company has been offered credit terms of 3/10, net 30. Using a 365-day year, what is the nominal cost of not taking advantage of the discount if the firm pays on the 35th day after the purchase?

1. 14.2%
2. 32.2%
3. 37.6%
4. 45.2%

57. Newton Corporation is offered trade credit terms of 3/15, net 45. The firm does not take advantage of the discount, and it pays the account after 67 days. Using a 365-day year, what is the nominal annual cost of not taking the discount?

1. 18.2%
2. 21.71%
3. 23.48%
4. 26.45%

58. Assume that Williams Corp is financed with a heavy reliance on short-term debt and short-term rates have increased. How do these facts impact the interest expense, net income, and financial risk for Williams Corp?

59. If a firm is offered credit terms of 2/10, net 30 on its purchases. Sound cash management practices would mean that the firm would pay the account on which of the following days?

1. Day 2 and 30.
2. Day 2 and 10.
3. Day 10.
4. Day 30.

^**60. The following forms of short-term borrowings are available to a firm:

• Floating lien
• Factoring
• Revolving credit
• Chattel mortgages
• Bankers' acceptances
• Lines of credit
• Commercial paper

The forms of short-term borrowing that are unsecured credit are

1. Floating lien, revolving credit, chattel mortgage, and commercial paper.
2. Factoring, chattel mortgage, bankers' acceptances, and line of credit.
3. Floating lien, chattel mortgage, bankers' acceptances, and line of credit.
4. Revolving credit, bankers' acceptances, line of credit, and commercial paper.

*61. A company obtaining short-term financing with trade credit will pay a higher percentage financing cost, everything else being equal, when

1. The discount percentage is lower.
2. The items purchased have a higher price.
3. The items purchased have a lower price.
4. The supplier offers a longer discount period.

^**62. If a firm borrows $500,000 at 10% and is required to maintain $50,000 as a minimum compensating balance at the bank, what is the effective interest rate on the loan?

1. 10.0%
2. 11.1 %
3. 9.1%
4. 12.2%

^**63. If a retailer's terms of trade are 3/10, net 45 with a particular supplier, what is the cost on an annual basis of not taking the discount? Assume a 360-day year.

1. 24.00%
2. 37.11%
3. 36.00%
4. 31.81%

64. Which of the following is not related to loans involving inventory?

1. Factoring.
2. Blanket liens.
3. Trust receipts.
4. Warehousing.

65. The London Interbank Offered Rate (LIBOR) represents an example of a

1. Risk-free rate.
2. Nominal rate.
3. Credit risk adjusted rate.
4. Long-term rate.

66. An advantage of the use of long-term debt as opposed to short-term debt to finance current assets is

1. It decreases the risk of the firm.
2. It generally is less costly than short-term debt.
3. It generally places fewer restrictions on the firm.
4. It is easy to repay.

^**67. The chief financial officer of Smith Glass Inc. follows the policy of matching the maturity of assets with the maturity of financing. The implications of this policy include all of the following except that

1. The seasonal expansion of cash, receivables, and inventory should be financed by short-term debt such as vendor payables and bank debt.
2. The minimum level of cash, receivables, and inventory required to stay in business can be considered permanent, and financed with long-term debt or equity.
3. Cash, receivables, and inventory should be financed with long-term debt or equity.
4. Long-term assets, like plant and equipment, should be financed with long-term debt or equity.

68. Which form of asset financing involves the public offering of debt collateralized by a firm's accounts receivables?

1. Trust receipts.
2. Warehousing.
3. Blanket inventory liens.
4. Securitization of assets.

^**69. Hagar Company's bank requires a compensating balance of 20% on a $100,000 loan. If the stated interest on the loan is 7%, what is the effective cost of the loan?

1. 5.83%
2. 7.00%
3. 8.40%
4. 8.75%

Items 70 and 71 are based on the following information:

CyberAge Outlet, a relatively new store, is a café that offers customers the opportunity to browse the Internet or play computer games at their tables while they drink coffee. The customer pays a fee based on the amount of time spent signed on to the computer. The store also sells books, tee shirts, and computer accessories. CyberAge has been paying all of its bills on the last day of the payment period, thus forfeiting all supplier discounts. Shown below are data on CyberAge's two major vendors, including average monthly purchases and credit terms.

^**70. Assuming a 360-day year and that CyberAge continues paying on the last day of the credit period, the company's weighted-average annual interest rate for trade credit (ignoring the effects of compounding) for these two vendors is

1. 27.0%
2. 25.2%
3. 28.0%
4. 30.2%

^**71. Should CyberAge use trade credit and continue paying at the end of the credit period?

1. Yes, if the cost of alternative short-term financing is less.
2. Yes, if the firm's weighted-average cost of capital is equal to its weighted-average cost of trade credit.
3. No, if the cost of alternative long-term financing is greater.
4. Yes, if the cost of alternative short-term financing is greater.

^**72. With respect to the use of commercial paper by an industrial firm, which one of the following statements is most likely to be true?

1. The commercial paper is issued through a bank.
2. The commercial paper has a maturity of 60-270 days.
3. The commercial paper is secured by the issuer's assets.
4. The commercial paper issuer is a small company.

^**73. A company obtained a short-term bank loan of $250,000 at an annual interest rate of 6%. As a condition of the loan, the company is required to maintain a compensating balance of $50,000 in its checking account. The company's checking account earns interest at an annual rate of 2%. Ordinarily, the company maintains a balance of $25,000 in its checking account for transaction purposes. What is the effective interest rate of the loan?

1. 6.44%
2. 7.11%
3. 5.80%
4. 6.66%

*74. A manufacturing firm wants to obtain a short-term loan and has approached several lending institutions. All of the potential lenders are offering the same nominal interest rate, but the terms of the loans vary. Which of the following combinations of loan terms will be most attractive for the borrowing firm?

1. Simple interest, no compensating balance.
2. Discount interest, no compensating balance.
3. Simple interest, 20% compensating balance required.
4. Discount interest, 20% compensating balance required.

^**75. Elan Corporation is considering borrowing $100,000 from a bank for one year at a stated interest rate of 9%. What is the effective interest rate to Elan if this borrowing is in the form of a discount note?

1. 8.10%
2. 9.00%
3. 9.81%
4. 9.89%

^**76. The Red Company has a revolving line of credit of $300,000 with a one-year maturity. The terms call for a 6% interest rate and a /% commitment fee on the unused portion of the line of credit. The average loan balance during the year was $100,000. The annual cost of this financing arrangement is

1. $6,000
2. $6,500
3. $7,000
4. $7,500

^**77. Which of the following financial instruments generally provides the largest source of short-term credit for small firms?

1. Installment loans.
2. Commercial paper.
3. Trade credit.
4. Mortgage bonds.

^**78. The prime rate is the

1. Size of the commitment fee on a commercial bank loan.
2. Effective cost of a commercial bank loan.
3. Rate charged on business loans to borrowers with high credit ratings.
4. Rate at which a bank borrows from the Federal Reserve central bank.

^**79. A compensating balance

1. Compensates a financial institution for services rendered by providing it with deposits of funds.
2. Is used to compensate for possible losses on a marketable securities portfolio.
3. Is a level of inventory held to compensate for variations in usage rate and lead time.
4. Is an amount paid by financial institutions to compensate large depositors.

^**80. On January 1, Scott Corporation received a $300,000 line of credit at an interest rate of 12% from Main Street Bank and drew down the entire amount on February 1. The line of credit agreement requires that an amount equal to 15% of the loan be deposited into a compensating balance account. What is the effective annual cost of credit for this loan arrangement?

1. 11.00%
2. 12.00%
3. 12.94%
4. 14.12%

Long-Term Debt

81. Which of the following statements is correct when comparing bond-financing alternatives?

1. A bond with a call provision typically has a lower yield to maturity than a similar bond without a call provision.
2. A convertible bond must be converted to common stock prior to its maturity.
3. A call provision is generally considered detrimental to the investor.
4. A call premium requires the investor to pay an amount greater than par at the time of purchase.

82. Which of the following are characteristics of Eurobonds?

1. They are always denominated in Eurodollars.
2. They are always sold in some country other than the one in whose currency the bond is denominated.
3. They are sold outside the country of the borrower but are denominated in the currency of the county in which the issue is sold.
4. They are generally issued as registered bonds.

83. At the inception of an operating lease how should the leased asset be accounted for on the lessee financial statements?

1. The present value of the future lease payments is recorded as an asset on the balance sheet.
2. The total amount of the lease payments is recorded as an asset on the balance sheet.
3. An asset is not recorded. The lease payments are expensed as rent as they are incurred.
4. The future value of the lease payments is recorded as an asset on the balance sheet.

84. Capital and operating leases differ in that the lessee

1. Obtains use of the asset only under a capital lease.
2. Is using the lease as a source of financing only under an operating lease.
3. Receives title to the asset in a capital lease.
4. Capitalizes the net investment in the lease.

85. Which of the following is an advantage of debt financing?

1. Interest and principal obligations must be paid regardless of the economic position of the firm.
2. Debt agreements contain covenants.
3. The obligation is generally fixed in terms of interest and principal payments.
4. Excessive debt increases the risk of equity holders and therefore depresses share prices.

86. All of the following are advantages of debt financing except

1. Interest is tax deductible.
2. The use of debt will assist in lowering the firm's cost of capital.
3. In periods of inflation, debt is paid back with dollars that are worth less than the ones borrowed.
4. The acquisition of debt decreases stockholders' risk.

87. If an investor is concerned about interest rate risk, the investor should consider investing in

1. Serial bonds.
2. Sinking fund bonds.
3. Convertible bonds.
4. Floating rate bonds.

88. Bonds in which the principal amount is paid as a series of installments over the life of the bond issue are called

1. Serial bonds.
2. Sinking fund bonds.
3. Convertible bonds.
4. Callable bonds.

89. Wilson Corporation issued bonds two years ago. If the _______ interest rate ______, the market value of the bond will decrease.

1. Coupon; increases.
2. Coupon; decreases.
3. Market; increases.
4. Market; decreases.

^**90. DQZ Telecom is considering a project for the coming year that will cost $50 million. DQZ plans to use the following combination of debt and equity to finance the investment:

• Issue $15 million of 20-year bonds at a price of 101, with a coupon rate of 8%, and flotation costs of 2% of par.
• Use $35 million of funds generated from earnings.

The equity market is expected to earn 12%. US Treasury bonds are currently yielding 5%. The beta coefficient for DQZ is estimated to be .60. DQZ is subject to an effective corporate income tax rate of 40%.

The before-tax cost of DQZ's planned debt financing, net of flotation costs, in the first year is

1. 11.80%
2. 8.08%
3. 10.00%
4. 7.92%

^**91. The best reason corporations issue Eurobonds rather than domestic bonds is that

1. These bonds are denominated in the currency of the country in which they are issued.
2. These bonds are normally a less expensive form of financing because of the absence of government regulation.
3. Foreign buyers more readily accept the issues of both large and small US corporations than do domestic investors.
4. Eurobonds carry no foreign exchange risk.

92. Which of the following provisions is generally considered detrimental to the investor?

1. Conversion.
2. Redeemable.
3. Callable.
4. Serial maturity.

93. Which of the following is not an advantage of leasing as a form of financing?

1. Up front costs may be less.
2. The provisions of the agreement may be less stringent than for other debt agreements.
3. The dollar cost.
4. The firm may be able to lease the asset when it does not have the credit capacity to purchase the asset.

94. Nerco has a bond issue that matures in fifteen years. Recently, the company's bond rating has gone from B to Baa. How would this affect the market price of the bonds?

1. Increase.
2. Decrease.
3. Remain the same.
4. The effect cannot be predicted.

Items 95 through 97 are based on the following information:

Watco, Inc. issued $1,000,000 in 8% bonds, maturing in ten years and paying interest semiannually. The bonds were issued at face value.

95. What can you assume about the interest rates at the time the bonds were issued?

1. The market rate for this bond was about 8%.
2. The nominal rate of interest was about 8%.
3. The coupon rate on the bond includes no premium for credit risk.
4. The risk-free interest rate is about 6%.

96. If the market rate of interest for this type of bond increases to 9%, which of the following is true?

1. The market value of Watco's bond will increase.
2. The market value of Watco's bond will decrease.
3. The effect will depend on the change in the LIBOR rate.
4. The effect cannot be predicted.

97. Assume that one of Watco's bonds with $1,000 face value is currently selling for $950. What is the current yield on the bond?

1. 8.00%
2. 9.00%
3. 7.56%
4. 8.42%

Equity

98. The market for outstanding, listed common stock is called the

1. Primary market.
2. New issue market.
3. Over-the-counter market.
4. Secondary market.

99. In capital markets, the primary market is concerned with

1. New issues of bonds and stock securities.
2. Exchanges of existing bond and stock securities.
3. The sale of forward or future commodities contracts.
4. New issues of bond and stock securities and exchanges of existing bond and stock securities.

*100. Which of the following is usually not a feature of cumulative preferred stock?

1. Has priority over common stock with regard to earnings.
2. Has priority over common stock with regard to assets.
3. Has voting rights.
4. Has the right to receive dividends in arrears before common stock dividends can be paid.

101. Which of the following is not an advantage of going public?

1. Access to capital.
2. Compliance.
3. Use of stock options.
4. Liquidity for owners' investments.

Items 102 and 103 are based on the following information:

The following information is available for Rothenberg, Inc.:

Optimal Capital Structure

102. What is Rothenberg's degree of operating leverage?

1. 1/5
2. 10
3. 5
4. 2/3

103. What is the degree of financial leverage for Rothenberg, Inc.?

1. 10
2. 5
3. 1/6
4. 1/10

104. Which of the following is an advantage of equity financing in comparison to debt financing?

1. Issuance costs are greater than for debt.
2. Ownership is given up with respect to the issuance of common stock.
3. Dividends are not tax deductible by the corporation whereas interest is tax deductible.
4. The company has no firm obligation to pay dividends to common shareholders.

105. Assume that Company A and Company B are alike in all respects except that Company A utilizes more debt financing and less equity financing than does Company B. Which of the following statements is true?

1. Company A has more net earnings variability than Company B.
2. Company A has more operating earnings variability than Company B.
3. Company A has less operating earnings variability than Company B.
4. Company A has less financial leverage than Company B.

106. Which of the following is not a source of capital used to finance long-term projects?

1. Common stock.
2. Long-term debt.
3. Preferred stock.
4. Line of credit.

107. Which of the following factors generally does not impact management's capital structure strategy?

1. Business risk.
2. Tax position.
3. Management aggressiveness.
4. Expected return on assets.

^**108. A firm with a higher degree of operating leverage when compared to the industry average implies that the

1. Firm has higher variable costs.
2. Firm's profits are more sensitive to changes in sales volume.
3. Firm is more profitable.
4. Firm is less risky.

*109. When a company increases its degree of financial leverage

1. The equity beta of the company falls.
2. The systematic risk of the company falls.
3. The unsystematic risk of the company falls.
4. The standard deviation of returns on the equity of the company rises.

*110. A company has made the decision to finance next year's capital projects through debt rather than additional equity. The benchmark cost of capital for these projects should be

1. The before-tax cost of new-debt financing.
2. The after-tax cost of debt financing.
3. The cost of equity financing.
4. The weighted-average cost of capital.

Items 111 and 112 are based on the following information:

Management of Russell Corporation is considering the following two potential capital structures for a newly acquired business.

111. Which of the following statements is not true if management decides to accept Alternative 1?

1. Alternative 1 is the more conservative capital structure.
2. Alternative 1 provides the greatest amount of financial leverage.
3. Net income will be less variable under Alternative 1.
4. Total interest expense will be less under Alternative 1.

112. Which of the alternatives has the lowest weighted-average cost of capital and how much is the differential?

1. Alternative 1 by 1.5%
2. Alternative 2 by 0.59%
3. Alternative 1 by 0.167%
4. The alternatives have equal weighted-average cost of capital.

Cost of Capital

113. Management of Kelly, Inc. uses CAPM to calculate the estimated cost of common equity. Which of the following would reduce the firm's estimated cost of common equity?

1. A reduction in the risk-free rate.
2. An increase in the firm's beta.
3. An increase in expected inflation.
4. An increase in the risk-free interest rate.

^**114. In general, it is more expensive for a company to finance with equity than with debt because

1. Long-term bonds have a maturity date and must, therefore, be repaid in the future.
2. Investors are exposed to greater risk with equity capital.
3. The interest on debt is a legal obligation.
4. Equity capital is in greater demand than debt capital.

115. Which of the following is not a characteristic of the capital asset pricing model for estimating the cost of equity?

1. The model is simple to understand and implement.
2. The model can be applied to all firms.
3. The model does not rely on any dividend assumptions or growth of dividends.
4. It is based upon the stock's actual market price.

116. Management of Terra Corp. is attempting to estimate the firm's cost of equity capital. Assuming that the firm has a constant growth rate of 5%, a forecasted dividend of $2.11, and a stock price of $23.12, what is the estimated cost of common equity using the dividend-yield-plus-growth approach?

1. 9.1%
2. 14.1%
3. 15.6%
4. 12.3%

117. If nominal interest rates increase substantially but expected future earnings and dividend growth for a firm over the long run are not expected to change, the firm's stock price will

1. Increase.
2. Decrease.
3. Stay constant.
4. Change, but in no determinable direction.

118. Assume that two companies, Company × and Company Y, are alike in all respects, except the market value of the outstanding common shares of Company × is greater than the market value of Company Y shares. This may indicate that

1. Company X's investors expect higher dividend growth than Company Y's investors.
2. Company X's investors expect lower dividend growth than Company Y's investors.
3. Company X's investors have longer expected holding periods than Company Y's investors.
4. Company X's investors have shorter expected holding periods than Company Y's investors.

119. Which of the following methods explicitly recognizes a firm's risk when determining the estimated cost of equity?

1. Capital asset pricing model.
2. Dividend-yield-plus-growth model.
3. Bond-yield-plus model.
4. Return on equity.

120. Assume a firm is expected to pay a dividend of $5.00 per share this year. The firm along with the dividend is expected to grow at a rate of 6%. If the current market price of the stock is $60 per share, what is the estimated cost of equity?

1. 8.3%
2. 6.0%
3. 14.3%
4. 12.0%

121. The bond-yield-plus approach to estimating the cost of common equity involves adding a risk premium of 3% to 5% to the firm's

1. Cost of short-term debt.
2. Cost of long-term debt.
3. Return on assets.
4. Return on equity.

^**122. In practice, dividends

1. Usually exhibit greater stability than earnings.
2. Fluctuate more widely than earnings.
3. Tend to be a lower percentage of earnings for mature firms.
4. Are usually changed every year to reflect earnings changes.

Items 123 and 124 are based on the following information:

Martin Corporation
STATEMENT OF FINANCIAL POSITION
December 31, 2012
(Dollars in millions)

Additional data

• The long-term debt was originally issued at par ($1,000/bond) and is currently trading at $1,250 per bond.
• Martin Corporation can now issue debt at 150 basis points over US Treasury bonds.
• The current risk-free rate (US Treasury bonds) is 7%.
• Martin's common stock is currently selling at $32 per share.
• The expected market return is currently 15%.
• The beta value for Martin is 1.25.
• Martin's effective corporate income tax rate is 40%.

^**123. Martin Corporation's current net cost of debt is

1. 5.5%
2. 7.0%
3. 5.1%
4. 8.5%

^**124. Using the Capital Asset Pricing Model (CAPM), Martin Corporation's current cost of common equity is

1. 8.75%
2. 10.00%
3. 15.00%
4. 17.00%

*Items 125 and 126 are based on the following information:

DQZ Telecom is considering a project for the coming year that will cost $50 million. DQZ plans to use the following combination of debt and equity to finance the investment.

• Issue $15 million of 20-year bonds at a price of 101, with a coupon rate of 8%, and flotation costs of 2% of par.
• Use $35 million of funds generated from earnings.

The equity market is expected to earn 12%. US Treasury bonds are currently yielding 5%. The beta coefficient for DQZ is estimated to be .60. DQZ is subject to an effective corporate income tax rate of 40%.

^**125. Assume that the after-tax costs of debt is 7% and the cost of equity is 12%. Determine the weighted-average cost of capital.

1. 10.50%
2. 8.50%
3. 9.50%
4. 6.30%

^**126. The Capital Asset Pricing Model (CAPM) computes the expected return on a security by adding the risk-free rate of return to the incremental yield of the expected market return that is adjusted by the company's beta. Compute DQZ's expected rate of return.

1. 9.20%
2. 12.20%
3. 7.20%
4. 12.00%

*127. When calculating the cost of capital, the cost assigned to retained earnings should be

1. Zero.
2. Lower than the cost of external common equity.
3. Equal to the cost of external common equity.
4. Higher than the cost of external common equity.

128. According to the Capital Asset Pricing Model (CAPM), the relevant risk of a security is its

1. Company-specific risk.
2. Diversifiable risk.
3. Systematic risk.
4. Total risk.

^**129. Hi-Tech Inc. has determined that it can minimize its weighted-average cost of capital (WACC) by using a debt/equity ratio of 2/3. If the firm's cost of debt is 9% before taxes, the cost of equity is estimated to be 12% before taxes, and the tax rate is 40%, what is the firm's WACC?

1. 6.48%
2. 7.92%
3. 9.36%
4. 10.80%

Items 130 through 132 are based on the following information:

A new company requires $1 million of financing and is considering two arrangements as shown in the table below.

In the first year of operations, the company is expected to have sales revenues of $500,000, cost of sales of $200,000, and general and administrative expenses of $100,000. The tax rate is 30%, and there are no other items on the income statement. All earnings are paid out as dividends at year-end.

130. If the cost of equity were 12%, then the weighted-average cost of capital under Arrangement #1, to the nearest full percentage point, would be

1. 8%
2. 10%
3. 11%
4. 12%

131. Which of the following statements comparing the two financing arrangements is true?

1. The company will have a higher expected gross margin under Arrangement #1.
2. The company will have a higher degree of operating leverage under Arrangement #2.
3. The company will have higher interest expense under Arrangement #1.
4. The company will have higher expected tax expense under Arrangement #1.

132. The return on equity will be <List A> and the debt ratio will be <List b> under Arrangement #2, as compared with Arrangement #1.

Asset and Liability Valuation

133. Which of the following methods of valuation provides the most reliable measure of fair value?

1. Use of a discounted cash flow method.
2. Market values obtained from active markets.
3. Combination of valuation models and active markets.
4. Sophisticated valuation models.

Mergers

*134. A parent company sold a subsidiary to a group of managers of the subsidiary. The purchasing group invested $1 million and borrowed $49 million against the assets of the subsidiary. This is an example of a

1. Spin-off.
2. Leveraged buyout.
3. Joint venture.
4. Liquidation.

^**135. The acquisition of a retail shoe store by a shoe manufacturer is an example of

1. Vertical integration.
2. A conglomerate.
3. Market extension.
4. Horizontal integration.

^**136. A horizontal merger is a merger between

1. Two or more firms from different and unrelated markets.
2. Two or more firms at different stages of the production process.
3. A producer and its supplier.
4. Two or more firms in the same market.

137. A soft drink producer acquiring a bottle manufacturer is an example of a

1. Horizontal merger.
2. Vertical merger.
3. Congeneric merger.
4. Conglomerate merger.

138. A shoe manufacturing firm acquiring a brokerage house is an example of a

1. Horizontal merger.
2. Vertical merger.
3. Congeneric merger.
4. Conglomerate merger.

Multiple-Choice Answers and Explanations

Answers

Explanations

1. (c) The requirement is to identify the function that is not related to financial management. The correct answer is (c) because internal control is a function of the controller's office. Answers (a), (b), and (d) are incorrect because the functions of financial management include: financing, capital, budgeting, financial management, corporate governance, and risk management.

2. (a) The requirement is to identify the formula for the inventory conversion period. Answer (a) is correct because the inventory conversion period describes the average time required to convert materials into finished goods and sell those goods. Answers (b), (c), and (d) are all incorrect versions of the formula.

3. (c) The requirement is to identify the formula for the calculation of the payables deferral period. Answer (c) is correct because the payables deferral period is equal to the average length of time between the purchase of materials and the payment of cash for them. Answers (a), (b), and (d) are all incorrect because they illustrate inaccurate versions of the formula.

4. (d) The requirement is to determine the false statement regarding working capital management. Answer (d) is correct because financing permanent inventory buildup with long-term debt is an example of a conservative working capital policy. Answers (a), (b), and (c) are all accurate statements about working capital management.

5. (d) The requirement is to identify the factor considered in determining the appropriate level of working capital. Answer (d) is correct because the main reason to retain working capital is to meet the firm's financial obligations.

Therefore, the amount is determined by offsetting the benefit of current assets and current liabilities against the probability of technical insolvency. Answer (a) is incorrect because it is a consideration regarding long-term financing. Answer (b) is incorrect because it is a consideration regarding capital structure. Answer (c) is incorrect because short-term debt is generally less expensive than long-term debt.

6. (a) The requirement is to identify the impact of decisions on the cash conversion cycle. The cash conversion cycle is equal to the Inventory conversion period + Receivables collection period − Payables deferral period. Answer (a) is correct because the impact of a decreased inventory conversion period is a reduction in the cash conversion cycle. Answers (b), (c), and (d) are incorrect because these actions would increase the length of a firm's cash conversion cycle.

7. (d) The requirement is to calculate the cash conversion cycle. The cash conversion period is calculated as the Inventory conversion period + Receivables collection period − Payables deferral period. Answer (d) is correct because the inventory conversion period is $2,500,000/$50,000 = 50 days, and the receivable conversion period is $2,000,000/$100,000 = 20 days. Therefore, the cash conversion cycle is equal to 50 days + 20 days − 30 days = 40 days. Answer (a) is incorrect because it erroneously adds the payable deferral period.

8. (b) The requirement is to calculate the inventory conversion period. The inventory conversion period is calculated as average inventory/(cost of sales per day). Answer (b) is correct because $5,000,000/($30,000,000/365) = 60.83 days.

9. (d) The requirement is to identify the definition of the payables deferral period. Answer (d) is correct because the payables deferral period is the average length of time between the purchase of materials and the payment of cash for them. Answer (a) is incorrect because the operating cycle is the period of time elapsing between the acquisition of goods and services involved in the manufacturing process and the final collection of cash from sale of the products. Answer (b) is incorrect because the inventory cycle is the average time required to convert materials into finished goods and sell those goods. Answer (c) is incorrect because the accounts receivable period is the length of time required to collect accounts receivable.

10. (c) The requirement is to identify the impact of the length of the cash conversion cycle on a firm's profitability. Answer (c) is correct because the longer the cash conversion cycle the greater the amount of time from when a firm pays its suppliers to the time it ultimately collects receivables. The greater the time frame the more likely the firm will have to borrow funds and incur interest expense which reduces profitability. Answers (a), (b), and (d) are incorrect because the incurrence of interest will reduce profitability.

11. (c) The requirement is to calculate the number of days' sales outstanding. Answer (c) is correct. One-third of the customers take advantage of the 5% cash discount and pay on day ten. The remaining two-thirds of the customers pay on day 20. Average days' sales outstanding is calculated as

Days' sales outstanding = (1/3) (10 days) + (2/3) (20 days) = 17 days

Answer (a) is incorrect because this inappropriately weights the two different types of customers. Answer (b) is incorrect because this uses a simple average of days rather than a weighted-average. Answer (d) is incorrect because this solution uses the 20-day collection period for customers not taking the cash discount as the days' sales outstanding, rather than the average days for payment by all customers.

12. (d) The requirement is to determine the effect of changing from using a depository transfer check to using a wire transfer. The change is feasible if the interest savings offsets the increased costs. For a fee of $25, the firm gets two extra days' interest on the average transfer amount. By dividing the $25 fee by the interest rate for two days, .04% (2 days × .02%), we get $62,500. Therefore, management should make the change if the average transfer is expected to be greater than $62,500. Answer (a) is incorrect because it is calculating assuming there is only a one-day decrease in float.

13. (c) The requirement is to consider the cash flow implications of electronic funds transfer. Answer (c) is correct because electronic funds transfer takes the float out of both the cash receipts and disbursements processes. It is beneficial to take the float out of the cash receipts process but not the cash disbursements process.

14. (c) The requirement is to determine the benefit or loss from establishing the lockbox system. The firm saves money if the interest savings is greater than the increased cost of processing cash receipts. The increased cost of processing cash receipts is equal to $5,000 ($10,000 bank charge − $5,000 cost savings). The interest savings is measured by multiplying the increase in average funds by the short-term interest rate. The firm will have use of an additional $300,000 ($100,000 × 3 days) in average funds. Therefore, the interest savings is equal to $15,000 ($300,000 × 5%), and the overall benefit is equal to $10,000 ($15,000 − $5,000). Answer (a) is incorrect because it ignores the interest savings. Answer (b) is incorrect because it only considers the bank charge.

15. (d) The requirement is to describe how firms attempt to manage float. Float is the time that elapses relating to mailing, processing, and clearing checks. A firm strives to minimize its cash receipts float to get use of the receipts as soon as possible, and to maximize its cash disbursement float to get use of the funds for as long as possible. Therefore, the correct answer is (d).

16. (d) The requirement is to calculate the financial cost/benefit of establishing a concentration banking arrangement. The cost savings in interest from establishing the arrangement is equal to $9,200 [($115,000 × 2 days) × 4%]. Therefore, answer (d) is correct because implementing the concentration banking arrangement would result in a net savings of $4,200 ($9,200 − $5,000). Answer (a) is incorrect because it only considers the $5,000 cost. Answer (c) is incorrect because it considers the $115,000 in daily cash receipts the benefit.

17. (d) The requirement is to calculate the financial cost/benefit of establishing a lockbox system. Answer (d) is correct because the solution is found by comparing the cost in fees to the benefits in terms of reduced interest costs. Since the float is reduced by three days the firm gets the use of $1,050,000 ($350,000 × 3 days) in additional funds that results in interest savings of $42,000 ($1,050,000 × 4%). Therefore, the net benefit is equal to $20,000 ($42,000 − $22,000). Answer (a) is incorrect because it only considers the bank fee. Answer (b) is incorrect because it only considers the net change in processing costs.

18. (c) The requirement is to calculate the financial costs/benefit of establishing a zero balance account system. Answer (c) is correct because the solution is found by comparing the cost in fees to the benefit in terms of reduced interest costs. Since the float is reduced by four days then the firm gets the use of $160,000 ($40,000 × 4 days) additional funds which results in interest savings of $7,200 ($160,000 × 4.5%). The $1,200 savings is the excess of the interest savings of $7,200 over the costs of $6,000. Answer (a) is incorrect because it only considerers the cost without considering the interest savings. Answer (b) is incorrect because it is calculated by considering the $7,200 interest savings as a cost and the $6,000 in maintenance and transfer fees as a benefit. Answer (d) is incorrect because it only considers the interest savings.

19. (b) The requirement is to identify the working capital technique that increases the payable float. Answer (b) is the correct answer because payment by draft (e.g., a check) is slower than other methods of payment such as electronic cash transfers. Answers (a) and (d) are incorrect because they are techniques designed to speed the processing of cash receipts. Answer (c) is incorrect because EDI involves processing transactions electronically. This would speed up the payment of payables.

20. (d) The requirement is to determine the optimal agreement for a lockbox system. The number of checks issued during the year is determined by multiplying 700 times 360 days, which results in a total of 252,000 checks. The total amount of collections is equal to $453,600,000 (252,000 checks × $1,800 per check). Answer (d) is correct because it results in the lowest cost of $122,500 ($1,750,000 × 7%), which is the cost of maintaining the compensating balance. Answer (a) is incorrect because it results in a cost of $126,000 ($.50 × 252,000 checks). Answer (b) is incorrect because it results in a cost of $125,000. Answer (c) is incorrect because it results in a fee of $136,080 (3% × $453,600,000).

21. (d) The requirement is to calculate the annual benefit from accepting the bank's proposal. Answer (d) is correct because the net benefit from the reduction of the cash receipts float is $12,000 [($100,000 × 2) × 6%] minus the annual service fee, $6,000 ($500 × 12 months), which is equal to $6,000. Answer (b) is incorrect because it ignores the bank service charge. Answer (c) is incorrect because it assumes only a one-day reduction in float.

22. (b) The requirement is to identify the term used to describe a required minimum checking account balance. Answer (b) is correct because a compensating balance is a minimum balance required by the bank to compensate the bank for services. Answer (a) is incorrect because transactions balance is the amount of funds the firm needs on deposit to conduct day-to-day transactions. Answer (c) is incorrect because this precautionary balance represents the balance available for emergencies. Answer (d) is incorrect because this speculative balance represents the balance available for bargain purchases.

23. (c) The requirement is to calculate the net benefit from accepting the bank's proposal. The correct answer is (c) because the annual benefit is $6,000 which is equal to the interest income $12,000 ($100,000 × 2 days × 6%) − $6,000 ($500 × 12) cost.

24. (b) The requirement is to calculate the net benefit of using the lockbox system. Answer (b) is correct because the net benefit is equal to $60,875, which is equal to the interest savings of $120,000 ($20,000 average payment × 50 payments × 2 days × 6%) minus the cost of the service of $59,125 [$50,000 + (50 payments per day × 365 days × $0.50)].

25. (b) The requirement is to identify the most important consideration with respect to short-tem investments. Answer (b) is correct because short-term investments must be available to convert to cash when needed. Therefore, risk and liquidity are the most important considerations. Answers (a), (c), and (d) are incorrect because they are important considerations with respect to long-term investments.

26. (d) The requirement is to identify the security that is not suitable as a marketable investment. Answer (d) is correct because convertible bonds are long-term investments that have more risk than securities that are typically used for short-term investment. The primary considerations regarding short-term investments are liquidity and safety. Answers (a), (b), and (c) are all appropriate as marketable investments. They are liquid and have a low degree of risk.

27. (d) The requirement is to identify the instrument with the highest return. Answer (d) is correct because commercial paper is issued by a corporation and, therefore, has more risk than Treasury notes, Treasury bonds, or money market accounts.

28. (d) The requirement is to identify the item that is not a characteristic of a negotiable certificate of deposit. The correct answer is (d) because negotiable certificates of deposit have lower yields than banker's acceptances and commercial paper—they have less risk. Answer (a) is incorrect because negotiable certificates of deposit do have a secondary market. Answer (b) is incorrect because negotiable certificates of deposit are regulated by the Federal Reserve System. Answer (c) is incorrect because they are usually sold in denominations of a minimum of $100,000.

29. (b) In a just-in-time (JIT) purchasing system, orders are placed such that delivery of raw materials occurs just as they are needed for production. This system requires the placement of more frequent, smaller orders and ideally eliminates inventories. Conversely, in a traditional system large orders are placed less frequently and extra inventory is carried to avoid stockouts and the resulting production delays during order lead time. Certain cost changes would encourage managers to switch to a JIT system. One is decreased cost per purchase order, which would increase the attractiveness of placing the many more orders required. Another is increased inventory unit carrying costs, which would make the elimination of inventories desirable.

30. (c) Calculation of the reorder point includes consideration of the average daily usage, average delivery time, and stock-out costs. Answer (a) is incorrect because ordering costs are included in determining the economic order quantity but not the reorder point. Answer (b) is incorrect because carrying cost is considered in determining the economic order quantity but not the reorder point. Answer (d) is incorrect because the economic order quantity is not considered in determining the reorder point.

31. (d) The requirement is to identify the item that involves an incorrect comparison of a just-in-time system and a traditional system. Answer (d) is correct because in a just-in-time system the lot size is based on immediate need; a traditional system bases lot size on formulas. Answers (a), (b), and (c) are all incorrect because they express correct comparisons of just-in-time and traditional systems.

32. (a) The goal of a just-in-time system is to identify and eliminate all non-value-added activities. One of the major features of a just-in-time system is a decrease in the number of suppliers to build strong relations and ensure quality goods. In a just-in-time system raw material is purchased only as it is needed for production, thereby eliminating the need for costly storage. In a just-in-time system, vendors make more frequent deliveries of small quantities of materials that are placed into production immediately upon receipt.

33. (c) The purpose of a just-in-time production system is to decrease the size of production runs while increasing the number of lots processed during the year. This production philosophy requires that inventory be delivered as it is needed, rather than held in large quantities. Inventory turnover is computed as

As average inventory decreases, inventory turnover increases. As average inventory levels decrease, inventory as a percentage of total assets will also decrease.

34. (d) The requirement is to determine the effect of a decrease in safety stock on Dee Co.'s economic order quantity (EOQ). The EOQ represents the optimal quantity of inventory to be ordered based on demand and various inventory costs. The formula for computing EOQ is

Safety stock is a buffer of excess inventory held to guard against stockouts. Safety stock is usually a multiple of demand and has no effect on a company's EOQ.

35. (a) The economic order quantity (EOQ) formula was developed on the basis of the following assumptions:

1. Demand occurs at a constant rate throughout the year and is known with certainty.
2. Lead-time on the receipt of orders is constant.
3. The entire quantity ordered is received at one time.
4. The unit costs of the items ordered are constant; thus, there can be no quantity discounts.
5. There are no limitations on the size of the inventory.

Answer (a) is correct because it is assumption 1. Answer (b) is incorrect because it contradicts assumption 5. Answers (c) and (d) are incorrect because they are the opposite of assumption 4.

36. (b) The requirement is to calculate the economic order quantity (EOQ). The EOQ formula is

In the above equation, a = cost of placing one order, D = annual demand in units, and k = cost of carrying one unit in inventory for one year. Substituting the given information, the equation becomes

37. (d) The requirement is to determine the order point for material X. When safety stock is maintained, the order point is computed as follows:

Daily demand is eighty units (20,000 units ÷ 250 days). Therefore, the order point is 3,200 units [(80 × 30) + 800].

38. (a) The requirement is to identify the impact of inventory levels on costs. Maintaining a low level of inventory requires that many smaller orders of inventory be made in order to satisfy customer demand. Answer (a) is correct because each order incurs ordering cost and as the quantity of orders increases the ordering costs will also increase. Answer (b) is incorrect because carrying costs are higher with a higher level of inventory. Answer (c) is incorrect because although the ordering costs are higher the carrying costs are lower. Answer (d) is incorrect because the ordering costs would be higher.

39. (d) The requirement is to identify an inventory carrying cost. The correct answer is (d). Part of the cost of holding inventory is the cost of obsolescence. Answer (a) is an example of a stockout cost. Answer (a) is a stock-out cost. Answer (b) and (c) are examples of ordering costs.

40. (d) The requirement is to identify the characteristic of JIT inventory systems. Answer (d) is correct because JIT systems rely on quality materials; otherwise production shutdowns will occur because no extra materials are available. Answer (a) is incorrect because there are no safety stocks in JIT systems. Answer (b) is incorrect because JIT is applicable to all size corporations. Answer (c) is incorrect because JIT generally is applied all along the supply chain.

41. (d) The requirement is to identify the factor not used in the economic order quantity formula. Answer (d) is correct because the volume of products in inventory is not a component of the economic order quantity formula. Answers (a), (b), and (c) are incorrect because they are all components of the EOQ formula.

42. (d) The requirement is to determine the cost savings from selecting one of the production alternatives. Under the level production alternative, the firm would incur an additional $40,000 [($1,500,000 − $2,000,000) × 8%] in inventory holding costs but it would save $50,000 in production costs. Therefore, answer (d) is the correct answer. Alternative 1 results in $10,000 ($50,000 − $40,000) in savings over Alternative 2.

43. (c) The requirement is to calculate the short-term interest rate that would cause the two alternatives to have equal costs. The cost of implementing Alternative 2 is the $50,000 in additional production costs. When the inventory holding costs related to Alternative 1 equals that amount the costs are equal. By dividing the $50,000 by the $500,000 in additional average inventory, we get 10% ($50,000 ÷ $500,000). Therefore, the correct answer is (c) because at a 10% interest rate the cost of holding the additional inventory under Alternative 1 is equal to the additional production costs under Alternative 2.

44. (b) The requirement is to determine the factor that would increase inventory levels. In answering this question, you should consider the components of the EOQ formula. The correct answer is (b) because if the cost of holding inventory decreases it would enable the firm to carry more inventory. Answer (a) is incorrect because a decrease in sales would result in a decrease in the required level of inventory. Answer (c) is incorrect because a decrease in sales variability decreases the required level of inventory. Answer (d) is incorrect because a decrease in the cost of running out of stock decreases the required level of inventory.

45. (a) The requirement is to identify the technique used to plan and control manufacturing inventories. Answer (a) is correct because materials requirements planning is an inventory planning technique. Answer (b) is incorrect because regression analysis is a technique used to estimate the relationship between variables. Answer (c) is incorrect because capital budgeting is a technique used to evaluate investments in capital assets. Answer (d) is incorrect because linear programming is a technique used to determine the optimal decision when resources are constrained.

46. (c) The requirement is to identify the definition of collection policy. Answer (c) is correct because a firm's collection policy is the diligence used to collect slow paying accounts. Answer (a) is incorrect because the discount policy is the policy regarding the percentage discount given for early payment. Answer (b) is incorrect because the credit policy is a firm's requirements for customers in order to grant them credit. Answer (d) is incorrect because the payables policy is unrelated to accounts receivable.

47. (b) The requirement is to identify which item is not an advantage of initiating seasonal dating. Seasonal dating is a procedure for inducing customers to buy early by not requiring payment until the customers' selling season, regardless of when the merchandise is shipped. Under seasonal dating the selling firm incurs higher credit costs, as customers take longer to pay. Therefore, answer (b) is correct because this is not an advantage of seasonal dating. Answer (a) is incorrect because under seasonal dating, customers buy earlier and the selling firm incurs lower storage costs. This is an advantage of seasonal dating. Answer (c) is incorrect because providing attractive credit terms for customers is an advantage of a seasonal dating policy. Answer (d) is incorrect because reduced uncertainty about sales volume is an advantage of a seasonal dating policy.

48. (c) The requirement is to calculate the total collections on or before January 11. Answer (c) is correct because if all customers take advantage of seasonal dating and all customers take the discount, then collections on or before January 11 will be

Answer (a) is incorrect because all customers take the discount and abide by the terms of the discount policy, so they will pay on or before January 11. Answer (b) is incorrect because this solution omits the collection of the January 1 sales revenue. Answer (d) is incorrect because this solution does not take the discount into account.

49. (b) The requirement is to identify the formula for days' sales in accounts receivable. Answer (b) is correct because days' sales in receivables provides an overall measure of the accumulation of receivables. It is calculated by dividing the balance of receivables by sales per day. Answers (a), (c), and (d) are incorrect because they do not accurately illustrate the formula.

50. (d) The requirement is to describe a firm's credit criteria. Answer (d) is correct because the credit criteria are the policies used to decide whether a customer should be extended credit. Answer (a) is incorrect because it describes the credit period. Answer (b) is incorrect because it describes a portion of the discount policy. Answer (c) is incorrect because it describes the collection policy.

51. (c) The requirement is to calculate impact of this change in policy on accounts receivable. Under the existing policy, sales are equal to $50,000,000, 70% of which are on credit. Therefore, the average accounts receivable balance is equal to $7,291,667 [($35,000,000 credit sales ÷ 360 days) × 75 days]. Under the new policy credit sales are estimated to be $28,500,000 [($50,000,000 × 95%) × 60%]. Accordingly, the average accounts receivable balance under the new policy is estimated to be $3,958,333 [($28,500,000 credit sales ÷ 360) × 50 days]. Answer (c) is correct because the change in accounts receivable balance is estimated to be a decrease of $3,333,334 ($7,291,667 − $3,958,333).

52. (b) The requirement is to calculate the effect of the new policy on net income before taxes. Answer (b) is correct because the decrease in operating income is equal to $2,166,667 [$2,500,000 loss in sales − ($3,333,334 × 10%) interest savings]. Answer (a) is incorrect because it only considers the loss in sales. Answer (c) is incorrect because it treats the entire $3,333,334 change in average receivables as a benefit.

53. (b) The requirement is to determine the factor that is not considered in determining whether to change credit policy. Answer (b) is correct because the current bad debt experience is irrelevant to the decision. Management should consider only those factors that change based upon the alternative selected. Answer (a) is incorrect because the cost of funds is relevant to the decision. Answer (c) is incorrect because if there is any impact on the current customer base, this factor should be considered. Answer (d) is incorrect because the impact on bank loan covenants is obviously relevant.

54. (d) The requirement is to calculate the annual cost of the financing. Answer (d) is correct because the total amount paid to the factor would be ($100,000 × 80%) × 10% + ($100,000 × 12) × 2% = $32,000. The net cost is equal to $14,000 ($32,000 − $18,000 cost savings). Therefore, the annual interest cost is equal to $14,000/$80,000 = 17.5%.

55. (d) The requirement is to calculate the benefit or loss from changing credit policy. Answer (d) is correct because the benefit is equal to the contribution margin received from the additional sales minus the cost of having incremental funds tied up in accounts receivable. The benefit from an increase in sales is equal to $144,000 ($720,000 sales × 20% contribution margin). The interest opportunity cost is equal to 75 days' interest on the variable portion of sales, or ($720,000 × 80%)/360 × 75 × 20% interest = $24,000. Therefore, the net benefit is equal to $120,000 ($144,000 − $24,000).

56. (d) The requirement is to calculate the cost of not taking a trade discount. The cost is calculated with the following formula:

Answer (d) is correct because the discount percentage is 3%, the total pay period is 35 days, and the discount period is 15 days. Therefore, the nominal cost is calculated as follows:

57. (b) The requirement is to calculate the cost of not taking a trade discount. The cost is calculated with the following formula:

Answer (b) is correct because the discount percentage is 3%, the total pay period is 67 days, and the discount period is 15 days. Therefore, the nominal cost is calculated as follows:

58. (b) The requirement is to analyze the impact upon a firm of rising short-term interest rates. A heavy reliance on short-term debt means that interest expense and the related net income will be variable and this increases the financial risk of the firm. Answer (b) is correct because if short-term interest rates increase then interest expense will increase which will cause a related decrease in net income.

59. (c) The requirement is to evaluate credit terms to made sound cash management decisions. Answer (c) is correct because a firm should take advantage of the cash discount and pay on the last day of the discount period, which is day 10. Answers (a) and (b) are incorrect because “2” is the amount of the percentage discount; not the discount period. Answer (d) is incorrect because if a firm pays bills on the final due date, it will not have taken advantage of cash discounts which are very lucrative.

60. (d) The requirement is to identify the forms of borrowing that are unsecured. Answer (d) is correct because revolving credit agreements, bankers' acceptances, lines of credit, and commercial paper all represent unsecured obligations. Answer (a) is incorrect because floating liens and chattel mortgages are secured. Answer (b) is incorrect because factoring agreements and chattel mortgages are secured. Answer (c) is incorrect because floating liens and chattel mortgages are secured.

61. (d) The requirement is to evaluate the cost of trade credit. Answer (d) is correct because if the discount period is longer, the days of extra credit obtained by forgoing the discount are fewer. This makes the trade credit more costly. Answer (a) is incorrect because the lower the discount percentage, the lower the opportunity cost of forgoing the discount and using the trade credit financing. Answers (b) and (c) are incorrect because percentage financing cost is unaffected by the purchase price of the items.

62. (b) The requirement is to calculate the effective interest rate on a loan with a compensating balance requirement. The interest rate is calculated with the following formula:

63. (d) The requirement is to calculate the cost of not taking a trade discount. The formula for computing the interest is

Therefore, answer (d) is correct.

64. (a) The requirement is to identify the term that is not related to loans involving inventory. Answer (a) is correct because factoring involves the sale of accounts receivable. Answer (b) is incorrect because a blanket inventory lien involves a legal document that establishes inventory as collateral for a loan. Answer (c) is incorrect because a trust receipt is an instrument that acknowledges that the borrower holds the inventory and the proceeds from sales will be put in trust for the lender. Answer (d) is incorrect because warehousing involves storing inventory in a public warehouse under the control of the lender.

65. (b) The requirement is to identify the nature of LIBOR. Answer (b) is correct because LIBOR, like the prime rate, is an example of a nominal rate. It is adjusted for inflation risk, but not credit risk. Answer (a) is incorrect because the risk-free rate is a theoretical rate that is not quoted. Answer (c) is incorrect because LIBOR is not credit risk adjusted. Answer (d) is incorrect because LIBOR is a short-term rate.

66. (a) The requirement is to identify the advantage of using long-term debt as a source of financing current assets. Answer (a) is correct because financing with long-term as opposed to short-term debt reduces the risk of the firm. Long-term debt does not have to be repaid as soon as short-term debt. Answer (b) is incorrect because long-term debt is generally more costly than short-term debt. Answer (c) is incorrect because the debt covenants are usually more restrictive in long-term debt agreements. Answer (d) is incorrect because early payment of long-term debt can result in prepayment penalties.

67. (c) The requirement is to identify the item that is not an implication of the policy of matching maturity assets with the maturity of financing. Answer (c) is correct because under this policy current assets are financed with current liabilities. Answers (a), (b), and (d) are incorrect because they are all appropriate implications of the policy.

68. (d) The requirement is to identify the term used to describe asset-backed public offerings. Answer (d) is correct because securitization of assets is the offering of debt collateralized by a firm's accounts receivable. Answer (a) is incorrect because a trust receipt is an instrument that acknowledges that the borrower holds a collateralized inventory and that proceeds from the sale will be put in trust for the lender. Answer (b) is incorrect because warehousing is the storage of inventory in a public warehouse that can only b removed with the lender's permission. Answer (c) is incorrect because a blanket inventory lien is a document that establishes the inventory as collateral for the loan.

69. (d) The requirement is to calculate the effective cost of a loan with a compensating balance requirement. Answer (d) is correct because the effective interest rate is equal to the interest paid, $7,000 ($100,000 × 7%) divided by the funds that are available, $80,000 (80% × $100,000). Therefore, the effective interest rate is equal to 8.75% ($7,000 ÷ $80,000). Answer (a) is not reasonable because the amount is less than the stated interest rate. Answer (b) is incorrect because it is the stated rate. Answer (c) is incorrect because it is computed by adding 20% of the stated rate to the stated rate.

70. (b) The requirement is to calculate the weighted-average annual interest rate for trade credit. If the company does not pay Web Master within the discount period, it will incur interest costs of $500 ($25,000 × 2%). This results in an annualized interest rate of 36.7347% [($500 ÷ $24,500) × 360 days ÷ (30 − 10 days)]. If the company does not pay the Softidee account during the discount period, it will incur interest cost of $2,500 ($50,000 × 5%). This results in an annualized interest rate of 23.6842% [($2,500 ÷ $47,500) × 360 days ÷ (90 − 10 days)]. To determine the weighted-average interest rate, we must first determine the average amount borrowed. For Web Master, this is equal to $24,500 × (20 days ÷ 360 days) = $1,361.11, and for Softidee, it is equal to $47,500 × (80 days ÷ 360 days) = $10,555.56. Therefore, the weighted-average interest rate is equal to 25.2% {[(36.7347% × $1,361.11) + (23.6842% × $10,555.56)] ÷ ($1,361.11 + $10,555.56)}. Answer (a) is incorrect because it uses weights of $25,000 and $50,000. Answer (c) is incorrect because it is based on weights of $24,500 and $47,500. Answer (d) is incorrect because it is the unweighted-average of the two rates.

71. (d) The requirement is to identify the statement that determines whether CyberAge should continue to use the trade credit. Answer (d) is correct because the company should continue to use the trade credit as long as the alternative cost of other forms of financing is higher. Answer (a) is incorrect because if alternative sources are less, the alternative should be used. Answer (b) is incorrect because in considering short-term financing alternatives, it is the marginal cost of capital that is important, not the weighted-average cost of capital. Answer (c) is incorrect because if the cost of long-term financing is greater, the trade credit should be used.

72. (b) The requirement is to identify the statement that is most likely true about commercial paper. Answer (b) is correct because commercial paper is normally issued with a short maturity period, usually 2 to 9 months. Answer (a) is incorrect because commercial paper is issued by the corporation. Answer (c) is incorrect because commercial paper is unsecured. Answer (d) is incorrect because commercial paper is typically issued by large corporations.

73. (a) The requirement is to calculate the effective interest on the loan. Answer (a) is correct because the effective interest is 6.44%. The effective interest rate is determined by calculating the net interest expense, which is $15,000 ($250,000 × 6%) minus the interest income from the compensating balance $500 ($25,000 × 2%) equals $14,500. Then, this amount is divided by the amount of money that the firm has available, $250,000 − $25,000 compensating balance. Thus, the effective interest rate is 6.44% ($14,500/$225,000).

74. (a) The requirement is to identify the loan with the most favorable terms. Answer (a) is correct because simple interest with no compensating balance is the most favorable terms from an effective interest basis. Answers (b), (c), and (d) are incorrect because discount interest and/or a compensating balance increase the effective interest rate on the loan.

75. (d) The requirement is to calculate the effective interest rate when a loan is in the form of a discounted note. When a note is on a discounted basis, the interest is withheld from the proceeds. Answer (d) is correct because the effective interest rate is calculated by dividing the total amount of interest by the amount of funds available. In this case, the interest is equal to $9,000 ($100,000 × 9%) and the funds available are $91,000 ($100,000 − $9,000). Thus the interest rate is 9.89% ($9,000/$91,000). Answer (b) is incorrect because it represents the stated rate, not the effective rate.

76. (c) The requirement is to calculate the annual cost of the financing arrangement. Answer (c) is correct because the annual cost of the arrangement is calculated as $7,000 (6% × $100,000) + [($300,000 − $100,000) × 1/2%)]. Answers (a), (b), and (d) are incorrect because they represent inaccurate computations of the cost of the financing.

77. (c) The requirement is to identify the largest source of short-term financing. Answer (c) is correct because trade credit is the largest source of short-term financing for most small firms. It occurs automatically with the purchase of goods and services. Answers (a) and (b) are incorrect because they are not the largest source of short-term financing for most small firms. Answer (d) is incorrect because mortgage bonds are a source of long-term financing.

78. (c) The requirement is to define the prime rate of interest. Answer (c) is correct because the prime rate of interest is the rate financial institutions charge their customers with the highest credit rating. Answer (a) is incorrect because a commitment fee is not related to the rate of interest. Answer (b) is incorrect because the effective rate on the bank loans of most firms is greater than the prime rate. Answer (d) is incorrect because the rate at which a bank borrows from the Federal Reserve central bank is the discount rate.

79. (a) The requirement is to describe the purpose of a compensating balance. Answer (a) is correct because a compensating balance provides a form of additional compensation to financial institutions. Answers (b), (c), and (d) are incorrect because they do not describe the purpose of a compensating balance.

80. (d) The requirement is to calculate the effective annual interest rate of the credit arrangement. Answer (d) is correct because the effective interest rate is equal to the interest cost divided by the available funds. The interest cost is $36,000 ($300,000 × 12%), and the available funds is equal to $255,000 [$300,000 − (15% × $300,000)]. Therefore, the effective interest rate is 14.12% ($36,000/$255,000).

81. (c) The requirement is to identify the correct statement about bond financing alternatives. Answer (c) is correct because a call provision is detrimental to the investor because he or she may be forced to redeem the bond. Answer (a) is incorrect because a bond with a call provision typically has a higher yield than a similar bond without a call provision. Answer (b) is incorrect because a convertible bond is convertible at the option of the holder. Answer (d) is incorrect because the relationship of the stated rate on the bond to the market rate determines whether or not the bond will sell for more than par value.

82. (b) The requirement is to identify the definition of Eurobonds. Answer (b) is correct because Eurobonds are always sold in some country other than the one in whose currency the bond issue is denominated. The advantage of Eurobonds is that they are less regulated than other bonds and the transaction costs are lower. Answer (a) is incorrect because Eurobonds are not always denominated in Eurodollars, which are US dollars deposited outside the US. Answer (c) is incorrect because foreign bonds are denominated in the currency of the country in which they are sold. Answer (d) is incorrect because Eurobonds are usually issued not as registered bonds, but as bearer bonds.

83. (c) The requirement is to identify the proper accounting for an operating lease. Answer (c) is correct because an operating lease is one that does not meet the criteria to be a capital lease. Operating leases are treated as rental agreements and the payments are expensed as rent as incurred. Answer (a) is incorrect because it describes the proper accounting for a capital lease. Answers (b) and (d) are incorrect because they describe accounting that is not proper for either type of lease.

84. (d) The requirement is to identify the difference between a capital and an operating lease. Answer (d) is correct because in a capital lease, the risks and rewards of ownership are transferred to the lessee. If the risks/rewards are not transferred, the lease is a rental arrangement and is called an operating lease. In accounting for a capital lease, the lessee capitalizes the net investment in the lease. Answer (a) is incorrect because the lessee obtains use of the asset in all lease agreements. Answer (b) is incorrect because the lessee uses the lease as a source of financing under a capital lease. Answer (c) is incorrect because the lessee does not receive title to the asset in all cases.

85. (c) The requirement is to identify the advantages/disadvantages of debt versus equity financing. Answer (c) is correct because the fixed obligation of interest and principal is an advantage to debt financing. Answers (a), (b), and (d) are incorrect because they are all disadvantages of debt financing.

86. (d) The requirement is to identify the advantages/disadvantages of debt versus equity financing. Answer (d) is correct because debt actually increases stockholders' risk because the financial leverage of the firm is higher. Answers (a), (b), and (c) are incorrect because they are all advantages of debt financing.

87. (d) The requirement is to identify what type of bond has less interest rate risk. Answer (d) is correct because a floating rate bond has a rate of interest that floats with changes in the market interest rate. Therefore, the market price of the bond does not fluctuate as widely. Answer (a) is incorrect because serial bonds are those that are paid off in installments over the life of the issue. Answer (b) is incorrect because sinking fund bonds are those for which the firm makes payments into a sinking fund to be used to retire the bonds by purchase. Answer (c) is incorrect because convertible bonds are those that may be converted into common stock.

88. (a) The requirement is to identify the defining characteristic of serial bonds. Answer (a) is correct because serial bonds are those that are paid off in installments over the life of the issue. Answer (b) is incorrect because sinking fund bonds are those for which the firm makes payments into a sinking fund to be used to retire the bonds by purchase. Answer (c) is incorrect because convertible bonds are those that may be converted into common stock. Answer (d) is incorrect because callable bonds are those that have a call provision that allows the firm to force the bondholders to redeem the bonds before maturity.

89. (c) The requirement is to identify the impact of changes in the market rate of interest on bond valuation. Answer (c) is correct because if the market rate of interest increases, the bond value will decrease (an inverse effect). Answers (a) and (b) are incorrect because the coupon rate does not change after issuance and determines the amount of the periodic interest payments, not changes in the bond valuation. Answer (d) is incorrect because if the market rate decreases, the value of the bond will increase.

90. (b) The requirement is to calculate the first-year, before-tax cost of the planned debt financing, net of floatation costs. The first year cost would be calculated by dividing the interest rate by the amount of funds received after floatation costs. Therefore, the interest cost before tax is equal to 8% ÷ (101% issue price − 2% floatation costs) = 8.08%. Therefore, the correct answer is (b).

91. (b) The requirement is to identify the reason for issuing Eurobonds rather than domestic bonds. Answer (b) is correct because Eurobonds are not subject to extensive regulation like US issued domestic bonds; therefore, they are less expensive to issue. Answer (a) is incorrect because Eurobonds are not denominated in the currency of the country in which they are issued. Answer (c) is incorrect because foreign buyers are not more readily accepting of the issues. Answer (d) is incorrect because Eurobonds do carry foreign exchange risk for the investor; they have losses if the US dollar declines relative to the country's currency.

92. (c) The requirement is to identify the bond provision that is generally considered to be detrimental to the investor. Answer (c) is correct because a callable bond is one that can be redeemed at the option of the issuer. The investor has no choice but to redeem the bond. Answer (a) is incorrect because a conversion feature means the bond can be converted to common stock at the option of the investor. This is a favorable provision for the investor. Answer (b) is incorrect because redeemable bonds are redeemable at the option of the investor. Answer (d) is incorrect because bonds with serial maturity allow the investor to select the desired maturity date.

93. (c) The requirement is to identify the statement that is not an advantage of leasing as a form of financing. Answer (c) is correct because the dollar cost to lease an asset is generally greater than the cost to purchase and finance through other means. Answer (a) is incorrect because leases often do not require down payments. Answer (b) is incorrect because the provisions of lease agreements are usually less stringent than for other forms of debt. Answer (d) is incorrect because firms may be able to lease when they do not have the credit capacity to buy an asset.

94. (a) The requirement is to identify the effect of an increase in bond rating. Answer (a) is correct because going from a B rating to a Baa rating is an increase in the bond rating indicative of lower risk. Therefore, the market value of the bonds should increase. Answers (b), (c), and (d) are incorrect because the bond value should increase.

95. (a) The requirement is to identify the statement that can be assumed from the case scenario. Answer (a) is correct because if the bond sold at face value, then the coupon rate of 8% must have approximated the market rate for this bond. Answer (b) is incorrect because the nominal rate does not include credit risk. Answer (c) is incorrect because the coupon rate, if it was about equal to the market rate, includes a credit risk premium. Answer (d) is incorrect because the risk-free interest rate is always about 1 to 2%.

96. (b) The requirement is to identify the correct statement regarding the effect of a change in the market rate. Answer (b) is correct because an increase in the market rate will cause the bond to reduce in value until it sells at a price that will result in a yield to maturity equal to the current market rate. Answer (a) is incorrect because the market rate would have to decline for the bond to increase in value. Answer (c) is incorrect because LIBOR is only indirectly related to the long-term bond rate. Answer (d) is incorrect because the change in value can be predicted.

97. (d) The requirement is to calculate the current yield on a bond. The current yield is equal to the annual interest paid divided by the bond market price. Watco's $1,000 bond pays $80 per year in interest, the $1,000 face value × the 8% coupon rate. Answer (d) is correct because the current yield is equal to 8.42% ($80 ÷ $950). Answer (a) is incorrect because 8% is the coupon rate.

98. (d) The requirement is to identify the purpose of the secondary market. Answer (d) is correct because outstanding stocks of publicly owned companies are traded among investors in the secondary market. The original issuer receives no additional capital as a result of such trades. Answers (a) and (b) are incorrect because firms raise capital by issuing new securities in the primary market, and the initial public offering market is a frequently used term for the market in which previously privately owned firms issue new securities to the public. Answer (c) is incorrect because the over-the-counter market is the network of dealers that provides for trading in unlisted securities.

99. (a) The requirement is to identify the purpose of the primary market. Answer (a) is correct because the primary market is the market for new stocks and bonds. Answer (b) is incorrect because existing securities are traded on a secondary market. Answer (c) is incorrect because the futures market is where commodities contracts are sold, not the capital market. Answer (d) is incorrect because exchanges of existing securities do not occur in the primary market.

100. (c) The requirement is to identify the characteristic that is not usually a feature of cumulative preferred stock. Answer (c) is correct because preferred stock usually does not have voting rights. Preferred shareholders are generally given the right to vote for directors of the company only if the company has not paid the preferred dividend for a specified period of time, such as ten quarters. Answer (a) is incorrect because preferred stock does have priority over common stock with regard to earnings, so dividends must be paid on preferred stock before they can be paid on common stock. Answer (b) is incorrect because preferred stock does have priority over common stock with regard to assets, so in the event of bankruptcy, the claims of preferred shareholders must be satisfied in full before the common shareholders receive anything. Answer (d) is incorrect because cumulative preferred stock does have the right to receive any dividends in arrears before common stock dividends are paid.

101. (b) The requirement is to identify the statement that describes an advantage of going public. Answer (b) is correct because the compliance cost of going public and complying with SEC regulations is substantial. Answer (a) is incorrect because going public does provide access to more capital. Answer (c) is incorrect because public companies can issue stock options to attract and retain management. Answer (d) is incorrect because owners obtain immediate liquidity for their investments when the firm goes public.

102. (b) The requirement is to calculate the degree of operating leverage of the company. The formula for degree of operating leverage is

In this case, the percent change in operating income is equal to 50% [($300,000 − $200,000) ÷ $200,000], and the percent change in unit volume is equal to 5% [(105,000 − 100,000 units) ÷ 100,000 units]. Therefore, the correct answer is (b) because DOL is equal to 10 (50% ÷ 5%).

103. (a) The requirement is to calculate the degree of financial leverage for the company. The formula for degree of financial leverage is

In this case, the percent change in EPS is equal to 500% [($1.20 − $0.20) ÷ $0.20], and the percent change in EBIT is equal to 50% [($300,000 − $200,000) ÷ $200,000]. Therefore, the DFL is equal to 10 (500% ÷ 50%), and answer (a) is correct.

104. (d) The requirement is to identify the advantages/disadvantages of equity financing. Answer (d) is correct because the lack of a firm obligation to pay dividends to common shareholders is an advantage of equity financing. Answers (a), (b), and (c) are incorrect because they are all disadvantages of equity financing.

105. (a) The requirement is to identify the impact of debt versus equity financing. Answer (a) is correct because Company A is more highly leveraged. It has greater fixed charges in the form of interest. Therefore, Company A will have more volatile net earnings than Company B. Answers (b) and (c) are incorrect because the level of fixed financing charges does not affect operating earnings variability. Operating income is computed before interest expense. Answer (d) is incorrect because Company A has greater, not less, financial leverage than Company B.

106. (d) The requirement is to identify the item that is not a potential long-term source of funding for a firm. Answer (d) is correct because a line of credit is a short-term financing source. Answers (a), (b), and (c) are incorrect because they are possible sources of financing for long-term projects.

107. (d) The requirement is to identify the factor that does not affect management's judgment about the firm's capital structure. Answer (d) is correct because the expected return on assets is not a factor that affects management's judgment about the firm's capital structure. Answer (a) is incorrect because the greater the inherent risk of a business, the lower the optimal debt to equity ratio. Answer (b) is incorrect because a major advantage of debt is the tax deductibility of interest payments. Answer (c) is incorrect because a firm's target capital structure will be affected by the risk tolerance of management. More aggressive management may take on more debt.

108. (b) The requirement is to identify a characteristic of higher operating leverage. Higher operating leverage involves more fixed costs, which results in more operating variability and more risk. Answer (b) is correct because a firm's profits are more sensitive to changes in sales volume when the firm is more leveraged. Answer (a) is incorrect because higher leveraged firms have less variable costs. Answer (c) is incorrect because the firm may or may not be more profitable. Answer (d) is incorrect because a highly leveraged firm is more risky.

109. (d) The requirement is to identify the consequences of an increase in financial leverage. Answer (d) is correct because when the degree of financial leverage rises, fixed interest charges rise. This causes the standard deviation of returns to equity holders to increase. Answers (a) and (b) are incorrect because an increase in the degree of financial leverage is associated with an increase in equity beta and an increase in the systematic risk of the company. Equity beta is a measure of systematic risk of the company. Answer (c) is incorrect because unsystematic risk of the company does not fall.

110. (d) Answer (d) is correct because a weighted-average of the costs of all financing sources should be used, with the weights determined by the usual financing proportions. Answer (a) is incorrect because the cost of funds for a particular project does not represent the cost of capital for the firm. The cost of capital should also be calculated on an after-tax basis. Answer (b) is incorrect because the cost of capital is a composite, or weighted-average, of all financing sources in their usual proportions. Answer (c) is incorrect because the cost of capital is a composite, or weighted-average, of all financing sources in their usual proportions. It includes both the after-tax cost of debt and the cost of equity financing.

111. (b) The requirement is to identify the statement that is not true regarding the acceptance of Alternative 1. Answer (b) is correct because Alternative 1 involves much less financial leverage than Alternative 2. Answer (a) is incorrect because Alternative 1 is the more conservative capital structure because it involves less debt. Answer (c) is incorrect because net income will be less variable under Alternative 1. Answer (d) is incorrect because total interest expense will be less under Alternative 1.

112. (b) The requirement is to compare the weighted-average cost of capital for the two alternatives. Answer (b) is correct because the cost of debt after tax for is 5.1% [6% × (100% − 15% tax rate)] for Alternative 1 and 5.95% [7% × (100% − 15% tax rate)] for Alternative 2. The weighted-average cost of capital for Alternative 1 is 7.55% [(5.1% × $3,000,000 ÷ $6,000,000) + (10% × $3,000,000 ÷ $6,000,000)], and the weighted-average cost of capital for Alternative 2 is 6.96% [(5.95% × $5,000,000 ÷ $6,000,000) + (12% × $1,000,000 ÷ $6,000,000)]. Therefore, the differential is 0.59% (7.55% − 6.96%). Answer (a) is incorrect because it results from an unweighted computation. Answer (c) is incorrect because it is the before-tax computation.

113. (a) The requirement is to identify the factor that affects the calculation of the cost of equity using CAPM. Answer (a) is correct because a reduction in the risk-free rate would reduce the required return demanded by stockholders. Answers (b), (c), and (d) are incorrect because an increase in these items would cause the estimated cost of common equity to increase.

114. (b) The requirement is to identify the reason why it is more expensive to finance with equity than with debt. Answer (b) is correct because equity holders are subject to more risk than debt holders. Therefore, they require a higher rate of return.

115. (d) The requirement is to identify the item that does not describe a characteristic of the capital asset pricing model. Answer (d) is correct because CAPM does not include the stock's market price in its computation. Answers (a), (b), and (c) are incorrect because they are all characteristics of CAPM model.

116. (b) The requirement is to apply the dividend-yield-plus-growth approach to calculate the cost of common equity. The formula for estimated cost of common equity is equal to the expected dividend divided by the stock price plus the growth rate. Therefore, the correct answer is (b) because the estimated cost of equity is 14.1% [(2.11/23.13) + 5%].

117. (b) The requirement is to identify the impact of an increase in nominal interest rates on a company's share price. Answer (b) is correct because an increase in the nominal interest rate would mean that investors would expect a higher return on all investments. If the stock earnings and dividend growth is unchanged, the stock price will decrease.

118. (a) The requirement is to identify the impact of investor expectations on stock price. Answer (a) is correct because if investors expect a higher dividend growth rate, the market value of the common shares will be greater. Answer (b) is incorrect because if investors expect a lower dividend growth rate, the market value of common shares will be lower. Answers (c) and (d) are incorrect because holding periods are not related to the market value of common shares.

119. (a) The requirement is to identify the technique that explicitly considers risk in calculating the firm's estimated cost of equity. Answer (a) is correct because CAPM is the only technique that explicitly considers risk in the form of the firm's beta. Beta measures the relationship between the price volatility of the market as a whole and the price volatility of the individual stock. Answers (b) and (c) are incorrect because they do not directly incorporate the firm's risk in the calculation of the estimated cost of equity. Answer (d) is incorrect because it is not utilized to determine the estimated cost of equity.

120. (c) The requirement is to use the dividend-yield-plus-growth-rate approach to calculate the estimated cost of equity. The estimated cost of equity is equal to the dividend divided by the price of the stock + the growth rate. Accordingly, answer (c) is correct because the estimated cost of equity is equal to 14.3% [($5 ÷ $60) + 6%].

121. (b) The requirement is to identify how the bond-yield-plus approach to estimating the cost of equity is applied. Answer (b) is correct because the bond-yield-plus approach involves adding a risk premium of 3% to 5% to the interest rate of the firm's long-term debt. Answers (a), (c), and (d) are incorrect because they involve items that are not components of the formula.

122. (a) The requirement is to identify the characteristic of typical dividend policies. Answer (a) is correct because management is hesitant to decrease dividends. Therefore, they are more stable than earnings. Answer (b) is incorrect because they do not fluctuate more widely than earnings. Answer (c) is incorrect because dividends tend to be higher for mature firms. Answer (d) is incorrect because dividends are usually not changed every year.

123. (c) The requirement is to calculate the current net cost of debt. The current cost of debt before tax is 8.5% (7% Treasury bond rate + 1.5%), and the cost of debt after tax is 5.1% [8.5% × (1 − 40% tax rate)]. Therefore, the correct answer is (c).

124. (d) The requirement is to calculate the cost of capital using CAPM. The CAPM formula is Cost of capital = Risk-free rate + (Market rate − Risk-free rate) × Beta. In this case, the estimated cost of equity is equal to 17% [7% + (15% − 7%) × 1.25]. Thus, the answer is (d).

125. (a) The requirement is to calculate the weighted-average cost of capital. The weighted-average cost of capital is determined by summing the cost of each funding source weighted by its percentage of the total. In this case, the funds received from the debt are equal to 99% (101% − 2%) × $15,000,000, or $14,850,000, and the funds from equity is $35 million, the amount of retained earnings. Therefore, total funding is $49,850,000. The weighted-average cost of capital is equal to ($14,850,000/$49,850,000) × 7% + ($35,000,000/$49,850,000) × 12% = 10.50%. Thus, the answer is (a).

126. (a) The requirement is to use the capital asset pricing model to compute the cost of equity (expected return of equity holders). The CAPM formula is: Cost of equity = Risk-free interest rate + (Market rate − Risk-free interest rate) × Beta. Therefore, the expected return = 9.2% [5% + (12% − 5%) × .60], or answer (a).

127. (b) The requirement is to specify the cost of capital assigned to retained earnings. Answer (b) is correct because newly issued or “external” common equity is more costly than retained earnings because the company incurs issuance costs when raising new funds. Answer (a) is incorrect because the cost of retained earnings is the rate of return stockholders require on retained equity capital. The opportunity cost of retained funds will be positive. Answer (c) is incorrect because retained earnings will always be less costly than external equity financing because earnings retention does not involve the payment of issuance costs. Answer (d) is incorrect because the cost is lower as described above.

128. (c) The requirement is to identify the relevant risk of a security according to CAPM. Answer (c) is correct because systematic risk is the component of the total risk of a security that cannot be eliminated through diversification and is relevant to valuation. Answer (a) is incorrect because “company-specific” risk can be eliminated through portfolio diversification and is not relevant to the valuation of the security. Answer (b) is incorrect because “diversifiable” risk can be eliminated through portfolio diversification and is not relevant to the valuation of the security. Answer (d) is incorrect because only the systematic component of total risk is relevant to security valuation.

129. (c) The requirement is to calculate the weighted-average cost of capital (WACC). Answer (c) is correct because the WACC is calculated as 9.36% {2/5 × [9% × (1 − 40%)]} + (3/5 × 12%). Answers (a), (b), and (d) are incorrect because they represent inaccurate computations of the cost of the financing.

130. (b) Answer (b) is correct because the weighted-average cost of capital is calculated as follows:

Answer (a) is incorrect because 8% is the cost of equity before tax. Answer (c) is incorrect because this solution uses the before-tax cost of debt rather than the after-tax cost of debt. Answer (d) is incorrect because 12% is the cost of equity.

131. (d) The requirement is to identify the true statement about the financing alternatives. Answer (d) is correct because taxes payable will be higher under Arrangement #1 because with lower interest expense, taxable income will be higher. Under Arrangement #1, interest expense will be $300,000 (.08) = $24,000, while under Arrangement #2, interest expense will be $700,000 (.10) = $70,000 per annum. Answer (a) is incorrect because expected gross margin is unaffected by the choice of financing arrangement. Answer (b) is incorrect because the degree of operating leverage is not affected by the method of financing. Answer (c) is incorrect because interest expense will be higher under Arrangement #2.

132. (a) The requirement is to calculate the return on equity and the debt ratio. Answer (a) is correct because return on equity is calculated as net income divided by the amount of equity invested. The debt ratio is the amount of debt financing divided by total assets. Calculations of the two ratios for both financing arrangements are as follows:

133. (b) The requirement is to identify the most reliable valuation method. Answer (b) is correct because the most reliable valuation comes from market values obtained from active markets. Answers (a), (c), and (d) are incorrect because these are all less reliable methods of determining fair value.

134. (b) The requirement is to identify the type of transaction described. Answer (b) is correct because a leveraged buyout is one that is financed primarily with debt using very little equity capital. Answer (a) is incorrect because a spin-off is a divestiture in which stock of a subsidiary are issued to existing shareholders of the parent. Answer (c) is incorrect because a joint venture is a project conducted jointly by two or more independent parties. Answer (d) is incorrect because liquidation involves the piecemeal sale of the assets of a firm.

135. (a) The requirement is to identify the type of merger described. Answer (a) is correct because vertical integration is a merger involving companies in the same industry, but at different levels of the supply chain. Answer (b) is incorrect because a conglomerate merger is one involving firms from different industries. Answer (c) is incorrect because market extension involves moving into new market areas. Answer (d) is incorrect because a horizontal merger involves firms that are competitors in the same market.

136. (d) The requirement is to identify a horizontal merger. Answer (d) is correct because a horizontal merger is one between competitors in the same market. Answer (a) is incorrect because it describes a conglomerate merger. Answers (b) and (c) are incorrect because they describe vertical mergers.

137. (b) The requirement is to identify the type of merger. Answer (b) is correct because a vertical merger is a merger between a firm and one of its suppliers or customers. A bottle manufacturer can supply bottles to be used by a soft drink producer. Answer (a) is incorrect because a horizontal merger is a combination of two firms producing the same type of good or service. Answer (c) is incorrect because a congeneric merger is a merger of firms in the same industry, but the two firms do not have a customer or supplier relationship (as in vertical merger). Answer (d) is incorrect because a conglomerate merger is a merger of companies in totally different industries.

138. (d) The requirement is to identify the type of merger. Answer (d) is correct because a conglomerate merger is a merger of companies in totally different industries. A shoe manufacturer and brokerage house are in totally different industries. Answer (a) is incorrect because a horizontal merger is a combination of two firms producing the same type of good or service. Answer (b) is incorrect because a vertical merger is a merger between a firm and one of its suppliers or customers. Answer (c) is incorrect because a congeneric merger is a merger of firms in the same industry, but the two firms do not have a customer or supplier relationship (as in vertical merger).

Written Communication Task

Written Communication Task 1

Talon, Inc. is a privately held manufacturing company. Management of the company is considering taking the company public through the issuance of common stock.

Terry Savage, the president of the company, has asked you prepare a memorandum describing the advantages and disadvantages of going public.

To:	Mr. Terry Savage, President Talon, Inc.
From:	CPA Candidate

Written Communication Task Solution

Written Communication Task 1

To:	Mr. Terry Savage, President Talon, Inc.
From:	CPA Candidate

As you requested, this memorandum describes the advantages and disadvantages of taking your company, Talon, Inc., public. A primary advantage of going public is that Talon will have access to a much larger pool of equity capital. The company's stock will trade on an organized market. Therefore, the company can more easily issue additional stock. Because the stock of the company is publicly traded, it can be used for business acquisitions, and the company can offer stock-based compensation to Talon's employees. Finally, the owners of Talon are afforded the opportunity to readily sell all, or a portion, of their investment in the company. Therefore, the owners' investments become liquid.

The primary disadvantage of going public is the cost. There are significant costs involved in the initial public offering of stock, and the continuing costs of compliance with SEC laws and regulations, including the Sarbanes-Oxley Act. Being a public company necessarily causes management to focus on maximizing stock price, which may not be in the best long-term interest of Talon. Finally, public companies must disclose significant amounts of information that becomes available to competitors, customers, and potential corporate raiders.

Because of these significant costs and benefits, it is important that the board of directors of Talon carefully evaluate the decision about whether or not to go public. If you need any additional information, please contact me.